DIVIDEND POLICY

a) Describe the alternative dividend policies that companies can adopt and their significance.

b) Discuss and apply the various arguments put forward by different schools about dividend policy
– dividend irrelevance, dividend relevance, mid-roaders schools as well as the role of market
imperfections in the debate.

c) Compute and interpret share price under the models representing each school of thought.

d) Examine the factors which determine a company’s dividend policy, with some reflections on
the evidence in Tanzanian market and beyond.

e) Analyse the alternatives to cash dividends such as share repurchases, and script dividend
showing the advantages and disadvantages of each alternative.

Describe the alternative dividend policies that companies can adopt and their significance.

The meaning of dividend and its relationship with financing

A dividend is a distribution of post-tax profits to shareholders, on a periodical basis. As in any

other form of business, the owners want to withdraw the profits earned by the business. It
effectively rewards shareholders for the risks undertaken by investing in the business and allows
them to share the prosperity of the business.

The retained earnings of the firm that are kept in the business, rather than being distributed as a
dividend, are an internal source of finance, to the extent they are represented by cash.
Consequently, a dividend policy that encourages lower dividends will provide higher internal
finance by way of retained earnings. The need for a company to obtain finance from external
sources is reduced.

Therefore, there is an inverse relationship between the dividend payout and the retained earnings
available for investment purpose. The higher the dividend, the lower is the residual balance of
earnings available for investment purposes, and vice versa.
Alternative dividend policies

Dividend policy is the policy that divides earnings attributable to equity shareholders into dividend
payout and retained earnings. The overall dividend policy is influenced by:

 Financing decision:

The decision on how much dividend is to be distributed to shareholders is a financing decision as

the retained earnings are an important internal source of finance. In case the firm has significant
investment opportunities and these investments are estimated to propel current growth rate, then
the firm would prefer to utilise the retained earnings for investment purpose. A dividend payout in
such a case would reduce the surplus available for long term financing. However, dividend may
be paid when major investment opportunities are not available.

 Creating value for the shareholders:

Shareholders may want to receive early returns in terms of regular dividends due to market
uncertainties. A higher dividend pay-out may help in enhancing share value. In contrast, a higher
payout would reduce the surplus available for investment. This may affect the forecasted EPS. On
the other hand, usage of retained earnings as a source of long-term finance will enhance the
forecasted EPS. Therefore, management has to view all the effects and strike a balance between
current shareholder expectations and strategies to enhance future value.

The following are the main alternative policies regarding dividends.

PAYOUT RATIO

Is the proportion of earning paid to equity shareholders.

Payout ratio = Dividend amount/Earnings(PAT) X 100%

FORMS OF DIVIDEND POLICIES

Dividend policy can take different forms which includes

 Constant amount of dividend policy

 Constant payout ratio
  Zero dividend payout policy
 Residual dividend policy

 Fixed percentage payout ratio

Dividend payout ratio is calculated as follows:

Total dividend paid to ordinary shareholders X 100%

Earnings after tax and preference dividends
OR DPS/EPS x 100%
This policy maintains a constant payout ratio. It is simple to operate and helps the company to
send clear signals to the shareholders about the company’s operating results.
Example
If a firm has a dividend pay-out ratio of 30%, then 30% of every shilling earned is distributed as
dividend.
Let’s assume the firm earned TZS 100 per share. Then 30% of 100, i.e. TZS 30 per share will be
distributed as dividend. If in year 2, the firm earns a profit of Tsh125 per share then dividend will
increase to TZS 37.5 per share.

 Constant or increasing dividend

A dividend can be kept constant or increasing in;
In the case of constant dividend policy, dividend is fixed irrespective of the level of earnings. The
same level is maintained year on year. If the company wishes to increase the threshold, it has to
reach an increased level of EPS and forecast to maintain that level. In case this policy is being
followed, the company has to ensure sufficient liquidity for dividend pay-outs.
Example
Assume in the year 1990 the firm adopted constant payout ratio calculate dividend for year
1991 to 1994

YEAR 1991 1992 1993 1994

Earnings 1500 1900 800 350
 Payout ratio 20% 20% 20% 20%
Dividend

In 1990 the firm adopted constant amount dividend policy and used it throughout all coming years
Required to compute payout ratio for year 1991 up to 1994

YEAR 1991 1992 1993 1994

Earning 1500 1900 800 350
Dividend 200 200 200 200
Payout ratio

 Zero dividend
Zero dividend cannot be a long-term policy. A new company may wish to first stabilise by
reinvesting substantial profits over the initial years, and then start paying out dividends. The
company can follow a zero-dividend policy for a short period.
Although a small minority of shareholders may accept it as a policy for reasons such as tax benefits
for capital gains, the majority of shareholders would like to get some dividends. In fact, the large
institutional investors who control the bulk of shareholdings these days rely on dividend income.
They are unlikely to be happy with a zero- dividend policy.
In this case, the company does not have to incur administrative costs associated with the payment
of dividends

 Residual Dividend Policy

Under this policy dividends are paid at last after all fund requirements have been met. From
distributable earning earned in the business, the first step is to look on investment opportunities,
it should finance these investment opportunities and the remainder is distributable to equity
shareholder
Example
TBM Ltd declared an interim dividend of TZS 50 per share and a final dividend of TZS 50 per
share. Over the same period, TBM Ltd reported net earnings of TZS 400 per share.
Required
Calculate the dividend payout ratio and comment on it. ANS 25%
Discuss and apply the various arguments put forward by different schools about dividend
policy – dividend irrelevance, dividend relevance, mid-roaders schools as well as the role of
market imperfections in the debate.

Dividend irrelevance
If the firm has certain investable opportunities, the retained earnings would be utilised for them.
In such case, no dividend will be paid.
Dividend irrelevance is based on the assumption that investors are indifferent between dividend
and capital gains. So long as the return from the business is greater than the cost of equity, they
are willing to forego dividend for higher growth, and consequently, the value of the firm will not
decrease.

Modigliani and Miller (MM) Hypothesis

Miller and Modigliani are the proponents of a school of thought that dividends are irrelevant as far
as share prices are concerned. They contended that share prices depend on the level of corporate
earnings which in turn depend on the company’s investment decisions.
Investors are rational and they look to maximise their wealth. The extent and timing of dividend
payouts is irrelevant. What affects the value of the firm is the earnings potential and the risk
associated with it. There may even be no dividends if the retained earnings are consumed by
investment projects. However, the expected future earnings of the company will push the share
prices up. In this manner, a shareholder gains in capital appreciation even if he does not receive
dividend payments.

Assumptions
This theory is based on the following assumptions:
(i) Capital markets are perfect.

 No floatation and transaction costs

 No single investor can influence the share price
 Free flow of information
 There are no taxes at the corporate or personal level.
(ii) There will be no change in business risk on account of financing investments through retained
earnings.

i. According to MM, the prevailing market price P o is determined as follows

 Po = (D1 + P1)/ (1 + Ke)
Where,
Po = current market price of share
D 1 = dividend (to be received at end of year 1)
P1 = Share price at the end of year 1
Ke = cost of equity capital

ii. If there is no external financing, the value of firm is equal to the number of times the price
of the share given by

nPo = (nD1 + nP1)/ (1 + Ke)

iii. If the firm were to finance all investment proposals, then the amount to be raised through
new shares is given by

nP 1 = I-(E-nD1)
nP 1 = I - E +nD1
Where,
nP1 = amount obtained through sale of new shares for investment
I = total investment requirement
E = Total earnings of the firm (EPS x number of outstanding shares)
nD 1 = total dividend paid ( DPS x number of outstanding shares)
(E-nD 1) = retained earnings
n = number of outstanding shares

Critical evaluation
The theory of dividend irrelevance is based on critical assumptions stipulated earlier. However, in
actual practice, these conditions are untenable. Let’s critically evaluate the validity of the theory
on account of two factors:

1. Imperfection of market
The assumptions include absence of flotation and transaction costs, taxation and no restrictions.
(i) Flotation costs
Flotation costs refer to the costs of raising funds through new issue of shares from the market.
These include advertising, underwriting commission, brokerage and related costs. It is assumed
that the company is indifferent between using internal financing and raising additional capital due
to absence of flotation costs. However, practically, since floatation costs would be involved, this
would reduce the funds raised from a new issue. For example, if the floatation cost is 5%, for every
TZS 1000 of funds raised, TZS 950 only would be available for investment purposes.
(ii) Transaction costs
Transaction costs refer to the costs of selling securities by the investors. Under the theory, MM
assumes that there are no transaction costs. Therefore, in case an investor requires liquidity, in the
absence of dividend he can sell the required shares and meet his cash flow requirements.
Furthermore, the assumption of free tradability of the shares is also questionable. If an investor is
looking at regular income in the form of dividend flows, the assumption of him being ready to use
the alternate route of selling the required shares for liquidity would be questionable.
(iii) Tax incidence
MM assumes that there are no taxes. Based on this, an investor is indifferent regarding the two
options: dividend payout v/s reinvestment. However, in actual practice, there are two tax
incidences which have to be taken care of:

 Dividend is taxable in the hands of the investor

 Capital gains arise only on sale of shares at a future date.
However, there is a difference on account of the timing of incurrence and quantum of tax. While
capital gains are required to be paid only in the event of sale of shares, dividend tax has to be
incurred in the period of dividend receipt. Furthermore, according to the applicable laws of each
country, the taxability of dividend and capital gains would be different.
Therefore, due to the effect of taxes which exist in practice, it is difficult to assume indifference
between retained earnings and dividend pay-out. As seen from the above analysis, due to
imperfections in the market, there are certain factors which would favour dividend payout (from
both investor and firm perspective) and some which would favour retained earnings. The theory
of dividend irrelevance is diluted due to the impractical assumptions.
2. Conditions of uncertainty
MM assumes a condition of certainty, which is questionable. The conditions of uncertainty can be
explained with respect to:
(i) Near v/s distant dividend
In case dividends are paid regularly, there is a surety of income, as against stock appreciation at a
future date which is uncertain and unproven. According to Gordon, investors are not indifferent;
they prefer near dividend to distant dividend.
(ii) Preference for current income
Investors require funds to meet their regular needs. They cannot depend on future cash flows to
fulfil their consumption requirements.

(iii) Information obtained with dividend

At the time of announcement of dividend policy for the period, the management provides first-
hand information on earnings, guidance etc. If the management recommends an increase in
dividend from the current stable levels, it is clear that there is a positive outlook. However, MM
argues that this information again pertains to expectation of future earnings - and dividend is
irrelevant.

DIVIDEND AND PRICE OF SHARE

Present value is the present value of all expected future cash flows
Price = D1/Ke
Price = (Do (1+g))/ (Ke−g)

Dividend relevance
This is an even earlier school of thought, which was prevalent before Miller and Modigliani
published their theory. The dividend relevance theory is exactly the opposite of the irrelevance
theory. It argues that dividend policies are relevant for share valuations.
Three theories which are based on dividend relevance:

1. Walter’s model
The model given by Prof James E. Walter is based on the relationship between the firm’s internal
rate of return or return on investments and the cost of capital. So long as the firm’s rate of return
(r) is higher than the cost of capital (k), the firm will retain the earnings. If r < k the investors are
better off receiving dividend and investing it in other avenues.
The model is based on the following assumptions:
(a) There is no change in business risk when new investments are undertaken.
(b) Key variables remain unchanged.
(c) Outside capital is not used for financing.
(d) The firm is a going concern.
The relationship between dividend and market value of a share according to Walter is given as

P = D + r/ke (E – D)
ke
Where,
P = market price of share
D = dividend per share
E = earnings per share
r = rate of return on firm’s investment
ke = cost of capital
The formula explains why the market price of companies which are on a growth trajectory is high
even when dividend is low. Similarly, it explains the reason why the share price of companies
which pay high dividends is also high.
r > ke Growth firm
r < ke Decline firm
r = ke Normal firm
QUESTION
Given earning is TZS 8milions and dividend paid out is 3millions. If the cost of equity and return
on investment are given as
a) r =10% Ke =8% (Pay less dividend to increase value)
b) r =10% Ke =15% (Pay more dividend)
c) r =10% Ke =10% (Dividend has no effect)

2. Gordon growth model

Gordon’s growth model also supports the theory that dividend is relevant. The assumptions for
this model are similar to Walter’s model.
Under Gordon’s model, the market price of a share is expressed as the present value of future
streams of dividends.
Po = E (1 –b)
ke –g
 OR Po = Do (1 +g)
ke - g
Where,
P = price of share
E = earnings per share
b = retention ratio
ke = cost of capital
r = growth rate
g = br

3. Lintner’s model
In 1956, John Lintner conducted a research by discussing with business men how they made their
dividend decisions. He formed a model based on that as:
D 1 = D 0+ ((EPS X Target payout)-D 0) X Af
Where, D 1 = dividend in year 1, D 0 = dividend in year 0,A f = adjustment factor
Based on the study, Lintner explained that firms fix the target payout ratios for a long term based
on return expectations. The dividend policy is changed only when there is surety that dividends
are sustainable.

Qn. Is there a relationship between the internal rate of return of the firm and the cost of capital
under Walter’s model?
ANS; The model given by Prof James E. Walter is based on the relationship between the firm’s
internal rate of return or return on investments and the cost of capital. So long as the firm’s rate of
return (r) is higher than the cost of capital (k), the firm will retain the earnings. If r < k, the investors
are better off receiving dividends and investing it in other avenues.

Compute and interpret share price under the models representing each school of thought.
Determination of share price under Modigliani & Miller Hypothesis (dividend irrelevance)
NBAA QUESTION
A risk class to which the company belongs has an approximate capitalisation of 13%. The company
has a capital of TZS 100 million shares of TZS 100 each. The dividend proposed at the end of year
1 is TZS 10 per share. The shares are currently quoted at par.
Required; calculate market price at the end of the year under each of following scenarios:
a. Dividend is declared ANS P1 = 103
b. Dividend is not paid ANS P1 = 113
c. Dividend is paid, earnings are TZS 50 million and the company wishes to make new
investments of TZS 100m. Find how many shares must be issued under the MM model
ANS 5,82,524 shares.
Determination of share price under Walter’s model
LLM Ltd has the following details
EPS TZS 100,
Dividend per share TZS 60
Capitalisation rate 10%
Company IRR is 15%. Estimate the market price per share. ANS P = TZS 1200

Determination of share price under Gordon’s growth model

ABC Ltd has shared the following details:
Earnings per share TZS 2000, IRR = 15%. Calculate the value of a share when:
1. D/P ratio 10%, retention is 90%, cost of capital is 18%. ANS = Tsh4444.44
2. D/P ratio is 40%, retention is 60%, cost of capital is 15%. ANS = TZS 13,333
NBAA QUESTIONS
QN 1. PTC Ltd has 50,000 equity shares at TZS 100 each outstanding on 1st April 20X0. The firm
plans to declare dividend of TZS 20 per share. The shares are currently quoted at par. The
approximate capitalisation rate is 15%. Under the MM model, calculate the price when:
(i) Dividend is declared ANS = P1 = 95
(ii) Dividend is not declared ANS = P1 = 115
(iii) How many additional equity shares need to be issued if the company needs TZS 2,000,000,
of which earnings for the year are estimated at TZS 1,200,000 and dividend payout will happen?
ANS = 18,947 shares.
QN 2. Determine the share price for Prime Retail Ltd using Gordon’s growth model.
Cost of capital 10%
Rate of return 8%
Earnings per share Tsh100
Retention ratio 0.4 ANS = Share price = TZS 882.35

QN 3. Information relating to James Plc:

Earnings of the company = TZS 1,000,000
Dividend payout =40%
No. of shares outstanding =200,000
Equity capitalisation rate =12%
Firm rate of return =16%
Calculate the market price per share. Also, determine the optimum dividend payout ratio for the
firm and the value of a share at that ratio. ANS = TZS 50

Examine the factors which determine a company’s dividend policy, with some reflections on
the evidence in Tanzanian market and beyond.
A company’s dividend policy has to take into account a number of factors ranging from
shareholder expectations, liquidity situations and investment opportunities to legal and regulatory
framework.

 Company’s financial requirements

One of the key factors influencing the dividend policy is the requirement of funds for investment.
Since dividend would reduce the profits ploughed back into business, it is critical to forecast the
funds required for investment over a sustained period before deciding on the quantum of dividend
that can be distributed.
In the case of companies which are in their growth phase, it is preferable to retain the profits for
investment as there is a requirement for significant funds for business purposes. On the other hand,
in the case of well established companies with a proven track record, they can have a stable
dividend policy and revise it whenever required, based on future earnings potential.
  Liquidity
Management needs to check the availability of cash, i.e. liquidity, before deciding upon the amount
of dividends. If the cash available is less than the dividend the company wants to distribute, then
it has to decide how to source the amount represented by the shortfall.
 Shareholders expectations
Dividend policy of a company should be guided by the expectation of the shareholders as regards
dividend income. Certain class of shareholders invest in well established companies to receive a
regular flow of income in the form of interim and annual dividends. It provides them with
assurance as to the return and liquidity of their investment. Therefore there are three aspects of
shareholder expectations:
1. Taxation
The tax laws applicable to the dividend payout influence shareholder expectations. In the case of
slab based personal taxation, investors in the higher income bracket prefer capital appreciation of
stock to dividend. This is because tax on dividend income would have to be paid in the same year
at the maximum marginal rate while taxation on appreciation (capital gains) will have to be
incurred only in the year of sale. Furthermore, in case tax laws support retention of shares for
increased tenure, taxation would be at a lower rate.
2. Investment opportunities
Investors would expect higher dividend payout if there is an opportunity cost in terms of alternative
investment opportunities available in the market.
3. Ownership dilution
In case of higher dividend payouts, the management may need to issue additional equity shares for
investment purposes. If it is not subscribed by existing shareholders, there would be dilution of
ownership and control.
QUESTION
What factors influence shareholder expectations with regards to dividend?

ALTERNATIVE TO CASH DIVIDEND POLICY

Analyse the alternatives to cash dividends such as share repurchases, and scrip dividend
showing the advantages and disadvantages of each alternative.
Dividends are basically distribution of profits to the shareholders. They normally take the form of
cash dividends. However, dividend can also be distributed in the form of stock in form of scrip
dividends or share repurchase.
  Scrip dividends
Commonly referred to as bonus shares, scrip dividend implies distribution of shares in place of
cash dividend. When companies are in need of cash to finance new projects, they prefer this
alternative.
The advantages of this alternative are:
(a) From the company’s perspective
(i) Helps to retain liquidity to meet investment needs of the firm.
(ii) Allows the company to reduce its gearing ratio i.e. debt to equity.
(iii) Complies with any restrictions on payment of cash dividend to shareholders as may be
imposed by any loan covenants.
(b) From the shareholder’s perspective
(i) From a tax viewpoint, it is better as the shareholder need not incur tax on cash dividend
(ii) In case cash dividend is paid and the company needs to issue fresh capital to meet its investment
needs, there is a risk of dilution of control. This is avoided by payment of scrip dividend.

Disadvantages of this alternative are:

(a) Issue of stock dividend at frequent intervals creates administrative hassles for the company. It
is difficult to determine if all stock dividends are captured at the market value per share.
(b) There is no inflow of funds to the shareholder and this does not increase his income stream. It
is a mere capitalisation of profits, of funds which already belongs to shareholders. There is just a
reassurance through issue of additional shares.
(c) Companies have to pay dividend distribution tax.

 Share repurchase
This happens when the firm has excess cash hence determined to pay it back to shareholders
through repurchase back of the share.

Purchase price = No of shares outstanding x Market price

No of share outstanding - No of share repurchased
Share purchased leads to increase in the market price per share for the remained share
Advantages of share repurchased
1. Increase in earnings per share
2. Save the constraints of paying cash dividend out of only earning
3. Increase the market price per share
Disadvantages of share repurchased
1. The company can execute share purchase if and only if has excess cash
2. Share repurchased has signalizing effect
SIGNALIZING EFFECT
• Can be good: When the market has positively taken the action of the company
• Can be bad: When market has negatively taken the action of the company
• Excess cash =No investment opportunities and ideas to invest in.
Share repurchased can be done in three forms
1. Open market share repurchase
Share repurchased is done in an open market through the broking house. The price will be
determined by the market
2. Fixed price tender offer
This is when the price and number of shares to be purchased is done and fixed by the company
Only the specified number will be repurchased at stated price
3. Dutch auction tender offer
Company declares the minimum and maximum price; shareholders submit no of shares they are
willing to sell. Based on these calculations are made to determine price to be used for repurchase
and No. of shares

NBAA QUESTIONS

Qn 1. Brica Ltd has provided the following details:

Dividend per share Tshs30, Earnings per share Tshs100, Cost of capital 10% and Firm’s rate of
return 12%.

Calculate the market price per share using

(i) Gordon’s model,

(ii) Walter’s model.

Qn 2. JFK Ltd has 1 million shares outstanding at the beginning of 20X0. The current market price
is Tshs1200 and the Board has approved a dividend of Tshs62 per share. The capitalisation rate
suitable for the risk class to which the company belongs is 9.8%.

Calculate the following:

(a) Based on the MM approach, the market price when

(ii) Dividend is declared

(iii) Dividend is not declared

(b) If the company proposes an investment of Tshs372 m and the income for the year is Tshs150m,
how many additional shares will it have to issue to finance the investment?

Qn 3. Shilo Designs Company is a small sized manufacturing entity engaged in the manufacturing
of electric parts. The firm has been following a policy of paying dividend every year. The shares
are listed on the stock exchange and currently command a price earnings ratio (P/E) of 1.5.

Earnings of the company Tshs. 500 million

Dividend Tshs. 375 million

Number of equity shares 20,000,000 @ Tshs. 250 per share

The firm is estimated to maintain the current rate of earnings on investment.

Required:

By applying Walter’s dividend model:

i. Determine the price of share

ii. Establish whether the Dividend Price ratio is optimal

Qn 4. Crane Ltd. is a listed in the local stock exchange. Currently, the company has 2 billion
outstanding shares selling at a market price of TZS. 100 per share. The company has no borrowing
and has internal funds available to make a capital expenditure of TZS. 30 billion. The capital
expenditure is expected to yield a positive net present value of TZS. 20 billion. The firm also wants
to pay a dividend per share of TZS. 15. Given the company’s capital expenditure plan and its
policy of zero borrowing, the company will have to issue new shares to finance payment of
dividend to its shareholders.

Required:

With supporting computations, explain how Crane Ltd.’s value will be affected

i. If it does not pay any dividend

ii. If it pays the TZS. 15 dividend

SEQ

1. Amazon Company Ltd. and Zodiac Company Ltd, are in the same risk class. Shareholders

expect Amazon to pay a TZS.400 per share dividend next year when the stock will sell for TZS.2,
000 per share. Zodiac Co. has a no-dividends policy. Currently, Zodiac stock is selling for TZS.2,
000 per share. Zodiac shareholders expect a TZS.400 capital gain over the next year. Capital gains
are not taxed, but dividends are taxed at 25 percent.

REQUIRED:

(i) What is the current price of Amazon stock? (4 marks)

(ii) If capital gains are also taxed at 25 percent, what is the price of Amazon stock?

(3 marks)

(iii) Explain the result you found in part (b) (ii) above. (2 marks)

2. The net income of GGM Corporation, which has 10,000 outstanding shares and a 100%

dividend payout policy, is TZS.32, 000. The expected value of the firm one year hence is TZS.1,
545,600. The appropriate discount rate for Magita is 12 percent.

REQUIRED:
(i) What is the current value of the firm? (2 marks)

(ii) What is the ex-dividend price of Magita’s stock if the board follows its current policy? (3
marks)

3. According to Modigliani and Miller (M & M) theory, dividend policy is irrelevant in a world
of frictionless capital market. How did Miller and Modigliani arrive to this conclusion? (6 marks)

(b) Discuss, using appropriate theories, any three determinants of dividend policy and decisions in
real world