Dividend Policies Adopted by Companies - Essay Example

? DIVIDEND POLICY Dividend is the payments that are given to the shareholders from the profits or reserves of a company. In the case of Associated British food company plc, the shareholders have experienced increasing dividends in the last four years. The management increased both the interim and final dividend throughout the four-year period. In 2007 the company paid an interim dividend of 6.5p which increased to 6.75p in 2008, 6.9p in 2009,7.6p in 2010 and finally 7.9p in 2011. For the case of the final dividend, the amount paid in 2008 was 13.5p, which was increased to 14.1p, 16.2p, 16.85p in 2009,200 and 2011 respectively (Associated British food, 2011). This is attributed to the increasing performance and profitability together with the increase in the performance of the general economy. Since the economy recovered from the recession and the inflation rates reduced, the company realized a reduction in the cost that made it post positive performance. The improving global economic performance also resulted in the increase in the sales turnover and improvement in ABF cash flows (Associated British food, 2011). Since the payments of dividends depends on the availability of cash flows, an increase in the cash inflows would result into an increase in the dividend that can be distributed to the company. Several theories have been developed o elucidate the relevance or irrelevance of dividends decision on the value of a firm (Lease, 2000). Modigliani and Millar dividend irrelevance theory asserts that dividends have no effect on the firms value in a perfect market because dividends are paid out of earnings and therefore whether distributed or not, it does not affect the firms earnings. Dividends have no effect on both equity and cost of equity (Baker, Powell & Veit, 2002). The bird in hand theory was also developed. According to this theory, dividend payments affect the value of a firm since investors are sure about the dividend earnings than the expected capital gains, which they consider as a bird in the bush (Miller & Kevin, 1985). The tax preference theory on the contrary claims that investors will prefer capital gains to the dividend because of the tax advantage associated with the capital gain. Since dividends attract higher taxes, investors will prefer capital gain. The signaling theory further argues that dividend payment is significant in a firm’s investment decisions because it acts as a signal to the performance of the company. A company with high dividends is said to have better future prospects hence this will attract investors; the theory is based on the assumption that capital markets are imperfect and investors have different levels of knowledge (Benartzi, Roni & Thaler,1997). Before selecting a dividend policy, company managements must take into consideration the likely impact of their dividend decisions. Dividend decisions of a firm are important, as it can be use in influencing the value to the shareholders. In paying dividend, firms will considerer several factors. First, the dividend policy can be determined by the financial requirements of a firm. A firm that has several positive investment projects may decide to increase the proportion that is retained to invest in the positive projects (Baker, Powell & Veit, 2002). Retention in this case provides the capital required to undertake the positive projects. Secondly, the dividend policy can also be determined by the nature of the company’s earnings. A company that realizes stable income in the financial performance can decide to increase the amount of dividends paid because of stability in the earnings whereas those with fluctuating incomes may reduce the amount of dividend distributed to the shareholders (Clayman, 2012). Moreover, firms’ liquidity also affects its dividend policy. A firm with better cash flows and which is liquid has the ability to make large dividend payments than that is not liquid. This is because dividends are always distributed out of cash and is therefore determined by the level of liquidity (Lease, 2000). In addition, the interest of the shareholders will influence a firm’s dividend policy. When shareholders demand payment of dividends as a way of earning their return, the company could decide to increase the amount of dividend it pays. On the other hand, there are investors who are not in need of cash and therefore look at the capital gain as the way of increasing their returns. These kinds of shareholders will support low dividend payout. Besides, the amount of dividends distributed depends on the contractual agreements that are entered into by the company owners of capital e.g. debtors to protect their interest. Legislations as well determine the proportions of earnings that may be distributed to the shareholders. A company that breaches the legal obligation may be fined or have sanction s imposed against making them abide by the legal requirements. Finally, the general economic conditions of inflation, economic cycles, and interest rates will also determine firm’s dividends policies. A cut in the dividends distributed implies a reduction I the amount of cash paid as dividends. This will have several impacts. This has become a major trend in most companies. By reducing the dividends paid, the firm will increase the proportion of retention that can be use in other positive investment purposes. A cut in dividends paid can result into a significant fall in the share price. Investors who rely on dividends will sell their stock because of the dividend cut believing that low dividend signifies future decline in performance (Litzenberger & Krishna, 1982). Moreover, by reducing the dividend payout, the firm wills reduce the tax obligations. The amount of tax paid on dividends s relatively higher than when profits are retained. These thus imply that a company that decide to cut the dividends paid ill reduce the tax obligation since dividends attract withholding tax. In addition, a decline in the amount of dividends distributed would improve a company’s cash flows. By retaining earnings, company will reduce the amount of cash outflows hence enhance its liquidity (Miller & Kevin, 1985). Moreover, the company’s interest cost will be reduced in the end because moist of its positive investments would be financed from retention. The amount of debt use to finance a company’s project will decline. Dividend payment also solves the agency problem by assuring investors of their returns (Chetty & Saez, 2007). Finally, the economic conditions may influence dividend decisions. A cut in dividends may be made during the recession, inflationary periods to avoid the adverse impacts of dividends on the company’s performance (Soter, Eugene & Paul, 1996). The cash retention could therefore be used to mitigate the adverse impacts of inflation and high interest on the company. In conclusion, dividend policy adopted by a company should not affect adversely the company’s performance and should reflect the economic conditions prevailing. The decisions can be reviewed to help improve the company’s performance in the market. Managers decision should be consistent with the firm behavior. References Associated British food 2011, Dividend history retrieved from http://www.abf.co.uk/Dividend%20history.aspx Baker, H, Powell, G & Veit, E 2002, ‘Revisiting Managerial Perspectives on Dividend Policy’, Journal of Economics and Finance , vol. 26, no. 3, pp. 267-283. Benartzi, S, Roni, M & Thaler, R 1997, ‘Do Changes in Dividends Signal the Future or the Past?’, Journal of Finance, vol.52, pp.1007-1034. Chetty, R & Saez, E 2007, An agency theory of dividend taxation, Cambridge, Mass.: National Bureau of Economic Research. Clayman, MR 2012, Corporate finance: a practical approach (2nd ed.), Hoboken, N.J: John Wiley & Sons. Lease, RC 2000, Dividend policy: its impact on firm value, Boston, Mass.: Harvard Business School Press. Litzenberger, R & Krishna, R 1982, ‘The Effects of Dividends on Common Stock Prices: Tax Effects or Information Effects?’, Journal of Finance, vol37, pp. 427-443. Miller, M & Kevin, R 1985, ‘Dividend Policy Under Asymmetric Information’, Journal of Finance, vol. 40, pp.1031-1051. Myron, G 1976, ‘Dividends, Earnings, and Stock Prices’, Review of Economics and Statistics, vol 41, pp. 99-105. Soter, D, Eugene, B & Paul, E 1996, ‘The Dividend Cut ‘Heard ’Round the World’: The Case of FPL’, Journal of Applied Corporate Finance, vol. 9, pp. 4-15. Read More