Dividend policy is the set of guidelines a company uses to decide how much of its earnings it will pay out to shareholders. Some evidence suggests that investors are not concerned with a company's dividend policy since they can sell a portion of their portfolio of equities if they want cash. This evidence is called the "dividend irrelevance theory," and it essentially indicates that an issuance of dividends should have little to no impact on stock price.
That being said, many companies do pay dividends, so let's look at how they do it.
There are three main approaches to dividends: residual, stability or a hybrid of the two.
Residual Dividend Policy
Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companies usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, deciding on dividends only if there is enough money left over after all operating and expansion expenses are met.
For example, let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, suppose this company has a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay for one-third of this project by using debt ($300) and two-thirds ($600) by using equity. In other words, the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000 - $600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000 - $1,000) for dividends. If any project required an equity portion that was greater than the company's available levels, the company would issue new stock.
Typically, this method of dividend payment creates volatility in the dividend payments that some investors find undesirable.
The residual-dividend model is based on three key pieces: an investment opportunity schedule (IOS), a target capital structure and a cost of external capital.
1. The first step in the residual dividend model to set a target dividend payout ratio to determine the optimal capital budget.
2. Then, management must determine the equity amount needed to finance the optimal capital budget. This should be done primarily through retained earnings.
3. The dividends are then paid out with the leftover, or residual, earnings. Given the use of residual earnings, the model is known as the "residual-dividend model."
A primary advantage of the dividend-residual model is that with capital-projects budgeting, the residual-dividend model is useful in setting longer-term dividend policy. A significant disadvantage is that dividends may be unstable. Earnings from year to year can vary depending on business situations. As such, it is difficult to maintain stable earnings and thus a stable dividend. While the residual-dividend model is useful for longer-term planning, many firms do not use the model in calculating dividends each quarter.
Dividend Stability Policy
The fluctuation of dividends created by the residual policy significantly contrasts with the certainty of the dividend stability policy. With the stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy reduces uncertainty for investors and provides them with income.
Suppose our imaginary company, CBC, earned $1,000 for the year (with quarterly earnings of $300, $200, $100 and $400). If CBC decided on a stable policy of 10% of yearly earnings ($1,000 x 10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if CBC decided on a cyclical policy, the dividend payments would adjust every quarter to be $30, $20, $10 and $40, respectively. In either instance, companies following this policy are always attempting to share earnings with shareholders rather than searching for projects in which to invest excess cash.
Hybrid Dividend Policy
The final approach is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general levels.
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