Thursday, September 01, 2011

All About Dividend Policy of Companies

The first step toward understanding the dividend policy is to recognize that it has different meanings for different people.

A decision on the dividends is often linked to other financing and investment decisions. Some companies pay lower dividends because the management is optimistic about the future and want to retain earnings to finance expansion. In this case, the dividend is a byproduct of investment decisions.

Suppose, however, that future opportunities vanish, company will announce a dividend increase and the share price collapses. In this case it is not always easy to lure investors (just be dividends) to stay-invested compromising their long term growth.

Another company could finance its investment by making extensive use of debt. This gives them the required liquidity for the payment of dividends. In this case, the dividend would be a byproduct of the decision to use debt. Therefore, we must isolate the dividend policy from other financial management problems.

The exact question that we ask is “What is the effect of a change in dividend policy of a company, without prejudice to its investment decisions and financing? Of course, the cash used to finance an increase in dividends have to come from somewhere else.

Maintaining the fixed capital expenditure and borrowing, there is only one possible source: bonus share issue. This dividend policy allows companies to retain their profits by not paying dividends but instead issuing bonus shares.

Companies do face a trade-off dividend policy. Businesses can distribute cash to their shareholders by paying dividends or by buying back its own shares (buy back).

The payment of dividends: In India the distribution of dividends is taken by the shareholders approving the budget. It decides on the granting of an ordinary dividend that does not necessarily have to be paid in a lump sum.

Limits to the distribution of dividends: the profits can be distributed in proportion to the results actually achieved in the financial statements. The board of directors may decide the distribution of an extraordinary dividend considering the if their balance sheet is healthy in term of accumulating reserves.

If there is a reduction that occurred in previous years that has led to a reduction of capital, company will not like share profits by distributing dividends till the capital has not been reinstated.

The predictability of dividends: The date that identifies if an investor is entitled to receive dividends, and anyone who holds shares before that date is entitled to the dividend. Dividends are paid in many forms: most of the dividends is paid in cash. For normal cash dividend, means that the company expects that they may be able to maintain this dividend payment in the future.

If the company does not want to give this type of insurance, they will instead pay dividend as ordinary and extraordinary. Investors should automatically understand that this is a special dividend and may not be repeated in future. Distribution of special dividends has never been a frequent phenomenon. There have been several cases of distribution by the banks near merger. Still extraordinary dividends are sometimes distributed after an acquisition.

Dividends are not always in cash: Often, companies distribute dividends in shares. You may notice that a stock dividend is very similar to a split of shares. Both increase the number of shares, and both reduce the value of each share, subject to all the other variables. None of the 2 helps you to become richer. The difference between the 2 cases is purely technical.

A stock dividend is in the accounts notes as a transfer from retained earnings to capital, while a splitting of shares appears as a reduction of the nominal value of each share. There are also other types of non-cash dividends. Companies for example, sometimes send to shareholders a sample of their products.

Who pays and who does not pay dividends: Among those companies that do not pay dividends are ones that paid dividends in past, but then entered into financial difficulties and were forced to conserve cash. The other companies who do not pay dividends are primarily growth companies as well as many fast-growing small businesses that have not yet reached its full economic profitability.

Investors in these companies are hoping that these companies will eventually able to generate enough profits and will start sharing them in the form of dividends. Investors is such shares mainly concentrate of market price appreciation. It seems that even the large companies in good economic health are less likely to pay dividends than they once were.

The share repurchase (buy back): the repurchased shares may be stored and sold from the assets of when the company would need liquidity. There is an important difference between the taxation of dividends and share buybacks.

While dividends are subject to their specific tax, shareholders who sell shares in a stock buyback only pay taxes on any capital gains realized. There are three main ways to buy back stock. The most common method is the one for which the company announces plans to buy shares on the market, just like any other investor (open market repurchase).

However, sometimes businesses are committed to regaining public offering with a number of shares at a specified price. Shareholders may then choose whether to accept this offer. Finally, the repurchase may take the form of a direct negotiation with a major shareholder.

The buybacks are as extraordinary dividends: they require a large amount of cash to be distributed to investors. But do not replace dividends. Most companies that repurchase shares is made ​​up of mature and profitable companies that also pay dividends. Therefore, the increase in the number of transactions to repurchase its own shares cannot explain the decrease in the share of firms that pays dividends.

Suppose a company has accumulated large amounts of cash not needed and would like to change its financial structure by replacing equity with debt. Normally it will repurchasing shares rather than distributing high dividends.

It is not surprising to find that share repurchases are more volatile than dividends: share buybacks explode in number during economic upswings, when firms accumulate excess liquidity, and decreased drastically during the recession. In some countries the share buyback is still banned, while many others are taxed as dividends, often at very high rates.

The repurchase of shares: the purchase of own shares must be approved by the board of directors, which should also galvanize the manner and duration of buying and holding. They can be purchased own shares within the limits of distributable profits and reserves resulting from the last approved financial statements.

What is the way in which companies decide to distribute dividends? the description of how dividends are determined can be summarized in four points:

1) companies have long-term objectives regarding the relationship of profit distribution (payout). In general, mature companies with stable earnings distribute a large amount of profits, growing businesses have low payout.

2) managers focus their attention more on dividend changes than on their absolute levels.

3) changes in dividends following the changes in long-term profits. Managers stabilize dividends. The transient changes hardly affect the profits on dividends.

4) managers are reluctant to change dividends or risk having to come back down. They worry in particular about the possibility of having to renege on a subsequent increase in dividends.
Experts have developed a model to explain with great clarity the payment of dividends. Here the model: Suppose that a company always adheres to its scheduled payout.

Then the following year the dividend payment (DIV 1) would equal a constant share of earnings per share (EPS 1): 1 DIV = dividend ratio target goal x = 1 EPS. The change in the dividend would be: 1 DIV – DIV 0 = change target goal x = ratio EPS 1 – DIV 0. A company always linked to their profit-sharing ratio will have to change the dividend to any change in earnings.

But the survey conducted, managers are reluctant to operate in this way. They believed that shareholders prefer dividends growing steadily. The variations of their dividends and then seemed to comply with the following model: 1 DIV – DIV 0 = correction factor x changes target = correction factor x (x objective relationship EPS 1 – DIV 0). The more society is conservative, moves more slowly towards its target and then lower its rate of correction.

The simple model suggests that the dividend depends in part on the current earnings of the company and in part by dividing the previous year which in turn depends on the profits of that year and dividing by the first of the year. We should be able to deliver dividends in terms of a weighted average between current and past earnings.

The probability of an increase in the rate of dividend should be increased during an increase in current earnings, should be reduced to some extent if they only increased the profits of previous years and so on. We expect that managers take into account the future prospects as well as past performance when setting the dividend.

The information content of dividends: In some countries you cannot trust the information provided by businesses. In such cases how does an investor separate marginally-profitable companies from those that really make a lot of profit? One clue is the dividend. They know that a company reports good earnings and pays generous dividends is putting his money into the hands of those who owns them (you shareholders).

We can therefore understand why investors should evaluate the information content of dividends and refuse to believe in profits reported by companies unless they are comforted by an appropriate dividend policy. Of course, firms can cheat in the short term, overestimating profits and trying to make the money to pay generous dividends. However, it is difficult to cheat in the long term, as a company that does not generate sufficient cash will not have enough to distribute to shareholders.

If a company chooses to distribute high dividends without having the cash flows they support, that company will eventually be forced to reduce its investment plans or return to the market to search for additional sources of funding. Each of these consequences has a cost. For this reason, the majority of managers does not increase dividends until it is quite certain that there will be sufficient cash flow to finance it (in future).

Note that investors do not put too much attention to the level of dividends a company, but are concerned about their change, they interpret as an important indicator of the sustainability of profits. It seems that investors in some countries give less importance to changes in dividends (eg Japan).

The information content of share buybacks: Unlike dividends, buybacks are frequently an event that is not repeated. It follows that a firm announcing a stock buyback program is not taking long-term commitments to earn and distribute cash. The information contained in the announcement of a buyback is therefore likely to be different from that related to the payment of dividends.

The companies bought back shares when they have accumulated more cash than they can invest in profitable projects or when you want to increase their level of indebtedness. None of the two circumstances is good news in itself, but shareholders are frequently relieved to see companies deploy excess liquidity rather than see it invested in unprofitable projects. The shareholders also know that companies have to serve a very high debt probably will try not to waste the cash flows they generate.

Announcements of stock buyback programs on the market has found that, on average, they are greeted by an abnormal rise in stock prices. The buybacks can also be used to signal management’s confidence in the future. Suppose you believe that your title is substantially underestimated. Announce that your company is willing to buy back a tenth of its shares at a price that is 20% higher than the current market price.

Investors jump to the obvious conclusion that you believe that the action is at a good price even at 20% more than the current market price. And if the management also undertakes not to sell their shares, the researchers found that ads to repurchase the shares through a public offering at a higher price than the market caused a sharp rise in share price.

The negatives of Dividend: we wonder now if the decision on dividends creates value or if prices react positively to announcements of dividend increase in effect only for a signal. There are three opposing points of view. On the right we have the conservatives who believe that a dividend increase will help to increase the value of the company. On the left we have the radicals who believe that an increase in dividends instead will contribute to diminish the value of the company.

The dividend policy is irrelevant in a financial market perfect: Suppose that your company has developed its investment program. Have you identified whether this investment plan will be funded through debt or you would like to consume retained earnings? In this situation you decide to distributed extra dividends. Now think what would happen if you want to pay dividends, without compromising the investment policy. The additional money must come from somewhere.

If the company sets the upper limit of borrowing, the only way to finance the dividend increase is to print new shares and sell them. The new shareholders will take part with their money only if you can offer shares that are worth as much as cost. But how is this possible if the activities of the company, its earnings, its investment opportunities and thus its market value are all unchanged? The answer is that there must be a value transfer from old to new shareholders.

The new come into possession of new shares, each worth less than before the stall of the dividend, while the old bear of a decrease in their share price, which offset its loss of the higher dividend they receive. Constitutes a difference for the old shareholders receive a dividend and a higher capital loss of similar size?

Yes, if that’s the only way to receive cash, but in an efficient financial market can raise money by selling the shares. So, the old shareholders can cash out by convincing the management to pay a dividend or by selling greater part of their shares. In both cases, there would be a value transfer from old to new shareholders.

The only difference is that in the first case, this transfer is determined by a dilution of the value of each share in the second case is determined by a reduction in the number of shares held by existing shareholders.
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