Category MBA

Establishing a dividend policy

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Dividend policy refers to the policy which is used as a guide when a firm makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.

Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.

Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

Factors which affect dividend policy

There are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints – this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Firm also cannot pay any part of par value of common stock. Sometimes, in addition to the inability to pay any part of par value of common stock, firm also may not pay any part of paid-in capital in excess of par.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negative signal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positive signal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Shareholders generally prefer fixed or increasing dividends. This decreases uncertainty and investors are likely to use lower rate at which earnings will be discounted. This will lead to an appreciation of share and an increase in shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

However, if the economy is growing very fast then the firm may have more acceptable investments to take advantage of. It can be best not to distribute dividends but rather use these funds for investments.

Changes in government policies and state of the industry must also be taken into account.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

If the firm will have to issue more stock to be able to pay out dividends than it may be in the best interest of the current stakeholders not to issue dividends to avoid potential dilution of ownership. Dilution of ownership occurs because after issuing of additional stock, retained earnings will have to be distributed over a larger amount of the shareholders. This leads to dilution of earnings for existing shareholders. This also leads to dilution of control.

Firms also need to consider the wealth level of the majority of its shareholders. If the majority of shareholders are lower income earners than they likely will need dividend income and will prefer payment of dividends. However, if the majority of shareholders are high income earners then they will likely to prefer appreciation of share as it will defer tax payment even if the tax applicable on dividends and capital gains is the same, as in US after 2003 Tax Act.

Interestingly, in an efficient market, preferences of the shareholders should be met by price mechanism. If dividend payments are lower than required by many investors than those investors will sell their shares. Share prices will drop and this will raise an investors’ expected return. Higher expected return will increase the weighted marginal cost of capital and intersection between IOS and WMCC schedules will occur at a lower optimal capital budget point. Due to higher WMCC, fewer of the projects will be acceptable and more of the retained earnings can be paid out as dividends. Therefore the owners’ preferences are satisfied by price mechanism.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.

Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

One of the reasons firms may want to pay dividends in years when the firm incurred a loss is to send positive signal to the market indicating that the loss is only a temporary phenomenon and that the company has its operations under control. Otherwise, shareholders may start selling shares which will decrease price of the shares and even further decrease wealth of the owners of the company (shareholders).

Lack of adequate cash and cash equivalents – occurs when firm do not have adequate cash and cash equivalents, such as marketable securities, to make dividend payments. Borrowing with intention to use funds to pay out dividends is usually not welcomed by lenders because the use of funds is not aligned with activity that would help firm to pay back debt to the lender. Borrowing to pay dividends is also usually not a wise business decision.

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Factors favouring higher and lower dividends

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Higher dividends

There are factors that make higher dividends beneficial. For example, higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

It is also suggested that for investors to sell current stock to obtain income equivalent to dividends is not the same psychologically as receiving dividends. It is harder psychologically to sell stock to obtain income than to use dividends to obtain income. Therefore, it is argued, that these two actions cannot be viewed as substitutes, as proposed by the dividend irrelevance theory. The above point suggests that shareholders who need income that comes from dividends are psychologically more comfortable with receiving dividends than with selling part of their shares.

Another argument for the benefits of higher dividends refers to the fact that $1 of dividends received now cannot be seen as equivalent to $1 of future dividends or stock appreciation to be received at some point in the future.

Investors will prefer $1 to be received now to $1 to be received in the future. The only way they will be indifferent is if the amount to be received in the future will be adjusted to account for the time value of money.

Time value of money refers to the fact that investors will prefer $1 today to $1 tomorrow. For example, if an investor can receive $100 today or a certain amount 1 year from now, the only way the investor will be indifferent is if the amount 1 year from now is larger by an equivalent to investor’s required return.

In other words, future dividends or share appreciation must bring benefit of $1 plus additional return based on the required return of the investor. Only in such case investor will be indifferent. If investor’s required return is 9% per year than the investor will be indifferent if $100 is received today or $109 received in 1 year from now.

Lower dividends

Transactions costs often make lower dividends more beneficial for stockholders and for the firm. It is more beneficial for a stock holder to have lower dividends if an investor intends to reinvest dividends in stock. This occurs because there are transactions costs that investor have to incur to buy stock such as brokerage fees.

The firm will benefit from paying lower dividends in the case where external financing is required. This is because external financing results in costs such as flotation costs. If firm just uses retained earnings available instead of paying out dividends then the costs of external financing will be avoided or decreased.

Tax that investors have to pay on capital gains is generally lower than tax that they have to pay on dividends (this, however, may differ depending on location of investors and is no longer applicable to US investors as a result of the 2003 Tax Act).

Moreover, tax on capital gains must only be paid in the future, when the gain will be realized. The tax on dividends must be paid when payment of dividends occurs. Therefore, from this perspective, it is generally more beneficial to reinvest earnings compared to paying it out as dividends to the shareholders.

Also, if investors want to reinvest dividends by buying more stock, investors still lose money by paying taxes on dividends. Therefore, an argument made by dividend irrelevance theory suggesting that investors can reinvest dividends by buying more stock and therefore obtaining the same result as by funds being reinvested is irrelevant as soon as assumptions of a perfect world (which includes the assumption that there are no taxes) is no longer hold.

 

Dividend relevance theory

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Dividend relevance theory was proposed by Myron J. Gordon and John Lintner. Dividend relevance theory suggests that investors are generally risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share appreciation and dividends tomorrow.

Dividend relevance theory proposes that dividend policy affect the share price. Therefore, according to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders.

Empirical studies do not support dividend relevance theory. However, actions of market participants tend to suggest that there is some connection between dividend policy and share price.

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Dividend irrelevance theory

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This theory was proposed by two Noble Laureates, Merton H. Miller and Franco Modigliani, and is also commonly called the M and M theorem. The theory was proposed in their article “Dividend Policy, Growth, and the Valuation of Shares,” which was published in the Journal of Business in October of 1961, pp. 411-433.

The theory suggests that, in a perfect world, dividends are irrelevant when the value of the stock and, therefore, of the firm is determined.

The theory implies that retained earnings belong to the shareholders of the company and shareholders are not concerned whether money is used to pay out dividends or for investment purposes because they benefit either way by receiving dividends or via share price appreciation.

If investors will require cash, they can always sell a few of the shares which increased in value due to investments.

Miller and Modigliani also suggest that the clientele effect exists. This refers to the tendency for investors to hold stocks which are in line with their dividend payment preferences.

Investors who prefer regular dividends hold stocks of the companies which provide such dividends and investors who prefer for funds to be reinvested and to be reflected in the share appreciation hold those stocks that are aligned with such preferences.

The clientele effect further supports the proposition that the dividend policy does not affect the value of the stock because investors obtain income from the shares in their preferred way.

Miller and Modigliani also suggest that if dividends affect stock price than it is because of the informational content in changes in dividends. Investors see changes in dividends as signals. Increases in dividends are seen as a positive signal pointing out that management expects earnings of the firm to increase in the future. Decrease in dividends is seen as negative signal which points out that management expects earnings to decrease in the future.

Overall, the dividend irrelevance theory suggests that firm do not require a dividend policy because it does not affect the value of the firm.

 

Residual theory of dividends

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Residual theory of dividends purports that dividends must only be distributed after firm undertakes all acceptable investments. To determine whether any retained earnings are left to be distributed to shareholders, the three steps described below are undertaken.

Step 1 – The optimal level of capital expenditures is determined by finding the intersection between the investment opportunities schedule and the weighted marginal cost of capital schedule.

Step 2 – Taking into account the optimal capital structure proportions, the amount of financing that must come from equity is determined.

Step 3 – Retained earnings are used to cover necessary expenditures in proportion to a company’s capital structure equity percentage. If retained earnings do not cover the portion that must come from equity then new stock is issued.

The dividends are only distributed if retained earnings were enough to cover the equity portion of the investment (the second portion of investment is covered by debt) and only if there are any funds left in the retained earnings after investment expenditure is covered.

The residual theory of dividends also implies that if companies do not have investments with internal rate of returns (IRR) higher than weighted marginal cost of capital (WMCC) or Net present value (NPV) higher than zero than all retained earnings should be distributed as dividends.

Test yourself:

ABC Company has a capital structure of 35% of debt and 65% of equity. ABC’s retained earnings in this financial period are $2,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if ABC will be able to distribute any dividends.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000) will come from debt. The ABC Company has $2,000,000 of retained earnings. Since only $1,560,000 is required to cover portion of funds that must come from equity, $440,000 (=$2,000,000-$1,560,000) is left in the retained earnings and can be distributed to shareholders as dividends.

Test yourself:

BCD Company has a capital structure of 35% of debt and 65% of equity. BCD’s retained earnings in this financial period are $1,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if BCD Company will be able to distribute any dividends in this financial period.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000), will come from debt. The firm has $1,000,000 in retained earnings. The additional common stock needs to be issued to the amount of $560,000 to obtain enough funds that must come from equity. Since retained earnings were completely used to cover the expenditures associated with investment, there can be no dividends that BCD Company can distribute to shareholders during this financial period.

From the above two examples it is evident how under the residual theory of dividends, dividends are only distributed if there is any money left in the retained earnings after all acceptable investments are undertaken.

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Declaring and payment of dividends

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The board of directors determines whether or not dividends will be declared for the current financial period. Such decisions are made during semi-annual or quarterly meetings of the board of directors.

If a decision to distribute dividends is made, it will be paid to all shareholders whose names are listed as shareholders on the record date.

Due to time that it takes for new shareholders to be listed, dividends are only paid out to those shareholders who acquired shares of the firm earlier than two business days before the record date.

Two business days prior to record date, along with usual fluctuations of the market, the stock price starts selling as ex dividend and drops by an amount close to the declared dividend. The payment date of the dividend usually occurs few weeks after the record date.

Test yourself:

ABC Company declared a quarterly dividend of $0.5 per share on 15th of November. You purchased 800 shares of ABC on 1st of November and 15% tax is applicable to any dividends received. Determine whether you are eligible to receive dividends and, if so, how much will you receive after tax is taken into account.

Solution:

The dividends were declared on 15th of November. Since you purchased stock on 1st of November, you are eligible to receive the dividends. Your before tax dividends amount to $400 (=800*$0.5). Your after-tax dividends amount to $340 (=$400*(1-.15)).

Dividend reinvestment plans (DRIPs) – many firms offer dividend reinvestment plans which allow current stockholders to use dividends to acquire more shares at about five percent below the market price of the firm’s shares.

This allows company to avoid under pricing and flotation costs involved in issuing new shares and shareholders also benefit due to lower prices per share. This arrangement makes obtainment of additional shares more attractive for current stockholders.

Dividend relevance and irrelevance

Whether dividend policy affects the share price and, therefore, a value of the firm is still an unresolved issue. Residual theory of dividends, the dividend irrelevance theory proposed by Merton H. Miller and Franco Modigliani, and dividend relevance theory proposed by Myron J. Gordon and John Lintner, provide different viewpoints on the issue and are briefly discussed in the next set of articles.

 

Importance of dividends and dividend policy

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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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Book value per share

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Book value per share is a value that common stock holders would have received if all assets of the firm were sold for its accounting value and if all liabilities were settled and residual value divided among common stock holders.

In other words, it is a book value of the firm (the net worth of the company, which is assets minus liabilities) divided by the number of shares of common stock outstanding.

The following formula is used to calculate book value per share:

Book value per share = TA-TL/Number of shares of common stock outstanding

Where TA is Total Assets and TL is total liabilities.

Book value per share method is criticized because it relies on historical data and does not take into account the future-expected earnings of the firm. Therefore, it does not reflect the real market value of the firm.

 

Overview of financial ratios

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Liquidity ratios

Current ratios measure liquidity, which refers to the ability of the firm to meet its short-term debt obligations. The formula for current ratio is as follows:

Current ratio=Current assets/Current liabilities

A positive current ratio is a must. A current ratio of at least two is generally advisable. If a company has current ratio of two, it means that it has current assets which would be able to cover current liabilities twice.

Activity ratios

Total asset turnover calculates how efficiently assets are used to generate sales. In other words, how efficiently the balance sheet is managed.

Total asset turnover=Sales/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Inventory turnover ratio measures the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory.

Inventory turnover ratio = Cost of goods sold/Inventory

The result of this ratio is only meaningful in comparison. It can be compared to industry averages, to firms past inventory turnover ratios and to inventory turnover ratios of competitors.

Industry averages differ significantly between industries for inventory turnover ratio. Inventory turnover is positive (higher than zero) as long as firm has any inventory. Generally high inventory turnover is considered to be a good indicator.

However, the norm would differ significantly between industries. If industry turnover is too high compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales.

Debt ratios

Debt ratio measures how many of firm’s assets are financed by debt. The formula for debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000. The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Debt-equity ratio measures how much of equity and how much of debt a company uses to finance its assets.

Debt-equity ratio = Total debt / Equity

If the debt-equity ratio is less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that debt is mostly used for financing. If the debt-equity ratio is equal to one, then it means that half of financing comes from debt and half from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher potential return. Financial risk refers to risk of firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due). The formula for the Times Interest Earned Ratiois as follows:

TIER=EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to Income Statement format to see how it is calculated).

For example, assume that ABC has an operating profit of $550,000 and interest charges of $100,000. The TIER of ABC is as follows:

$550,000/$100,000=5.5

One should also compare ratios of individual firms to industry averages, to obtain a better understanding. It is generally advisable that TIER should be between 3 and 5.

ABC’s TIER could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk the firm takes is lower than average, but so is the return.

Profitability ratios

Operating profit margin measures how much of each sales dollar remains after all costs except for interest, tax and preferred dividends are deducted.In other words it measures how efficient the business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin = Operating profit/Sales

For example, if ABC has a operating profit of $500,000 and sales of $3,000,000 then the operating profit margin is calculated as follows

Operating profit margin = $500,000/$3,000,000

Operating profit margin = 0.167 or 16.7%

The higher the operating profit margin, the better it is.

Return on total assets (ROA) is also called return on investment (ROI). It refers to how effective management is in generating returns on assets of the firm.

ROA/ROI=Earnings available for common stockholders/Total assets

For example, if ABC’s total assets are $3,500,000 and the earnings available for common stockholders is $400,000 than

ROA/ROI=400,000/3,500,000

ROA/ROI=0.11

This means that for every dollar of assets, ABC earned 11 cents. The more the firm earns on every dollar of assets the better.

 

Financial leverage

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Financial leverage is the relationship between operating profit and EPS (earnings per share). In short, it measures the level of debt. It is a measure of how the potential use of fixed financial costs (e.g. interest on debt) can enlarge the effect that change in operating profit (EBIT) has on EPS (earnings per share).

When does a firm have financial leverage?

If a firm has mixed financial costs, it has financial leverage. Due to financial leverage (existence of fixed financial costs), any increase in EBIT will result in even larger increases in EPS and any decrease in EBIT will result in even larger decreases in EPS.

How to calculate degree of financial leverage (DFL) of the firm?

To calculate degree of financial leverage, which is just a way to measure financial leverage of the firm, we can follow the following formula:

DFL =% change in EPS/% change in EBIT

Therefore, if the degree of financial leverage is greater than 1, then financial leverage exists (which is the case as long as the company has fixed financial costs). Also, any increase in financial leverage results in an increase in risk and any decrease in financial leverage results in a decrease in risk.

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