Week 11 Dividend Policy

The primary objective of financial management is the maximization of shareholder's wealth. To achieve this objective, management, the custodians of shareholders' interests, are faced with three important categories of decision making namely, investment, financing and dividend decisions. Investment decisions determine the total value and types of assets a firm employs. Financing decisions determine the capital structure of the firm and forms the source on which investment decisions are made. Dividend decisions in the form of dividend policies, which form the focus of this study, involve the determination of the pay out policy that management follows in determining the size and pattern of cash distributions to shareholders over time (Lease, 2000). According to Botha (Feldstein&Green,2002), the investment, financing and dividend decisions are interdependent and must be resolved simultaneously. A combination of these policy decisions should theoretically maximize shareholders' wealth.

Growth in the valuation model of share price represents the earnings generated by investment decisions in projects that create excess cash flows. Management has to decide how these earnings are to be allocated, either by reinvesting in the assets of the firm or by way of a distribution to shareholders in the form of a dividend. In making its decision, management has to constantly strive to increase the value of the firm. This increased value of the firm results in a concomitant increase in the value of shareholders' wealth

In order to create excess cash flows, management has to invest in project that have positive net present values (NPV'S). This is known as applying the NPV rule. The excess cash flows generated by positive NPV projects result in higher earnings. According to Frankfurter (2002), management can either decide to distribute these earnings as a cash dividend or reinvest them in the firm to generate even higher cash flows in the future. The decision to pay a dividend would depend on whether the firm can invest the excess earnings  in positive NPV projects in the future. In maximizing shareholders' wealth, management should only invest in projects with positive NPV values otherwise excess earnings should be paid out to shareholders in the form of a dividend.

Kaen(2003) states if dividends are paid out to shareholders only after surplus earnings have been invested in positive NPV projects then the firm follows a residual dividend policy. In this situation, the payments of dividends are closely linked to the availability of excess earnings due to the availability of positive NPV projects. Because of this link between dividends and earnings, dividends will mimic earnings from one period to another. If earnings are good and there are only a limited number of positive NPV projects to invest in then the residue of earnings are high and high dividends will be paid to shareholders. The opposite would be true if the situation is reversed. This volatility in dividend payments to shareholders from period to period would negatively influence share price because of the difficulty in predicting future dividends, a key determinant of share price.

A managed dividend policy, on the other hand, attempts to smooth dividend payments relative to earnings and investments. By following this policy, management attempts to fix dividend payments to certain levels of earnings and will only increase dividend payments once an increased level of earnings can be sustained. According to Lease et al (2000), under a managed dividend policy, managers are managing the dividend level and growth. Dividends grow in even increments and are predictable. Shareholders would have much more confidence in predicting the dividend in the following year than would shareholders under a residual policy.