DIVIDEND POLICY -A CHAPTER IN MY BOOK ENTITLED CORPORATE FINANCE, INVESTMENT AND DIVIDEND POLICY ON AMAZON
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A company’s dividend policy dictates the amount of dividends paid out by the company to its shareholders and the frequency with which the dividends are paid out. When a company makes a profit, they need to make a decision on what to do with it. They can either retain the profits in the company (retained earnings on the balance sheet ), or they can distribute the money to shareholders in the form of dividends. Chen(2023)? posits that a dividend policy is a policy a company uses to structure its dividend payout . Put simply, a dividend policy outlines how a company will distribute its dividends to its shareholders. These structures detail specifics about payouts, including how often, when, and how much is distributed. There are three different types of dividend policies ie stable, constant, and residual? and each with its own benefits. Dividend policies are not ?mandatory, as some companies choose not to reward shareholders with dividends
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A? Dividend
A dividend is the share of profits that is distributed to shareholders in the company and the return that shareholders receive for their investment in the company. The company’s management must use the profits to satisfy its various stakeholders, but equity shareholders are given first preference as they face the highest amount of risk in the company. A few examples of dividends include:
1. Cash dividend
A dividend that is paid out in cash and will reduce the cash reserves of a company.
2. Bonus shares
Bonus shares refer to shares in the company are distributed to shareholders at no cost. It is usually done in addition to a cash dividend, not in place of it.
Examples of Dividend Policies
The dividend policy used by a company can affect the value of the enterprise. The policy chosen must align with the company’s goals and maximize its value for its shareholders. While the shareholders are the owners of the company, it is the board of directors who make the call on whether profits will be distributed or retained.
The directors need to take a lot of factors into consideration when making this decision, such as the growth prospects of the company and future projects. There are various dividend policies a company can follow such as:
1. Regular dividend policy
Under the regular dividend policy, the company pays out dividends to its shareholders every year. If the company makes abnormal profits (very high profits), the excess profits will not be distributed to the shareholders but are withheld by the company as retained earnings. If the company makes a loss, the shareholders will still be paid a dividend under the policy.
The regular dividend policy is used by companies with a steady cash flow and stable earnings. Companies that pay out dividends this way are considered low-risk investments because while the dividend payments are regular, they may not be very high.
2. Stable dividend policy
Under the stable dividend policy, the percentage of profits paid out as dividends is fixed. For example, if a company sets the payout rate at 6%, it is the percentage of profits that will be paid out regardless of the amount of profits earned for the financial year.
Whether a company makes $1 million or $100,000, a fixed dividend will be paid out. Investing in a company that follows such a policy is risky for investors as the amount of dividends fluctuates with the level of profits. Shareholders face a lot of uncertainty as they are not sure of the exact dividend they will receive.
3. Irregular dividend policy
Under the irregular dividend policy, the company is under no obligation to pay its shareholders and the board of directors can decide what to do with the profits. If they a make an abnormal profit in a certain year, they can decide to distribute it to the shareholders or not pay out any dividends at all and instead keep the profits for business expansion and future projects.
The irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack liquidity . Investors who invest in a company that follows the policy face very high risks as there is a possibility of not receiving any dividends during the financial year .
4. No dividend policy
Under the no dividend policy, the company doesn’t distribute dividends to shareholders. It is because any profits earned is retained and reinvested into the business for future growth. Companies that don’t give out dividends are constantly growing and expanding, and shareholders invest in them because the value of the company stock appreciates. For the investor, the share price appreciation is more valuable than a dividend payout.
The dividends and dividend policy of a company are important factors that many investors consider when deciding what stocks to invest in. Dividends can help investors earn a high return on their investment, and a company’s dividend payment policy is a reflection of its financial performance.
The Concept of Dividend Irrelevance Theory
Chen(2023)? opines that dividend irrelevance theory posits that dividends don’t have any effect on a company’s stock price. A dividend is typically a cash payment made from a company’s profits to its shareholders as a reward for investing in the company.
Dividend irrelevance theory goes on to state that dividends can hurt a company’s ability to be competitive in the long term since the money would be better off reinvested in the company to generate earnings .
Although there are companies that have likely opted to pay dividends instead of boosting their earnings, there are many critics of dividend irrelevance theory who believe that dividends help a company’s stock price to rise.
Understanding Dividend Irrelevance Theory
Dividend irrelevance theory suggests that a company’s payment of dividends should have little to no impact on the stock price. If this theory holds true, it would mean that dividends do not add value to a company’s stock price.
The premise of the theory is that a company’s ability to earn a profit and grow its business, not dividend payments, determines a company’s market value and drives the stock price. Those who believe in dividend irrelevance theory argue that dividends don’t offer any added benefit to investors and, in some cases, argue that dividend payments can hurt the company’s financial health.
Dividend irrelevance theory was developed by economists?Merton Miller ?and?Franco Modigliani ?in 1961. The duo are also responsible for the Modigliani-Miller theorem .?Both were awarded the Nobel Prize in Economics.
Dividends and Stock Price
Dividend irrelevance theory holds that the markets perform efficiently so that any dividend payout will lead to a decline in the stock price by the amount of the dividend. In other words, if the stock price was $10, and a few days later, the company paid a dividend of $1, the stock would fall to $9 per share. As a result, holding the stock for the dividend achieves no gain since the stock price adjusts lower for the same amount of the payout.
However, stocks that pay dividends, like many established companies called blue-chip stocks, often increase in price by the amount of the dividend as the book closure date approaches. Although the stock can decline once the dividend has been paid, many dividend-seeking investors hold these stocks for the consistent dividends that they offer , which creates an underlying level of demand .
Also, the stock price of a company is driven by more than the company’s dividend policy. Analysts conduct valuation exercises to determine a stock’s intrinsic value . These often incorporate factors, such as:
Dividends and a Company’s Financial Health
Dividend irrelevance theory suggests that companies can hurt their financial well-being by issuing dividends, which is not an unprecedented occurrence.
Taking on Debt
Dividends could hurt a company if the company is taking on debt , in the form of issuing bonds to investors or borrowing from a bank’s credit facility , to make their cash dividend payments.
Let’s say that a company has made acquisitions in the past that have resulted in a significant amount of debt on its balance sheet . The debt-servicing costs or interest payments can be detrimental. Also, excessive debt can prevent companies from accessing more credit when they need it most. If the company has a hard-line stance of always paying dividends, proponents of dividend irrelevance theory would argue that the company is hurting itself. Over several years, all of those dividend payouts could have gone to paying down debt. Less debt might lead to more favorable credit terms on the remaining outstanding debt, allowing the company to reduce its debt-servicing costs.
Also, debt and dividend payments might prevent the company from making an acquisition that might help increase earnings in the long term. Of course, it’s difficult to pinpoint whether dividend payments are to blame for a company’s underperformance. Mismanaging its debt, poor execution by management, and outside factors, such as slow economic growth, could all add to a company’s difficulties. However, companies that don’t pay dividends have more cash on hand to make acquisitions, invest in assets, and pay down debt.
CAPEX Spending
If a company is not investing in its business through capital expenditures (CAPEX) , there could be a decline in the company’s valuation as earnings and competitiveness erode over time. Capital expenditures are large investments that companies make for their long-term financial health and can include purchases of buildings, technology, equipment, and acquisitions.
Investors that buy dividend-paying stocks need to evaluate whether a management team is effectively balancing the payout of dividends and investing in its future.
Dividend Irrelevance Theory and Portfolio Strategies
Despite dividend irrelevance theory, many investors focus on dividends when managing their portfolios . For example, a current income strategy seeks to identify investments that pay above-average distributions (i.e., dividends and interest payments). While relatively risk-averse overall, current income strategies can be included in a range of allocation decisions across a gradient of risk.
Strategies focused on income are usually appropriate for retirees or risk-averse investors. These income-seeking investors buy stocks in established companies that have a track record of consistently paying dividends and a low risk of missing a dividend payment.
Blue-chip companies generally pay steady dividends . These are multinational firms that have been in operation for a number of years, including Coca-Cola, PepsiCo, and Walgreens Boots Alliance. These companies are dominant leaders in their respective industries and have built highly reputable brands, surviving multiple downturns in the economy.
Also, dividends can help with portfolio strategies centered around the preservation of capital . If a portfolio suffers a loss from a decline in the stock market, the gains from dividends can help offset those losses, preserving an investor’s hard-earned savings.
The reason why; companies pay dividends
Companies pay dividends as a way to share profits with shareholders. Not all companies pay dividends.
How dividends are paid
In general, dividends are paid in cash. Dividend payments can also be reinvested in the stock distributing them to buy more shares.
Eligibility for stock dividends
Shareholders who buy or already own a company’s stock before the ex-dividend date will receive dividends on the date of payment.?A company’s board of directors determines these dates.
Dividend irrelevance theory maintains that dividend payments don’t impact a company’s stock price. The theory was developed by economists Merton Miller and Franco Modigliani, both Nobel laureates.
The theory is not without its critics. For example, some maintain that a company’s ability to pay out regular dividends signals financial strength and sustainability to investors, which can positively impact a stock’s price.
??? Modigliani–Miller Propositions
In a now-classic paper, Nobel Prize-winning economists Franco Modigliani and MertonMiller (1958) argued that given certain assumptions, a company’s choice of capital structure does not affect its value. In short, managers cannot change firm value simply by changing the company’s capital structure. In their work, Modigliani and Miller (MM) used simplifying assumptions to show the irrelevance of capital structure to firm value, and then they relaxed the assumptions to show the impact of taxes and financial distress costs on capital structure. Modigliani and Miller’s work provides us with a starting point and allows us to examine what happens when the assumptions are relaxed to accommodate real-world considerations.
1.Homogenous? Expectations??????????????????????????
? Investors agree on a given investment’s expected cash flows.?????????????????????????????????????????????????????
2. Perfect capital markets???
No transaction costs no taxes, no bankruptcy costs.
Everyone has the same information.
3.Risk Free Rate
Investors can borrow and lend at the risk-free rate.
4. No agency costs.
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Managers always act to maximize shareholder wealth.
5. Independent decisions.
Financing and investment decisions are independent of each other.
Let’s begin by imagining a company’s capital structure as a pie, with each slice of the pie representing a specific type of capital (e.g., common equity or debt) and the size of the pie representing the company’s total value. We can slice the pie in any number of ways, yet the total size remains the same. This is equivalent to saying that the company’s value, or present value of expected cash flows, remains the same no matter how the capital slices are allocated as long as the future cash flow stream is expected to remain the same and the risk of that cash flow stream, as reflected by the company’s cost of capital, remains the same.
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MM Proposition I without Taxes: Capital Structure Irrelevance
Given their assumptions, Modigliani and Miller proved that changing the capital structure does not affect firm value in part because individual investors can create any capital structure they prefer for the company by borrowing and lending in their own accounts in addition to holding shares in the company.
As an example, suppose that a company has a capital structure consisting of 50% debt and 50% equity and that an individual investor would prefer that the company’s capital structure be 70% debt and 30% equity. That investor can borrow money to finance their share purchases so that their ownership of company assets reflects their preferred 70% debt financing. This would be equivalent to buying stock on margin.This action has no effect on the company’s expected operating cash flows and no impact on company value.
Modigliani and Miller use the concept of arbitrage to demonstrate their point:
?If the value of an unlevered company (i.e., a company without any debt) is not equal to that of a levered company, investors could make a riskless arbitrage profit at no cost by selling shares of the overvalued company and using the proceeds to buy shares in the undervalued company, forcing their values to become equal.
In other words, the value of the levered company (VL) is equal to the value of the unlevered company (VU), or VL = VU. A crucial implication is that in the absence of taxes, the weighted average cost of capital is unaffected by capital structure. Note, however, that this proposition holds only under the restrictive assumptions of Modigliani and Miller. The importance of the Modigliani and Miller result is that it demonstrates that managers cannot create firm value simply by changing the company’s capital structure. In other words, the value of a company is determined solely by its cash flows, not by its relative reliance on debt and equity capital. Adding leverage increases the risk to equityholders because greater debt increases the probability of bankruptcy. As a result, equityholders will demand a higher return as leverage increases in order to offset the increase in risk. However, overall cost of capital does not change, so there is no change in the value of the company. Note that Modigliani and Miller did not assume away the possibility of bankruptcy. They simply assumed there is no cost to bankruptcy. Given their assumptions of perfect capital markets—in which there are no taxes, transaction costs, or bankruptcy costs, and in which all investors have equal (“symmetric”) information—capital structure does not affect the value of the company and is irrelevant. This forms the basis of the Modigliani and Miller Proposition I—and II, which follows.
MM Proposition II without Taxes: Higher Financial
Leverage Raises the Cost of Equity
According to MM Proposition I, the value of the company remains unchanged or constant as the capital structure changes. Therefore, the weighted average cost of capital must also remain constant as capital structure changes. Since the cost of debt is lower than the cost of equity because debtholders have a priority in claims, it holds that as the company uses more debt, its risk goes up and the cost of equity must increase.
MM Proposition II holds that the increase in the cost of equity must exactly offset the greater use of lower cost debt.
MM Proposition II without taxes:The cost of equity is a linear function of the company’s debt-to-equity ratio
In their analysis, Modigliani and Miller prove that in the absence of corporate taxes, the cost of equity is equal to
re = r0 +( r0-rd)D/E
where re is the cost of equity, r0 is the cost of capital for a company financed only with equity (i.e., an all-equity company), rd is the cost of debt, D is market value of debt, and E is the market value of equity. Equation 1 is a linear function with intercept equal to r0 and slope equal to the quantity (r0 – rd). In short, higher leverage raises the cost of equity but does not change firm value.
Consider the example of the Leverkin Company, which currently has an all-equity
capital structure. Leverkin has expected annual cash flows to equityholders (which we denote as “CFe”) of $5,000 and a cost of equity, which is also its WACC, of 10%. For simplicity, we assume that all cash flows are perpetual. Therefore, Leverkin’s value is equal to
V= CFe ?????=? $5000???? = $50,000?
?Rwacc???????????? 0.10
Now suppose that Leverkin plans to issue $15,000 in debt at a cost of 5% and use the proceeds to buy back $15,000 worth of its equity.
Under MM Proposition I, VL = VU, so the value of Leverkin must remain the same at $50,000. Under MM Proposition II, the cost of Leverkin’s equity when it has $15,000 debt and $35,000 equity is
re = 0.10 + (0.10-0.05) $15,000
?????????????????????????????????? $35,000
????????????????????? = 0.12143 =12.143%
Chen(2023) in his work; on Dividend Policy: What it is and How the 3 Types Works; adopted the guidelines highlighted below in his discussion.
How a Dividend Policy Works
Some companies choose to reward their common stock shareholders by paying them a dividend . A dividend is paid on a regular basis and usually represents a portion of the profits that these companies earn. This gives shareholders a regular stream of income, which is why dividend-paying stocks are a favorite for some investors.
Having a dividend policy in place is important for dividend-paying companies. This is a structure that highlights several key points, including:
These decisions are made by a company's management team. It must also decide what, if any, other factors may have to be put in place that would influence dividend payments. An additional factor to consider includes providing shareholders with the option to take their dividends in cash or allowing them to reinvest them by purchasing additional shares through a dividend reinvestment program (DRIP) .
There are three types of dividend policies: a stable dividend policy, a constant dividend policy, and a residual dividend policy. These are highlighted in more detail below. Companies that choose not to pay their shareholders a dividend have no dividend policy, as paying a dividend isn't mandatory. Their focus may be to grow their businesses by reinvesting their profits.
Some researchers?suggest?the dividend policy is theoretically irrelevant because investors?can sell a portion of their shares or portfolio if they need funds. This is the dividend irrelevance theory , which infers that dividend payouts?minimally affect a stock's price.
Types of Dividend Policies
Stable Dividend Policy
A stable dividend policy is the easiest and most commonly used. The goal of this policy is?to provide shareholders with a steady and predictable dividend payout each?year, which is what most investors?seek. Investors receive a dividend regardless of whether earnings are up or down.
The goal is to align the dividend policy with the long-term growth of the company rather than with quarterly earnings volatility. This approach gives?the shareholder?more certainty concerning?the amount and timing of the dividend.
Constant Dividend Policy
The primary drawback of the stable dividend policy is that investors may not see a dividend increase in boom years. Under the constant dividend policy, a company pays a?percentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings.
If earnings are up, investors get a larger dividend and if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when dividend income is highly volatile.
Residual Dividend Policy
The residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With?a residual dividend policy, the company pays out what dividends remain?after the company has paid for capital expenditures (CAPEX) and working capital.
This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.
Despite the suggestion that the dividend policy may be irrelevant, it is income for shareholders. Company leaders are often the largest shareholders and have the most to gain from a generous dividend policy.
Example of a Dividend Policy
Kinder Morgan (KMI ) shocked the investment world when in 2015 it cut its dividend payout by 75%, a move that saw its share price tank. But many investors found the company on solid footing and making sound financial decisions for their future.
In this case, cutting its dividend actually worked in its favor. Six months after the cut, Kinder Morgan saw its share price rise almost 25%. In early 2019, the company raised its dividend payout again by 25%, which helped to reinvigorate investor confidence in the energy company.12
What Are Dividends?
Dividends are paid by companies to their common shareholders. They represent a portion of the corporate earnings or profits that companies want to share with their investors. Dividends are paid at regular intervals, either monthly, quarterly, or annually. As such, they provide a regular stream of income for investors. Dividends are commonly offered by companies whose primary focus isn't growth. Major companies like Coca-Cola, Apple, Microsoft, and Exxon Mobil.
What Are the Main Types of Dividends?
Dividend-paying companies have several options when it comes to the type of dividend they offer shareholders. They can pay dividends in cash, which is the most common type, or they can offer stock dividends, give shareholders additional (existing) shares in the company. Other, less common types of dividends are the scrip dividend, property dividend, and special dividend.
Do All Companies Pay Dividends to Their Shareholders?
No, not all companies pay dividends to their shareholders. And they are not mandatory. A company's board of directors decides what to do with its profits. Some choose to reinvest the money they earn back into the company to fuel growth. These companies have no dividend policy. Others choose to take a portion of the profits and pay dividends to their investors on a regular basis.
Dividend-paying stocks can give you a steady stream of income while adding value to your portfolio. But before you jump in, make sure you review the dividend policies of certain companies. These policies are set by corporate management and highlight how much to pay, when, and how often.
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