Dividend policy is a companys policy with regard to distribution of earnings to the shareholders. Brealey and Myers (2000, p. 439) defined dividend policy as the trade-off between retaining earnings and distributing it to the shareholders. Dividend policy has a major impact on the financial structure, corporate liquidity, growth of a company and its share price. Retained earnings help fund investments to grow business. Increasing dividend can cause a company to increase borrowings to fund payments.
Modigliani and Miller (1961) said that in absence of different tax treatments and transaction costs, dividend policy is irrelevant and does not result in any change in a firm's value. However, with differences in tax rates, dividend policy is relevant as one of the main aims of a management is to maximise shareholders' wealth.
The residual theory suggests that internal source of funding is cheapest and hence should be maximised before resorting to external funding. This implies that a company should focus only on retention of earnings for investment opportunities and dividend payment should be secondary issue based on whatever is left profitable investments (Lee and Lee, 2006, p. 231). This theory does not explain instances when firms borrow to pay dividends to their shareholders.
Dividend declaration sends signals to the shareholders about future earnings of a company. Announcements of cuts in dividends are met with share price declines and thus managements are apprehensive of increasing dividends if they cannot be sustained in the future.
Lintner (1956) conducted a series of interviews with managers to understand dividend policy of companies and suggested the following dividend determinants:
Managements adhere to a dividend payout ratio based on the nature of their businesses because established companies with stable earnings tend to have higher dividend payout ratios. Grullon et. al (2002) said that constant dividend increases are an indication of a firm's transition from a growth phase to a more mature phase. A near constant growth of dividend informs shareholders that a firm is a mature business capable of generating cash year on year.
This is because established firms have fewer avenues for organic growth and their cash inflows are stable with less chances of a drop in their earnings. High growth companies, on the other hand, tend to pay less proportion of their earnings in dividends because of higher investment and working capital requirements.
The dividend policy can also be influenced by investor profile. The management of a company can either spend earnings on investment in new projects or return it to investors. The decision to increase shareholders' wealth by investing in projects or paying out higher dividends can have an impact on shareholder profile. Investment in new projects will result in lower dividend payments but gains will come through capital appreciation and thus, it will attract higher tax paying investors. Higher dividend payments will attract investors that look for regular income. Depending upon the profile of major shareholders', a management may decide on either growth in investments or dividends to increase shareholders' wealth. The large number of shareholders infers that Debenhams' management is unlikely to use shareholder profile in deciding dividend policy. A study based on a survey of financial executives concluded that managements do not seem to make dividend decisions by taking into account the needs of regular income seeking investors (Brav et al., 2005, p. 483).
Watson and Head (2004) pointed out that stockholders can gain their profits through a series of policies which can be combined in a year. However, it usually takes one of the following alternatives which are a cash dividend policy, shares dividend policy and shares repurchase policy.
Cash dividend policy, paying out in the form of real cash, is the most common method of dividends payments. Companies share profit with stockholders by distributing corporate income to them. Stockholders who receive this kind of dividend are taxable in the year they are paid as it is regarded as investment income. Under the UK taxation, the basic rate of income tax rate is 20 % and higher rate is 40%. Dividend income basic tax rate is 10% and higher rate is 32.5%. If the dividend paid is higher to reach the higher rate, then shareholders will need to pay income tax rate (20%) and dividend rate (32.5%).
Companies who adopt shares dividend policy or scrip dividends are paying out by issuing additional shares to stockholders. They are usually issued on the basic of the proportion of shares owned. For example, for every 200 shares of stock hold, 10% stock dividend will produce 20 extra shares. By doing this, companies are capable of increasing total number of shares but decreasing the price per share and it will not change market capitalization or the total value of the shares hold. Shares dividend policy is not a common method as stockholders should pay unreasonably higher transaction costs if they want to sell some shares to other.
Shares repurchase, also known as share buyback, is the repurchase of the shares by companies themselves. It enables companies to return their wealth to stockholders by exchanging for their shares. Beside, Brealey, Myers and Allen (2008) conducted four main ways for companies to repurchase share. Firstly, companies announce their share repurchase plans in the open market. Secondly, companies can negotiation with major stockholders directly. Thirdly, companies can repurchase share through the Dutch and the auction. Fourthly, it offers to repurchase a specified number of shares at a set price through bidding. Shares repurchase have tax advantage to stockholders as they only need to pay 40% of the income tax rate if they sell back the shares. From the perspective of companies, share repurchase can enhance the undervalued share. If company's stock is undervalued, management may tender for shares at a 'premium'.
Take Debenhams for example, Debenhams plc is a British retailer operating in United Kingdom, Ireland and Denmark, with 73 franchise stores in 26 countries. It provides customers with a unique, differentiated and exclusive mix of Debenhams' own brands, international brands and concessions. Table 1 shows the dividend payable for 2009 to 2012. Debenhams plc did not pay any dividends in 2009 and 2010. The reason why Debenhams did not pay dividend in 2009 and 2010 is that they used cash to reduce debt. They paid back debt of £100 million and £75 million in October 2009 and January 2010. However, after adjusting the level of debt and future earnings, Debenhams began to pay dividend in 2011 which is 3.00 pence per share and it increased to 3.30 pence per share. Therefore, Debenhams plc's dividend policy is influenced by their capital structure.
Debenhams plc announced a share buyback programme in October 2011. The company subsequently spent £20 .1 million on purchasing 23.6 million of shares in 2012. If the repurchase are aimed to improve the interests of the investors and the position of the firm, then the share price will increase. After announcing the news of share repurchase, Debenhams shares have climbed from 0.9 p to 81.4 p as a result (Guardian, 2013). It indicates that market response to Debenhams's share repurchase policy is positive.
Debenhams decided to use share buyback policy only after the leverage declined to close to 1 times EBITDA. This infers two things about the dividend policy of Debenhams. First of all, there is a relationship between Debenhams's dividend policy and its capital structure or gearing. Only after Debenhams realising that their leverage is conservative and is unlikely to cause financial crisis did they return higher amount of payments to stockholders.
The second thing is that Debenhams wants to use excess cash which is £120 million by capital investment to return to shareholders through share buybacks and maintain a steady increase in dividend (Guardian, 2013). According to Skinner (2008), the existed companies are not only paying dividends because those who only pay dividends are extinct. A steady rate of increasing dividend conveys good news about future dividends, which is also useful in equity valuation.
Using the excess cash to repurchase the shares enables Debenhams to become more flexible. Unlike cash dividend payments, reductions in share buybacks do not result in significant negative share price reaction. This allows the management of a firm to return excess cash to shareholders without having to be concerned about negative reactions if they reduce or eliminate share buybacks in the future.
The dividend policy of Debenhams was based on both cash payments as well as share buybacks in 2012. Share buybacks allowed the management to return higher cash to shareholders without being concerned about the ability to do so in the future. Cash dividends increased by 10% only.
