Dividend Policy

Topics: Finance, Dividend, Investment Pages: 7 (1959 words) Published: February 27, 2011
Dividend Theory

1. Discuss the factors which may impact on a firm’s dividend policy? .Industry and Company Variations
Payout ratios vary amongst different industries e.g. firms within the telecoms and utilities sectors may typically payout around 60% of earnings in dividends, whilst retailers and computer software companies may typically payout around 20% of earnings in dividends Legal Constraints

1. Legal constraints can be viewed in the context of three broad areas; 2. it is illegal to use the firm’s capital to make dividend payments, 3. dividends must be paid out of present and past net earnings, 4. dividends cannot be paid when the firm is insolvent

Restrictive Covenants
These tend to have more impact on dividend policy than legal constraints. The covenants effectively restrict the amount of dividend that can be paid to ensure that debt is serviced appropriately. They are included in loan agreements, lease contracts and bond agreements. They can often specify that dividends can only be paid once earnings reach an agreed Tax

The tax laws which shareholders are subject to can determine whether they would prefer dividend income or capital gains. In some instances, the tax rate on dividend income may be higher than that on capital gains. Also, dividends tend to be taxed immediately, whereas capital gains tax may be deferred into the future. Liquidity and Cash Flow Considerations

Clearly the more liquid a firm is the more able it is to pay dividends. Many rapidly growing firms faced with potentially profitable investment opportunities may have difficulties maintaining liquidity and paying dividends at the same time and may favour retention. Borrowing Capacity

A company’s ability to borrow can give it flexibility in relation to the payment of dividends. The more access a firm has to the variety of borrowing opportunities available , the better able it will be to make dividend payments. Earnings Stability

Many large widely held firms are reluctant to lower their dividend, even in times of financial distress. A firm with a stable history of earnings is usually more willing to pay a higher dividend than a firm with erratic earnings.

In periods of high inflation, firms may be forced to retain a higher percentage of earnings to meet the additional costs associated with funding its assets. Shareholder Preferences (Clientele Effect)

It has been argued that firms tend to develop there own ‘clientele’ of investors e.g. Investors will be attracted to firms that have dividend policies consistent with the investors objectives. Protection against dilution

Some firms choose to retain more of their earnings to avoid dilution.

2. Identify the key factors identified by M&M to suggest that dividend policy should have no impact on the value of a firm. Informational Content
M&M acknowledge the empirical evidence indicating that changes in dividend policy affect share prices. Many firms favour a stable dividend policy. An increase in dividends conveys a certain type of information to shareholders e.g. the expectation of higher future earnings. A cut in dividends may be viewed as conveying unfavourable information. M&M argue that the informational content of dividend policy influences share prices , not the pattern of dividend payments Signalling Effects

Changes in dividend payments represent a signal to investors concerning management’s assessment of future prospects. Management as an insider is perceived to have more access to complete information about future profitability than is available to investors outside the firm (information asymmetries). Dividend changes may provide unambiguous signals about the firms future prospects – information that cannot be conveyed fully through other methods – e.g. annual reports and presentations. Clientele Effect

M&M also claim...
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