Name: Mitch Mureithi Kaniaru ID: 623824 Semester: Summer 2011 Course: Fin 4050 (Financial Information Systems)

Date Due: 23rd July 2011 Assignment: Term Paper Lecturer: Albert Bwire
In not less than 2000 words, discuss the practical reasons that influence a firms dividend policy

Introduction
There are a number of reasons or factors that influence a firms dividend policy. However, before we can look into these factors, we first have to go over the basics. So the first question that we have to ask ourselves is, what are dividends?

Dividends are amounts paid to shareholders due to ownership of shares. Dividends are usually paid from a percentage of the earnings of the company. This means that dividends are paid when there is a surplus in revenue. Companies however, dont always pay out dividends with their earnings, they can decide to either pay dividends or retain them. There are different types of dividends paid to shareholders and they include:

Cash Dividends
Cash dividends are the most common type of dividends. They are paid out to shareholders in the form if real cash. It is also taxable in the year its paid because these dividends are considered to be investment income.

Stock Dividends
These are dividends paid out to shareholders in the form of additional shares of stock. These shares offered are either that of the issuing company or that of one of its additional corporations. The shares offered are usually issued in proportion to the shares owned. The market capitalization of the shareholder is not changed even though it increases the total number of shares and at the same time reduces the price of each share. This is similar to a stock split.

Property Dividends
These dividends are paid to shareholders in the form of products and services from the company that or that of one of its additional corporations. When paying this type of dividend, the company will usually use securities of other firms owned by the company.

After looking at the different types of dividends, the next question we should ask ourselves is, What is dividend policy?

Dividend policy is the method in which a company uses in order to decide on how much dividends it will pay the shareholders of the company. This means that the decision on whether to pay dividends or retain the earnings is determined using the dividend policy. This means that it is a guideline developed as a way of making dividend payments to shareholders.

The dividend policy is very important, especially to the managers of a company because a firm paying high dividends is a sign of good financial health. This makes a good dividend policy very advantageous to the company and its shareholders.

However, a change in the dividend policy cannot result in an increase of a companys value. This was proven by Miller and Modigliani in 1961, where in a perfectly efficient market, a firms value cannot be increased by changing the dividend policy of the firm. The flaw however with this hypothesis, is that perfectly efficient markets dont exist in real life.

That is why there are many other theories, such as:

John Lintner Theory (1956)

John Lintner carried out research on different firms dividend policy. He came up with the conclusions that: y Managers considered each years dividend in relation to last years payment rather than determining the dividend afresh each year in relation to the companys current earnings and investment requirements. y y Management seem to have in mind a long term target payout ratio. Dividends increased with earnings, but only to the extent that the dividend increases appeared to be sustainable.

The determinant of the dividend policy according to Lintner (1956) is the managers use of the previous years dividend policy and adjusting this pay-out ratio to fit into the current years dividend policy. This method is widely used by local firms to pay dividends to ordinary shareholders of a company.

Lintner therefore formulated a formula that can determine the changes in dividends a company should pay from its previous year: Dt = S ZEPSt Dt-1

Where: EPSt = Is the earnings per share in period t Z S = Long run target payout ratio = Adjustment factor.

Signalling Theory
This theory states that information can affect the dividend policy paid out to shareholders. For example, if there has been a notice or announcement of a constant increase of 5% in the dividend pay-out ratio, then the price per share will remain constant because the increase was expected. However, if the company states a 5% increase and actually give a 25% increase in the dividend pay-out ratio, then this will result in the price of stocks rising. The changes in the price of stock show that important information is contained in dividend announcements. So, dividend announcements provide investors with information previously known only to management. In a nutshell, this theory is based on the assumption that information is not available to investors at the same time.

Clientele Effect
The clientele effect states that investors are attracted to different company policies. This means that when a company's policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move. For example, a company that pays high dividends and has attracted clientele whose investment goal is to obtain stock with a high dividend payout. If the company decides to decrease its dividend, these investors will sell their stock and move to another company that pays a higher dividend. As a result, the company's share price will decline.

As we see above, all these theories have one thing in common. They show that dividend increases the value of a firms equity. Therefore investors are more attracted to firms who are paying higher dividends.

So what are the different approaches firms can take to their dividend policy? Well, there a number of approaches and they include:

Fluctuating Dividends Policy

Firms use this policy when they have a number of investment opportunities to choose from or if their capital expenditure is not stable. This means that the firm would rather invest its revenue than pay dividends to shareholders. The firms that use this policy are usually those that finance any new investments or projects with their internally made revenue. So, in this case, the dividends are only once paid when there is money left to spare after investing.

Stable Dividends Policy

Firms use this policy to improve the value of each share. Firms therefore that have a stable dividend policy will attract investors because they will be seen as less risky and that is what increases the marketability of the firms shares. Such a policy also improves on the firms financial planning. This occurs because the firm can determine with certainty the amount of dividends it will pay out when doing their cash flow budget. Companies that use this policy often set their dividends at a fixed fraction of the companys earnings.

Constant Dividends Policy

Firms that use this policy have a fixed percentage as its dividend policy. For example, a firm can state that 20% of its net income at the end of the period will be for paying dividends. This means that the amounts paid each year will be different because of the fluctuations in the companys net income for the year. If this is the case, it therefore means that in the event that the firm makes a loss, then no dividends will be paid and the market price of the shares will reduce.

Hybrid Dividends Policy

This dividend policy has features of both fluctuating and stable dividends policy. This means that it contains, in normal income years, a stable dividend policy. However, in years of high income, an incremental percentage is used to determine the dividend policy. This policy is very flexible, but the certainty of future cash flows to investors is very low.

We have gone through the different types of dividend in the paper, as well as look at the different approaches firms can take to their dividend policy. So the next step is to look at the factors that would most likely influence a firms dividend policy.

The Factors That Influence a Firms Dividend Policy

So what are the factors that influence that would influence a firms dividend policy?

Stability of Earnings
The stability of the earnings is dependent on the nature of the business. The nature of the business is therefore important to the dividend policy. Businesses which have stable earnings tend to have a consistent dividend policy in comparison to those which dont have stable earnings. For example, businesses such as monopolies and duopolies will always have stable earnings, however, businesses that face high competition or that produce homogeneous products are not guaranteed stable earnings. This is why the nature of the business is very important.

Liquidity of Funds
How fast or easy it is for a firm to turn its assets into cash is a very important factor in influencing the dividend policy. This is because, when a firm is paying dividends, they are paying cash outwards. So, if a company cant get cash quickly from its large amount of assets, then it cant pay high dividends to its shareholders, so it would have a low dividend policy. However, if a firm is highly liquid and can get cash very easily from its large amount of assets, then they can have a high dividend policy since the cash to pay the shareholders is available. The amount of assets doesnt matter unless its insufficient to pay the shareholders. The liquidity of a firm depends on the investment and financial decisions of the firm. This determines the

expansion rate and the way in which the company will finance them. If the cash position of the firm is weak, then the stock dividends will be distributed. However, if the cash position is good, then the company can distribute the cash dividends.

The Age of the Company

The age of the company is very important because it counts when deciding on the firms dividend policy. This is because newly formed firms find it difficult to pay its shareholders since its main objective when so young is to grow and expand using its little earnings. Old firms on the other hand, are more established, meaning it easier for them to have a more stable and consistent dividend policy.

Needs for Additional Capital

When a firm is in need of additional capital, they will most likely have a low dividend policy. This is because firms, such as small businesses, find it difficult to raise revenue for its growth and expansion. This is why they will most likely use the profits made for the year for expansion. Therefore it is only natural for the firm to keep majority of its revenue for expansion, rather than use these funds to pay shareholders. This explains why a firms need for capital influences a firms dividend policy.

Government Policies
The government and its policies play a part in the determining of a firms dividend policy. Government policies such as labour laws, tax laws, government restrictions, industrial policies and other policies affects the dividend policy because these policies affects the earnings of the company. For example, a government restriction such as a certain percentage limit on the distribution of dividends in an industry will affect the way in which a firm will set its dividend policy.

Tax Policies
Tax affects the dividend policy of a firm. This is because, if a firm has to pay high taxes, then it will reduce the earnings of the company. As a result, a reduction in the companys revenue means a reduction in the amount of money it has to pay dividends, thus a low dividend policy.

For example, in India, dividends that go beyond 10% in the form of paid up capital are subject to a tax dividend of 7.5%.

Legal Requirements
The accounting profession has rules or guidelines in which it is governed by. These guidelines are backed up by the law. An example of one of these guidelines can be; companies are required take into account depreciation on its fixed and tangible assets before declaring the dividends on its shares. Another example could be that the payment of dividends on preference shares takes priority over the payment of ordinary dividends. This therefore shows how these legal requirements are a factor in determining firms divided policy.

Dividend Rates of Past Years and Competitors

The previous years dividend policy is important in determining the current years dividend policy. This is because; the directors should make the current dividend policy rate to be an average of the previous years rate. This is so that investors dont speculate and reduce the trustworthiness of the companys shares in the stock exchange. The dividend policy of competitors is also important, so that the dividend ratios can be kept at around the same area in the industry.

Access to Funds
The ease of access to funds, both internally and externally is a factor in determining the dividend policy of a firm. Older, more established firms find it easy to borrow funds from external sources, so they can afford to give a larger dividend pay-out ratio in comparison to a smaller firm. Small firms find it difficult to get external sources of funds, so it relies on its internally made revenue. This means that they will have to give a small dividend pay-out ratio so that is can grow and meet its obligations.

The Control Policy

The level of control of the company the directors want to keep is a factor in determining the dividend policy of the firm. This is because, the sale of shares is a sale of ownership of the company and control therefore comes with ownership. So, if the directors want to keep control

and not to distribute it to many people (shareholders), then they can have a policy which pays dividends at a low rate. In order for the management to keep this control, then the company will have to rely on their retained earnings. However, there are some managers who dont really care about the level of control and will have a dividend policy that will be beneficial to them. This is how control affects the dividend policy.

Time for Payment of Dividends

The time in which the firm pays its dividends is very important. This is because dividends are a cash outflow and its best for the firm to pay these dividends when they least need the finances. So, good management should plan to pay dividends when they dont have any obligations to make cash payments. Such businesses include those that have peak and off peak seasons. Meaning the firm can predict on what time they will have revenues throughout the year. This is why time is an important factor when determining the dividend policy.

Conclusion
The way in which the firm decides to pay its dividends is affected by many factors. These factors, as seen above are both internal and external. So there are factors that are in the control of the management and there are those that are beyond the control of managers. So, determining a suitable dividend policy is dependent on the type of business, the age of the business and many other factors that make a dividend policy suitable to their current situation.

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