Dividend policy

MINISTRY OF EDUCATION AND SCIENCE OF THE REPUBLIC OF KAZAKHSTAN

INTERNATIONAL ACADEMY OF BUSINESS

DEPARTMENT OF FINANCE

 

 

 

 

 

 

 

 

 

 

 

TERM PAPER

 

On discipline “Financial management”

 

Dividend Policy: essence and features

 

 

 

 

 

 

 

 

 

Done by:

3^rd year student

F-1001

Mussin Chingiz

 

Checked by:

Associate professor, DBA

Omarova A.Sh.

 

 

 

 

 

 

 

 

Almaty, 2013

 

Content

Introduction……………………………………………………………………...…3

Chapter 1. Dividend Policy and possibility of choice………………………..…4

Chapter 2. Dividend Policy in Kazakhstani companies………………………......12

Chapter 3. Problems and Opportunities of the Dividend Policy development…...19

Conclusion………………………………………………………………….…..…22

References……………………………………………………………………..….24

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Introduction

The term "dividend policy" is related to the distribution of profits in joint stock companies. However, considered the principles and methods of distribution of profit are not only applicable to public companies, but also to businesses of any other legal forms of activity. Distribution of profit in the Company represents the most sophisticated version of it, and therefore elected to consider all aspects of the mechanism. In principle, the broader interpretation of the term "dividend policy" can be to understand the mechanism of formation of the profit share paid to the owner in accordance with the proportion of its contribution to the total equity of the enterprise. The main purpose of the development dividend policy is to establish the necessary proportionality between current consumption and future owners of the profits of its growth, maximizing the market value of the company and ensuring its strategic development. With this objective notion of dividend policy can be formulated as follows: dividend policy is an integral part of the general policy of profit management is to optimize the proportions between consumption and capitalized its parts in order to maximize the market value of the company. Distribution of profits directly implements the management of the main goal - improving the welfare of the owners of the enterprise. It forms the proportions between current payments they return to capital in the form of dividends, interest and growth of these revenues in the period, due to increasing security of invested capital. At the same owners of the company independently develop these areas to meet their needs over time. The distribution of income is the main tool for influencing the growth of the market value of the company. In this form of direct impact is manifested in providing growth capital in the process of capitalization of retained earnings, and indirectly it provides the basic proportions of the distribution. The distribution of earnings is made according to the specific policy underworked, it is based on dividend policy, the formation of which is one of the most difficult tasks of a general policy of profit management company. This policy is designed to reflect the requirements of the overall development strategy, provide an increase in its market value, generate the necessary investment resources, to provide the material interests of the owners and staff. The aim of the course work is the study of the theoretical foundations of the dividend policy of the company, as well as analysis of the dividend policies of the Kazakhstani companies. To achieve this goal it is necessary to put the following tasks:

• Consider the concept of dividend policy and the types of dividend payments;
• To understand the contemporary politics of domestic enterprises;
• To analyze the liquidity ratios and profitability;
• To analyze the structure of the balance sheet;
• To analyze the financial stability of the enterprise;
• To analyze the potential bankruptcy of the enterprise;
• To draw conclusions and to justify the proposal.

 

Chapter 1

 

Dividend Policy and possibility of choice

 

Third Article of the First Chapter of the Law about Joint-stock companies states that joint-stock company is a legal entity, which have right to issue shares in order to raise funds for its activities  The Company owns the property, separate from the assets of its shareholders, and does not meet their obligations. The Company shall be liable for its obligations to the extent of their property.

Joint Stock Company is an organization pursuing profit as the main objective of its activity. JSC in contrast to the limited liability partnership have function of the unifying of the capital, which implies no need for personal involvement of shareholders in the business of the company. This function provides entities that are not parties of the JSC with the ability to control business of the company and to manage important issues related to the property of the company. One of the fundamental principles of the joint-stock company is the separation of the share capital of the company on an equal number of shares, each of which is expressed in share. Share is a security issued by joint-stock company and certifying the right to participate in the management of the company, right to receive the dividend on it and part of the company's assets upon liquidation, as well as other rights provided  by the Law about Joint-stock companies and other legislative acts of the Republic of Kazakhstan.[1]. Shareholders have the ability to quit the company only by selling their shares to another subject. As a result, property basis of the JSC is not affected, which ensures the stability of the structure of the company (as opposed to a limited liability company, where you can go out, taking the property from the company)¹. It seems necessary to pay attention to the concept of the relationship of the shareholder and the joint-stock company. The Law states that rights of the shareholders have obligatory nature, but from the theoretical point of view this statement isn’t reasonable. Because obligation assumes that it have property nature of relations and rigid relationship between the debtor and the creditor in which the creditor is entitled to claim and the debtor is obliged to fulfill. Basic shareholder rights can be divided into four groups:

• the right to participate in the management of the company;
• the right to information about the activities of the company;
• entitled to a share of profits (dividends) of the Company;
• right to liquidation quota (part of the assets remaining after liquidation).

The first two categories of rights, as we see, are not the property (at least, this issue is controversial), which contradicts the essence of a debt relationship, the next two are different in that their implementation is not unconditional. Thus, the right to the dividend is realized only if the income is received by company and the decision to pay dividends, and not on the use of the profit in any way, the right to a liquidation quota is realized only after the liquidation of any assets remaining after satisfaction of all creditors' claims. It is also contrary to the essence of a liability relationship. In support of this situation there are two possible theoretical constructs. The first is that the relationship between the shareholder and JSC obligation arises not from the date of purchase of shares a shareholder, but with the emergence of specific conditions for the implementation of certain fixed laws is possible, for example, the adoption by the Board of Directors decides on the payment of dividends. The second construction is that the relationship between the shareholder and the company explained not in terms of obligation relations, but otherwise. The relationship of the shareholder and the company may be called corporate, thus in this context, the essence of corporate relations can be defined as follows. This is a legal relationship, which mediates the management of a legal person, carried out by the participants, combines both proprietary and non-proprietary elements and assumes conditional nature of a relationship of obligation between the parties. As a general rule, there is no shareholders' responsibility for the obligations of JSC, and they bear the risk of loss of their contribution to the company's assets, in other words - the risk of losses associated with the operations of the company to the value of shares held by individual shareholders.

Key questions solved during the implementation of the dividend policy

Dividend is the value of assets of the joint stock company to be distributed among the shareholders in proportion to their share in the net profit of the reporting period. Typically, the amount of dividends does not exceed the net profit for the period. The dividend policy of the Company includes a choice of the following issues:

1. Should the corporation pay all or part of the net profit to shareholders in the current year or invest it for future growth.

2. Under what circumstances company should change the value of the dividend yield, whether to stick in the long-term dividend policy to one or to have opportunity to be changed frequently.

3. To decide in what form payments to the shareholders should be paid either in the form of money in proportion to the existing shares, or in the form of additional shares or the repurchase of shares. Usually the term dividend is used to refer to a payout of cash, which is a shareholder’s result of the distribution of the net profits of the corporation in proportion to the number of shares. Broader concept of dividends used for any direct payments to the corporation to its shareholders. Diagrams of all payments under this approach are considered as part of the dividend policy.

4. To decide what specific payment schemes are going to be used. If cash payments are proportional to the holding of shares, then what should be the frequency of payments and their absolute value. If the repurchase of shares is specified, the company should decide what is the purchase price. Usually declared cash payment is expressed in monetary units per share, but it can be expressed as a percentage of the market price or a percentage of the profit. The dividend is declared, excluding income tax.

Since the main criterion for evaluating financial decisions is an increase in the market price of capital, it is important to understand how different factors affecting the dividend policy will be affected by the selection of capital appreciation. There are different views on the net effect of the dividend policy. In order to understand the main arguments in favor of this or that position, we consider two extreme (alternative) positions:

1) The choice of dividend policy has an impact on the price of capital, and the corporation should look for the optimal value of the dividend yield. There are to views on this position:

a) The increase in dividend increases the cost of capital (conservative or traditional theory);

b) There is an interest of shareholders in the low value of the dividend yield because, high dividend yield ratio reduces the cost of capital (radical theory) because of tax payments;

2) The supporters of alternative position argue that dividend policy does not affect the cost of capital. Thus, a second look at the dividend policy states that there is no problem of optimizing the yield and dividend payments forms

There are different types of the theories of the development of the dividend policy. The main types of which are:

• Theory of preference dividends;
• Theory of independence of dividends;
• Theory of minimization of dividends;
• Signal theory of dividends;
• Theory of the effect of the clientele.

The theory of preference dividends (the theory of "bird in hand"). This theory was developed by Myron Gordon and John Lintner as a response to Modigliani and Miller's dividend irrelevance theory. Authors of bird in hand theory argued that dividends have a lower risk than a capital gain, so the company should establish a high dividend payout ratio and offer a high rate of dividend per share, to minimize the cost of its capital.

Each unit of revenue paid to investors in the form of dividends, are free from risk, and so it is worth more than the income, receipt of which is deferred to the future. Therefore, maximization of dividend payments is more preferable than income capitalization. The objections of opponents of this theory are basically boil down to the argument that the use of risk factors is impossible, since shareholder reinvests dividends in shares of this or any other company. A risk factor is taken into account individually by each investor and depends on the overall level of risk of economic activity, rather than the characteristics of the dividend policy. Bird-in-the-hand theory was criticized by Modigliani and Miller who claimed that dividend policy does not affect the firm's cost of capital and that investors are totally indifferent if they receive more dividend or capital gains. They called Gordon and Lintner's theory a bird-in-the-hand fallacy indicating that most investors will reinvest the dividend in the similar or even the same company and that company's riskiness is only affected by its cash-flows from operating assets.

The original proponents of the dividend irrelevance theory were Merton Miller and Franco Modigliani(MM). They argued that the firm’s value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the firm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.

To understand MM’s argument, recognize that any shareholder can in theory construct his own dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a 5% dividend can “create” it by selling 5% of his stock. Conversely, if a company pays a  higher dividend than an investor desires, the investor can use the unwanted dividends to buy additional shares of the company’s stock. If investors could buy and sell shares and thus create their own dividend policy without incurring costs, then the firm’s dividend policy would truly be irrelevant.

In developing their dividend theory, Mm made a number of important assumptions, especially the absence of taxes and brokerage costs. If these assumptions are not true, then investors who want additional dividends must incur brokerage costs to sell shares and must pay taxes on any capital gains. Investors who do not wand dividends must incur brokerage costs to purchase shares with their dividends. Because taxes and brokerage costs certainly exist, dividends policy may well be relevant.

Tax-Preference Theory. Taxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. This is known as the "tax Preference theory".

Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control. Capital gains are also not realized in an estate situation. For example, suppose an investor purchased a stock in a company 50 years ago. The investor held the stock until his or her death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation. Litzenberger and Ramaswamy based this theory on observation of American stock market. They presented three major reasons why investors might prefer lower payout companies. Firstly, unlike dividend, long-term capital gains allow the investor to deffer tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future. Secondly, up until 1986 all dividend and only 40 percent of capital gains were taxed. At a taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on long-term capital gains. Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but defferal issue still remains. Finally, if a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them on the death day at their base costs and avoid capital gains tax payment. The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. MM's dividend-irrelevance theory assumes that investors can affect their return on a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decision since they can simulate their own dividend policy. Recall that the MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. As a result, a stockholder can construct his or her own dividend policy. Suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor can sell some of the company's stock to replicate the cash flow the investor expected. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy since they can simulate their own. Much like a company can signal the state of its operations through its use of capital-financing projects, management can also signal its company's earnings forecast through changes in its dividend policy.

Dividends are paid out when a company satisfies its internal needs for cash. If a company cuts its dividends, stockholders may become worried that the company is not generating enough earnings to satisfy its internal needs for cash as well as pay out its current dividend. A stock may decline in this instance. Suppose for example Newco decides to cuts its dividend to $0.25 per share from its initial value of $0.50 per share. How would this be perceived by investors? Most likely the cut in dividend by Newco would be perceived negatively by investors. Investors would assume that the company is beginning to go through some tough times and the company is trying to preserve cash. This would indicate that the business may be slowing or earnings are not growing at the rate it once had. The Clientele Effect.

A company's change in dividend policy may impact in the company's stock price given changes in the "clientele" interested in owning the company's stock. Depending on their personal tax situation, some stockholders may prefer capital gains over dividends and vice versa as capital gains are taxed at a lower rate than dividends. The clientele effect is simply different stockholders' preference on receiving dividends compared to capital gains. For example, a stockholder in a high tax bracket may favor stocks with low dividend payouts compared to a stockholder in a low tax-bracket who may favor stocks with higher dividend payouts.

The residual-dividend model is a model that a company can utilize to set a target dividend payout ratio. The residual-dividend model is based on three key pieces:

1.An investment opportunity schedule (IOS),

2.Target capital structure

3.Cost of external capital

Procedure for the Residual-Dividend Model

1.The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget.

2.Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings.

3.The dividends then are paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model".

As an example, Newco generates sales of $7 million with earnings of $2 million. The company's optimal capital structure is 50% equity/50% debt. With $2 million in earnings, Newco reinvests the entire amount back into the company. In this case, Newco would have to borrow $2 million to maintain its optimal capital structure.

If Newco, however, needed to reinvest only half of the $2 million back into the company, Newco would then have $1 million in residual earnings to pay dividends. Given the reduced reinvestment, the company would thus have to borrow only $1 million to maintain its optimal capital structure. Advantage of the Residual-Dividend Model.With capital-projects budgeting, the residual-dividend model is useful in setting longer-term dividend policy.

Disadvantage of the Residual Dividend Model. Dividends may be unstable. Earnings from year to year can vary depending on business situations. As such, it is difficult to maintain with certainty stable earnings and thus a stable dividend.

 

While the residual-dividend model is useful for longer-term planning, many firms do not use the model in calculating dividends each quarter.

Dividend payouts follow a set procedure as follows:

1.Declaration Date

Declaration date is the announcement that the company's board of directors approved the payment of the dividend.

2.Ex-Dividend Date

The ex-dividend date is the date on which investors are cut off from receiving a dividend. If for example, an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend. This date is two business days before the holder-of-record date. The ex-dividend date is important as, from this date and forward, new stockholders will not receive the dividend. As a result, the stock price of the company will be reflective of this. For example, on and after the ex-dividend date, a stock most likely trades at lower price, as the stock price is adjusted for the dividend that the new holder will not receive.

3. Holder-of-Record Date

The holder-of-record (owner-of-record) date is the date on which the stockholders who are to receive the dividend are recognized.