Question

Critically Analyse the various types of Dividend policies and theories under the following headings:

2.1 Residual Dividend Approach

2.2 The Clientele Effect of Dividends

2.3 Share repurchase

2.4 Current income

2.5 Floatation Costs

Answer 1

Residual Dividend Approach:

The Residual Dividend Model is a method a company uses to determine the dividend it will pay to its shareholders.
Companies that use retained earnings to finance new projects use this method. The company first determines which new projects it wants to finance, dedicates funds to those projects, and then distributes any leftover profits to its shareholders as dividends.
This model can lead to unpredictable and inconsistent dividend returns for the investor. However, the company's goal is to generate further profits from the projects it funds, which benefits the shareholders overall.

The Residual Dividend Model is an outgrowth of The Modigliani and Miller Theory that posits that dividends are irrelevant to investors. This school of thought believes that investors do not state any preference between current dividends and capital gains. It goes on to say that dividend policy does not determine the market value of a stock.

The Clientele Effect of Dividends

Clientele effect describes the change in the company’s stock price according to the demands and goals of investors in reaction to a tax, dividend or other policy change affecting the company. The clientele effect assumes that investors are attracted to different company policies and that when a company's policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move.

Studies showed that investors tend to invest in firms whose dividend policy matches their preferences. Thus the dividend policy of the firm attracts investors who like it and the supply of dividends is adjusted according to the demand of investors.

Share repurchase

A dividend payment is a direct payment of cash to shareholders whereas a share buyback is an alternative form of shareholder distribution, where a company buys back its own stock from shareholders, effectively reducing the number of outstanding shares and increasing the proportional rights of any single share.

A share buyback reduces the number of shares outstanding and increases the proportional rights of any single share. Thus, assuming a certain amount of earnings, the earnings per share would be higher due to the share buyback and shareholders who want to continue to be invested in the company in the long term would benefit from this.

Current income

Current income refers to cash flows that are anticipated in the immediate to short-term. Current income investing is an investing strategy that seeks to identify investments that pay above-average distributions. Common current income sources include dividends and interest payments

Floatation Costs

Flotation costs are the costs that are incurred by a company when issuing new securities. The costs can be various expenses including, but not limited to, underwriting, legal, registration, and audit fees. Flotation expenses are expressed as a percentage of the issue price.

The concept of flotation costs is strongly related to the concept of cost of capital. Since flotation expenses affect the amount of capital that can be raised by issuing new securities, the costs must somehow impact a company’s cost of capital. There are two main views regarding the matter:

Approach 1: Incorporate flotation costs into the cost of capital

The first approach states that the flotation expenses must be incorporated into the calculation of a company’s cost of capital. Essentially, it states that flotation costs increase a company’s cost of capital. Recall that the cost of capital of a company consists of the cost of debt and cost of equity. Thus, expenses affect the cost of capital by changing either cost of debt or cost of equity, depending on a type of securities issued (e.g., issuance of common stock affects the cost of equity).

For example, let’s assume that a company issues new common shares. Before the transaction, a company’s cost of equity can be calculated using the following formula:

Cost of Equity = (D1/P0)+ g

where,
D1 is the Dividend per share after a year
P0 is the current price of the shares being traded in the market
g is the Growth rate of dividend over the years

However, the issuance of new shares causes a company to incur flotation expenses. Thus, the current share price (denoted as ) must be adjusted for the effect of such costs.
As a result, the cost of equity formula adjusted for the flotation costs will look:

Cost of Equity = (D1/ P0 [1-F]) + g
Where,
D1 is the Dividend per share after a year
P0 is the current price of the shares being traded in the market
g is the Growth rate of dividend over the years
F is the percentage of flotation cost

Nevertheless, the abovementioned approach is not accurate because the incorporation of flotation expenses does not depict the actual picture. In such a scenario, the cost of capital is overstated by the percentage of flotation expenses incurred. The costs of flotation are non-recurring expenses that are incurred by a company only once when new securities are issued.

Approach 2: Adjust the company’s cash flows
Alternatively, the second approach is to adjust the company’s cash flows for the flotation expenses. Unlike the first method, the adjustment approach does not modify the actual cost of capital. Instead, a company deducts the costs from the cash flows that are used in the calculation of net present value (NPV).
The cash flow adjustment method was initially suggested by John R. Ezzell and R. Burr Porter in the article “Flotation Costs and Weighted Average Cost of Capital.” The main idea behind the method is that the costs are only one-time expenses paid to third parties.
The approach of deducting the flotation expenses from the company’s cash flows is more appropriate than the direct incorporation of the costs into a cost of capital because it considers the one-time nature of the expenses. Simultaneously, a company’s cost of capital remains unaffected by the flotation expenses, and it is not overstated.