Importance of dividends and dividend policy

Dividends are payments made by an organization to its shareholders from earnings generated in current or previous periods. Shareholders earn income from two sources, the capital gain due to appreciation of share and dividend yield. Dividend yield is calculated by dividing the current dividend by the price of a share.

Test yourself:

You purchased shares of ABC Company for $50 per share. Two months after the purchase of shares you received a dividend of $3 per share. What is the dividend yield on the ABC shares?

Solution:

The dividend yield = 3/50=6%.

The stock value is determined based on the present value of all expected dividends to be received from share over the infinite future period that firm is expected to be operational. Expected cash dividends give an indication of the firm’s current and future performance.

The constant growth valuation model can be used to evaluate the expected growth of a share price. The formula for the constant growth valuation model (Gordon model) is as follows: Po=D1/(r-g). As can be seen from this formula, if dividends do not grow then the share price will stay the same as long as required return stays the same. Assuming that required return is constant, for a share price to grow the dividends need to grow as well.

Test yourself:

ABC’s dividends over last few years were as follows:

2010: $3

2009: $2.9

2008: $2.4

2007: $2.3

2006: $2.1

2005: $2

The required return is 12%. What is the price of the share? What would be the price of the share if growth of the dividends were zero and the next period’s dividend would be $3.25?

Solution:

First we need to find the growth rate with the help of a financial calculator. The calculation is as follows:

PV: -2

FV: 3

N: 5

I: calculate = 8.45%

The ABC’s share price is found with the help of the Gordon model Po=D1/(r-g):

Po=3*(1+.0845)/(.12-.0845)

Po=3.25/.0355

Po=$91.65

To find the share price if the growth of dividends were zero we would use the formula Po=D1/r (for zero growth valuation model)

Po=3.25/.12

Po=$27.08

Without growth in dividends, ABC’s share price is valued to be significantly lower.

Dividend policy is less important than capital budgeting and capital structure decisions. However, generally, dividend policies are expected to influence the price of shares.

Cash dividends are paid out of the retained earnings. Retained earnings are an internal source of financing. Therefore, if a business requires financing then the bigger the cash dividends, the higher the amount of external financing will be required. External financing can be in the form of debt or equity.

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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