# Dividend policies and dividend payout ratio

An important concept to know when it comes to the distribution of dividends is the dividend payout ratio. The dividend payout ratio indicates which percentage of each dollar earned is distributed in cash to the shareholders. It is calculated as follows:

Dividend payout ratio = cash dividend per share/earnings per share

Generally the higher the dividend payout ratios the more attractively are shares of the firm seen by investors. Dividend payout ratios vary significantly between industries and organizations. The liquidity position of the company is one of the factors that affect the dividend payout ratio the company selects.

Test yourself:

ABC Company issued cash dividends of \$3 per share. ABC’s earnings per share are \$8. What is the dividend payout ratio?

Solution:

Dividend payout ratio of ABC = 3/8= 37.5%

This indicates that out of each dollar of earnings, 37.5% is distributed to shareholders as cash dividends.

Constant payout ratio dividend policy – according to this dividend policy, stockholders receive dividends at a fixed percentage rate from earnings every financial period that resulted in a profit. In financial periods when loss is incurred, no dividends are distributed. Dividends increase or decrease based on the amount of profit the firm made during a particular year. This type of dividend policy is not recommended because fluctuations in the dividends from one period to another may adversely affect the share price.

Constant dollar (stable) dividend policy – according to this dividend policy, a fixed amount of dollars per share are paid each period which resulted in a profit. The amount of fixed dollar dividend only increases after an increase in earnings proves to be stable.

Regular with extras dividend policy – according to this dividend policy, fixed amount of dollars per share is paid every period. On years when the profit exceeds normal, extra dividend is paid.

Residual dividend policy – This dividend policy is aligned with the residual theory of dividends. The residual from retained earnings is paid after all acceptable investments were undertaken.

# Target dividend payout ratio

It is advisable for firms to establish target dividend payout ratio and then use it for guidance in determining dividend levels. Target dividend payout ratio refers to a specific percentage of earnings that firms would like to pay in dividends.

For example, if the target dividend payout ratio is 40% then the firm intends to try to keep its dividends around 40% of its earnings. The target dividend payout ratio is very useful in cases of constant dollar dividend policy and regular with extras dividend policy. Under these policies a regular dividend is paid each period. However, organizations can use the target dividend payout ratio as a guide to decide when dividends can be adjusted to reflect a stable new level of earnings.

Shareholders usually prefer regular and regular with extras dividend policies because it involves a smaller degree of uncertainty regarding the dividends to be received in each period.

Cash dividends and stock dividends

Cash dividends are dividends which are paid out in cash to the shareholders via cheque or electronic transfer. When cash dividends are distributed to shareholders, the share price tends to drop by an amount similar to the cash dividend. This occurs because the economic value was distributed from the firm to shareholders. Shareholders have to pay tax on cash dividends. Therefore, the amount that they receive decreases in value.

Stock dividends are dividends paid out in additional stock. There is no cash outflow. The funds are just shifted between accounts (from retained earnings to common stock and paid-in capital in excess of par).

If a company issues a 3% stock dividend this means that if one owns 100 shares of this company than 3 additional shares will be received. Overall, stock dividends do not bring any value to the shareholder. Stock dividends decrease the share price.

To determine by how much share price will decrease, let’s look at an example. Assume that shares of ABC sold for \$17 each. ABC decided to distribute a 10% stock dividend. The share price will decrease as follows: \$17 * (1/1.1)=\$15.45.

If individual Y owned 1,000 shares before the stock distribution, after stock distribution individual Y will own 1,100 shares. The market value of shares of individual Y remains unchanged as shown below:

1,000 * \$17     = \$17,000

1,100 * \$15.45 = \$16,995

Therefore, as can be seen from the above, the shareholders’ market value of shares remains unchanged.

If the most recent earnings of ABC were \$350,000 and individual Y owned 1% of the firm’s shares than earnings per share before stock dividends were \$3.5 (\$350,000/\$100,000). If earnings are expected to stay the same than after the stock dividends, then earnings per share would decrease to \$3.18 (\$350,000/\$110,000). Individual Y’s share in earnings stays the same. It was \$3,500 (3.5*1000) and now it is \$3498 (3.18*1,100).

Shareholders do not really obtain real value due to such stock dividends. It is more a perceived value of obtaining more stock. Consequently, shareholders generally do not have to pay tax on stock dividends unless the cash dividend option is present. For organizations, stock dividends are more costly but can be appropriate if the organization needs cash to finance a rapid growth.

Test yourself:

ABC shares are currently sold for \$20 each. ABC decided to distribute 5% stock dividend. By how much the share price will decrease?

Solution:

The share price will decrease as follows: \$20 * (1/1.05)=\$19.05.

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# Establishing a dividend policy

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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# 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.

# 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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# Gordon model (Constant-Growth Valuation Model)

The Gordon model is one of the models used in dividend valuation. It is very simple, as long as one knows the formula, which is:

P0=D1/(rs-g)

Also sometimes presented as: P = D/(k-g)

Where:

P0 or P – price of the stock

D1 or D – per share dividend expected at the end of year 1 (at the end of the next financial period)

rs or k – required return for equity investor

g – constant growth rate (expected annual growth of dividends)

Gordon model is usually used for mature companies only since it is assumed that annual growth of dividends remains constant.

It is very important to note that if you are only given the current per share dividend (D0, per share dividend received in this financial period), then you will need to adjust it for the next financial period before you can use it in the Gordon model. To do this you will need to take the current dividend and multiply it by (1 + g). The calculation is as follows:

D1=D0*(1+g)

The original equation of the Gordon model (P0=D1/(rs-g)) calculates the price of the share. However, you are looking for the cost of common stock. Therefore, you need to rearrange equation of the Gordon model as follows:

rs = (D1/Po) + g

Now you just plug in the numbers into the adjusted Gordon equation and you will be able to obtain the cost of common stock. Because common stock is paid out of the after-tax earnings, the tax adjustment is irrelevant.

Sometimes it is necessary to find the growth rate (g) first, before you can calculate the cost of the common stock (rs) with the help of the Gordon model. To do so, you need to find out what was the per share dividends applicable to common stock over the last few years (this information will be given). After obtaining this information, you can calculate the growth rate.

It is best to explain this with an example.

EXAMPLE 1:

Calculating the growth rate, which is necessary for usage of the Gordon model:

The information given below is on per share dividends applicable to common stock over the last few years. You need to find the growth rate of dividends over the given period.

Per share dividends from 2005-2010:

2010 – \$4

2009 – \$3.96

2008 – \$3.76

2007 – \$3.27

2006 – \$3.25

2005 – \$3

Now, by using a financial calculator, you can calculate the growth rate as follows:

PV = -3 (per share dividend in 2005, the first year from which per share dividend information is available)

FV = 4 (per share dividend in 2010, the per share dividend in the current period)

N = 5 (number of periods over which growth occurred)

Find I = it will be 5.92% (this number represents growth of dividends over the given period)

EXAMPLE 2:

Using the growth rate (found above) in the Gordon model:

Now, if we know that the growth of the dividends is expected to be the same into the future and the price of the stock is \$55, we can compute the cost of common stock (rs) as follows:

rs=(4*(1+0.0592)/55)+0.0592

rs=0.0770+0.0592

rs=0.1362=0.14%

The cost of common stock also represents the return that investors expect to earn from their shares. If the actual return is less – investors will sell their stock.

# Test yourself

The ordinary share is currently sold for \$40 each. The growth of shares was 10% over the last 5 years and is expected to be the same in the future. A dividend of \$3.5 dollars was paid to shareholders in the current period.

REQUIRED: What is the cost of an ordinary share?

SOLUTION:

We need to use the adjusted Gordon model. In other words, we need to use the formula: rs = (D1/Po) + g

Rs=(3.5*(1+.1)/40) +.1

Rs=(3.85/40) +.1

Rs=19.63%

Note that the dividend is adjusted for growth in the next period by multiplying the current dividend by (1+g).

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# Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

# Example

Assume ABC Company has an operating profit of \$550,000 and interest charges of \$100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

\$550,000/\$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (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 taken may be lower than average, but so is the return.

When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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# Fixed Payment Coverage Ratio

The fixed payment coverage ratio measures the ability of the enterprise to meet all of its fixed-payment obligations on time. In other words, the fixed payment coverage ratio measures the ability to service debts.

As outsiders, when analyzing the capital structure decisions of firms, we can use the fixed payment coverage ratio as an indirect measure of the level of debt in the firm’s capital structure. Commonly, the lower the ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk.

The formula for the fixed payment coverage ratio is as follows:

Fixed Payment Coverage Ratio = EBIT+LP/I+LP +((PP +PSD)*(1/1-T))

Where:

EBIT = earnings before interest and tax (operating profit)

LP = lease payments

I = interest charges

PP = principal payments

PSD = preferred stock dividends

T = tax rate

# Test yourself

Assume ABC Company has an operating profit of \$550,000 and interest charges of \$100,000. The lease payments are fixed at \$20,000, principal payments are at \$60,000 and preferred stock dividends are at \$15,000. The corporate tax rate of ABC is 40%.

The fixed payment coverage ratio of ABC is calculated as follows:

= 550,000+20,000/100,000+20,000+((60,000+15,000)*(1/1-T))

= 570,000/120,000+((75,000)*1.67)

= 570,000/120,000+125,250

= 570,000/245,250

= 2.3

The fixed payment coverage ratio of ABC is 2.3. Since EBIT is more than two times larger than fixed-payment obligations, it appears that ABC is in a strong position to live up to its fixed-payment obligations as they come due. However, as with all financial ratios, the ratio should be compared to the industry average before any conclusions are drawn.

# Note the following

Generally, the higher the ratio the lower the risk that  enterprise will not be able to meet its fixed-payment obligations on time. Therefore, generally, a higher ratio is better. However, as with times interest earned ratio, cognizance needs to be taken of the fact that the higher the ratio the lower the risk and lower the return.

Therefore, at some point, the fixed payment coverage ratio may be too high. This will occur if a business is unnecessarily careful with taking up more debt. This will result in very low risk, but also in lower return. This, of course, is not aligned with the overall goal of the enterprise, which is the maximization of the wealth of its shareholders.

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