A dividend policy is “the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders” (Investopedia). There are many varying policies that can be adopted, and each company can determine its own policy.
When deciding on how much to pay out in dividend in a year, the directors should firstly consider the company’s current dividend policy, as this may have a significant impact on the decision.
Changing the dividend policy will result in a change in dividend pay out. This is commonly seen as a signal (‘The Signalling Effect’) to the market of the information held by the company (information asymmetry). A decrease in dividends is perceived by the market to be a sign that the company has performed poorly and does not have enough profit to distribute the same level of dividends. An increase has the opposite effect in that the company sends the signal that it is prosperous and it is a sign that the company will perform well again.
It is because of this that many see a stable increase in dividend as the most favourable dividend policy (Dividend Stability). The strength of the market signal is such that some companies will pay out dividends that will continue this stable increase even if the company has not made profits (they will instead pay them out of retained earnings).
However, if the company has a reputation for maintaining a stable dividend policy, it will be expected of them to continue this stability. This therefore puts added pressure on the company to generate profits to satisfy this dividend policy.
In addition, the annual return received by shareholders is made up of dividends and capital gains. However, the share price continuously fluctuates, and thus capital gains is a highly uncertain return for shareholders, and also means that should the share price fall, capital gains will fall too. Therefore it is argued that shareholders value dividends above capital gains – the bird-in-hand theory. This suggests that, the dividend policy is more likely to focus on increasing dividends (cash in hand) than capital gains.
Gordon (1959) suggested a direct relationship between the dividend payout ratio and the price-earnings ratio, indicating that a high dividend increases the share price of the firm, and thus increases the capital gains as a subsequent benefit. In contrast, the ‘tax’ argument suggests that a lower dividend payout would be preferable, as if dividends are taxed at a higher rate than capital gains, investors will prefer higher returns on their capital gains.
The Clientele Effect suggests that shareholders are attracted to companies that suit their return requirements, whether this be dividends or capital gains. This may be due to the shareholders cash requirements, tax position and prospects for current or future wealth.
For a more in-depth look at dividend policy and factors affecting the policy chosen by a particular company, click here.
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