Dividend policy: theories, approaches and alternatives to cash dividends

At the end of a good year, a company has ₦100m of profit. It can pay it all to shareholders, keep it all to fund new projects, or split it. Shareholders have different wishes: a retired teacher wants income, a young investor wants growth. The board’s choice sends a signal to the market, affects the share price and has to be funded from cash, not just from profit. This is the dividend decision.

This topic covers why dividend policy matters, Modigliani and Miller’s theory that it does not, the real-world influences that make it matter, the traditional view, the clientele effect, the bird-in-hand argument and dividend signalling, the main approaches (constant pay-out, residual, hybrid and special dividends), the practical and legal limits, the alternatives to a cash dividend and the key dates.

The previous area covered strategic management. The next topics cover emerging issues and technology in finance. Neither the May 2014 nor the November 2014 Pathfinder sets a stand-alone question on dividend policy, but a dividend calculation often sits inside valuation and financing questions.

Key terms in plain English

Syllabus check

This topic is in syllabus area C (financing decisions), under sources of finance. It covers:

• the theories of dividend policy and their assumptions;
• the approaches a company can take and the practical influences on the amount;
• alternatives to a cash dividend.

CAMA 2020 and dividends

The Companies and Allied Matters Act 2020 (CAMA 2020) sets the legal limits on dividends. Under CAMA 2020, dividends are paid only out of distributable profits (ss. 426 and 427).

Why dividend policy matters

Earnings are either paid out or retained. Retained earnings fund investment. Most companies announce a dividend policy and keep paying even when they raise new capital. The aim of management is to maximise shareholder wealth, which comes from the dividend and from the capital gain in the share price.

The dividend decision is a decision on how the return is delivered: how much to pay now and how much to reinvest so that it comes back as a capital gain.

Modigliani and Miller: dividend irrelevance

MM built a model on simplifying assumptions: perfect capital markets (all investors value securities alike, no dealing costs, perfect information) and no tax (or no difference between tax on dividends and on gains). They did not say the real world is like this. The model sets a base from which to measure the effect of real influences.

Conclusion: dividend policy is irrelevant. The total value of a company is the same at a pay-out of 0%, 100% or anything between. Value depends on earning power from investments. If a company with ₦100m of earnings has positive-NPV projects costing ₦100m, it can keep the earnings or pay them out and raise ₦100m of new equity.

If it pays out, the existing shares fall by the amount of the dividend, and the new equity replaces that value, so total equity value is unchanged. A shareholder who wants cash can take a dividend or sell some shares and be no worse off.

Real-world influences

• Transaction costs: selling shares to create income costs money, so income investors prefer dividends.
• Taxation: if dividends are taxed more heavily than gains, shareholders prefer gains, and the opposite also holds.
• Imperfect information: shareholders cannot be sure of the value of the future gains, so many prefer cash now.
• Costs of raising capital: issuing new shares costs money, so retaining earnings can be cheaper than paying out and raising equity.
• Shareholder preferences: some want income, some want growth and many want a mix. Microsoft paid no dividend for many years, then announced a very large distribution (ICAN’s example).

The traditional view and the relevance theories

The traditional view is that dividend policy should be set to maximise share value. Retained earnings give growth, which raises later dividends. The best policy is the one that maximises the price in the dividend growth (Gordon) model, P0 = D1 ÷ (ke − g). It describes practice but does not explain it.

• Clientele effect: because of different tax treatment and dealing costs, shareholders care how the return arrives. A company should pick a policy and keep to it, so that it attracts shareholders who like it.
• Bird-in-hand: a certain dividend now is worth more than an uncertain future gain, so investors generally prefer dividends.
• Signalling: managers know more than shareholders (information asymmetry) and can use dividends to signal prospects. A dividend higher than expected may signal confidence and raise the price. A lower one may signal trouble and lower it. A clear explanation can reduce the effect. Research suggests that dividends do reduce information asymmetry.

Approaches to dividend policy

Constant pay-out ratio (stable policy)

Dividends are a set percentage of earnings, so they rise and fall with earnings. If earnings per share grow each year, so do dividends, and shareholders can predict them from profit forecasts.

Residual policy

Invest in every positive-NPV project first, fund it from retained earnings if possible, and pay the residual as the dividend. It maximises value in theory but dividends fluctuate with the projects available, so shareholders cannot predict them. Many firms that keep a fixed debt-to-equity ratio end up with a residual policy, because the ratio decides how much of each project is funded by equity.

Hybrid policy

A mix of the two: a regular dividend that can be kept up, plus an extra dividend when the year is good. Cyclical industries tend to use it.

Special dividend

A one-off distribution, usually of cash, after exceptionally strong results or when the company has a large surplus (ICAN gives Microsoft’s $32 billion payment in 2004), or when it changes its financial structure or spins off a subsidiary.

Practical influences

• Investment opportunities: if few projects earn enough, surplus cash should go back to shareholders.
• Legal constraints: dividends come only from distributable profits, and loan agreements may add limits to protect lenders.
• Liquidity: retained profit is not retained cash. A profitable company may be short of cash, and a dividend must not threaten liquidity.
• Other factors: the policies of similar firms, loan repayments, tax and inflation.

Alternatives to a cash dividend

• Scrip dividend: new shares instead of cash. It keeps cash in the company without cutting the dividend. Exchange rules may require a cash alternative, and scrip dividends are uncommon in Nigeria.
• Share repurchase: an over-capitalised company with surplus cash buys back shares. A higher dividend may signal that high payments will continue, but a buy-back does not change expectations of future dividends.

Dates

A dividend may be final only, or interim plus final. Declaration date: the board announces it. Record date: the share register is closed to decide who is paid. Payment date: the dividend is paid. In practice there is also an ex-dividend date: a buyer after that date does not get the dividend, so the share price drops by about the dividend.

The rules in more depth

Why MM is still taught

It shows what drives value (investment returns) and lets us test each real-world factor one at a time.

Why the traditional view and MM can both be partly right

In the real world each factor pulls differently. Taxes and costs may favour retention, while uncertainty and preferences favour payment.

Why a cut in dividend hurts the price

Shareholders read it as bad news, even if the cut is sensible. The company should explain it.

Why retained cash is not retained profit

Profit may be tied up in inventory and receivables. A dividend is paid in cash.

Effect on analysis

When you advise on a dividend, state the policy, test it against investment needs, cash, the legal limit and the signal.

Worked examples

1. 20% pay-out:
   retention 80%, g = 8%.
   D0 = 20, D1 = 20 × 1.08 = 21.60.
   P0 = 21.60 ÷ (0.12 − 0.08) = ₦540.
2. 40% pay-out:
   g = 6%.
   D0 = 40, D1 = 42.40.
   P0 = 42.40 ÷ 0.06 = ₦706.67.
3. 60% pay-out:
   g = 4%.
   D0 = 60, D1 = 62.40.
   P0 = 62.40 ÷ 0.08 = ₦780.
4. The company earns 10% on retained cash, which is below the 12% shareholders require, so paying more raises the price. If it could earn more than 12%, retaining would raise value.

1. Year 1: total 9m = equity + 0.5 equity, so equity = 6m and debt = 3m.
   Dividend = 10 − 6 = ₦4m.
2. Year 2: equity = 3 ÷ 1.5 = 2m.
   Dividend = 10 − 2 = ₦8m.
3. The dividend doubles from one year to the next, which shows the weakness of the residual policy.

1. Cash dividend.
   20,000 × 3 = ₦60,000.
2. Scrip alternative.
   60,000 ÷ 60 = 1,000 new shares.
3. The company keeps ₦60,000 for each such holder, and the shareholder’s stake rises by 5%.

1. Shares bought.
   200 ÷ 50 = 4m.
   Shares left = 96m.
2. EPS before.
   300 ÷ 100 = ₦3.00.
   EPS after = 300 ÷ 96 = ₦3.125.
3. EPS rises, but only because the share count falls. In practice the lost interest on the cash lowers earnings a little.

How to score full marks

• State the theory with its assumptions and then the real-world departures.
• Calculate the policy results and compare them.
• Test the dividend against investment needs, cash and the legal limit.
• Mention the signal a change would send.
• Consider alternatives such as scrip dividends and buy-backs.
• Recommend a policy and give the reason.

Common mistakes in the exam

• Saying MM claim that dividends do not exist.
• Giving the theory but not the assumptions.
• Confusing the clientele effect with signalling.
• Paying a dividend that exceeds distributable profits or available cash.
• Forgetting that a scrip dividend keeps cash in the company.
• Treating a dividend cut as neutral news.

Quick revision

• Return = dividend + capital gain.
• MM: irrelevant with perfect markets and no tax.
• Real world: transaction costs, tax, information, issue costs, preferences.
• Relevance: clientele, bird-in-hand, signalling.
• Approaches: constant pay-out, residual, hybrid, special.
• Limits: investments, law, liquidity. Alternatives: scrip, buy-back.
• CAMA 2020: ss. 426, 427, 432, 308.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

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