Question

Dividend Policy (Ch 15) : Explain clearly and completely?

What are the Pros and cons of a high dividend payout and factors related to these?
Why dividend stability is important (especially information signaling, clientele effect)?
Stock dividends and stock splits Stock repurchases?
Relevant dates (from book on your own)?

Answer 1

1 . Paying dividends to investors has several advantages, both for the investors and the company:

Investor Preference for Dividends
The investors are more interested in a company that pays stable dividends. This assures them of a reliable source of earnings, even if the market price of the share dips.

Bird-in-hand Fallacy
This theory states that the shareholders prefer the certainty of dividends in comparison to the possibility of higher capital gains in future.

Stability
Investors prefer companies that have a track record of paying dividends as it reflects positively on its stability. This indicates predictable earnings to investors and thus, makes the company a good investment.

Benefits without Selling
Investors invested in dividend-paying stocks do not have to sell their shares to participate in the growth of the stock. They reap the monetary benefits without selling the stock.

Temporary Excess Cash
A mature company may not have attractive venues to reinvest the cash or may have fewer expenses related to R&D and expansion. In such a scenario, investors prefer that a company distributes the excess cash so that they can reinvest the money for higher returns.

Information Signalling
When a company announces the dividend payments, it gives a strong signal about the future prospects of the company. Companies can also take advantage of the additional publicity they get during this time.

Paying dividends also has several disadvantages:

Clientele Effect

If a dividend-paying company is unable to pay dividends for a certain period of time, it may result in loss of old clientele who preferred regular dividends. These investors may sell-off the stock in short term.

Decreased Retained Earnings

When a company pays dividends, it decreases its retained earnings. Debt obligations and unexpected expenses can rise if the company does not have enough cash.

Limits Company’s GrowthPaying dividends results in

Paying dividends result in the reduction of usable cash which may limit the company’s growth. The company will have less money to invest in the business growth.

Logistics

The payment of dividends requires a lot of record-keeping at the company’s end. The company has to ensure that the right owner of the share receives the dividend.

2. Stability or regularity of dividends is considered as a desirable policy by the management of most companies. Shareholders also generally favour this policy and value stable dividends higher than the fluctuating ones. All other things being the same, stable dividends have a positive impact on the market price of the share.

Stability of dividends sometimes means regularity in paying some dividend annually, even though the amount of dividend may fluctuate from year to year and may not be related with earnings. There are a number of companies which have records of paying dividend for a long unbroken period. More precisely stability of dividends refers to the amounts out regularly. Three distinct forms of such stability may be distinguished.

From the point of view of shareholders as well as company the stability of dividends has various advantages.

1. Resolution of investor’s uncertainty:

When a company follows a policy of stable dividends, it will not change the amount of dividend if there are temporary changes in the earnings, Thus, when the earnings of a company fail and it continues to pay same amount of dividend as in the past, it conveys to investors that the future of the company is bright than suggested by drop in earnings.

2. Investor’s desire for current income:

The investors who desire (old and retired persons, women, children etc.) to receive a regular dividend income, will prefer a company with stable dividends to one with fluctuating dividends.

3. Institutional investors’ requirements:

The financial institutions like IFC, IDBI, LIC and UTI Generally invest in the shares of those companies which have a record of paying regular dividends.

4. Raising additional finances:

A stable dividend policy is also advantageous to the company in its efforts to raise external finances. Stable and regular dividend policy tends to make the shares of a company and investment rather than a speculation.

The loyalty finds goodwill of shareholders towards the company increases with a stable dividend policy.

3. Stock dividends

Like cash dividends, stock dividends and stock splits also have effects on a company's stock price.

Stock dividends are similar to cash dividends; however, instead of cash, a company pays out stock. As a result, a company's shares outstanding will increase, and the company's stock price will decrease. For example, suppose Newco decides to issue a 10% stock dividend. Each current stockholder will thus have 10% more shares after the dividend is issued.

Stock Splits

Stock splits occur when a company perceives that its stock price may be too high. Stock splits are usually done to increase the liquidity of the stock (more shares outstanding) and to make it more affordable for investors to buy regular lots (a regular lot = 100 shares). Companies tend to want to keep their stock price within an optimal trading range.

Stock Repurchase
A stock repurchase occurs when a company asks stockholders to tender their shares for repurchase by the company. This is an alternate way for a company to increase value for stockholders. First, a repurchase can be used to restructure the company's capital structure without increasing the company's debt load. Additionally, rather than a company changing its dividend policy, it can offer value to its stockholders through stock repurchases, keeping in mind that capital gains taxes are lower than taxes on dividends.