Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess earnings so as to fund future growth internally. By with holding current dividend payments to shareholders, managers of growth companies are hoping that dividend payments will be increased proportionality higher in the future, to offset the retainment of current earnings and the internal financing of present investment projects.
Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth companies would prefer managers to have a share buyback program, whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends.
Capital structure substitution theory and dividends
The capital structure substitution theory (CSS)[1] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on the hypothesis that management "manipulates" capital structure such that earnings per share (EPS) are maximized.
As a corollary, the CSS theory is seen to provide management with (some) guidance on dividend policy - more directly in fact than other approaches, such as the Walter model and the Gordon model.
In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.
The theory provides an explanation as to why some companies pay dividends and others do not:
When redistributing cash to shareholders, management can typically choose between dividends and share repurchases.
In most cases dividends are taxed higher than capital gains, and thus investors - and management - would typically be expected to select a share repurchase.
However, for some companies share repurchases lead to a reduction in EPS, and it in those cases the company would select to pay dividends.
From the CSS theory, then, it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than
should prefer dividends as a means to distribute cash to shareholders, where
- D is the company's total long-term debt
- is the company's total equity
- is the tax rate on capital gains
- is the tax rate on dividends
Companies may then "target" a dynamic Debt-to-equity ratio.
The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.
Low-valued, high-leverage companies with limited investment opportunities and a high profitability, use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.[2]
Walter's model
Walter's model
[5]
holds that dividend policy is a function of the relationship between the company's return on investment and its cost of equity, and hence also affects the value of the company.
The argument
[6]
is that capital retained will be invested by the firm in its profitable opportunities, whereas dividends paid to shareholders are invested elsewhere.
Here, the firm's achievable rate of return, r, reflects as its return on equity; while the shareholders' required rate of return, is proxied by the firm's cost of equity, or ke.
Thus, if r < ke then the firm should distribute the profits in the form of dividends; however, if r > ke then the firm should invest these retained earnings.
The model assumes, at least implicitly, that retained earnings are the only source of financing, and that ke and r are constant (given these, the approach is subject to criticism).
Firm value, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is then expressed [6] via:
where,
- P = Market price of the share
- D = Dividend per share
- r = Rate of return on the firm's investments
- ke = Cost of equity
- E = Earnings per share
Residuals theory of dividends
Under a Residual Dividend policy,
[7]
[8]
dividends are paid out from "spare cash" or excess earnings - this is to be contrasted with [7] a "smoothed" payout policy.
A firm applying a residual dividend policy will evaluate its available investment opportunities to determine required capital expenditure, and in parallel, the amount of equity finance that would be needed for these investments; it will also confirm that the cost of retained earnings is less than the cost of equity capital. If appropriate, it will then use its retained profits to finance capital investments. Finally, if there is any surplus after this financing, then the firm will distribute these residual funds as dividends.
This policy will attract investors who appreciate that the firm is employing its capital optimally;[7] it also delays (or removes) the payment of the secondary tax on dividends. This policy, furthermore, requires fewer new stock issues and hence lower flotation costs.[8]
At the same time, a variable dividend policy may send conflicting signals to investors. It also represents an increased level of risk for investors, as dividend income remains uncertain, and the share price may respond correspondingly.
See also Residual income valuation and Retained earnings § Tax implications.