CIMA F3 Syllabus B. Sources of long term funds - Dividend Theories - Notes 1 / 4
Dividend policy
A decision to increase capital investment spending will increase the need for financing, which could be met in part by reducing dividends.
In a perfect market - Miller and Modigliani
Miller and Modigliani showed that, in a perfect capital market, the value of a company depended only on its investment decision, and not on its dividend or financing decisions.
In a perfect market, the value of a company is maximised when all positive NPV projects are invested in.
This affects share price NOT dividend policy.
In a perfect market the share price reflects all future dividends, so shareholders who were unhappy with the level of dividend declared by a company could gain a ‘home-made dividend’ by selling some of their shares.
This is possible since there are no transaction costs in a perfect capital market.
M & M's dividend irrelevancy theory:
Shareholders return can be measured as the aggregate of dividends plus growth in share price.
Bird in the hand view
Many say there is a clear link between dividend policy and share prices.
For example, it has been argued that investors prefer certain dividends now rather than uncertain capital gains in the future (the ‘bird-in-the-hand’ argument).
Imperfect markets
The real world markets are semi strong, not perfect.
So information knowledge of managers and shareholders are not equal.
Therefore a change in dividend policy could be seen by investors (with less information than managers) as a ‘signal’ and so affect the share price.
Signalling effect
The size and direction of the share price change will depend on the difference between the dividend announcement and the expectations of shareholders.
This is referred to as the ‘signalling properties of dividends’.
Clientele Effect
Apple shares have outperformed the market massively in the last few years.
This means that Apple shareholders are enjoying huge share price increases (capital growth).
These shareholders cannot get such returns by investing elsewhere so do not want their money back from Apple yet.
Consequently Apple’s dividend policy to date is zero dividends despite its huge cash balances
This is referred to as the ‘clientele effect’.
A company with an established dividend policy is therefore likely to have an established dividend clientele.
The existence of this dividend clientele implies that the share price may change if there is a change in the dividend policy of the company, as shareholders sell their shares in order to reinvest in another company with a more satisfactory dividend policy.
Legal Constraints
Three general rules are followed when paying dividends:
The Net Profit Rule
dividends can only be paid from current and past earnings
Capital Impairment Rule
prevents payment from the value of shares on the balance sheet
Insolvency Rule
dividends cannot be paid when insolvent or if the payment makes the firm insolvent
Forms of Dividends
Types of payment:
Cash dividends
Stock dividends: Corporations distribute dividends in the form of new shares to existing shareholders
Stock split: Issue new shares to existing shareholders by splitting existing shares (E.g., 2-for-1 split)
Reverse split: Issue new shares to replace out shares but results in a reduction in number of outstanding shares (E.g., 1-for-2 shares)
A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend.
It is offered pro rata to existing shareholdings.
Advantages of a Scrip dividend
From a company point of view, it has the advantage that, if taken up by shareholders, it will conserve cash, i.e. it will reduce the cash outflow from a company compared to a cash dividend.
This is useful when liquidity is a problem, or when cash is needed to meet capital investment or other financing needs.
Another advantage is that a scrip dividend will lead to a decrease in gearing, whether on a book value or a market value basis, because of the increase in issued shares.
This decrease in gearing will increase debt capacity.
A disadvantage of a scrip dividend is
that in future years, because the number of shares in issue has increased, the total cash dividend will increase, assuming the dividend per share is maintained or increased.