Theories of Dividend Policy
1. Residual theory
The essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed.

Using this approach, the firm would treat the dividend decision in three steps, as follows:
Step 1: Determine its optimal level of capital expenditures for the year or period under review.
Step 2: Using the optimal capital structure prepositions, estimate the total amount of equity financing needed to support the expenditures generated in step 1.
Step 3: Because the cost of retained earnings, kr, is less than the cost of new company ordinary shares, ke, use retained earnings to meet the equity requirement determined in step 2. If retained earnings are inadequate to meet this need, sell new ordinary share. If the available retained earnings are in excess of this need, distribute the surplus amount, the residual, as dividends.

With the residual dividend policy, the primary focus of the firm’s management is indeed on investment, not dividends. Dividend policy becomes irrelevant, it is treated as a passive rather than an active, decision variables. The view of management in this case is that the value of the firm and the wealth of its shareholders will be maximised by investing the earnings in the appropriate investment projects, rather than paying out as dividends to shareholders.

Dividends will only be paid when retained earnings exceed the funds required to finance the suitable investments projects. Conversely, when the total investment funds required exceed retained earnings, no dividend will be paid.

2. Irrelevancy theory
The effect of dividends on market price per share has been a controversial one for many years. In 1961, Modigliani and Miller (MM) published an important article dealing with dividends and their effect on shareholders’ wealth. The whole divided irrelevance school originated with this publication.

MM argued that share valuation is a function of the level of corporate earnings, which reflects a company’s investment policy, rather than a function of the proportion of a company’s earnings paid out as dividends.

MM further argued that, given the irrelevance of a company’s capital structure, investment decisions were responsible for a company’s future profitability and hence the only decisions determining its market value.
MM then concluded that share valuation is independent of the level of dividend paid by a company.

MM’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a shareholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s share. If the cash dividend you received was too small, you can just sell a little bit of your share in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be the same.

3. Dividend Relevance (Traditional view of dividend decisions)
Obviously, the assumptions made by MM are unrealistic. In the real world, investors might prefer one dividend policy over another. If so, a firm’s dividend policy is relevant. According to the dividend relevance theory, then, dividend policy can affect the value of a firm through investors’ preferences.

One of MM’s assumptions that have been hotly debated is that dividend policy does not affect investor’s required rate of return on equity, Ke. For example, Myron Gordon and John Lintner argued that investors prefer to receive dividends ‘today’ because current dividend payments are more certain than the future capital gains that might result from investing retained earnings in growth opportunities, so Ke should decrease as the dividend payout is increased. In effect Gordon and Lintner said that investors value a cedi of expected dividends more highly than a cedi of expected capital gains because the dividend yield component,
d/Po is less risky than the capital gains component, g, in the total expected return equation

Some arguments have been put forward to indicate that payment of dividend is relevant to the investors. These are now considered in turn.
1. Signaling effect (Information Content)
Dividend signaling – an increase in dividends would signal greater confidence in the future by managers and would lead investors to increase their estimate of future earnings and cause a rise in the share price.

The relevance of dividend is based on the premise that the mere payment of dividends imparts certain information to shareholders, known as the information content of dividend theory. This idea implies that dividends have an impact on share prices because they communicate information to investors about the firm’s profitability. An increase in the dividend rate, for example, says favourable things about the future outlook of the company. It has been suggested that implicit in the MM dividend irrelevance argument is this assumption that the market knows a company’s expected return stream exactly and discount this stream to determine the value of the firm. Advocates of information content argue that what is really valued in the marketplace is the perceived return stream. If this is the case, then changes in dividend policy will alter the market’s perception about the firm and therefore affect the valuation process.

This argument implies that dividend policy is relevant. Firms should attempt to adopt a stable (and rising) dividend payout to maintain investors’ confidence.

2. Preference for current income (bird in the hand)
Lintner and Gordon argued that dividends are preferred to capital gains due to their certainty. This is often referred to as the bird in the hand argument and means that an investor will prefer to receive a certain dividend payment now rather than leaving the equivalent amount in an investment whose future value is uncertain. Current dividends, in this analysis, represent a more reliable return than future capital gains.

When MM concludes that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own. If they don’t care, the firm’s dividend policy will not affect the firm’s share price and, consequently, dividend policy will not affect the firm’s required rate of return on equity capital (Ke). Myron Gordon and John Lintner, however, argue that Ke decreases as the dividend pay-out increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a cedi of dividends that they are certain to receive than on a cedi of expected capital gains. They base this argument on the fact that, when measuring total return, the dividend yield component, d/po, has less risk than the growth component g.

If dividends are preferred to capital gains by investors, dividend policy has a vital role in determining the market value of a company. Companies that pay out low dividends may experience a fall in share price as investors exchange their shares for those of a different company with a more generous dividend policy.
3. Clientele effect
It has been suggested that investors are not indifferent as to whether they receive dividends or capital gains. Preferences for one or the other can arise for two main reasons.

Some shareholders require dividends as a source of regular income. This is true of small shareholders such as pensioners and institutional investors such as pension funds and insurance companies. These institutions have regular liabilities to meet.

This need is balanced by stock exchange dealers, who over a small holding period prefer capital gains to dividends payment.
Preferences for dividends or capital gains due to their different tax treatment. A key premise of the irrelevance argument is that investors are indifferent as to whether they receive their return in dividend income or share appreciation. In the absence of personal taxes, this premise is reasonable. However, once differential personal taxes are considered, there may well be a preference for long-term capital gains, since they are taxed at lower rates then cash dividends. Moreover, the tax on capital gains are deferred until an investor actually disposes of the shares. Thus, once personal taxes are considered, it follows that for a given level of risk, investors will require a higher total return on a security the larger the proportion of its return attributable to dividends, since dividends are subject to a higher rate than long-term capital gains.

The existence of preference for either dividends or capital gains means that investors will be attracted to companies whose dividends policies meet their requirements. Each firm will therefore build up a clientele of shareholders who are satisfied by its dividend policy. The implication for a company is that a significant change in its dividend policy could give rise to dissatisfaction among its shareholders, resulting in downward pressure on its share price.

4. Free cash flow Hypothesis
If it is the intent of the financial manager to maximise the value of the firm, then investors should prefer that a firm pay dividends only if acceptable capital budgeting opportunities do not exist. We know that acceptable capital budgeting projects increase the value of the firm. We also know that, because flotation costs are incurred when issuing new shares, it costs a firm more to raise funds using new ordinary shares than it does using retained earnings. So, to maximise value, where possible, a firm should use retained earnings rather than issue new ordinary shares to finance capital budgeting projects. Thus, dividends should be paid only when free cash flows in excess of capital budgeting needs exist. If management does otherwise, the firm’s value will not be maximised.

According to the free cash flow hypothesis, the firm should distribute any earnings that cannot be reinvested at a rate at least as great as the investor’s required rate of return. Everything else equal, firms that retain free cash flows will have lower values than firms that distribute free cash flows, because the firms that retain free cash flows actually decrease investors wealth by investing in projects with IRR< Ke.

The free cash flow hypothesis might help to explain why investors react differently to identical dividend changes made by similar firms. For example, a firm’s share price will not change dramatically if it reduces its dividend for the purpose of investing in capital budgeting projects with positive NPVs. On the other hand, a company that reduces its dividend simply to increase free cash flows will experience a significant decline in the market value of its shares, because the dividend reduction is not in the best interests of the shareholders. Thus, the free cash flow hypothesis suggests the dividend policy can provide information about the firm’s behaviour with respect to wealth maximization

5. Tax aversion
In many countries, dividends have historically been taxed at higher rates than capital gains. In the 1970s, U.S. tax rates on dividend income were as high as 70%, while the taxes on capital gains were 35%. In the late 1990s, the rates were much lower, but the same general relationship was still in place. Dividends were taxed as ordinary income with rates as high as 39.1 %, while long-term capital gains were taxed at 20%. This situation is currently similar in Ghana. Dividends are taxed at 10% whereas capital gains from the sale of share from the stock exchange market are zero.

Under such a situation, according to the tax-aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax-aversion theory implies that investors would want companies to have a zero-dividend pay-out ratio so that they will not be burdened with higher tax rates. In the real world, tax laws often prevent companies from accumulating excess earnings, making dividend payments necessary.

The results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy. Research suggests that higher tax rates do result in lower dividend pay-outs. There is empirical support for the “bird-in-the-hand” theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles are satisfied.                                      (5 points at 2 marks each)

The choice of whether to repatriate earnings from a foreign subsidiary is one of the most important decisions in multinational financial management.
Dividend repatriations represent significant financial flows for parent companies and contribute to dividend payments. The factors that affect dividend repatriation policies can be grouped as follows:

• Financing factors
  Repatriation policies may reflect financing concerns of parents who draw on subsidiary cash flows to finance domestic expenses. Two examples of such domestic expenses are dividend payments to external shareholders and capital expenditures in the home countries.
• Dividend policy
  Dividend repatriations from foreign affiliates may also offer an attractive source of finance for payments of dividends to common shareholders especially when the parent company may prefer a smooth dividend payment pattern and domestic profitability is in decline.
  The dividend payments of a subsidiary may also be affected by the dividend policy of the parent company. For example if the parent company operates a constant payout ratio policy, then the subsidiary will have to adopt a constant payout ratio policy too.
• Tax regime and dividend payments
  Tax considerations are thought to be the primary reason for the dividend policies inside the multinational firm. For example, the parent company may reduce its overall tax liability by receiving larger amounts of dividends from subsidiaries in countries where undistributed earnings are taxed.
• Managerial control
  Another reason that may determine repatriation policies is the inability to fully monitor foreign managers, especially when affiliates are partially owned.
  The desire to control corporate managers around the world carries implications for dividend policies. A multinational firm’s central management can use financial flows within the firm to evaluate the financial prospects and needs of wide-ranging affiliates and to limit the discretion of foreign managers.
  It may be sensible to mandate dividend payments to monitor foreign managers, limits their ability to misallocate funds, and to extract returns on investments.
• Timing of dividend payments
  The timing of payments may also be equally important. For example, a subsidiary may adjust its dividend payments to a parent company in order to benefit from expected movements in exchange rates. A company would like to collect early (lead) payments from currencies vulnerable to depreciation and to collect late (lag) from currencies which are expected to appreciate.
  Also given that tax liabilities are triggered by repatriation, these tax liabilities can be deferred by reinvesting earnings abroad rather than remitting dividends to parent companies.
  The incentive to defer repatriation is much stronger for affiliates in low-tax countries, whose dividends trigger significant parent tax obligations, than they are for affiliates in high-tax countries – particularly since taxpayers receive net credits for repatriations from affiliates in countries with tax rates that exceed the parent country tax rate.

Dividend policy refers to decisions concerning paying out earnings to shareholders and retaining earnings for reinvestment. In theory, optimal dividend policy is one that strikes a balance between current dividend and futures growth to minimize WACC while maximizing stock value. To craft an appropriate dividend policy for GGML, the directors would have to consider several factors, including the following:

• Legal requirements – There are certain provisions in the Companies Code that restrict dividend payment with a view to protecting the interest of lenders. For instant, a company cannot pay out more dividends than distributable earnings in its reserves.
• Investment opportunities/requirements – When a firm is presented with a lot of investment opportunities that are in line with its growth strategy, it would require more financing. As earnings retention is the first choice on the pecking order, higher investment requirements would restrict dividend payment. As a fast growing company, GGML’s investment requirements would be high; and so may have to maintain a dividend policy that retains more earnings to fund investments. If GGML revises its growth strategy and rather pursues a lower growth rate, it can maintain a dividend policy that pays out relatively more dividends.
• Alternative sources of finance – The amount of dividends the company can afford to payout is influenced by the variety of financing sources available to the company. If the company has access to a variety of financing sources (including debt financing), then it can afford to maintain a dividend policy that pays out more dividends. However, considering the fact that GGML is rather repaying debt and not getting more, it cannot afford to maintain a dividend policy that pays out more cash to
  shareholders.
• Tax implications for shareholders – Earnings payout or retention has tax implications for shareholders. For instance if tax on dividend is lower than tax on capital gains, majority of shareholders may prefer current dividends to future capital gains.
  

Dividend capacity which is the amount of dividend a firm can afford to pay to its shareholders is measured by free cash flow to equity (FCFE). GGML’s free cash to equity for the recent year and the coming three years are computed below:

MAXIMUM DIVIDEND FOR RECENT YEAR:

For the past financial year, GGML can afford to pay maximum dividends of GHS30.1m, which is 10.2% of earnings. This implies that company cannot meet its IPO promise of 20% payout ratio.

Recommendation for next 3 years:
The FCFE projections for the coming three years suggests that the company can pay a maximum dividend of GHS55.42m in 2016, GHS86.76m in 2017, and GHS125.72m in 2018.
The ratio of dividend capacity to net income (i.e. maximum payout ratio) ranges from 15.3% to 23.5% over the coming three years. However, to maintain a smooth dividend payout policy, the directors may consider the minimum payout ratio in the range (which is about 15%) or the average (which is about 20%).