Dividends are payments made to stockholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods.
Dividends may affect capital structure: Retaining earnings increases common equity relative to debt. Financing with retained earnings is cheaper than issuing new common equity.
There are basically two options that a firm has while utilizing its profits after tax:
- Sloughing back the earnings by retaining them
- Distribute the same to the shareholders. (Cash Dividends or stock dividends)
Option I is suitable for firms that need funds to finance their long-term projects, which have growth potential and sufficient profitability.
Option II is suitable for that firm whose objective is to maximize the shareholder's wealth.
What is a dividend policy?
In Finance Management, once a company makes a profit, it must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.
Residual Dividend Policy: The term residual dividend refers to a method of calculating dividends. A dividend is a payment made by a company to its shareholders. It is essentially a portion of the company's profits that is divided amongst the people who own stock in the company. A residual dividend policy is one where a company uses residual or leftover equity to fund dividend payments. Typically, this method of dividend payment creates volatility in the dividend payments that may be undesirable for some investors.
Dividend Policy and Stock Value:
- Dividend Irrelevance Theory: This theory purports that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
- Optimal Dividend Policy: Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm's stock price.
- Dividend Relevance Theory: The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.
Various Dividend Models:
- Dividend Relevance Model
- Traditional Model
- Walter Model
- Gordon Model
- Dividend Irrelevance Model
- Miller & Modigliani Position
Traditional models: It is given by B Graham and DL Dodd. This model lays down a clear emphasis on the relationship between the dividends and the stock market. According to this model, the stock value responds positively to higher dividends and negatively when there are low dividends.
This model establishes the relationship between market price and dividends using a multiplier.
P/E ratios are directly related to the dividend payout ratios i.e. a higher dividend payout ratio will increase the P/E ratio and vice-versa.
P = m (D+E/3)
Where; P = market price
M = multiplier
D = Dividend per share
E = Earnings per share
- P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose payout is low but its earnings are increasing.
- This approach does not hold good for those firm whose payout is high but have slow growth rate.
- There may be few investors who would prefer the dividends to the uncertain capital gains and a few who would prefer low taxed capital gains.
- These conflicting factors have not been properly explained by traditional approach.
Walter Model: The dividend policy given by James E Walter considers that dividends are relevant and they do affect the share price. In this model, he studied the relationship between the internal rate of return (r) and the cost of capital of the firm (K), to give a dividend policy that maximizes the shareholders’ wealth.
The model studies the relevance of the dividend policy in three situations;
r > Key
r < Key
r = Key
According to Walter When r > Key the firm has to adopt Zero% payout policy.
r < key the firm has to adopt 100% payout policy.
r = key any policy between 0 to 100% payout.
Types of Dividends:
- Cash dividends: Money paid to stockholders, normally out of the corporation's current earnings or accumulated profits. All dividends must be declared by the board of directors and are taxable as income to the recipients.
- Stock Dividends: A dividend payment made in the form of additional shares, rather than a cash payout. Also known as a "scrip dividend.
Dividend Yield: A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:
Dividend Yields=Annual Dividends per share/Price Per share