Costs Associated with Dividend Policy

2.    Costs Associated with Dividend Policy

Capital floatation costs are a deterrent substituting external finance for retained earnings but there are other costs affected by the dividend decision.

If shareholders are left to make their own dividends by selling some shares, this involves brokerage and other selling costs that, on a small number of shares, can be extremely an economic. In addition, if they have to be sold during a period of low share price, capital losses may be suffered.

Another important factor is taxation. First, when the company distributes dividend it has to pay an advance installment of corporation tax (ACT), currently one quarter of the amount paid. But the offset against mainstream liability to pay corporation tax will be delayed by at least one year. Indeed, if the company does not currently pay this type of tax, the delay in setting off ACT will be even longer, and this will tend to restrain extravagant dividend distributions.

Second, from the investors’ viewpoint profitability invested retained earnings should increase share values, enabling shareholders to create their own dividends. Selling shares creates a liability to capital gains tax, currently 20%, 23% or 40%, but subject to a fairly generous exemption limit. By comparison, dividends in the hands of shareholders attract

higher rate of income tax (up to 40%). Thus higher-rate taxpayers may prefer comparatively low dividend payouts to minimize their tax burden.

Third, financial institutions confuse the taxation picture even more, through their major holdings in the shares of quoted companies. They are able to set off dividends received against dividends paid for tax purpose but some may be liable to capital gains tax if they sell shares to make dividends.

The effect of taxation on dividend decision is difficult to analyse. It may be argued that companies attract investors who can match their personal taxation regimes to company’s dividend policy, and that those who don’t join a particular ‘taxation club’ will invest elsewhere. If this were true, however, a change in company’s dividend policy would probably not find favour with its shareholders clientele. And would consequently affect share values, which seem to support the argument that dividend policy matters.

3.    Other Arguments Supporting the Relevance of Dividend Policy.

Activity:

As a potential investor, how would you react to the following questions?

a.    Would you prefer cash dividends now, against the promise of future, perhaps uncertain, dividends?

b.    Would you prefer a stable, growing dividend to one that fluctuates in sympathy with company’s investment needs?

c.    If a company, in whose shares you invest, increases or decreases its dividend, would it change your personal investment policy?

In answer in question (a) you probably opted for cash now rather than cash you may never see. The future is uncertain and most people take much convincing that it is in their interests to postpone income. Although the equity shareholder by definition is the risk-bearer, he is also entitled to a reasonable resolution of dividend prospects to compensate for the additional risk he carries. An investor will almost certainty pay higher price for earlier rather than later dividends.

In question (b), in definition, a fluctuating dividend is more risky than a stable dividend. Investors will pay more for stability, especially if it is linked with steady growth. Research has shown that, in general, dividends follow a pattern of stability with growth. Maintenance

 

of the previous year’s dividend is the first consideration, with growth added when directors feel that a higher plateau of profitability has been consolidated.

As regards question (c), you would no doubt be very happy about an increase, and might even be prompted to buy more shares – thus helping to put the market price up. Conversely a decreased dividend would cause to review your investment, perhaps even to sell your shares to take advantage of better investment opportunities elsewhere. Investors tend to believe that dividend changes provide information regarding a company’s futures prospects, and they react accordingly.

4.    Practical Factors Affecting Dividend Policy

Whatever dividend policy is thought to be best for a company in theory, certain practical factors influence the decision.

Availability of profit The Companies Act 1985 provides that dividends can only be paid out of accumulated realized profit less realized losses, whether these are capital of revenue. Previous or current years’ losses must be made good before a distribution can be made. If an asset is sold, any realized profit or loss arising can be distributed; but any profit or loss arising from revaluation of an asset cannot be distributed – unless and until the asset is sold.

Availability of cash Profit may be earned during a year and yet it may hot be possible to pay a dividend because of lack of cash. This can arise for different reasons. It may already have been expected or be needed to replace fixed and working assets, perhaps at inflated prices. Large customers may not yet have paid their accounts or cash may be needed to repay a loan.

Other restrictions The company’s articles association may limit the payment of dividends or a lender by insert into a loan agreement to restrict the level of dividends. A company’s dividend policy cannot be so outrageously different from policies followed by similar companies in the same industry; otherwise the market price of its shares could fall. Dividends may be restricted by government prices and incomes polices.

5.    Alternatives to Cash Dividends

In recent years companies have introduced more flexibility into their dividend policy by either:

·     issuing shares in place of cash dividends (‘scrip’ dividend);

·     repurchasing their shares.

Script dividends Companies may give their shareholders the option to receive shares rather than cash. This has the effect of maintaining company liquidity, and enabling the company to increase earnings by investing the retained cash. However company has to pay ACT on the distribution, and the shareholders have to pay income tax.

Thus, the shareholders can increase his investment in the company, without expense associated with the public issue or a purchase on a stock market, but the same time retain the option to convert his shares into cash at a future date.

Repurchasing shares Since 1981 companies have been allowed to purchase their own shares subject to certain restrictions, and the prior authorization of their shareholders. This is normally done by utilizing distributable profits, and the shares must be cancelled after purchasing.

Repurchasing of shares may be carried out for any of the following reasons:

·     to repay surplus cash to shareholders;

·     to increase gearing by reducing equity capital;

·     to increase EPS by reducing the number of shares related to an unchanging level of profit, and hopefully, therefore, the value of each remaining share;

·     to purchase the shares of a large shareholders.

Summary

In this report we have explored an important and long-standing issue in financial research: how do corporations finance themselves, the shares issuing in the Stock Market Exchange and dividend policy of the companies.

And the situation is that the rapidly expanding companies suffer from the retained profit insufficiency and one of the solutions of this financial problem is going public.

But it is not surprising that existing shareholders dig more deeply into company’s pocket by claiming dividends. And of course the public company is subject to more scrutiny than a private one.

Thus I think only when all other sources are exhausted your can dilute already existing shareholders’ control over the company. However corporations willingly make issues of shares and pay dividends. So how are their dividend, financial and investment policy reconciled? This question has exercised the minds of academics and financial managers in recent years without any completely satisfactory answer being produced.

References

1.    Anjolein Schmeits, ‘Essay on Corporate Finance and Financial Intermediation’, Thesis publishers, 1999, 225-246.

2.    Geoffrey Knott, ‘Financial Management’, Creative Print and Design, Third edition, 1998,

300-337.

3. Kovtun L.G., ‘English for Bankers and Brokers, Managers and Market Specialists’, Moscow NIP“2”, 1994, 340-350.