Dividend payout policies

Cash Dividends

• Cash dividend: cash payment made quarterly or semi-annually to shareholders.
• Distribution of after-tax profit.

Dividend Policies

• Constant payout ratio policy: Fixed percentage of annual profits as dividends.
  • Advantage (firm): easy to operate, clear signal.
  • Disadvantage (firm): constrains reinvestment, unsuitable for volatile profits.
  • Disadvantage (Investor): Uncertainty.
• Stable or steadily increasing dividends: Constant or growing dividend in money or real terms.
  • Allows firms to avoid volatility; suitable for mature firms with stable cash flows.
  • Drawback: investors may expect indefinite continuation.
  • Based on long-term forecast of sustainable earnings & gradual adjustment towards a target payout ratio.
• Zero dividend policy: No dividend at all.
  • Easy to operate, cheap, & suitable during growth phase.
  • Should increase share prices.
  • Not acceptable ongoing, especially with institutional investors.
• Residual dividend policy: Dividends paid after all positive NPV projects are taken.
  • Suitable for growth-stage firms with funding difficulties.
  • High dividend swings may increase required rate of return.

Stable or steadily increasing dividend

• Expected increase in dividends = Increase in earnings * target payout ratio * adjustment factor
• Expected dividend = last dividend + (expected increase in earnings * target payout ratio * adjustment factor)
• Even with falling earnings, firms might continue increasing dividends if sustainable earnings estimates remain high.

Alternatives to Cash Dividends

• Special dividends: Higher cash payouts due to outstanding performance.
  • Reasons: unsustainable earnings increase, adjust capital structure, please shareholders without commitment, lack of growth, signaling.
• Scrip dividends: Offer of additional shares in proportion to existing holdings.
  • Allows firm to keep cash, usually higher value than cash dividends.
  • Shareholders wealth not affected.

Share Repurchase

• Alternative to cash dividends; IBM is a notable example.
• Impact: Higher EPS, ROE, and gearing.
• Forms: Tender offer, stock market purchase, arrangement with individual shareholders.
• Reasons: Stocks underpriced, offset stock option dilution, increase EPS, flexibility for shareholders, utilize temporary cash flows, tax advantages, anti-takeover measure, modify capital structure.
• Disadvantages: High repurchase price, may signal lack of positive NPV projects, potential tax authority objections, boost share price before option expiry.

Combining Cash Dividends and Share Repurchase

• Firms set distribution target, dividing it into dividends and repurchases.
• Flexibility in adjusting total distribution.
• Special dividends and share repurchases supplement regular dividends.
• Extraordinary cash can trigger special dividends or buybacks.

Special dividends vs. share repurchase

• Theoretically equal impact on shareholder wealth, but tax differences may favor share repurchase.

Dividend Safety

• Dividend payout ratio (D/E) and dividend coverage ratio (E/D) are examined.
• Mature firms: 40-60% payout ratio, 1.7-2.5 coverage ratio.
• Coverage ratio drops to 1: Dividends are at risk of cut.

Free Cash Flow to Equity (FCFE)

• Represents cash available for distribution as dividends.
• $FCFE = cash flow from operations - capital expenditure - increase in working capital + borrowing$
• $FCFE<em>{2023} = Profits</em>{2023} - \Delta assets<em>{2023} + \Delta debt</em>{2023}$

How the Decision to Pay Dividends is Determined

• Legal constraints: Dividends paid from accumulated net realized profits, debt covenants.

Dividend Theories

• Dividend Irrelevancy (Modigliani and Miller): In a perfect market (no transaction costs, taxes, bankruptcy costs, free information, equal borrowing/lending rates), dividend decision is irrelevant to firm value.
  • Investment decision (positive NPV projects) increases shareholders wealth.

Dividend Policies: Practical Considerations

• Bird in the hand: Dividends preferred over capital gains due to certainty.
• Signaling: Dividend changes convey information about company prospects.
• Dividend stability: Investors prefer stable dividends; changes reflect sustainable earnings.
• Clientele effect: Shareholders preferences (income needs, taxable income) affect dividend preferences; policy changes can impact share price.
• Life cycle: Mature companies may have higher payout ratios.
• Agency Theory: High dividends may be used to ensure shareholders approval is needed for new projects.
• Other Practical Determinants: Liquidity, covenants, profit volatility, competitor policies.