CORPORATE FINANCIAL MANAGEMENT

Corporate Financial Management

Corporate Financial Management

Introduction

The dividend decision is an integral part of the firm's strategic financing decision. It essentially involves a firm's directors deciding how much of the firm's earnings, after interest and taxes (EAIT), should be distributed to the firm's ordinary shareholders in return for their investment in the firm, and how much should be retained to finance future growth and development. (Sterk and Vandenberg 2004 441-55)The objective of the firm's dividend decision, like all financial decisions, should be the maximisation of shareholder wealth.

If an optimal dividend policy does exist then clearly managers should concern themselves with its determination; if it does not, then any dividend policy will do, as one policy will be equal to another. It should be noted that the dividend decision and dividend policy relate only to ordinary share capital. (Asquith and Mullins 2003 77-96)The payment of preference share dividends is not considered part of a firm's dividend policy, as the level of, or method of calculating, the preference dividend is fixed in advance by the terms and conditions of the original preference share offer.

Once a dividend policy has been formulated, setting out the amount and timing, etc. of dividend payments, it should be followed with stability and consistency as its guiding principles. As we shall discuss later, changes to a firm's dividend policy can be interpreted in various ways by the financial markets, sometimes with dramatic consequences for the firm's share price.

You will note that the dividend decision is made at the level of the firm's most senior managers - at board of director level. It is the directors who will decide the amount and timing of dividend payments. Under UK company law the directors cannot be compelled to recommend a dividend and shareholders cannot vote themselves a higher dividend than that recommended by the directors. (Bajaj and Vijh 2004 193)

Multiple Measures of Dividend Policy

Dividend "policy" implies a conscious management of dividend distributions over time. Surveys indicate that managers tend to focus on the payout ratio in the long run, but smooth dividends in the short run. (Baker et al 2004 1-8) In the longer run, the level of the firm's average payout ratio captures the firm's commitment to the level of dividend distribution out of earnings. However, over time the firm need not adhere to the same short-run payout ratio to accomplish the longer-run objective unless earnings are stable.

If dividends per share are consciously smoothed relative to earnings, the firm's payout ratio will be volatile. The greater the volatility in the payout ratio, the greater the smoothing of dividends. The volatility of dividends around their trend reflects the inherent dividend stability aspects of the policy. (Woolridge 2002 237-47)Measures of the average payout ratio (APOR), dividend stability around the dividend time trend (R2LDPS), and payout ratio volatility (SDPOR) are used to represent the firm's policy with respect to dividend levels, stability, and smoothing.

The residual theory of dividend policy

The essence of the residual theory of dividend policy is that the ...