Dividend Policy

DIVIDEND THEORY

The current literature puts forward three main theories intended to explain dividend policy methodology, each of which centers on the idea of sending residual income to investors:

• Pure Residual Dividend Policy - states that when the return on a company's equity capital is greater then the rate of return an investor can obtain by reinvesting that capital dividends in other investments with equivalent risk, the investor prefers such dividends to a corporation acting on its behalf and reinvesting its earnings rather than issuing dividends, the Company can determine which option is more suitable to benefit investors by first identifying the company's optimal capital budget, thereby recording the level of equity capital required, and then maintaining the amount of income required to finance capital equity in the capital budget and allowing for "residual" funds (unused income from internal investments) after reinvestment that is mandated to be issued as dividends (Droms 218). Therefore, dividends are a function of income fluctuations, and this method allows for significant dividend fluctuations along with changes in income and company investment opportunities. As a result, all remaining income is paid out which leads to investment opportunities. As a result, all remaining earnings are paid out which causes the dividend payout ratio to fluctuate. This policy also results in dividends that vary from year to year, and when equity investment is greater than income, then equity financing must be initiated to create a residual (Droms, 1990).
• Smoothed Residual Dividend Policy - indicates that dividend fluctuations are kept at a minimum. Changes in dividend policy tend to lag Shapiro's earnings fluctuations, as "Dividends are set equal to the long-term residual between expected earnings and investment terms. Dividend changes, in turn, are made only when this long-term residual process is expected to change; earnings fluctuations are believed to be temporary is ignored in setting dividend payments. The obvious preference is a stable, but steadily increasing, dividend per share" (Shapiro 532-533). Thus, the dividend payout ratio fluctuates significantly with this payment method, and the dividend could potentially exceed the residual if earnings are unexpectedly low.
• Constant Remaining Payout Dividend Policy - suggests maintaining a constant dividend payout ratio, which causes dividends to fluctuate along with earnings.
• Small Quarterly Dividends with Annual Bonuses - denotes small periodic dividends and annual "bonus" dividends offered to investors if earnings exceed expectations. Companies that experience wide fluctuations in income and investment often use this policy. This option benefits management, because they have cash flexibility, and also investor flexibility because they are guaranteed a small annual dividend.

This article was written to fulfill Dr Darmawan's financial management course assignment