Financial Strategy
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Declaration
Dividend Policy
Companies have the obligation of ensuring that all the shareholders are satisfied to fullest. Therefore, in order for the management to achieve this, they strictly observe the payment of dividends to ensure that they are paid on time and in the correct amounts. Dividend policy is a guideline that is followed by organizations regarding the manner in which they should pay some of their earnings to their shareholders. This amount is referred to as the dividend share. Every shareholder ought to be aware of the dividend earnings that they should expect at the end of each payment period. The dividends are the rewards that the shareholders receive as a result of having invested in the company and therefore, they expect that amount to be at the maximum return while they maximize their wealth. The key to attracting new investors is for the management to ensure that they pay such returns on time and work their level best to earn as much profit as possible. Whenever a company makes less, it is the shareholders that suffer most because there will be no funds to pay their dividends. Also, the dividend policy of a company has a great impact on its long-term financial plans and the wealth of their shareholders. The company has to plan for future finances to ensure that they do not pay many dividends hence leaving them with limited cash to run their business activities. In the event whereby they have limited finances, then the company will have to look for external financial aid, most likely getting a loan. This is not a good way of running a company and hence, the necessity of well-planned dividend policy. Also, there are different dividend policy theories that a firm can choose from when planning on the best way of paying dividends to its shareholders. The choice of these theories depends on the preferences of the shareholders and the available investment opportunities for the firms ( Murtaza, Iqbal, Ullah, Rasheed & Basit, 2018).
There are four types of dividend policies
* Regular dividend policy: this is a guideline whereby dividends are paid at the usual rate stated by the organization. The retired and widows most prefer it.
* Stable dividend policy: this type of dividend policy is established in three forms whereby the constant dividend per share allows a company to pay a constant amount despite the number of earnings of each year. Organizations using this kind of policy usually have a reserve for dividend equalization to ensure that they have sufficient funds to pay out their dividend during the period when the company was not able to make enough profits. As well, the constant payout ratio allows a firm to pay dividends as a specific percentage of the total earnings. This means that the amount paid to the shareholders fluctuates depending on the profits made by the organization. Also, other companies prefer to have a fixed lowest amount of dividend that they should pay and an additional amount depending on the profits made. This is known as the stable rupee dividend plus extra dividend. Hence, in no given year, the shareholders fail to get a certain amount as dividends.
* Irregular dividend policy: This policy is followed on an account that the company lacks liquid resources, experience an uncertainty of its earnings, has unsuccessful business operations and fears the impact that would be brought by a regular dividend policy on the financial position of the company.
* No dividend policy: This policy is chosen by companies which are not in a good financial position and are seeking to save funds for future growth and expansion. The policy is usually dropped once the company can pay dividends to its shareholders (Shah, 2015).
Dividend Policy Theories
Walter's Model
According to Professor Walter, the investment and dividend policies of an organization coexist and cannot be isolated. The decisions made regarding each of the policies have a huge impact on the value of the organization. He outlines the relationship that exists between the internal rate of return ( r ), required a rate of return ( k ) or rather the firm's cost of capital. The firm's dividend policy will thus be determined by the internal and expected rates of return. Therefore, in a case whereby the firms return on investments is higher than its cost of capital, then it should retain the earnings. On the other hand, it is right for the firm to distribute its dividends if the return of investment is lower than the cost of capital (Priya & Mohanasundari, 2016).
In other terms, when the rate of return exceeds the cost of capital, then it means that the firm has many investment opportunities that are expected to make profits. Hence, the organization can earn more as compared to the investor's expectations. As a result, the dividend policy of such a firm is given by a dividend payout ratio of zero. This is an indication that the firm has to retain all the earnings in order to maximize the market value of its shares (Chenchehene & Mensah, 2015). On the other hand, if the internal rate of return is less than the cost of capital, it means that the firm does not have future investment opportunities that can be profitable for the company. Hence, retaining the earnings is not profitable because the firm is already in its declining stage. Also, the investors would prefer to be paid the earnings regarding dividends so that they can invest in other firms that are doing well financially. Therefore, such firms would maximize their share value by paying all the dividends to the shareholders. The dividend policy ratio will be 100%. As well, if the internal rate of return is equal to the cost of capital, then it means that the market value of the shares will remain constant regardless of whether the earnings are distributed to the investors or not.
Below is a formula that Walter invented to calculate the amount of dividend to be payed
P=(d/k) + ((r(E-D)/k)/k whereby,
E = Earnings per share;
P = Market price per share;
D = Dividend per share;
r = Internal rate of return;
k = Cost of capital or capitalization rate (Barnes, 2015).
Assumptions of The Walters Theory
The firm does not depend on external sources of finance such as equity capital or debts. It relies on its earnings for growth
The theory assumes that the dividend per share and the earnings per share do not fluctuate.
The cost of capital and the firm's internal rate of return remain a constant.
The firm is assumed to have a long life
The earnings of the firm are distributed to the shareholders or reinvested within the firm.
Criticism of the Walters Theory
Walter assumes that the retained earnings are the only sources for funding the new investments yet in a real-world situation, this is not realistic. Therefore, the model is only applicable in rare cases because firms require the benefits of optimum capital.
The internal rate of return does not remain a constant in the real world because the more investments that a firm engages in, the more the internal rate of return declines.
Also, the cost of a firm's capital cannot remain a constant as assumed by Walter because the various changes in the risk patterns of organizations result in a corresponding change in its cost of capital. The effect of risk on a firm cannot be ignored because the business world is uncertain.
Gordons Model
According to Gordon, the dividend policy of a given form is determined by its investment opportunities that have been speculated to be profitable. Therefore, in the case whereby the internal rate of return is higher than the firm's cost of capital, then the firm is viable for growth. This means that the value per share increases as well as the retention ratio. The retention ratio is the amount that a firm opts to keep for reinvestment and other uses instead of paying it out as dividends to its shareholders. Hence, in this case, the firm is obligated to retain more of its earnings as compared to what they distribute to shareholders.
On the other hand, if the internal rate of return is less than the firm's cost of capital, then the firm is said to be in a declining phase. Such...