In setting dividend policy, management must pay regard to various practical considerations, [1] [2] often independent of the theory, outlined below.
In general, whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power: when cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
At the same time, although the decisioning must weigh the best use of those resources for the firm - i.e. investment needs and future prospects - it must also take into account shareholders' preferences, and the relationship with capital markets more broadly.
As regards the firm: If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then management should return some or all of the excess cash to shareholders as dividends.
However, potentially limiting any distribution, the firm's overall finances, liquidity, and legal / debt covenants in place will also be of relevance.
Management may also wish to avoid "unsettling" the capital markets [1] by changing policy abruptly; see below re signaling.
Re the former, for example, the thinking is dividend payments, and share price, will be higher in the future, (more than) offsetting the retainment of current earnings.
Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.
Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action.
[4] The theory, more generally, is framed in the context of capital structure, and states that — in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market — the enterprise value of a firm is unaffected by how that firm is financed: i.e. its value is unaffected by whether the firm is funded by retained earnings, or whether it raises capital by issuing shares or by selling debt.
The dividend decision, relating to both equity financing and retained earnings, is, in turn, value neutral.
[1] Here investors are seen to prefer a “bird in the hand”: i.e. dividends are certain as compared to income from future capital gains.
is the value of dividends at the end of the first period, which may be substituted with earnings multiplied by a retention ratio.
Further, an implication as regards policy, is that (per the formula) dividends are paid only where investors’ required return - i.e. cost of equity, ke - is greater than the company’s sustainable growth rate.
Conversely while the company is enjoying growth in excess of other comparable firms (and ke) then it should not pay dividends, instead, funding its capital requirement with retained profits.
John Lintner provides an explicit formula for determining dividend policy; [5] it is particularly relevant to a publicly traded company.
The theory followed the observation [5] that companies often set their long-run dividends-to-earnings target as a function of expected NPV positive "projects" (see capital budgeting).
The theory is based on the hypothesis that management "manipulates" capital structure such that earnings per share (EPS) are maximized.
In fact, CSS reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa.
In most cases dividends are taxed higher than capital gains, and thus investors - and management - would typically be expected to select a share repurchase.
Low-valued, high-leverage companies with limited investment opportunities and a high profitability, use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.
The value of the company, then, may be seen as the present value of the return on investments made from retained earnings, and a theoretical value is expressed [11] as:
[dubious – discuss] where The model assumes, at least implicitly, that retained earnings are the only source of financing, and that ke and r are constant; given these assumptions, the approach is subject to [11] some criticism.
A firm applying a residual dividend policy will evaluate its available investment opportunities to determine required capital expenditure, and in parallel, the amount of equity finance that would be needed for these investments; it will also confirm that the cost of retained earnings is less than the cost of equity capital.
Finally, if there is any surplus after this financing, then the firm will distribute these residual funds as dividends.
Although absent of any explicit link to value, such an approach may, in fact, impact share price: This policy will attract investors who appreciate that the firm is trying to employ its capital optimally (and will require fewer new stock issues with correspondingly lower flotation costs); [12] it also delays (or removes) the payment of the secondary tax on dividends; see Retained earnings § Tax implications.