CHP 12: DIVIDEND POLICY
CHP 12: DIVIDEND POLICY
Objective: To understand theories and practical approaches to dividend policy, including dividends for a multinational organization.
DIVIDEND POLICY
Topics Covered:
Dividend Irrelevance Theory
Drivers of Dividend Policies
Alternative Dividend Policies
Other Distribution Methods
Practical Considerations
DIVIDEND CAPACITY
Estimating
Preventing Overtrading
Legal Restrictions
Multinational Corporations
INTERNATIONAL DIVIDEND POLICY
Blocked Remittances
1.0 Introduction
The board of directors must decide when to pay a dividend and when to retain earnings in the company.
1.1 Dividend Irrelevance Theory
According to Modigliani and Miller, dividend policy is irrelevant to shareholder wealth in a perfect capital market. This theory follows from their assumptions made in the earlier "without tax" theory of gearing (as detailed in Chapter 4) which asserts that the value of a company emerges solely from its project cash flows and their associated risks.
Key Aspects of Dividend Irrelevance:
Capital Structure Independence: The financing decision or the dividend decision does not influence the company's projects and therefore does not affect shareholder wealth.
Homemade Dividends: If no dividend is paid and shareholders desire income, they can create their own "homemade" dividend by either selling shares or borrowing against their shares. Conversely, if a dividend is received and shareholders seek capital gains, they can reinvest by purchasing more shares or investing elsewhere.
Characteristics of a Perfect Capital Market:
Rational investors exist.
No transaction costs are present.
There are no tax distortions.
Information costs are non-existent.
An active market is established.
Contentions against Assumptions:
In practice, these assumptions may not hold true, making the theory a subject of contention.
1.2 Drivers of Dividend Policies
1.2.1 Signalling
Directors possess more information about the company’s health and future earnings than shareholders.
Setting a dividend is a discretionary decision with real cash implications, serving as a market signal regarding company stability. An unexpected rise in dividend per share generally results in a rise in share price, and vice versa.
1.2.2 Clientele Theory
Different shareholder groups favor distinct dividend policies. Some shareholders prioritize capital gains, while others seek income due to tax implications.
A company's historical dividend policy can attract specific clienteles. Alterations to this policy may cause drops in share price due to incurred transaction costs for new investors.
1.2.3 Cum-div and Ex-div Share Values
Upon an expected dividend payout, the share price is expected to drop from its cum-div price to its ex-div price, with the difference aligning with the dividend per share.
However, shareholder wealth remains unchanged since, prior to the dividend, shareholders owned shares, and post-dividends, they hold cash and shares.
1.2.4 Bird-in-the-Hand Theory/Fallacy
The idea that shareholders prefer immediate cash dividends rather than future cash flows indicates support for immediate dividends.
Retained earnings can yield returns ($k_e$), compensating investors for their risks unless reinvested in negative NPV projects.
1.2.5 The Dividend Valuation Model
The growth rate of future dividends is contingent upon the retention ratio— the proportion of profits reinvested— and the return on reinvested profits.
Hence, increased dividends today potentially lower the long-term growth rate. The relationship can be mathematically described via Gordon's growth approximation:
where:$g$ = growth rate,
$b$ = retention ratio,
$r$ = return on reinvested profits.
1.3 Alternative Dividend Policies
1.3.1 Stable Dividend
A stable dividend maintains either a constant dividend per share or a constant growth rate of dividends, promoting perceived stability to shareholders and supporting a consistent share price.
Directors should base this policy on long-term affordability estimates despite short fluctuations in earnings.
1.3.2 Constant Payout Ratio
This policy involves distributing a constant ratio of each year’s earnings as dividends. Although logical, this method introduces uncertainties and is rarely employed by quoted companies.
1.3.3 Residual Dividend Policy
Under this approach, the company utilizes retained earnings to finance all positive NPV projects, distributing any remaining earnings as dividends.
This model correlates to the Pecking Order Theory, suggesting that retained earnings constitute the least expensive financing method, hence are prioritized for project funding.
This policy might cause fluctuating dividends, which, while justifiable in cases of dividend cuts, is uncommon among listed companies.
1.3.4 Zero Dividend Policy
High-growth companies may reinvest all excess cash during initial years, notably when access to external financing is limited.
Over time, the company should transition to paying dividends once fewer positive NPV projects are available. Predicting the initiation of dividend payments remains challenging.
1.4 Other Distribution Methods
Just like dividends, these methods necessitate having adequate distributable reserves and liquidity for funding.
1.4.1 Share Buyback Programs
Companies may perform share buybacks by directly soliciting shareholders through a tender offer or purchasing shares at market prices.
Shares may either be cancelled or held as treasury shares without voting rights or dividends.
The total buyback value reduces distributable reserves and results in fewer shares outstanding, likely boosting metrics like Earnings per Share (EPS) and Return on Equity (ROE).
Advantages of Share Buybacks:
Signals surplus cash generation.
Indicates that directors prefer investing surplus cash rather than pursuing risky or extravagant ventures.
It suggests perceived undervaluation of shares, making buybacks a prudent investment.
Provides shareholders with an option to reinvest elsewhere, especially when firms lack positive NPV projects.
Buybacks usually undergo classification as capital gains, often resulting in favorable tax treatment.
1.4.2 Special Dividends
Larger-than-expected dividends may elevate market expectations for future dividends.
To avoid sustainable dividend expectations, a company might declare a larger dividend as a special or bonus dividend to signal that exceptional cash surpluses may be returned intermittently, while not expecting them as standard future dividends.
1.4.3 Scrip Dividends
A scrip dividend offers shareholders the choice of receiving cash or additional shares instead of cash.
Choosing shares enables the company to retain cash for reinvestment, aligning with pecking order theory's preference for internal financing.
Shareholders may prefer shares to increase holdings without incurring trading commissions.
Signalling implications exist as equity issuance can avoid negative connotations without directly indicating a decline in dividends.
1.5 Practical Considerations
Company law: A dividend can only be legally distributed if a credit balance exists on retained earnings per the statement of financial position.
Liquidity position: Actual cash is needed, not just profits, to disburse dividends.
Earnings volatility: Steady earnings allow for maintaining larger dividends.
Signalling: Dividend declarations can signal future company prosperity. Stock prices may react negatively to dividend cuts, even to fund promising projects.
Shareholder Clienteles: Different groups prefer distinct approaches – dividends vs. capital gains.
Transaction Costs: Such costs can influence the ability to "manufacture" dividends as hypothesized by Modigliani and Miller.
2.1 Estimating Dividend Capacity
2.1.1 From Cash Flow Data
Dividend capacity results from Free Cash Flow to Equity (FCFE) after net reinvestment:
Calculation Process:
Start with ( FCFE_{ ext{pre-reinvestment}} )
Deduct Net Reinvestment:
2.1.2 From Net Income
In cases where cash flow data lacks direct availability, derive FCFE (post-reinvestment) from the net income figure by applying the following adjustments:
2.2 Restricting Dividends to Prevent Overtrading
In scenarios of rapid business expansion with the risk of overtrading, restricting dividends might be prudent to ensure sustainable growth funding.
Calculation of Reduction in Dividend:
Unfunded Days Calculation:
Cash Cost of Sales:
2.3 Legal Restrictions on Use of Dividend Capacity
Companies generally may only distribute accumulated realized profits, allowing dividends during loss periods provided previous profits offset these losses (maintaining positive retained earnings is vital).
In certain conditions and under local regulations, it may be permissible to rectify a debit balance on retained earnings as part of a capital restructuring plan. Resuming dividend payment post-loss can attract fresh equity investments.
2.4 Multinational Corporations
For companies with overseas operations, additional dividend capacity expectation arises from profits generated by foreign subsidiaries, leading to unique challenges including:
The proportion of earnings subsidiaries should remit to the parent company.
Restrictions imposed by host governments on outbound remittances.
Convertibility limitations when the local currency is not deemed stable.
Tax implications at the level of dividends received vs. profits of subsidiaries.
Existence of bilateral tax treaties to provide double taxation relief.
Strategies for Maximizing Dividend Capacity from Overseas Subsidiaries:
Configuring blocked remittances through legitimate methods such as management fees, license fees, and royalty payments.
Engaging in political lobbying to secure rights to convert foreign earnings to hard currency.
Using transfer pricing strategically to shift profits from high to low-tax jurisdictions while adhering to legal standards.
Employing a "dividend mixer company" to amalgamate dividends from overseas before remitting a single dividend to the parent company to enhance claims for double tax relief.
Transferring foreign assets to offshore entities to mitigate capital gains taxes upon disposal, in compliance with legal constraints.
3.1 Management of Blocked Remittances
When remittances are blocked, multinationals must contemplate strategies for profit transfer from subsidiaries to the parent. Potential approaches may comprise:
Adjusting transfer prices for goods or services supplied by the parent to the subsidiary, adhering to "arm's length" requirements.
Charging management fees from the parent to the subsidiary, especially justifiable during early investment years but potentially complicated later when local management takes over.
Recipient of royalty payments or license fees concerning intellectual property owned by the parent, offering flexible avenues, especially in the new economy context.
Arranging loans from the parent to the foreign subsidiary to extract profits via interest rather than dividends.
Risks Associated with These Methods:
Reputation Risk: Ethical concerns might lead investors to divest shares out of fear of regulatory circumvention.
Political Risk: Host governments could retaliate against perceived exploitation of their regulations, which might threaten assets.
Legal Implications: Strategies may face legal scrutiny under anti-avoidance laws; hence, seeking legal counsel is crucial before proceeding.