Introduction
A dividend policy is one of the best policies that an organization’s board of directors can make. A Company like linear technology that is trying to choose the best dividend, is contemplating making a very important policy that will see a company grow to great heights. There are many factors that affect dividend policy and they include market consideration, legal, contractual, cash flow position, and internal constraints, the firm’s growth prospects, owner considerations.
Growth prospects: First the firm evaluates its needed financing in light of its future growth prospects if there is the availability of outside financing and the exact funds needed affects the need for retained earnings to financial growth. This is because the firm’s financial requirements are directly related to the degree of asset expansion to be undertaken. If the firm is in the growth stage, it may need all the funds it can get to finance capital expenditure. High-growth firms typically find themselves constantly in need of funds. Their financial requirements may be characterized as large and immediate. Again if there are other sources of funds for planned expansion then dividend policy will take a different position. This means that firm must evaluate its financial position from both profitability and a risk standpoint in order to develop insight into its ability to raise capital externally. They have determined not only its ability to raise funds but also the cost and quickness with which financing can be obtained. A firm like Linear technology that is growing depends heavily on internal financing through retained earnings in order to take advantage of the profitable projects available to it. It is therefore quite likely to pay out only a very small percentage of its earnings as dividends.
The more stable firm that needs capital funds only for planned outlays is better advised to pay out a large proportion of its earnings, especially if it has ready sources of financing, instead of retaining these earnings and investing them in marketable securities until the planned outlay must be made. The firm’s owners, is assumed, can earn a greater return on other investments. When funds are needed, the firm should obtain them externally.
In coming up with establishing a dividend policy, the primary concern should be how to maximize the firm’s owner’s wealth over the long run. Although it is impossible to establish a policy that has a favorable effect on the wealth of the majority o the owners. The tax status of a firm’s owner can have a significant effect on the firm’s dividend policy. If a firm has a large percentage of wealthy stockholders who are in a high tax bracket, it may pay out a low percentage of its earnings in order to provide its owners with income in the form of capital gains as opposed to dividends. On the other hand, a firm may have mostly lower-income shareholders who need dividend income and are in a low tax bracket. A firm should also not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments. The firm should evaluate the returns expected on its investment opportunities and determine whether greater returns are obtainable from external investments such as government securities or other corporate stocks. If it appears the owner has better opportunities externally, the firm should pay out a high percentage of its earnings. If the firms’ investment opportunities are at least as good as similar risk external investments, a low payout of earnings is justifiable. A firm should not retain funds in the form of marketable securities in order to make some future outlay; rather, it should pay out these earnings now and raise the needed funds later when the outlay must be made. The effect on the management of the firm should also be considered before this policy is designed.
Therefore it is important that the stockholders recognize the firms’ motives for dividend policy. Although the ultimate dividend policy depends on numerous factors, the avoidance of shareholder discontent is important. If the shareholders become dissatisfied with the existing dividend policy, they may sell their shares increasing the possibility that control of the firm will be seized by some outside group.
Legal, contractual and internal constraints: – The firm’s dividend policy is often constrained by certain legal, contractual/ or internal factors. The legal factors result from certain state laws, the contractual constraints typically result from certain loan covenants, and the internal constraints are the result of the firm’s liquid–asset position.
Legal constraints: there is four basic legal a constraint confronting the corporation with respect to cash dividend payments. They concern capital, net profits, insolvency, and accumulation of excess profits.
Capital impairments: most states prohibit corporations from paying out as cash dividends any portion of the firm’s capital stock as measured by the par value of the common stock, but also any capital paid –in excess of par. Capital impairment restrictions are generally established in order to provide a sufficient equity base to protect creditors’ claims on the firm’s assets.
Insolvency: If a firm has overdue liabilities or is legally insolvent, many states prohibit the payment of cash dividends. This restriction is intended to protect the firm’s creditors by prohibiting the liquidation of a near-bankrupt firm through the payment of cash dividends to owners. The payment of cash dividends by an insolvent firm could seriously impair its creditor’s claim in bankruptcy.
Contractual constraints: often the firm’s ability to pay cash dividends is constrained by certain protective covenants in a term loan agreement, a bond indenture, a preferred stock agreement, or a lease contract. Generally, these constraints either prohibit the payment of cash dividends until a certain level of earnings has been achieved or limit the number of dividends paid to a certain amount or percentage of earnings. Since cash is required to pay dividends, constraints on dividend payment help to protect creditors.
Internal constraints:- the firm’s ability to pay cash dividends is generally constrained by the amount of excess cash available. Of course, it is possible for a firm to borrow funds to pay dividends: but if borrowing were necessary, the minimum dividend would most likely be paid. Lenders are not especially interested in loaning money for dividend payments, since they produce no tangible or operating benefits that will help the firm repay the loan. It is important to keep in mind that, although a firm may have high earnings, its ability to pay dividends may be constrained by a low level of liquid assets.
Market considerations:- In establishing a dividend policy, it is important to consider certain behavior aspects of the securities market. Since the wealth of the firm’s owner is reflected in the market price of the firm’s shares an awareness of the market’s probable response to certain types of dividend policies is helpful in formulating a suitable dividend policy. The marketplace views the firm’s dividends as a source of information. The firm should attempt to develop a dividend policy that provides owners and prospective investors with positive information, therefore reducing their uncertainty about the firm’s future success. By paying fixed dividends on a continuous basis, the firm gives its owners a feeling of confidence in its continued success. It is quite important for the firm to consider the views and reactions of the marketplace to dividends in formulating a dividend policy.
Situation
Linear Technology which is Headquarters in California and formed in 1981 is trying to design a dividend policy. The company is in the industry of semiconductors where they are involved in designing, manufacturing, and marketing semiconductors that are used in cell phones, digital cameras, and many others. The company has been growing in profitability for the last five years but lack a dividend policy until they announced their dividends in 1992. In 1994 a dividend policy of $ 0.05 was availed and constituted 15% of the earning at that year. It was argued that it was too low but was good to enable the dividends to remain sustainable since they had not come up with a dividend payout ratio that could be sustainable and this will fluctuate the dividends to the shareholders.
They continued to pay dividends quarterly until the year 2002 when they wanted to change the dividend policy by increasing it. However, at the same time, the payout was ranging between 25% to 30%. The company had accumulated large reserves and cash flows and they which led to the need for a change of dividend policy. Because of this constant policy, some shareholders acquired their shares because they a stable dividend policy adopted by the company. If there is consistency in the policy on dividends, many investors would be put off the shares as they would not know whether the levels of dividends would suit their preferences or not. The lack of popularity of the dividends of the shares would have an adverse effect on their price and, therefore, on the cost of capital. Even if a particular business were to be fairly consistent in its dividend policy, but then undertook a major change, those of its shareholders who particularly liked the previous dividend policy would probably seek to move to the shares of a business with a dividend policy more acceptable to them. While it might well be the case that a new clientele would find the dividend policy attractive, the friction caused by one set of investors selling to a new set of investors would have a net adverse effect on the shareholders. Not only this, but the uncertainty in the minds of investors that the change may precipitate, as to how consistent the dividend policy was likely to be in the future, could also have a dampening effect on the share price.
Analysis
The dividend payout for linear technology should be in line with the dividend policy of this other firms in the same industry. Intel has been paying dividends for the last ten years on quarterly basis of $ 0.1 per share and has had splits to cover for the growth for capital gains for the shares. In the same industry maxim also introduced a quarterly dividend of $ 0.02, this firm had the same performance with Linear technology. Another industry player, Microsoft, had taken a regular dividend of $ 0.04 quarterly.
Looking at the cases of the industry one we be persuaded to believe that the industry has chosen a more stable dividend for their shareholders and seems industry players have accepted that it is desirable for dividends to remain relatively stable, with a possible rising trend over the years. This is because:
- Shareholders favor reliable income from their investment as this facilities financial planning;
- A steady dividend trend seems to indicate a stable and well-managed company;
- In an information-hungry situation as the stock market is any announcement is likely to be seen as conveying implicit information beyond what it actually sates. Thus the announcement of dividend substantially below that of the deep pessimism about may be read as an assurance that profits are expected to reach higher levels.
If dividend is to be insulated from fluctuations on profit then clearly caution is required. If a company distributes the whole of its profit then a temporary setback must mean that dividends are cut. If it distributes only part of its profit there is much more room to maintain the dividend over the bad years. However the directors of companies in these industries would regard consistency of dividend policy as important from what is seen. This is so that investors may know as part of their investment strategy, whether as share is getting maximum distribution or getting capital gains due to the maximum amount retention for expansion.
Usually the basis for determining the amount of the dividend is financial or cash flow position of the company. The simple rule is that if the company can invest its profit within the business more profitably than its shareholders could invest it elsewhere, then it should retain the profit. If not should distribute it. However one will not avoid observing that:
- In deciding whether or not to pay a dividend one should, have regarded to each individual shareholder’s opportunity cost of capital and this is brought into equilibrium with the equity cost of capital by market forces.
- A full application of this principle may lead to a rate of dividend which fluctuated widely. We have already implied that this would be undesirable. The dividend would obviously vary with the profit and with the investment opportunities which were currently available.
- With a business which was expanding rapidly because there were abundant attractive investment opportunities open to it these may absorb the whole of the profit and still require further equity finance, i.e. in effect a negative rate of dividend. In real life it is most unlikely that company could continuously raise new capital if it never paid a dividend.
- The capital budgeting decision may indicate that dividend in excess of profit should be paid. The privilege of limited liability may sometimes, therefore be gained at the cost of investing to yield a return at below the cost of capital.
However this must be considered in line with the constrains before a dividend decision:
- Legal; The company law allows the payment of dividend only out of profits calculated on conventional accounting principles.
- Conventional; Is part of the lore stock market that a company is favored by investors if its dividends are basically stable overtime. A gentle upward movement is to be desired but violent fluctuations in either direction are not. This coupled with the legal factors often leads to a very cautious policy.
- Liquidity; Regardless of other considerations a company will be unable to pay a dividend if cash is not available thus even borrow by overdraft
- Financial; The profits should be retained when they can profitably be invested within the business but not otherwise residue of the profit for which there is no profitable use. The analysis is quite straightforward-retained earnings becoming a component of the cost of capital.
Conclusion
When the industry players are establishing dividend policy, it is important to consider certain behavior aspects of the securities market. Since the wealth of the firms’ owner is reflected in the market price of the firms’ shares an awareness of the markets probable response to certain types of dividend policies is helpful in formulating a suitable dividend policy.
Most shareholders and directors in the industry seem believe in the fixed level of dividends as opposed to fixed payout ratio, which is found by dividing the dividends per share by the earnings per share, is held constant, the shareholders may receive no dividends in lean periods and high dividends when earnings are high. This is because paying a dollar-dividend eliminates uncertainty about the magnitude of dividends, the earnings of the firm are likely to be discounted at a lower rate and the value of the firms stock is likely to remain at a reasonable high level. In this industry it seems a stable dollar dividends are considered preferable to the variable dividends that may result from a fixed payout ratio.
Continuous dividend payment as in this industry has introduced a certain degree of certainty. This reduces shareholder uncertainty of returns, by making the amount of the dividend payment predictable and frequent. The continuous payment of cash dividends, regardless of their magnitude, reduces shareholder uncertainty and lowers the rate at which earnings are discounted. The net effect should therefore be an increase in the market value of the firms stock and therefore in the owners wealth.
The informational content of dividends: shareholders often view the firm’s dividend payments as an indicator of the future success of the firm. A stable, continuous dividend conveys to the firms’ owners that the firm is sound and there is no reason for alarm. If the firm passes a dividend payment in a given period due to a loss or very low earnings, shareholders are quite likely to react unfavorably. The nonpayment of the dividend creates uncertainty about the firms’ future successes, and this uncertainty is likely to result in low stock values. Even if current earnings are low, affirm should continue its dividend payment in order to avoid conveying negative information to owners and prospective investors. Owners and investors generally construe a dividend payment during a period of losses as an indication that the loss is temporary.
Recommendation
The company should adopt a policy similar to the other industry players which they are operating currently. They should invest some of cash they have accumulated and at the same time try to increase the dividend amount instead of the proposed a dividend ratio. This is because a dividend ratio will make the dividends unstable to the shareholders. This is because from the point of view of the shareholders dividends will be seen as only a part of his return from the investment in the company. The capital growth which occurs will also be important. In assessing the company’s success he will have a particular interest in the figure for earnings per share which will include all profit whether distributed or not.
However from the point of view of the company retained earnings may be an important source of investment funds but it has to be recognized that they a have cost, just as does finance from other sources and must, therefore, be deployed in profit-able uses. The dividend decision is thus one in which the financial manager is greatly concerned.
Therefore the company should increase the dividend to $ 0.1 and inform the shareholders of the increase as result of accumulated profits. Some of the remaining should be invested in diversified investments that will help the company improve its profitability and make the remain competitive in the market by attract more investors eventually improving creditworthiness of the company.
References
- Ghetti A. (2008); Terrific introduction to financial management; Amazon
- McLaney E., (2003; Business finance theory and practice; Prentice Hall
- Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. ISBN-13: 978-0-07-353059-8/ISBN-10:0-07-353059-X