Dividend and payout policy - Residual policy, stability, and...

Learning Outcomes

After reviewing this article, you will be able to explain how companies determine dividend and payout policies using the residual approach; distinguish between stable, constant ratio, and residual dividend policies; and evaluate the practical constraints affecting the amount and stability of dividends paid. You will also be able to discuss the implications for shareholder expectations, financial planning, and exam assessment.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the theoretical and practical factors influencing dividend and payout policy decisions. In revision, focus on the following areas:

• The rationale behind different dividend policy models, including residual and stable policies
• The residual approach to dividend setting and its impact on shareholder returns
• Reasons companies maintain stable or progressively growing dividends
• Practical constraints on dividend payments, such as legal, liquidity, and growth needs
• The calculation and relevance of free cash flow to equity in determining dividend capacity

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. In the residual dividend policy, when are dividends paid to shareholders?
2. Which of the following is a main reason why many companies adopt a stable or gradually increasing dividend, even if profits vary? a) It always maximises shareholder wealth
   b) It signals financial stability to the market
   c) It maximises tax efficiency for all shareholders
   d) It increases gearing
3. Name two constraints that might prevent a company from increasing its dividend despite strong profits.
4. A company earns $10 million, has positive NPV investment opportunities needing $7 million, and sufficient cash. According to the residual approach, what is the maximum total dividend payable?

Introduction

Dividend and payout policy focuses on the decisions companies make about distributing profits to shareholders versus retaining funds for investment. Shareholders generally receive value in the form of dividends (regular or special) or through capital gains linked to retained earnings that finance growth. The main theoretical reason for dividend decisions relies on whether retained earnings can be invested to generate returns above the shareholders’ required rate. However, practical factors—such as market expectations, legal restrictions, liquidity, and the company’s reinvestment plans—often complicate this decision.

Understanding different policy models, including the residual, stable, and constant payout ratio approaches, and the reasons companies might depart from theory due to real-world constraints, is essential for the AFM exam.

Dividend Policy Models

Dividend policies provide a framework for consistent decision-making on profit distribution.

Stable Dividend Policy

Many public companies pursue a stable dividend policy—a fixed or gradually increasing amount per share—regardless of short-term variability in profit.

Key Term: Stable Dividend Policy
A dividend strategy in which a company maintains a fixed or steadily growing dividend per share, even when earnings fluctuate, to provide predictability to shareholders.

Choosing a stable policy reassures investors about future income, attracts institutional shareholders, and avoids negative market reactions associated with dividend cuts. However, it can strain companies if profits fall sharply or cash is tight.

Constant Payout Ratio Policy

Some companies pay a fixed percentage of earnings as dividends, so shareholders’ income rises and falls with profits. This approach is simple and directly links owner returns to performance but leads to unpredictable income for shareholders, which many dislike.

Residual Dividend Policy

In theory, if shareholder wealth maximisation is the goal, the company should retain profits if it has projects that return more than the shareholders’ required return. Any profits left over (the ‘residual’) can then be paid as dividends.

Key Term: Residual Dividend Policy
A policy where dividends are distributed only after all profitable investment opportunities have been funded; dividends are the ‘residual’ after investment needs are met.

This method ensures that only genuinely surplus cash is paid out, aligning retained earnings with value-creating investment.

Worked Example 1.1

A company expects annual earnings of $12 million. Its positive NPV projects require $9 million. What is the dividend per the residual policy, and what if investment needs rise to $13 million?

Answer:
With $12 million earnings and $9 million needed for investment, the company can distribute up to $3 million in dividends. If investment needs increase to $13 million, all earnings are required—no dividend is paid.

Exam Warning

The exam may present scenarios with fluctuating profits or investment needs. Make sure you clearly differentiate between dividend policy approaches and can justify why a company might not follow the pure residual model.

Constraints on Dividend Policy

Even if theory suggests a certain dividend should be paid, practical issues may restrict the payout.

Legal Restrictions

Most jurisdictions only permit payment of dividends from realised, accumulated profits. This ensures capital is not eroded, protecting creditors.

Key Term: Dividend Capacity
The maximum amount a company can pay as dividends, considering profits available for distribution, legal limits, and operational cash requirements.

Liquidity and Free Cash Flow

Dividends cannot be paid without enough accessible cash. Sometimes, companies show strong profits but lack liquidity due to working capital needs or prior investments.

Key Term: Free Cash Flow to Equity (FCFE)
The cash flow available for distribution to shareholders after all expenses, taxes, working capital needs, and necessary investment in fixed assets and debt payments.

Growth and Financing Requirements

Rapidly growing companies may withhold dividends—even with healthy profits—to fund expansion without raising new capital. This often leads to low or zero payout ratios for high-growth businesses.

Shareholder Preferences and Market Expectations

Some investors require stable income, so abrupt dividend changes may unsettle the share price or investor base. Directors may maintain the dividend even during a bad year, smoothing income for shareholders.

Tax and Regulatory Factors

Dividend payments may trigger tax implications for shareholders or the company, influencing the timing or level of the payout. In multinational groups, remittance restrictions or exchange controls can block payment of dividends from subsidiaries.

Debt Covenants and Financial Ratios

Loan covenants may limit dividend payments to maintain interest cover ratios, reduce gearing, or protect creditors’ interests—overriding other considerations.

Worked Example 1.2

A company has distributable profits and sufficient cash but a loan agreement preventing payment of dividends if the interest cover falls below 3x. After last year's poor results, interest cover stands at 2.8x. What must directors consider?

Answer:
The company cannot pay a dividend if this would breach the loan covenant. Legal and contractual constraints take precedence, even if there appears to be cash and profit available.

Comparing Policy Approaches

Summary

Dividend and payout policy balances shareholder expectations, corporate investment requirements, and legal and financial constraints. While the residual approach maximises theoretical value, in practice companies must weigh stability and practical barriers. Stable dividend policies dominate in established firms, while flexible payouts and constraints are common in growing or indebted companies.

Key Point Checklist

This article has covered the following key knowledge points:

• Distinguish between stable, constant, and residual dividend policies
• Explain the rationale for the residual dividend approach
• Describe the factors leading companies to adopt a stable dividend policy
• Identify key constraints limiting dividend payments in practice (legal, cash, covenants, growth demands)
• Discuss the role of free cash flow to equity and dividend capacity in setting payout policy

Key Terms and Concepts

• Stable Dividend Policy
• Residual Dividend Policy
• Dividend Capacity
• Free Cash Flow to Equity (FCFE)