Dividend Policy
Financing Decisions
Dividend Policy
Syllabus tag: KASNEB CPA | Intermediate Level | CA22 Financial Management | Topic 6 Dividend Policy
Lesson objectives
By the end of this topic, you will be able to:
- Compute payout ratio, retention ratio, dividend cover and dividend yield
- Link retention to growth and to the share price
- Explain the residual, stable and constant payout policies
- Outline the dividend irrelevance argument and the practical objections
- Distinguish a bonus issue, a scrip dividend and a share buyback
Why this matters
Cost of Capital used the dividend growth model without asking who decides the dividend. This topic does. The decision matters because every shilling paid out is a shilling not reinvested.
One company throughout
Earnings KES 6,400,000; 800,000 shares; dividend per share KES 3.20; share price KES 40; return on equity 12%.
EPS = 6,400,000 / 800,000 = KES 8.00
Words to know
- Payout ratio — the share of earnings paid out as dividend.
- Retention ratio — the share kept in the business. The two sum to 100%.
- Dividend cover — how many times earnings cover the dividend.
- Dividend yield — dividend as a percentage of the share price.
- Clientele effect — investors gravitate to companies whose payout suits their own tax position and income needs.
- Signalling — the information a dividend change conveys, whether or not the company intends it.
The four measures
| Measure | Working | Result |
|---|---|---|
| Payout ratio | 3.20 / 8.00 | 40% |
| Retention ratio | 100% − 40% | 60% |
| Dividend cover | 8.00 / 3.20 | 2.5 times |
| Dividend yield | 3.20 / 40 | 8% |
Payout ratio and dividend cover are the same fact stated two ways: cover is simply the reciprocal of the payout ratio. Quoting both adds nothing, and an examiner asking for one does not want the other.
Retention, growth and price
Retained earnings fund growth:
g = b × ROE = 0.60 × 12% = 7.2%
Feed that into the Gordon model:
P0 = D1 / (Ke − g) = (3.20 × 1.072) / (0.15 − 0.072) = 3.43 / 0.078 = KES 43.98
This is where the tension lives. Raising the dividend increases D1, which pushes the price up. But it also cuts retention, which lowers g, and that pushes the price down. Which effect wins depends on whether the company can reinvest at a return above its cost of equity.
:::checkpoint A company earning a 12% return on equity has a cost of equity of 15%. Should it retain more or pay out more? Explain using the relationship between ROE and Ke, not just the formula. :::
Three policies
- Residual. Fund every worthwhile project first; pay out whatever is left. Logical, and it produces a dividend that swings wildly year to year.
- Stable. Set a dividend the company is confident of maintaining, and raise it only when the increase looks permanent. Most listed companies do this.
- Constant payout. Pay a fixed percentage of earnings. Simple, but the dividend then rises and falls with profit.
Does the policy affect value?
The irrelevance argument. In a perfect market, a shareholder wanting cash can sell a few shares, and one not wanting cash can reinvest the dividend. The company's policy therefore cannot change what anyone is worth. Value comes from the investment decisions, not from how the returns are packaged.
Why it does not hold in practice.
- Taxes. Dividends and capital gains are taxed differently, so investors are not indifferent between them.
- Transaction costs. Selling shares to manufacture income is not free.
- Signalling. A dividend cut is read as bad news even when management explains it as reinvestment, so cuts are avoided long past the point where they would make sense.
- Clientele. Retired investors holding a share for its income do not welcome being told to sell part of their holding instead.
Bonus issues, scrip dividends and buybacks
Bonus issue. Free shares from reserves. A 1-for-4 issue takes the share count from 800,000 to 1,000,000 and EPS from 8.00 to KES 6.40. No cash moves and no shareholder is better off — each simply owns more, smaller pieces of the same company.
Scrip dividend. Shares offered in place of a cash dividend. The shareholder chooses; the company conserves cash.
Share buyback. The company purchases its own shares. Buying back 100,000 shares leaves 700,000 and lifts EPS to KES 9.14. Cash does leave the company, so unlike a bonus issue this is a real distribution — an alternative to a dividend rather than a cosmetic change.
:::checkpoint A bonus issue lifts the share count and cuts EPS, yet share prices often do not fall by the full proportion. Suggest why, and say what that tells you about what the announcement signals. :::