Dividend Policy

ACCA Director Author

Dividend Policy

Dividend Policy

Contents:

• Theories of dividend policy
• Common dividend policies
• Dividend policy for multinational businesses
• Transfer pricing for multinational businesses

Referenced syllabus: A.2 (c); A.5 (a ii); A.6

Sketch

• Equity shareholders demand returns from investments they made in the form of dividends which increases cost of capital in the business.
• This in turn reduces the project value if it is discounted on a higher cost of capital.

Theories of dividend policy

Traditional view:

Share price reflects both current and future dividends based on shareholders’ required return.

The following factors are considered when deciding how much dividends should be paid out:

• Profitability – Companies need to maintain a healthy level of retained earnings. Therefore, a consistently high dividend payout could damage its profitability.
• Legal constraints - Most company laws require dividends can only be paid out of accumulated earnings, and they should not be paid if the business is insolvent.
• Other restraints – A loan covenant may require dividends can not be paid out before loans are repaid.
• Inflation – Businesses may need to retain some profits to deal with expected inflation.
• Liquidity – Cash level reduces if dividends are paid out to shareholders.
• Gearing level – Paying out dividends effectively worsens the business gearing level which makes it harder to obtain future debt finance.
• Clientele effect – Shareholders usually expected a consistent dividend policy, ie with stable or a steady growth in dividends each year, otherwise, they may sell shares with low dividends and buy shares with higher dividends.
• Signalling effect - A cut in dividends may be interpreted by shareholders as a signal that the business future is terrible because shareholders’ wealth may be thought to reduce.

Case study – Glencore:

Glencore decided not to pay a proposed $2.6 billion in 2020 dividends after reporting a decrease in half-year profits because of weaker commodity prices and the impact of the coronavirus pandemic. Its share price fell by more than 6% in 20 days since this announcement.

Irrelevancy theory by Modigliani and Miller (M&M):

In M&M’s theory, the dividend policy does not affect business value as in the prefect market, the share price reflects all future dividends. The savings from a cut in dividends would be invested in other positive NPV projects which in turn, remain the business value.

To put it simply, it assumes shareholders see what they own as they view the company as a ‘glass’, profits are either paid out or retained because profits still belong to them. Therefore, it makes no difference in whether dividends are paid out or not.

This theory holds true once the following assumptions are met:

1. Market is perfect – If businesses do not pay dividends, they will retain profits to invest in positive NPV projects which again, increase shareholders’ wealth. However, if businesses do not reinvest the dividends savings into other positive NPV projects, share price changes.
2. No taxes – Shareholders do not care about the dividend policy if there is no capital gains tax nor personal income tax. However, shareholders may prefer a higher dividends payout if the personal income tax is low.
3. No transaction costs – If there are no transaction costs, it makes no difference in shareholders’ cash flows if either shares are sold to obtain a capital gain or dividends are obtained. However, there are transaction costs when trading shares and this means many shareholders may prefer dividends rather than selling their shares to reduce these costs.

Common dividend policies

1. Constant dividend or constant growth in dividends:

The most common dividend policy is to increase the dividend by a predictable amount each year, ie 4%.

• Advantage - The increase would ideally be above the inflation rate so that shareholders see a real increase in dividends that they receive each year.
• Disadvantage - Companies may struggle to maintain growth in dividends when earnings are flat or falling, and they may be forced to change the policy, otherwise liquidity problems may arise, and the number of long term investment opportunities may reduce.

2. Constant payout ratio:

A constant percentage of earnings out as a dividend, ie 50% of earnings are paid out as a dividend each year.

• Advantage - Ensuring companies to retain earnings for future possible long-term investment opportunities, ie a fall in earnings would reduce the dividends payout.
• Disadvantage – Dividends payout may be quite volatile, given the earnings are different from each year having an adverse effect on share price as a result.

3. Residual dividend:

The company pays a dividend to shareholders only if the earnings cannot be reinvested in positive NPV projects. Most companies may estimate the amount of cash needed in investment projects in a few years, and it then decides how much dividends to be paid out to shareholders.

• Advantage – Businesses could take advantage of good investment chances and finance these in the simplest way (retained earnings).
• Disadvantage – This works if shareholders are looking for high share price growth rather than high dividend income. It tends to work well in the growth phase of the company.

4. Scrip dividend:

Cash is replaced by shares as dividends to existing shareholders. Scrip dividend is often known as a bonus issue or stock dividend in some countries. Share capital increases (total nominal value) as more shares are issued, and this is then deducted from reserves.

5. Stock split:

This is to subdivide existing shares. However, no new shares are issued, but this is usually a bullish sign to investors. Besides, the trading price could be lowered to a reasonable range, and hence liquidity of shares could be improved.

Case study – Share split by Tesla

As its share price hit more than $1,400 in August 2020, in order to make stock ownership more accessible to employees and investors, Tesla decided to split its shares on a five for one basis. The share price was almost $300/share after the split.

6. Share buyback:

Companies buy their own shares back from existing shareholders via open market purchases, an invitation to shareholders to tender or an arrangement with particular shareholders.

Benefits of share buyback:

• With the share buyback scheme, the shareholders can choose whether or not to sell their shares back to the company. In this way they can manage the amount of cash they receive.
• With dividend payments, and especially large special dividends, this choice is lost, and may result in a high tax bill (such as personal income tax).
• As the share capital is reduced, the earnings per share and the share price may increase.
• Share buybacks are normally viewed as positive signals by markets and may result in an even higher share price.
• There will be no expectations of continued increased dividends for the company, and this is good for future liquidity.

Case study - Gree Electric

The share buyback by Gree Electric since July 2020 did not help with its share price falling from RMB 59.5/share down to RMB 55/share in one month although shares will be then used to motivate management. The continuous decrease in its share price is partly due to its diversification strategy, ie the move to produce chips and mobiles.

ABOUT ACCA and GlobalAPC:

Dive deep into the intricacies of Advanced Financial Management and unlock your potential with our comprehensive ACCA online courses at Global APC. This article serves as a valuable resource, meticulously crafted by our seasoned ACCA tutor, aiming to shed light on the most critical and popular areas of the ACCA Advanced Financial Management exam. As a leading provider in ACCA education, Global APC ensures that this content is not only rich in quality but also tailored to meet the specific needs of ACCA aspirants worldwide. Our online courses are designed to empower students with the knowledge and skills needed to excel in their ACCA journey, focusing particularly on the areas that matter the most. Whether you are aiming to grasp complex financial management concepts or enhance your strategic decision-making abilities, our courses are your gateway to success. Embrace the opportunity to learn from the best and make a significant stride in your ACCA preparation with Global APC.

Embark on a journey of academic excellence and professional growth with Global APC's ACCA online courses. If this article has sparked your interest and you are eager to delve deeper into the world of Advanced Financial Management, we warmly invite you to explore our courses further at www.globalapc.com. For those aspiring to join the prestigious ACCA community and take a giant leap in your finance career, visit www.accaglobal.com to start your student journey. Don't miss out on the chance to learn from the best and elevate your ACCA preparation to new heights with Global APC!

Categories: : Advanced Financial Management (AFM)