IFFM Blog #6: Dividend Policy

Dividend Policies determines when, how much cash and if a company should provide a pay out to the comapany's owners in form of dividend rather than repurchases of shares, reinvestments or reduction of debt. (Kennon, 2017) Such decisions are made by the company's board of directors, and it is up to them to formulate an effective dividend policy to provide maximum returns to its shareholders and yet, ensuring the continuity of the company's sustainability.

The constraints in the construction of dividend policies come in four categories:

1. Legal
• In reference to The Companies Act, it is specified that dividends should only be paid out of realised profits, inclusive of realised profits made in previous years
2. Regulatory & Governmental
• Regulatory requirements may affect a companies ability to provide a payout to the shareholders. Windfall or supplementary taxes can be sometimes be targeted at regulated industries. Hence, further impeding their ability to provide potential dividend for the work year.
3. Contractual/Obligation
• Dividends can be restricted in form of a contractual clause, laying out criterias of when dividends can be paid out. If the conditions are not met, shareholders are obligated to wait out on dividends until all conditions are satified.
4. Liquidity
• Cash is key as dividends are essentially cash outflow and therefore to pay shareholders their dividends, the company must either raise cash from internal free cash flows or from taking on further debt.

On one end of the spectrum, Modigliani and Miller (1961) argue that dividends are irrelevant because investors can sell a portion of their share in order to generate cash-flow. However, on the other end, bird-in-the-hand argument indicates that shareholders prefer dividends over capital gains for consumptive and risk-hedging reasons. (Bhattacharya, 1979)

Certain companies takes their earnings and place it back into asset base to expand at high returns on capital, resulting in dividend declaration decades after. One example of such companies is Microsoft where it held back on dividend payouts to hoard and retain earnings which allowed the return on equity to enlarge into incredible proportions. In short, if an individual had invested $100 in the Microsoft's IPO in 1986, come 2016 the investment would have grown to $53,827 in stock and $11,635 in dividends before tax. (Kennon, 2017)

However, current times suggests that level of dividends have great importance. Companies tend to avoid low dividend to so as to not lose investor confidence but also providing high dividend can be detrimental to the sustainability of the company in the long term. 

Refernces:
Kennon, J. (2017). Determining a Company's Dividend Payout Policy. [online] The Balance. Available at: https://www.thebalance.com/determining-a-company-s-dividend-payout-policy-356100 [Accessed 31 Jan. 2018].

Bhattacharya, S. (1979). Imperfect Information, Dividend Policy, and "The Bird in the Hand" Fallacy. The Bell Journal of Economics, 10(1), p.259.