Dividend Policy

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Dividend Policy

Dividend policy

Executive summary

Once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn affect investors and perceptions of the company in the financial markets.

Objective

Dividend is a taxable payment declared by a company's board of directors and given to its shareholders out of the company's current or retained earnings. This coursework examines and investigates into the dividend policies adopted by companies listed on the London stock exchange and the factors that determine dividend policy.

Introduction
Firms use dividends as a mechanism for financial signaling to the outsiders regarding the stability and growth prospects of the firm. Secondly, dividends play an important role in a firm's capital structure. Yet another set of studies have established the relationship between firm dividend and investment decisions. According to the "residual dividend" theory, a firm will pay dividends only if it does not have profitable investment opportunities, i.e., positive net present value projects

Methodology
Major theoretical and empirical papers on dividend policy are identified and reviewed. Critically discussed and compared dividend policies of three different companies.

Literature Review

The first empirical study of dividend policy was provided by Lintner (1956), who surveyed corporate managers to understand how they arrived at the dividend policy. Lintner found that an existing dividend rate forms a bench mark for the management. Companies’ management usually displayed a strong reluctance to reduce dividends. Lintner opined that managers usually have reasonably definitive target payout ratios over the years, dividends are increased slowly at a particular speed of adjustment, so that the actual payout ratio moves closer to the target payout ratio.

Dividend irrelevance theory If a company makes money, in the form of cash inflows, that money belongs to shareholders. It should not matter whether a company keeps money and invests it or returns the money to shareholders. This is what is assumed, correctly, by most valuation methods. It is also possible to show that it should make little difference to investors whether dividends are paid or not as investors they can reproduce the cash flows of different dividend policies. For example, if a company pays out dividends, but an investor would prefer the money to be re-invested, then the investor can simply use the dividends to buy more shares.

Dividend relevance theory Dividend relevance is a theory relating to the impact of dividends on organizations and individual investors. The theory advanced by Gordon and Lintner, establishes that there is a direct relationship between a firms dividend policy and its market value. Investors respond to receiving actual cash returns. Gordon and Lintner refer to this as the “Bird in hand theory” another name for dividend relevance. According to the Hewitt Investment Group, “Gordon and Lintner”assert that dividends received today are preferable to future dividends, which are subject to uncertainty. Higher certainty will cause investors to ascribe a higher risk premium to those payments, thereby increasing a firms cost of capital (by decreasing the value of stock)” (Hewitt, 2002, p. 5).

Miller and Modigliani [1961] view dividend payment as irrelevant. According to them, the investor is indifferent between dividend payment and capital gains.

Miller and Rock [1985], for instance, develop a model in which dividend announcement effects emerge from the asymmetry of information between owners and managers. The dividend announcement provides shareholders and the marketplace the...
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