1. The dividend policy
Ordinary dividends are defined as cash from the company's profit distribution to shareholders (Garvey, G. T. and Swan, P. L. 1994). In other words, the dividend is the share of company profits for investors, to give for the investors a share of capital. Companies are able to distribute free cash flow by paying a dividend and trusts are able to distribute free cash flow by paying a distribution. Dividend policy refers to the decision by companies to pay out net profit or retained earning to shareholders as dividend or alternatively to reinvest those profits as retained earning (Dunstan, B 1992). One of the biggest wish of shareholders is receiving high dividends. However, a high dividend rate is not really a sigh of successful business. An unreasonable high dividend policy will be considered as a “milking machine”, which will squeeze the capital that business needs to reinvest.
2. The importance of Dividend policy
When a company generates free cash flow, it can retain all or part of this cash flow for future use or, alternatively, it can pay a dividend to its shareholders. The dividend policy decision is tied directly to the financing of a company (Walker, S. and Partington, G 1999).
There are three criterion include: the foundational concept, the managerial considerations and the design approach, that are needed to critically evaluate the importance of an effective dividend policy.
a. The foundational concept
Company may also elect to pay special dividends. This allows companies to pay additional one-off dividends to their shareholders. (Brown, P and Clarke, A 1993). Dividend decisions of firms are considered as a message, which can be dissected and evaluated the financial condition as well as business operations and management capability. This is reflected from the fact that a dividend decisions of firms the market can be evaluated positively or negatively by the rise or fall of stock prices. Reasonable dividend strategy not only helps companies obtain growth financing effectively but also improve the liquidity of shares, attracting new shareholders. Depending on the business operations and development stages of the businesses that the dividend is determined as appropriate. For example, A enterprise which is in the technology sector are at the stage of development will tend to pay lower dividends, or even not pay dividends for years to focus on re-investment expansion; whereas , B enterprise has a maturity in the field of facilities and infrastructure service will generally pay dividends regularly and stability.
While earnings are influenced by unpredictable developments in the economy and industry in which a company operated, dividends are set by directors, who usually like to pay a smooth and growing dividend stream. An appropriate dividend policy will depend on the structure of the company’s share register as different shareholders may have varying dividend preferences (Balachandran, B. and Nguyen, T 2004):
• Retail investors tend to value progressive dividend policies _ an increasing ordinary dividends on an absolute per share basic
• Institutional investors generally recognize the capital theory of a proportional dividend policy _ ordinary dividends paid as a percentage of earnings
A progressive versus proportional dividend policy reflects the balance between paying increasing dividends to reward shareholders and retaining profits to pursue growth opportunities or other capital expenditure.
b. The manager consideration
There is no requirement that a company pay its shareholders any particular amount of dividend at any particular time. However, since shareholders are the residual claimants of the company’s cash flows, they do in a sense own the amounts of cash that the company produces net of all other contractual requirements. Financial managers of a company must decide how much of its residual cash should be paid as dividends to...
References: • Dunstan, B. (1992), “ Understanding Finance with The Australian Financial Review”, Financial Review Library, Sydney
• Knox, D
• Lonergan, W (2003), “ The valuation of Business, Shares and Other Equity”, 4th Edition, Allen & Unwin, Sydney , NSW
• O’Brien, J
• Copeland, T. E. and Weston, J. F (1992), “Financial Theory and Corporate Policy”, McGraw-Hill, California
• Officer, R (1994), “The cost of capital under an imputation system of taxation”, Accounting and Finance, vol.34
• Harris, R. and Marston, F (1992), “Estimating shareholders risk using analysts’ growth forecasts”, Financial Management, vol. 21
• Fama, E (1970), “Efficient capital markets”, Journal of Finance, vol
• Miller, M. H. and Modigliani, F. (1961), “Dividend policy, growth and the evaluation of shares”, Journal of Business, vol.34
• Brown, P
• Shevlin, T (1982), “ Australian corporate dividend policy: Empirical evidence”, Accounting and Finance
• Walker, S
• Balachandran, B. and Nguyen, T (2004), “Signaling power of special dividends in an imputation environment”, Accounting and Finance, 44
• Partington, G (1984), “Dividend policy and target payout rations”, Accounting and Finance, vol.3
• Lintner, J (1956), “Distribution of incomes of corporations among dividends, retained earnings, and taxes”, American Economic Review, Vol.46
Please join StudyMode to read the full document