Dividend policy and firm value

The dividend decision is an integral part of the firm's strategic financing decision. It essentially involves a firm's directors deciding how much of the firm's earnings, after interest and taxes (EAIT), should be distributed to the firm's ordinary shareholders in return for their investment in the firm, and how much should be retained to finance future growth and development. (Sterk and Vandenberg 2004 441-55)The objective of the firm's dividend decision, like all financial decisions, should be the maximisation of shareholder wealth. If an optimal dividend policy does exist then clearly managers should concern themselves with its determination; if it does not, then any dividend policy will do, as one policy will be equal to another. It should be noted that the dividend decision and dividend policy relate only to ordinary share capital. (Asquith and Mullins 2003 77-96)The payment of preference share dividends is not considered part of a firm's dividend policy, as the level of, or method of calculating, the preference dividend is fixed in advance by the terms and conditions of the original preference share offer. Once a dividend policy has been formulated, setting out the amount and timing, etc. of dividend payments, it should be followed with stability and consistency as its guiding principles. As we shall discuss later, changes to a firm's dividend policy can be interpreted in various ways by the financial markets, sometimes with dramatic consequences for the firm's share price. You will note that the dividend decision is made at the level of the firm's most senior managers - at board of director level. It is the directors who will decide the amount and timing of dividend payments. Under UK company law the directors cannot be compelled to recommend a dividend and shareholders cannot vote themselves a higher dividend than that recommended by the directors. (Bajaj and Vijh 2004 193)Payment of dividendsIn the UK, in common with many other countries, dividends are usually paid to shareholders twice a year. An interim payment is made half-way through the financial year, with a final payment being made after the end of the financial year. Dividends are paid to the shareholders listed on a firm's Share Register on a specified date, known as the Record Date. (Sterk and Vandenberg 2004 441-55) In the stock market, shares of listed companies are traded on what is known as either a cum-dividend or ex-dividend basis. A listed company's shares are traded cum-dividend for a period after the company announces its results, interim and final. When the shares are trading cum-dividend, buyers of the shares will be entitled to

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receive the dividend payment. When the shares are trading ex-dividend, buyers will not be entitled to receive a dividend payment. This explains why (assuming the absence of any other relevant factors) there is usually a drop in a share's price, roughly equivalent to the value of the dividend per share, when the share goes ex-dividend. (Impson 2005 422-27)For instance, distributing capital or certain types of reserves (e.g. share premium account) as dividends is prohibited by company law. The determination of distributable profits is set out in a detailed code of statutory regulations. For public and private companies, the Companies Act 2003 defines distributable profits as: 'accumulated realised profits, so far as not previously utilised by distribution or capitalisation, less accumulated realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made'. These legal restrictions on the payments of dividends are necessary to maintain the capital of a company and to protect the rights and claims of creditors. The relevance (or irrelevance) of dividend policy to the value of the firm has been one of the most widely researched topics in finance and accounting. Arguments have been advanced on all sides of the issue. Given the inability to structure a single conceptual relationship between dividend policy and the value of the firm, empirical studies of the relationship between dividends and firm value have taken on increased importance. Previous studies have used either short-run measures of stock price or risk-adjusted returns to measure firm value. (Jose and Stevens 2004 652)Dividend announcement studies have examined the immediate reaction of the firm’s stock price to a dividend announcement to determine if the stock price falls by more or less than the amount of the dividend. Findings from announcement studies suggest that investors discount dividends. Other studies have tested for the relationship between risk-adjusted returns and dividend yield. Using short-run holding periods, these studies have found that investors require higher risk-adjusted returns from higher dividend yield stocks. While there are controversies over the short-run measures and assumptions of asset pricing models relating returns to firm value, the empirical findings have consistently suggested that higher dividend commitments lower the value of the firm. (Bernstein 2005 4-15)Multiple Measures of Dividend PolicyDividend \implies a conscious management of dividend distributions over time. Surveys indicate that managers tend to focus on the payout ratio in the long run, but smooth dividends in the short run. (Baker et al 2004 1-8) In the longer run, the level of the firm's average payout ratio captures the firm's commitment to the level of dividend distribution out

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of earnings. However, over time the firm need not adhere to the same short-run payout ratio to accomplish the longer-run objective unless earnings are stable. If dividends per share are consciously smoothed relative to earnings, the firm's payout ratio will be volatile. The greater the volatility in the payout ratio, the greater the smoothing of dividends. The volatility of dividends around their trend reflects the inherent dividend stability aspects of the policy. (Woolridge 2002 237-47)Measures of the average payout ratio (APOR), dividend stability around the dividend time trend (R2LDPS), and payout ratio volatility (SDPOR) are used to represent the firm's policy with respect to dividend levels, stability, and smoothing. The dividend payment In practical terms a firm's dividend payment is important to its shareholders. It is part of the return which shareholders receive for their investment in the firm. The dividend payment is also a favoured method by which shareholders and investors estimate a firm's share value, where the value of a share is equal to the present value of the expected future dividend payments - the dividend valuation model Notice the tendency for the final dividend to be significantly greater than the interim - this is the common, financially prudent, approach adopted by most company boards. (Michaely 2005 573)Clearly directors will wish to be certain of how a company has performed for the year overall, before committing valuable cash resources to a dividend payment. Shareholders, depending upon the individual company's articles of association, may have the right to receive dividends in the form of fully paid ordinary shares instead of cash, if they so elect. Under such a plan shareholders can, if they wish, use the entire cash dividend to buy additional shares of the company in the market, usually at a competitive dealing rate. (Christie 2004 459-80)Dividend coverThe dividend cover ratio indicates the vulnerability, or the margin of safety, of dividend payments to a drop in earnings. Notwithstanding the abolition of ACT, tax credits will continue to be available to individual shareholders resident for tax purposes in the UK, although the amount of the tax credit will be reduced to one-ninth of the amount of the net, or cash dividend - equivalent to 10 per cent of the gross dividend. Lower and basic rate taxpayers, as before 6 April 2006, will have no farther liability to tax on their dividends. Higher rate tax payers will, as before, be able to offset the tax credit against their liability to tax on the gross dividend. UK resident individual shareholders who are not liable to income tax in respect of the dividend will not generally be entitled to reclaim any part of the tax credit. Tax credits are no longer available to UK pension funds. (Baker et al 2003 78-84)Under legislation introduced in the Finance

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(No. 2) Act 2005, UK pension funds are not entitled to reclaim the tax credits on dividends paid to them by a company. Similarly, after 6 April 2006 tax credits in respect of dividends paid, which constitutes the income of a charity or venture capital trust, will not be repaid. There is some speculation that, in the future, companies may increase their dividend distributions to compensate these investing institutions for the loss of their tax credits. (Miller 2003 1031)Over time many theories on dividend policy, often controversial ones, have emerged. The central area of controversy has, and continues to be, concerned with whether or not there is a real connection between dividend policy and the market value of the firm. In this section we will review the following main theories of dividend policy:1 the residual theory of dividend policy;2 dividend irrelevancy theory;3 the bird-in-the-hand theory;4 dividend signalling theory;5 the dividend clientele effect;6 agency cost theory.

The residual theory of dividend policyThe essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed. Recall from the previous chapter that, according to Myers' Pecking Order Theory, managers will prefer to utilise retained earnings as the primary source of investment financing, before resorting to issuing debt or equity. Retained earnings are the most important source of financing for most companies. (Ang 2003) They are a cheaper source of finance than making a fresh issue of equity due to expensive equity issue costs (e.g. advertising, brokerage and underwriting fees). The existence of these issue costs - which are examples of real world market imperfections it is suggested by some theorists, would lead companies to favour using retained earnings to finance investment projects rather than making a fresh equity issue. This implies a residual approach to dividend policy, as the first claim on retained earnings will be the financing of investment projects. With a residual dividend policy, the primary focus of the firm's management is indeed on investment, not dividends. Dividend policy becomes irrelevant; it is treated as a passive, rather than an active, decision variable. (Crutchley 2004 36-46)The view of management in this case is that the value of the firm and the wealth of its shareholders will be maximised by investing earnings in appropriate investment projects, rather than paying them out as dividends to shareholders. Thus managers will actively seek out, and invest the firms earnings in, all acceptable (in terms of risk and return) investment projects, which are expected to

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