Tag Retained earnings

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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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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Weighted Marginal Cost of Capital (WMCC) and Investment Opportunities Schedule

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By finding all break points, we can construct the weighted marginal cost of capital – WMCC – schedule. (WMCC) schedules show the relationship between the level of total new financing and a company’s weighted average cost of capital.

Thereafter, we can construct the investment opportunities schedule (IOS), which is a graph where the business’s investment opportunities are ranked based on their returns and financing required, arranged from the highest returns and all the way to the lowest returns. It is the decreasing function of the level of total financing.

If we combine the weighted marginal cost of capital (WMCC) schedule and investment opportunities schedule (IOS), we can use it to make investment decisions. The rule is to invest in projects up to the point on the graph where marginal return from investment equals its WMCC (where IOS=WMCC).

All projects on the left of the point where IOS=WMCC will maximize shareholders wealth and all points on the right of the point where IOS=WMCC will decrease shareholders’ wealth.

It is important to note that the majority of firms stop investing before the marginal return from investment equals its weighted marginal cost of capital (WMCC). Therefore, the majority of businesses prefer a capital rationing position (the position below the optimal investment budget, which is also called the optimal capital budget).

Test yourself

ABC Company has to make an investment of $1,000,000. The long-term debt weight in the capital structure is 35%. ABC has $700,000 of retained earnings but 50% of it must be paid to common stock shareholders in the form of dividends. Preferred stock is currently not used as a source of finance by ABC.

What are the weights that ABC will have for each source of capital?

SOLUTION:

Firstly, we need to find out how much of retained earnings ABC has left after payment of dividends to shareholders: $700,000*0.5=$350,000.

Therefore, the weight of retained earnings is 35% ($350,000 out of $1,000,000).

$1,000,000-$350,000 (35%, funds available from long-term debt source) – $350,000 (35%, funds available from retained earnings) = $300,000 (30%)

Therefore, the weights are as follows:

Long-term debt – 40%

Retained earnings – 35%

Common stock – 30%

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Finding the after-tax cost of retained earnings (rr)

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The cost of retained earnings is the same as the cost of new common stock less flotation costs. Therefore, it is cheaper for businesses to use retained earnings compared to issuing new common stock.

Retained earnings are already earnings after-tax. Therefore, no tax adjustment is required when calculating the cost of retained earnings.

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