Dividend represents a share profit distributed to shareholders of a corporation, according to a certain payout ratio or more precisely according to certain dividend policy. Prudent companies save their cash until opportunities arise for acquisitions that have a real effect on earnings. Barring that, companies can decide to return cash to shareholders through dividends rather than buybacks.
Shareholders can then decide for themselves whether to buy more company shares with their dividend income or to use it on something else. Although dividend payments lead to taxes for investors, they give the individual more control than do share buybacks I- What is “dividend policy” Dividend policy decisions about when and how much of earnings should be paid as dividends. Earnings that are paid out as dividends cannot be used by the firm to invest in projects with positive net present values—that is, to increase the value of the firm.
With sales of $14. 3 billion in 2005, the company is committed to a digitally-oriented growth strategy focused on helping people better use meaningful images and information in their life and work. Kodak’s payout ratio ranged from 41. 1% to 52. 5% from 1975 to 1982 and it averaged to 50% during those 8 years. Earnings were relatively stable during those years, and dividends clearly tracked earnings. After 1980, Kodak’s earnings were much less stable. Global competition intensified.
Kodak lost major suit to Polaroid and booms and recessions alternated to lead to earnings variability. Management stopped increasing dividend when earnings fell but did not cut the dividend, even when earnings failed to cover the dividend. Thus, in 1985 and 1986, the payout ratio averaged more than 100%. Maintaining the dividend was Kodak’s way of signaling to stockholders that management was confident that the earnings decline was only temporary and that earnings would soon resume their upward trend. This was indeed the case.
Kodak’s earnings increased by almost 300% from 1986 to 1990,and its 1990 dividend payout ratio was approximately 50% which is about where Kodak likes to keep it. During the period from 19991 through 1993 Kodak maintained its dividend at the 1990 level despite a huge drop in earnings in 1990 level. There are two reasons for paying a stable and predictable dividend rather than following the residual dividend policy, where the dividend paid is set equal to the actual earnings minus the amount of retained earnings necessary to finance the firm’s optimal capital budget. Due the information content, a fluctuating payment policy would lead to greater uncertainty than would a stable policy.
Many stockholders use dividends for current consumption and they would be put to trouble and expense if they had to sell part of their shares to obtain cash if the company cut the dividend; this is in addition to the anxiety a dividend cut would cause them. Corporation’s actions such as delaying some investment projects or even issuing new common stock make it possible for a company to avoid the problems associated with unstable dividends.
If Eastman Kodak had paid out a constant percentage of earnings, it would have had to cut its dividend in several different years and this would have caused its stock price to fall sharply because investors would have taken the dividend reduction as a signal that management thought the earnings drops were permanent. However, Kodak’s stock price was relatively stable during the 1980s and early 1990s , in spite of earnings fluctuations. In the mid 1950s Lintner conducted a classic series of interviews with corporate managers about their dividend policies.
His description of how dividends are determined can be summarized by four statements:
- Firms have long-run target dividend payout ratios.
- Managers focus more on dividend changes than on absolute levels. Thus, paying a $2. 00 dividend is an important financial decision if last year’s dividend was $1. 00 but no big deal if last year’s dividend was $2. 00.
- Dividend changes follow shifts in long run sustainable earnings. Transitory changes are likely to affect dividend payouts.
- Managers are reluctant to make dividend changes that might have to be reversed.
They are particularly worried about having to rescind a dividend increase. Lintner suggests that the dividend depends in part on the firm’s current earnings and in part on the dividend for the previous year which in turn depends on that year’s earnings and the dividend in the year before. So dividend is a weighted average of current and past earnings. Note that Kodak’s long-run target payout ratio has been relatively constant expect for the depressed periods in the 1980s and in 1990s, it has fluctuated in the 40% to 50% range. Kodak like most companies establishes a target payout ratio.
The target is not hit in every year, but over time the average payout has been close to the target level. Of course, the target would change if fundamental changes in the company’s business were to occur. A policy of paying a low regular dividend plus a year-end extra good years is a comprise between a stable dividend and a constant payout rate. Such a policy gives the firm flexibility, yet investors can count on receiving at least a minimum dividend. Therefore, if a firm’s earnings and cash flows are volatile, this policy may be its best choice.
The directors can set a relatively regular dividend, low enough so that it can be maintained even in low profit years or in years when a considerable amount of retained is needed and then supplement it with an extra dividend in years when excess funds are available B) Clientele Dividend Theory: Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.
Investors might choose a particular stock due to the firm’s dividend policy—that is, some investors prefer dividends and others do not. If such a clientele effect does exist, then we would expect that a firm’s stock price will change when its dividend policy (payment) is changed. Capital market imperfections include also substantial transaction costs and differential interest rates. These all interfere with the dividend irrelevancy. Argument based on perfect capital markets, meaning that an individual cannot ‘costless’ adjust her dividend pattern to fit her preferred consumption pattern.
Therefore shareholders may prefer companies to supply them with their desired dividend pattern thereby creating a certain demand for specific patterns. Investors are attracted to different company policies, and when the company policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move. Unfortunately, this may mean that the shareholders may incur costs of adjustment. Therefore, an easily identifiable dividend pattern may avoid such costs to the shareholder.
At the same time, the company may incur consequential costs in the form of missed investment opportunities or costs of raising finance due to free cash flow shortage. That said, it is probably best that a company follows a consistent dividend policy that will hopefully attract the suitable clientele and minimize both adjustment costs for the investors and also the discussed consequential costs. Investors, who prefer regular cash income, are in a relatively low tax bracket and are risk averse, will probably be attracted companies that have high payouts, such as utilities companies.
Growth companies normally pay lower dividends and reinvest more of their free cash flows in new projects and expansion, thus providing higher capital appreciation. These companies attract investors in the high tax brackets with no pressing needs for cash. Another imperfection of capital markets is the need for information which is neither costless nor universally available. Therefore, a dividend declaration which is both free and universally available is thought to signal information to the market. Managers are extremely reluctant to cut dividends because a reduction in dividend is often read by the clientele as unfavorable information. Therefore, they generally increase dividends only if they are confident that future free cash flows will enable them to retain the established pattern.
A lot of controversies regarding taxes and dividend policy have attracted many academic interests. Financial theorists such as Brennan (1970), Masulis & Trueman (1988) have stipulated that taxes affect organizational corporate dividend policy. If this speculation were true, changes in corporate dividend payout would be expected whenever the government changes its income tax policy.
However, this does not always apply especially in the banking business. Linter (1956) had asserted that the major determinants of dividend policy are the anticipated level of future earnings and the pattern of past dividend. International Research Journal of Finance and Economics – (2008) . This discrepancy may have underpinned Modigliani & Miller (1961) theory, which provided a platform for the enormous debates and researches on dividend policy. Dividends are usually paid to owners or shareholders of business at specific periods.
This is apparently based on the declared earning of the company and the recommendations made by its directors. Thus, if there are no profits made, dividends are not declared. But when profits are made, the company is obligated to pay corporate tax including other statutory taxes to the government. This is an essential corporate responsibility particularly profit making companies. The taxes no doubt reduce the profits available at the disposal of the organizations, either to be retained or distributed as a dividend to shareholders of the company.
Dividend policy is the trade-off between retaining earning and paying out cash or issuing new shares to shareholders. Some firms may have low dividend payout because management is optimistic about the firm’s future and therefore wishes to retain their earnings for further expansion. It is hard to deny that taxes are important to investors. Although, dividend affects the shareholders tax liability, it does not in general alter the taxes that must be paid regardless of whether the company distributes or retains its profit (Brealey, Myers & Marcus 1999).
It is difficult to divorce dividend policy formulation of firms from the tax effect it attracts. The key tax features has to do with the taxation of dividend income and capital gains. For individual shareholders, effective tax rates on dividend are higher than the tax rates on capital gain. Dividends received are taxed as ordinary income. Capital gains are taxed at somewhat lower rates, and the tax on a capital gain is deferred until the stock is sold. Capital gains taxation makes the effective tax rate much lower because the present value of the tax is less.