Summary DIVIDEND POLICY DIVIDEND THEORIES

SUMMARY NOTES

BY

STEPHEN ODHIAMBO





DIVIDEND POLICY & DIVIDEND THEORIES



4.1 INTRODUCTION

Dividends are part of the earnings which are distributed to the ordinary shareholders for
investing in the company. The dividend decision is important to the company because
of two main reasons:-

• It provides the solution to the dividend puzzle i.e. Does payment of dividend
increase or reduce the value of the firm?
• It is part of the company’s financing strategy i.e. payment of high dividend
means low retained earnings and hence the need for more debt capital in the
company’s capital structure.
In this lesson we will seek to answer some critical questions surrounding the dividend
puzzle. These are:-

• When should the firm pay dividend?
• How much dividend should the company pay?
• How should the firm pay dividends?
• Why should the firm pay dividends?
•
• Lecture outline
• 4.1 When to pay dividend
• 4.2 Dividend policy
• 4.3Different forms of dividends
• 4.4Dividend theories

, • 4.5Normal practice in dividend payment
•
• Learning outcomes
• By the end of this chapter you should be able to
• Explain why firms pay or not pay dividends
• Justify why a firm may not distribute all its earnings as dividends
• Explain the different forms of dividends
• Critique the dividend theories and relate them to the practice
•
•
4.2 When should the firm pay dividends
A company can pay dividends twice in the course of the year that is interim and final or
it can pay dividends once in a year that is final dividends.

The question on whether to pay interim and final or just the final dividend will depend
on:-

• The company’s liquidity position.
• The expectation of the shareholders.
• The need for cash for financing purposes.




• How much dividend to pay
There are four different dividend policies which influence the amount of dividend
per share a company can pay. These include:-

• Constant pay out policy
• Constant or fixed Dividend per share policy
• Low constant DPS plus bonus or surplus
• Residual dividend policy



4.3.1 Constant payout policy

, Under this policy a company could pay a fixed proportion of its earnings attributable
to ordinary shareholders as dividends. Since the earnings fluctuate over time the
EPS and the total dividends payable and dividends per share will also fluctuate over
time.

This policy has the following implications:-

• It creates uncertainty as to the amount of dividend income receivable by the
shareholders.
• The shareholders may require a higher rate of return to compensate them
for the uncertainty.
•
4.3.2 Constant or fixed DPS policy

Under this policy the company could pay a fixed amount of DPS irrespective of the
levels of earnings. Therefore in this case the ordinary shareholders are treated as
preference shareholders because they receive fixed dividends. In this case the EPS may
fluctuate over time but the DPS remains constant. This policy has the following
implications:-

• It creates certainty and its therefore preferable to the low income
shareholder’s who have a high preference for dividends instead of capital
gains.
• The certainty reduces the shareholders required rate of return.
• When the firm has high earnings more income will be retained for future
financing needs.
4.3.3 Low constant DPS plus bonus or surplus

Under this policy the DPS is set at a very low level and paid every year. However, a
bonus or extra dividend is paid in the years of supernormal earnings. This extra
dividend is paid in such a way that it’s not seen as a commitment for the firm to
continue paying it in the future. Therefore, the EPS will be fluctuating every time
while DPS will remain constant with occasional bonuses or surplus.