Chapter 8
Dividend policy
Outcome
By the end of this session you should be able to:
 evaluate dividend policies for an incorporated entity that meet the needs
and expectations of shareholders
 evaluate alternatives to cash dividends and their impact on shareholder
wealth and entity performance measures
 recommend appropriate dividend policies, including consideration of
shareholder expectations and the cash needs of the entity
Chapter 8
Overview
Chapter 8
1
M & M’s dividend irrelevancy theory
1.1 M & M’s assumptions
 There exists a perfect capital market.
 There are no transaction costs.
 There are no taxes, or dividends and capital gains are taxed in the same way.
 The entity’s s operating cash flows are the same no matter which dividend
policy is adopted.
1.2 Statement of theory
The pattern of dividend pay outs should be irrelevant.
As long as companies continue to invest in positive NPV projects,
the wealth of the shareholders should increase whether or not the
company makes a dividend payment in the year
Therefore, M & M suggested that entities should focus on investment policy rather
than dividend policy, and that if investors required income, they could sell shares to
‘manufacture’ dividends.
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2
Practical dividend policy considerations
2.1 The interests of shareholders
If the shareholders don't feel that the business's dividend policy meets their
expectations, they will sell their shares, perhaps causing the share price to fall
Two important considerations:
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2.2 Dividend signaling
Investors read signals into the company's dividend
decision and that these signals say as much about the
company's future financial performance as they say
about its past financial performance.
Thus management will not necessarily reduce the dividend per share just
because last year's performance was poor, if they believe that next year's
performance will be good.
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2.3 The cash needs of the entity
Investment, financing and dividend decisions are all interlinked.
Therefore, it is important to also consider the impact of investment and financing
when considering dividend policy. Different types of business will have very different
cash needs and will therefore have to set their dividend, investment and financing
policies accordingly.
Examples
 Company with a poor credit rating – might struggle to raise finance from external
sources, so its cash needs might have to be met by restricting the amount of
dividends it pays out.
 Growing company – many potential investment opportunities, which will have to
be met by balancing dividend policy alongside external finance sources.
 Well-established, stable company – might be cash rich, so might be able to afford
to pay out large dividends without compromising its internal cash needs.
Chapter 8
3
Dividend policy in the real world
3.1 Balancing the theoretical and practical considerations
In the real world managers have to make a judgment on
dividend policy after taking many varying factors into account.
Summary of key considerations:
 The clientele effect – What dividends are the shareholders expecting?
 The cash needs of the company
 Signalling – What dividend did the company pay last year?
 Legal factors – Is it legal to pay out a dividend?
 Debt covenants e.g. is there a minimum gearing ratio imposed on the
company as a covenant in a debt agreement?
 Tax implications – What is the tax impact for shareholders of paying
dividends?
 Link to investment and financing – What investment opportunities does the
company face? How difficult/expensive is it to raise external finance?
 Inflation – what dividend increase is needed to maintain the purchasing
power of last year's dividends?
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3.2 Dividend policy in practice
Chapter 8
4
Scrip dividends and share repurchase
4.1 Scrip dividends
Shareholders are offered bonus shares free of charge as an
alternative to a cash dividend.
Reasons for a scrip dividend
 If the company wishes to retain cash in the business.
 If shareholders wish to reinvest dividends in the company but avoid
brokerage costs of buying shares.
 If there are tax advantages of receiving shares rather than cash (in some
jurisdictions)
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Impact of a scrip dividend
 If all shareholders opt for bonus shares, the scrip issue has the effect of
capitalizing reserves. Reserves reduce and share capital increases.
N.B. The disadvantage to shareholders is that, unlike reserves, share capital is
non-distributable in the future.
 Both share price and earnings per share will fall due to the greater number
of shares in issue – although the overall value of each shareholder’s shares and
share in future earnings theoretically remain unchanged.
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4.2 Share repurchase
An alternative to paying a dividend is to buy back shares.
Used when the company has no positive NPV projects to invest in,
so it returns the cash to shareholders.
Alternatively, a company may decide to use a one-off large dividend
to return surplus cash to shareholders.
If all shareholders agree to the repurchase, both a share
repurchase and a one-off large dividend have the same impact on
the cash, and the gearing of the company.
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Advantages of share repurchase
 Choice for investors.
 Lower future total dividends.
 Can change control.
 No change in the share price – paying a dividend would
lower the share price.
 Removes the dividend policy precedent – failing to repeat a
large one-off dividend can send the market a negative signal.
Disadvantages of share repurchase.
 Approval needed in general meeting – more time consuming.
 Difficult to set a fair price for the repurchase – company will
hope for a lower price whereas shareholders will hope for a
higher price.
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4.3 The impact of scrip dividends and share repurchase on financial ratios
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Illustrations and further practice
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Scrip dividends：Now try TYU question 6 from Chapter 9.
Share repurchase: Now try Illustration 3 from Chapter 9.
OT Questions
You should now be able to answer all the TYU questions from Chapter 8
in the Study Text and questions 105 to 111 inclusive, 114, 116 and 118
from the Exam Practice Kit.
For further reading, visit Chapters 8 and 9 from the Study Text