Dividend policy

Dividend policy, in financial management and corporate finance, is concerned with [1] the policies regarding dividends; more specifically paying a cash dividend in the present, as opposed to, presumably, paying an increased dividend at a later stage. Practical and theoretical considerations will inform this thinking.

Management considerations

In setting dividend policy, management must pay regard to various practical considerations, [2] [1] often independent of the theory, outlined below. In general, whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power: when cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program. At the same time, although the decisioning must weigh the best use of those resources for the firm - i.e. investment needs and future prospects - it must also take into account shareholders' preferences, and the relationship with capital markets more broadly.

As regards the firm: If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then management should return some or all of the excess cash to shareholders as dividends. However, potentially limiting any distribution, the firm's overall finances, liquidity, and legal / debt covenants in place will also be of relevance. Management may also wish to avoid "unsettling" the capital markets [2]

Relevance of dividend policy

There are several schools of thought on dividends, in particular re their impact on firm value. [3] A key consideration will be whether there are any tax disadvantages associated with dividends: i.e. dividends attract a higher tax rate as compared, e.g., to capital gains; see dividend tax and. Here, per the Modigliani–Miller theorem, as below: if there are no such disadvantages - and companies can raise equity finance cheaply, i.e. can issue stock at low cost - then dividend policy is value neutral; if dividends suffer a tax disadvantage, then increasing dividends should reduce firm value. Regardless, but particularly in the second (more realistic) case, other considerations apply; see.

Modigliani-Miller theorem

The Modigliani–Miller theorem states that dividend policy does not influence the value of the firm.[4] The theory, more generally, is framed in the context of capital structure, and states that — in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market — the enterprise value

External links

Dividend Policy by Alex Tajirian
Corporate Dividend Policy by Henry Servaes (London Business School) and Peter Tufano (Harvard Business School)

References

Aswath Damodaran (N.D.). Returning Cash to the Owners: Dividend Policy^
Ken Garrett (ND). Dividend theory. Association of Chartered Certified Accountants^
See Dividend Policy, Prof. Aswath Damodaran

Capital structure substitution theory and dividends

The capital structure substitution theory (CSS)[6] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on the hypothesis that management "manipulates" capital structure such that earnings per share (EPS) are maximized. As a corollary, the CSS theory is seen to provide management with (some) guidance on dividend policy - more directly in fact than other approaches, such as the Walter model and the Gordon model. In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.

The theory provides an explanation as to why some companies pay dividends and others do not: When redistributing cash to shareholders, management can typically choose between dividends and share repurchases. In most cases dividends are taxed higher than capital gains, and thus investors - and management - would typically be expected to select a share repurchase. However, for some companies share repurchases lead to a reduction in EPS, and it in those cases the company would select to pay dividends. From the CSS theory, then, it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than should prefer dividends as a means to distribute cash to shareholders, where Companies may then "target" a dynamic Debt-to-equity ratio.

The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way. Low-valued, high-leverage companies with limited investment opportunities and a high profitability, use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.[7]

D is the company's total long-term debt

is the company's total equity

is the tax rate on capital gains

is the tax rate on dividends

Management considerations

Relevance of dividend policy

Modigliani-Miller theorem

See also

External links

References

Gordon model

Lintner's model

Capital structure substitution theory and dividends

Dividend signaling hypothesis

Walter's model

Residuals theory of dividends