Dividend Policy free essay sample

Once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn affect investors and perceptions of the company in the financial markets. Objective Dividend is a taxable payment declared by a companys board of directors and given to its shareholders out of the companys current or retained earnings. This coursework examines and investigates into the dividend policies adopted by companies listed on the London stock exchange and the factors that determine dividend policy. Introduction Firms use dividends as a mechanism for financial signaling to the outsiders regarding the stability and growth prospects of the firm. Secondly, dividends play an important role in a firms capital structure. Yet another set of studies have established the relationship between firm dividend and investment decisions. According to the residual dividend theory, a firm will pay dividends only if it does not have profitable investment opportunities, i. . , positive net present value projects Methodology Major theoretical and empirical papers on dividend policy are identified and reviewed. Critically discussed and compared dividend policies of three different companies. Literature Review The first empirical study of dividend policy was provided by Lintner (1956), who surveyed corporate managers to understand how they arrived at the dividend policy. Lintner found that an existing dividend rate forms a bench mark for the management. Companies’ management usually displayed a strong reluctance to reduce dividends. Lintner opined that managers usually have reasonably definitive target payout ratios over the years, dividends are increased slowly at a particular speed of adjustment, so that the actual payout ratio moves closer to the target payout ratio. Dividend irrelevance theory If a company makes money, in the form of cash inflows, that money belongs to shareholders. It should not matter whether a company keeps money and invests it or returns the money to shareholders. This is what is assumed, correctly, by most valuation methods. It is also possible to show that it should make little difference to investors whether dividends are paid or not as investors they can reproduce the cash flows of different dividend policies. For example, if a company pays out dividends, but an investor would prefer the money to be re-invested, then the investor can simply use the dividends to buy more shares. Dividend relevance theory Dividend relevance is a theory relating to the impact of dividends on organizations and individual investors. The theory advanced by Gordon and Lintner, establishes that there is a direct relationship between a firms dividend policy and its market value. Investors respond to receiving actual cash returns. Gordon and Lintner refer to this as the â€Å"Bird in hand theory† another name for dividend relevance. According to the Hewitt Investment Group, â€Å"Gordon and Lintner†assert that dividends received today are preferable to future dividends, which are subject to uncertainty. Higher certainty will cause investors to ascribe a higher risk premium to those payments, thereby increasing a firms cost of capital (by decreasing the value of stock)† (Hewitt, 2002, p. 5). Miller and Modigliani [1961] view dividend payment as irrelevant. According to them, the investor is indifferent between dividend payment and capital gains. Miller and Rock [1985], for instance, develop a model in which dividend announcement effects emerge from the asymmetry of information between owners and managers. The dividend announcement provides shareholders and the marketplace the missing piece of information about current earnings upon which their estimation of  the firms future (expected) earnings is based. The latter, of course, determines the current market value of the firm. In this respect, we can clearly see the role played by dividends. The dividend announcement provides the missing piece of information and allows the market to establish the firms current earnings. These earnings are then useed in predicting future earnings. John and Williams [1985] construct an alternative signaling model in which the source of the dividend information is liquidity driven. There are other factors influencing a firms dividend policy. For example, some studies suggest that dividend policy plays an important role in determining firm capital structure and agency costs. Since Jenson and Meckling [1976], many studies have provided arguments that link agency costs with the other financial activities of a firm. Easterbrook [1984] says that firms pay out dividends in order to reduce agency costs. Dividend payout keeps firms in the capital market, where monitoring of managers is available at lower cost. If a firm has free cash flows [Jensen (1986)], it is better off sharing them with stockholders as dividend payout (or retiring the firms debt) in order to reduce the possibility of these funds being wasted on unprofitable (negative net present value) projects. Factors determining Dividend Policy External Factors 1) Phase of trade cycle:-During the phase of boom, company may not like to distribute huge amount of profit by way of dividend though earning capacity is more because company will like to retain more profit which can be used during depression. Similarly, during depression company will like to hold dividend payment in order to preserve its liquidity position. 2) Legal Restrictions:-If a company wants to pay dividend in cash, provisions of company’s act 1956 are required to be followed by company. If the company wants to issue bonus shares, relevant SEBI guide lines are required to be followed by the company. 3) Tax Policy:-From companies point of view dividend can be paid out of profit after tax. From shareholders point of view, dividend received by them is considered to be a taxable income which increases their individual tax liability. 4) Investment Opportunities:- If investment opportunities involve higher rate of return than cost of capital, the company will like to retain profits to be invested in these projects. )Restrictions imposed by lending institutions:- Sometimes, lending banks or financial institutions impose certain restrictions on the company preventing payment of dividend if certain conditions are not fulfilled such as interest on loan is not regularly paid by company. Internal Factors 1) Attitude of Management:-If attitude of management is aggressive, it may decide to pay more dividend as the management is interested in increasing income of share holders. Whe re as if the attitude of management is conservative, company will like to retain more profits to take care of contingencies. ) Age of Company:-A growing concern will like to retain maximum profit in business in order to raise the funds while old company may follow high dividend policy. 3) Composition of Share Holders:-If a company is Private Ltd. Company having, having less number of shareholders, the company will like to retain more profits and reduces dividend. If the company is a public limited company, tax brackets of individual shareholders may not have significant impact on dividend policy of company. ) Nature of Business:-A stable company may follow long term dividend policy where as an unstable company may like to retain its profits during boom to ensure dividend policy is not affected by cyclical variations. 5) Growth rate of company:-A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs. However, care should be taken by management to invest only in those projects which yield more returns than its cost of capital. 6) Liquidity Positions:-Be fore formulating dividend policy due considerations should be given to liquidity position of ompany. Example at present, company’s cash position may be comfortable, but it may need cash within a short time to pay installments of term loans or to pay creditors for materials. In such case, finance manager may not like to impair its liquidity for making dividend payment. 7) Customs Traditions:-also affect dividend policy. Exploration and production activities include oil and natural gas exploration and field development and production (upstream activities); together with pipeline transportation and natural gas processing (midstream activities). The British Petroleum PLC pays to its shareholders dividends every three months, i. e. quarterly, in cash. The following table shows the three years Dividends (pence per ordinary share) BP PLC. As I have mentioned earlier that BP pays its shareholders every three months however, I have only declared the total yearly figure of the last three years.