Dividend Policy · Dividends are: . Discretionary and decided by the board of directors · Declared with the company's financial results (interim and final) · Paid to shareholders: · in cash on a per share basis; or · in new shares if the shareholder elects (scrip dividend) · Only payable if there are sufficient retained earnings but can be paid if uncovered by annual earnings · Dividend ratios: · Dividend cover = earnings per share # dividend per share (i.e. 2x) · Dividend yield = dividend per share # clean share price (i.e. 3%) The Dividend Decision · Does a company's dividend policy affect shareholder wealth? · Dividend policies: · Regular - long-term pattern and level of payments · Complementary - one-off or short-term payments · Considerations by the directors when deciding policy: · Zero or non-zero policy? · Stable or fluctuating dividend? · Pay-out ratio (level of regular dividend relative to annual earnings)? · Use of complementary policies? Regular Dividend Policies · Zero dividend policy · Constant dividend policy: · Same dividend each year · Progressive dividend policy: · Dividend increases year on year at a similar rate · Constant pay-out ratio: · Dividends paid are a constant proportion of annual earnings per share · Residual approach: · Dividends are only paid if cash remaining after investment
Regular Dividend Policies 6 5 4 Dividend per Share 3 2 1 0 Time -Zero =Constant Progressive Constant Pay-Out Residual M&M's Dividend Irrelevance Theory · According to Modigliani and Miller (1961), dividend policy is irrelevant to shareholder wealth because: . The value of the company is the sum of the future cash flows of its investment projects discounted by investors' required rate of return · As long as the company is financing projects which increase shareholder wealth it does not matter how the finance is raised - either externally or internally via a dividend cut · Investors that require income can generate "home-made" dividends by selling some of their shares Example · M&M plc. has £1m retained earnings and has identified a positive NPV project which requires an investment of £1m. It can either: 1. Invest in the project from retained earnings and pay no dividend; or 2. Invest in the project by raising external finance and pay a dividend; or 3. Pay a dividend and do not invest in the project · In a perfect market: 1 and 2 are equivalent and both increase shareholder wealth by the NPV of the project; but 3 is inferior as it leads to no change in shareholder wealth Perfect Market Assumptions- • No transaction costs but:
· Creating "home-made" dividends incurs direct costs for shareholders · Raising finance incurs indirect costs for shareholders · No (differential) investor taxation but: · Shareholders are subject to different taxes levied at different rates and thus not indifferent to income or capital gains · No information asymmetry but: · Directors are always privy to inside information · Shareholders only receive company information periodically Dividend Relevance Theories . The