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M.Sc. Finance

M.Sc. International Banking and

Finance and

M.Sc. International Accounting and Financial

Studies

FINANCE III

UNIT 3

DIVIDENDS

PREVIEW

Aims

The aims of this unit are to provide an introduction to the dividend behaviour of

companies, to consider the relationship between the dividend policy of a company and

the value of its shares, and identify the primary factors that a company should take into account in developing its dividend policy.

Objectives

After completing this unit you should be able to

• understand the primary characteristics of the dividend policies adopted by companies in the UK;
• analyse the market’s reaction to dividend announcements;
• explain the nature of the dividend irrelevancy theory;
• appreciate the role of transactions costs, taxes, and costly and imperfect information in influencing dividend decisions;
• explain the nature and role of the clientele effect;
• evaluate the empirical evidence relating to dividend decisions; and
• differentiate between relevant and irrelevant considerations in taking dividend decisions.

INTRODUCTION

Expected dividends are generally perceived to be critical determinant of the price of a

share. Investors are assumed to buy shares for the dividends they are expected to

produce. This allows share prices to be modelled as the present value of the expected value of the stream of future dividends. But even if it is accepted that expected

dividends are a key determinant of share prices it does not necessarily mean that a

company can influence its share price by changing its dividend policy – the proportion of its earnings or profits paid out as dividends to shareholders.

It is not feasible for a company to change its dividend policy without this affecting either its investment policy or the level of its external funding. A company that

decides to pay out more of its earnings in the form of dividends will have less earnings

available for use within the company. This implies it will either have to cut back on its investments in new assets, or if its investment plans are to be maintained it will have to issue more shares or increase its borrowing.

Consider a company with promising investments to exploit. It can fund its investment programme by retaining earnings or by seeking funds externally. If it chooses to retain earnings the dividends paid to shareholders in the short term will be lower than they would be if external funding was arranged. The shareholders of a company funding its investments by retentions at the expense of immediate dividends can expected to be compensated for their short term sacrifice by higher dividends in the future. Whilst they will have to wait for these future cash dividends it does not mean that their investment return will be any lower in the short term. In principle the value of their shares should increase in line with retentions, producing capital gains to

dividend policy given investment policy, is ‘obvious once you think of

it’. It is, after all, merely one more instance of the general principle that there are no ‘financial illusions’ in a rational economic environment. Values are determined solely by real considerations – in this case the earning power of the firm’s assets and its investment

policy – and not on how the fruits of the earnings power are

‘packaged’ for distribution .”

Miller and Modigliani (1961)

The debate on dividend policy is to a large extent concerned with the question of whether or not the composition of the expected return on a share, in the form of the expected dividend yield and the expected capital gain yield,

E ( R

) = E ( D jt +1 ) + E ( Pt − 1 ) − Pt

jt

t t

influences the overall expected rate of return. If the view that the market favours high payouts is correct the higher the expected dividend payment in relation to retentions the higher the share price. The higher the share price associated with high payout implies a lower overall expected rate of return. Of course if this line of reasoning is correct a company increasing its payout ratio would see its share price increase, producing on a temporary basis a high rate of return. The alternative view put forward by Miller and Modigliani is that its share price is independent of the payout policy and the breakdown of its expected return into the dividend yield and capital gains yield.

Before embarking on a more detailed discussion of dividend policy we should establish some realistic expectations about the possibility of resolving the issues surrounding dividend policy. Fisher Black of the Black and Scholes model, one of the outstanding figures in the development of modern financial theory, has written

“ What should the individual investor do about dividends in his portfolio? We don’t know.

What should the corporation do about the dividend policy? We don’t

• companies typically pay out a relatively high proportion of their earnings in the form of dividends;
• dividends constitute the most important form of payout of cash by firms to shareholders, but this can also be done at the individual firm level through the repurchase of shares and at the aggregate level by takeovers paid for in cash;
• many shareholders in the USA, and to a lesser extent in the UK, receive large dividend payments on which substantial amounts of tax are paid, despite their appearing to be more tax efficient ways of securing the returns from their investment;
• companies tend to be very cautious about increasing dividends and are very reluctant to cut dividends, and appear to engage in dividend smoothing exercises; and
• the stock market appears to react positively to the announcement of dividends increases and negatively to dividend decreases.

MECHANICS OF DIVIDENDS PAYMENTS

Prior to the announcement of a dividend payment the market will have formed a view

of the prospects of the company and this will be embodied in the share price. If the

proposed dividend differs from that expected by the market there is likely to be a

reappraisal by the market of the firm’s investment value, and a change in the share

price will possibly follow. In theoretical terms this is interpreted as an information

effect: the price of the share changes in response to the new information contained in the difference between the proposed dividend payment and the payment anticipated by

the market. But this is not simply a response to the payment of a smaller or larger

dividend than expected. The price reaction is likely in part at least to be the result of a change in expectations with respect to subsequent dividend payments. As we shall

see later, significant share price changes are usually attributed to a re-assessment of

the longer term ability of the company to generate earnings.

When a company pays dividends it is disbursing some of its assets to its shareholders so we would expected the market value of its equity to fall in the absence of taxes and transactions costs. The share price can be expected to fall in line with the dividend payment. The value of shareholders’ stake in the company falls whilst their holdings of cash increase.

Dividends will be paid to the shareholders of record on a date which is specified when the proposed dividend is announced. Following the announcement the share is trade in what is referred to as a cum-dividend basis: the entitlement to the expected dividend is bought and sold along with the share. This will continue up to the ex-dividend date

• the day on which the share ceases to be traded with an entitlement to the dividend. When a share goes ex-dividend a fall in the share price can be anticipated. It seems

reasonable to assume that the price investors will be prepared to pay immediately

before the share goes ex-dividend will exceed the price immediately afterwards by the amount of the dividend:

P (^ Cum^ −^ dividend^ )^ −^ P (^ Ex^ −^ dividend^ )^ =^ Dividend Per Share

dividend pa yment date day day

time

Figure 3.1(b) Dividend Announcements And Ex-Dividend Price Reactions

Continuing Market Adjustments And Change In Expectations

Share Price Pt

announcement ex

dividend pa yment date day day

time

Firms are not under any contractual obligation to pay a dividend. Whether a dividend will be paid, and how much is paid, are decisions taken by a company’s board of directors. The decisions are constrained to the extent that dividends must be paid from realised profits. Companies may pay out more in the form of dividends than their current profits in any one year, but only if the company has built up retained earnings in previous years. Dividends cannot be paid if this implies that the company’s capital will be reduced. (Dividends are paid from cash rather than current

Figure 3.2 Dividend Payout Ratio: UK Industrial And

Commercial Companies, 1963-

Per Cent

40

Source: Economic Trends Annual Supplement 1994, Bond et al (1995)

The higher payout ratio for the UK is reflected in a higher than average dividend yield as indicated in table 3.1. (In principle a lower than average price-earnings could produce a higher dividend yield even though the payout ratio was no higher than average – but the price-earnings ratio in the UK is no lower than that of other countries.)

Table 3.1 Dividend Yields in the G7 Countries, 1992 and 1993

Canada 2.5 2. France 2.9 2. Germany 1.7 2. Italy 1.6 2. Japan 0.8 0. UK 3.9 3. US 2.7 2.

Source: Bond et al (1995)

DETERMINING DIVIDENDS PAYMENTS

One of the most important studies of how companies determine their dividend policies

was undertaken some forty years ago by Lintner (1956). The study does not attempt

to relate the dividend policy of a company to its share price or return to shareholders so cannot throw any direct light on the relationship between a company’s value and its dividend policy, but it has been very influential in developing our understanding of

in period t ;

is the dividend in the previous period;

is the long run target

payout ratio; and is the adjustment factor.

the dividend in period t being simply the last dividend plus the change in dividend:

Dt = Dt − 1 + Δ D t

For example, a company might have a target payout ratio of 0.6 and an adjustment factor of 0.75. In the long term it aims at paying out 60 per cent of its earnings. But if in the short term earnings increases and a dividend based on the long term payout ration would exceed the previous dividend the firm will only increase its dividend by

75 per cent of the difference between the two. Assume a company with a dividend of

£1.20 in the last period records earnings per share in the current period of £3.00. A payout ratio of 60 per cent suggests a dividend of £1.80. If the dividends is increased to this level and earnings fall in subsequent time periods such a dividends payment may not be sustainable. So recognising this, the dividends is only increased by 0.75 of the difference between the long term target of £1.80 and the last dividend paid of

£1.20. This gives an increase of 0.95 times 60p or 45p and a dividend of £1.65 for the

current period. [see the example below on how dividends would evolve for a

company over time.]

Based on this analysis, Lintner used the following statistical model to explain dividend changes of companies over time:

Δ D it

= a i + si [ z e EPS it − D i , t − 1 ] + U it

where

i

a i

U it

refers to firm i

a constant terms; and

an error term

It was found to be possible on this basis to explain 85 per cent of the changes in the

dividend for the companies

in Lintner’s sample (the average value of z

and s were

found to be 50 per cent and 30 per cent respectively). Fama and Babiak (1968) report more comprehensive tests and further provide support for Lintner’s model. (The found that adding a term for the lagged earnings and suppressing the constant term only produced marginal improvements over the basic Lintner model). The following example illustrates the mechanical operation for the Lintner model.