Chapter-16 Dividend policy
Dividend Decision
Dividend decision involves decision making on:
➢ Whether the company should pay the dividend
➢ If the dividend is to paid, the how much dividend to pay
➢ For debt providers, interest is paid as return on their investment
➢ For equity providers, return can be put in the form of dividend or capital
appreciation
Theories of dividend policy
1. Dividend irrelevancy theory-
➢ This theory is put forward by Modigliani and Miller
➢ No taxes are levied on the dividend
➢ There are no legal restrictions on the dividend payment
➢ There is no fear with management holding the shareholder’s money
➢ No agency cost- cost of the company misusing their money
➢ Shareholders are indifferent, they do not have any expectation
➢ Dividend signalling theory is not considered
2. Residual theory-
Residual theory says when there are profits,
➢ The profits must first be invested in profitable projects and the residual
profits should be paid to the shareholder
➢ In case where the projects are not profitable, then they should not be
invested but they need to be distributed to shareholders as dividend.
3. Dividend relevance-
It brings in all the above practical considerations and considers dividend to be
relevant for any decision on shareholder wealth. It can have an adverse effect on
shareholder wealth:
➢ Reductions in dividend can convey bad news to shareholders
➢ Changes in dividend policy, particularly reductions may conflict with
investor liquidity requirements
➢ Changes in dividend policy may upset investor tax planning
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4. Dividend Signalling-
In any listed company, the impact of company’s activity on the share price is very
important. If a company makes an announcement, they should be careful of the
signal sent across in the market. Investors do not have perfect information
concerning the future prospects of the company. Many authorities claim that the
pattern of the dividend payments is a key consideration on the part of investors
when estimating future performance.
Alternative to cash dividend
1. Share repurchase-
➢ Uses excess cash available to buy back shares as an alternative to a
dividend.
➢ Alternative is to pay one-off surplus as a special dividend
2. Scrip dividends-
➢ A scrip dividend is where the company allows its shareholders to take their
dividend in the form of new shares rather than cash.
➢ A scrip dividend is not to be confused with a bonus issue.
➢ A bonus (scrip) issue is a method of altering the share capital without
raising cash, it is done by changing the company’s reserves into share
capital.
➢ A bonus issue is not an alternative to a cash dividend