Dividend policy, infinancial management andcorporate finance, is concerned with^[1][2]the policies regardingdividends; more specifically paying acash dividend in the present, as opposed to, presumably, paying an increased dividend at a later stage. Practical and theoretical considerations will inform this thinking.

In setting dividend policy, management must pay regard to variouspractical considerations,^[1][2]often independent of the theory, outlined below.In general, whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power:when cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through ashare buyback program.At the same time, although the decisioning must weigh the best use of those resources for the firm - i.e. investment needs and future prospects - it must also take into account shareholders' preferences, and the relationship withcapital markets more broadly.

As regards the firm:If there are noNPV positive opportunities, i.e. projects wherereturns exceed thehurdle rate, and excess cash surplus is not needed, then management should return some or all of the excess cash to shareholders as dividends. However, potentially limiting any distribution, the firm's overall finances, liquidity, and legal /debt covenants in place will also be of relevance. Management may also wish to avoid "unsettling" the capital markets^[1] by changing policy abruptly; see below re signaling.

As regards shareholders: As a general rule, shareholders of "growth companies" would prefer managers to retain earnings so as to fund future growth internally (or have a share buyback program) whereas shareholders ofvalue or secondary stocks would prefer the management to distribute surplus earnings in the form of cash dividends.Re the former, for example, the thinking is dividend payments, and share price, will be higher in the future, (more than) offsetting the retainment of current earnings.SeeClientele effect.

Regarding both:Management must choose theform of the dividend distribution, generally as cashdividends or via ashare buyback. Various factors may be taken into consideration: where shareholders must paytax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" fromstock rather than in cash; seeCorporate action.

There are severalschools of thought on dividends, in particular re their impact on firm value.^[3] A key consideration will be whether there are any tax disadvantages associated with dividends: i.e. dividends attract a higher tax rate as compared, e.g., tocapital gains; seedividend tax andRetained earnings § Tax implications.Here, per theModigliani–Miller theorem, as below: if there are no such disadvantages - and companies can raise equity finance cheaply, i.e. canissue stock at low cost - then dividend policy is value neutral; if dividends suffer a tax disadvantage, then increasing dividends should reduce firm value.Regardless, but particularly in the second (more realistic) case, other considerations apply; seeCorporate finance § Dividend theory.

The Modigliani–Miller theorem states that dividend policy does not influence the value of the firm.^[4] The theory, more generally, is framed in the context ofcapital structure, and states that — in the absence of taxes, bankruptcy costs,agency costs, and asymmetric information, and in anefficient market — theenterprise value of a firm is unaffected byhow that firm is financed: i.e. its value is unaffected by whether the firm is funded byretained earnings, or whether it raises capital byissuing shares or byselling debt.

The dividend decision, relating to both equity financing and retained earnings, is, in turn, value neutral.^[1]Here, shareholders areindifferent as to how the firm divides its profits between new investments and dividends. The logic, essentially, is that capital used in paying out dividends will be replaced by new capital raised through issuing shares. The latter will increase the number of shares,diluting earnings, and hence lead to a decline in share price.Thus any increase in firm value because of the dividend payment (e.g. per theGordon model, as below, wherevalue is a function of dividend) will be offset by the decrease in value due to raising new capital.

In contrast to the above, under thedividend discount model,^[2] and particularly the “Growth model” ofMyron J. Gordon, the value of the firm (or at least its equity) is explicitly a function of dividends paid.^[1] Here investors are seen to prefer a “bird in the hand”: i.e. dividends are certain as compared to income from future capital gains.The resultant valuation formula thus returns value as thepresent value of “all” future dividends:

${\displaystyle P=\frac{D_1}{r-g}}$

where:${\displaystyle P}$ is the current stock price;${\displaystyle g}$ is the constant growth rate in perpetuity expected for the dividends;${\displaystyle r}$ is the constantcost of equity capital (k_e) for that company;${\displaystyle D_1}$ is the value ofdividends at the end of the first period, which may be substituted with earnings multiplied by aretention ratio.

This formula, essentially, applies aperpetuity formula to the current dividend, set to grow ata sustainable rate. Strictly, it is then to be applied only to “mature “companies. Further, an implication as regards policy, is that (per the formula) dividends are paid only where investors’required return - i.e.cost of equity, k_e - is greater than the company’ssustainable growth rate. Conversely while the company is enjoying growth in excess of other comparable firms (and k_e) then it should not pay dividends, instead, funding its capital requirement with retained profits.

John Lintner provides an explicit formula for determining dividend policy;^[5]it is particularly relevant to apublicly traded company. A key model-assumption is that management will consider two factors in determining the dividend amount, with both indicating higher dividends correspondingly. The first is thenet present value of future earnings; the second is the sustainability of these earnings. At the same time, any policy must recognize that investors will prefer to receive their dividend with (some) certainty, and thus, if possible, management will maintain a constant rate of dividend (even if the results in a particular period are not up to the mark). The theory followed the observation^[5] that companies often set their long-rundividends-to-earnings target as a function ofexpected NPV positive "projects" (seecapital budgeting).

Expressed as a model, two parameters are considered: the target payout ratio and the rate at which current dividends adjust to that target:

where:

• ${\displaystyle D_t}$ is the dividend per share at time${\displaystyle t}$
• ${\displaystyle D_{t-1}}$ is the dividend per share at time${\displaystyle (t-1)}$, i.e. last year's dividend per share
• ${\displaystyle \rho }$ is the adjustment rate or the partial adjustment coefficient, with${\displaystyle 0\le \rho \le 1}$
• ${\displaystyle D_t^{\ast }}$ is the target dividend per share at time${\displaystyle t}$, with${\displaystyle D_t^{\ast }=\tau \cdot E_t}$
• ${\displaystyle \tau }$ is the target payout ratio on earnings per share (or on free-cash-flow per share), with${\displaystyle 0\le \tau \le 1}$
• ${\displaystyle E_t}$ is the earnings per share (or free cash flow per share) at time${\displaystyle t}$

When applying this model to U.S. stocks, Lintner found${\displaystyle \rho \simeq 30\mathrm{\%}}$ and${\displaystyle \tau \simeq 50\mathrm{\%}}$.

The above implies some symmetry. However, in reality, the progression of dividends is asymmetric: increases in dividend are usually small and frequent, while decreases (including cutting the dividend altogether) are large and infrequent.

Thecapital structure substitution theory (CSS)^[6] describes the relationship between earnings, stock price andcapital structure of public companies. The theory is based on the hypothesis that management "manipulates"capital structure such thatearnings per share (EPS) are maximized. As a corollary, the CSS theory is seen to provide management with (some) guidance on dividend policy - more directly in fact than other approaches, such as the Walter model and the Gordon model. In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.

The theory provides an explanation as to why some companies pay dividends and others do not: When redistributing cash to shareholders, management can typically choose between dividends andshare repurchases. In most cases dividends are taxed higher thancapital gains, and thus investors - and management - would typically be expected to select a share repurchase. However, for some companies share repurchases lead to a reduction in EPS, and it in those cases the company would select to pay dividends.From the CSS theory, then, it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than

${\displaystyle \frac{D}{E_{\text{q}}}>\frac{1-T_{\text{C}}}{1-T_{\text{D}}}-1}$

should prefer dividends as a means to distribute cash toshareholders, where

• D is the company's total long-term debt
• ${\displaystyle E_{\text{q}}}$ is the company's total equity
• ${\displaystyle T_{\text{C}}}$ is the tax rate on capital gains
• ${\displaystyle T_{\text{D}}}$ is the tax rate on dividends

Companies may then "target" a dynamicDebt-to-equity ratio.

The CSS theory does not have 'invisible' or 'hidden' parameters such as theequity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.Low-valued, high-leverage companies with limited investment opportunities and a high profitability, use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.^[7]

The dividend signaling hypothesis^[8][9]posits that acompany's announcement of an increase in dividend payouts constitutes an opportunityto signal to the market that the firm is "better off than the average". Increasing a company's dividend payout may then predict (or lead to) favorable performance of the company's stock in the future. (See alsoEarnings guidance.)

The theory is built on the assumption that, although in aperfect market there is noinformation asymmetry, in practice^[9] the firm's management will be better informed than the market inestimating the true value of the firm.(SeeEfficient-market hypothesis.)It has some support ingame theory,^[8] constituting a form of "signaling game".

Note that the concept of dividend signaling has been contested.^[8] At the same time, however, the theory is still used by some investors,^[8] and is supported by empirical studies^[9] showing that a firm's share price may increase significantly upon announcement of dividend increases, despite the cost inherent in thedividend tax.

Walter's model^[10] holds that dividend policy is a function of the relationship between the company'sreturn on investment and itscost of equity; a corollary is that the dividend decision will also affect thevalue of the company.

The underlying argument^[11] is that capital retained will be invested by the firm in its profitable opportunities, whereas dividends paid to shareholders are invested elsewhere.Here, the firm's achievablerate of return,r, is proxied by itsreturn on equity; while its shareholders'required rate of return is proxied by the firm's cost of equity, ork_e.Thus, ifr <k_e then the firm should distribute the profits in the form of dividends; however, ifr >k_e then the firm should invest these retained earnings. The value of the company, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is expressed^[11] as:

${\displaystyle P=\frac{D+r((E-D)/k_e)}{k_e}}$^{[dubious –discuss]}

where

• P = Market price of the share
• D = Dividend per share
• r = Rate of return on the firm's investments
• k_e = Cost of equity
• E = Earnings per share

The model assumes, at least implicitly, thatretained earnings are the only source of financing, and thatk_e andr are constant; given these assumptions, the approach is subject to^[11] some criticism.

Under a Residual Dividend policy,^[12][13] dividends are paid out from "spare cash" orexcess earnings; this is to be contrasted with^[12] a "smoothed" payout policy.A firm applying a residual dividend policy will evaluate its available investment opportunities to determine requiredcapital expenditure, and in parallel, the amount of equity finance that would be needed for these investments; it will also confirm that the cost of retained earnings is less than thecost of equity capital. If appropriate, it will then use its retained profits to finance capital investments. Finally, if there is any surplus after this financing, then the firm will distribute theseresidual funds as dividends.

Although absent of any explicit link to value, such an approach may, in fact, impact share price:This policy will attract investors who appreciate that the firm is trying to employ its capital optimally (and will require fewer newstock issues with correspondingly lowerflotation costs);^[12] it also delays (or removes) the payment of the secondary tax on dividends; seeRetained earnings § Tax implications.^[13]At the same time, however, such a policy may result in conflicting signals (see above) being sent to investors. It also represents an increased level of risk for investors, as dividend income remains uncertain, and the share price may respond correspondingly; seeResidual income valuation.

• Clientele effect
• Dividend puzzle
• Look-through earnings
• Dividend payout ratio
• Dividend yield
• Dividend cover
• Dividend future
• Ex dividend

• Dividend Policy by Alex Tajirian
• Corporate Dividend Policy by Henry Servaes (London Business School) and Peter Tufano (Harvard Business School)

• Dividends
• Financial risk management
• Investment
• Corporate finance
• Financial management

• CS1 errors: missing periodical
• Articles with short description
• Short description matches Wikidata
• All accuracy disputes
• Articles with disputed statements from June 2024