Dividend Policy

Introduction

There has been considerable debate on how dividend policy affects a firm's value. Researchers such as Gordon (1959) believed that dividends increase shareholders wealth, Miller and Scholes (1978) considered dividends to be irrelevant and others such as Litzenberger and Ramaswamy (1979) thought that dividends decrease shareholders wealth.

As a result, a number of studies have been undertaken to solve the "dividend puzzle", a concept which tries to answer the question of whether paying dividends actually makes a difference or not. Many economists argue that dividends should not have any effect on the investor's valuation of the company because the investor is an owner of the firm and should be indifferent to either getting the dividends or having them reinvested in the firm.

The above conclusion, nevertheless, has proven futile as, in the majority of the cases; investors do demand some type of a dividend payment (Cohen, 2002). As a result, it's important for firms to have a dividend policy in order which will help them make decisions regarding paying cash dividend in the present or paying an increased dividend at a later stage.

The Determinants of Dividend Policy

An optimum dividend policy is one that strikes a balance between current dividends and future growth and should be based on two basic objectives - maximizing the wealth of the firm's owners and providing sufficient funds to finance growth. The determinants of a firm's dividend policy are discussed below.

The prevailing dividend and corporate tax rate is major factor effecting the dividend policy of firms. Dividend payments made by firms increase the taxes paid by individual investors because; however, the profits that are not distributed are treated as capital gains and are not taxed until the shares are sold (Barclay, Smith Jr. and Watts, 1995). This increases the tax liabilities of individual investors, thus requiring the firm to increase the rate of return on the equity. However, this doesn't imply that firms should follow a no dividend policy. It should compare the latest dividend and corporate tax rates before making a dividend decision. All other things being constant, when dividend rates are higher than corporate tax rates, a firm will have an incentive to reduce the dividend payouts (Ross, Westerfield, Jordan, 2008).

According to the current taxing system, the shareholders pay dividend tax subject to the conditions shown in table 1. Companies pay dividends out of profits on which they have already paid tax. To take account of this, a tax credit is offered by the government to the shareholders to offset against any Income Tax that may be due on their 'dividend income' (sum of the dividend(s) received and the tax credit(s)). Thus, the dividend paid to shareholders represents 90 per cent of their 'dividend income'. The remaining 10 per cent of the dividend income is made up of the tax credit. So, lower rate taxpayers (refer table 1), will have no further tax to pay on dividends, as the 10% tax credit cancels out the 10% 'dividend ordinary rate'. The corporate taxes for 2009-12 are shown in Table 2

Investment opportunities play a major role in defining the dividend policy of a firm. Companies having few major investment opportunities are more likely to payout a high percentage of their earnings. As a result, higher dividends should be expected from stable and low growth industries. On the other hand, high growth industries with lots of investment opportunities are likely to pay low dividends as they have profitable uses for their capital (Barclay, Smith Jr. and Watts, 1995).

Dividends policy decisions are also affected by the signaling effects of their policy. Paying out high dividends shows that the company is confident about its current and future profitability. The credibility of the signal lies in the fact that if management increases its regular dividend payments without the expectation of future cash flows, the firms will have difficulty sustaining these higher payouts (Barclay, Smith Jr. and Watts, 1995). As a result, management will have to cut the dividend and thus the stock prices will reduce.

Liquidity position is another determinant of the dividend policy. A firm must have enough cash available to payout dividends. The predictability of future profits can also affect the dividend payout ratio of a firm. If a firm predicts high profit in the future, it's more likely to pay higher dividends. This is so because firms aim to increase their dividend amount every year as declining dividends could give out negative signals about the firm. Lastly, inflation affects dividend policy in a way that if the price of the machinery used by a company increases, then it will have to rely on its retained earnings and thus will have to lower its dividend payments.

Tesco

Tesco plc (LSE: TSCO) is the third-largest retailer in the world measured by revenues and the second-largest measured by profits (Global powers of retailing report, 2010). It is a constituent of the FTSE 100 Index.

Tesco's profits have been increasing substantially over the past decade. As a result, it has been paying very high dividends to its shareholders. Tesco has had an unbroken record of more than 20 years of above average dividend increases (see Table 3) (Early Retirement Investor, 2010). In 2006, Tesco announced a new dividend policy of "increasing its dividend pay-outs broadly in line with its earnings growth rate" (Early Retirement Investor, 2010) which it has easily achieved in the past 5 years. Its interest coverage has also increased from 5.7 times in July, 2010 to 6.3 times in 2011 with a simultaneous decline in net debt (The Motley Fool, 2011).

Tesco comes under the 'Food and Drug retailer' sector which is a stable and a low growth industry. However, Tesco's low payout ratio along with the increasing expansion opportunities abroad, gives Tesco an encouraging dividend growth potential. For instance, on 24th November, 2011, the Indian government passed an act that encourages foreign retailers to open their stores in India. This could turn out to be a big opportunity for Tesco and If Tesco plans to start operating in India; it could decrease dividends for shareholders in the future.

High dividends have given