Factors affecting dividend policies and types of dividend policies

Introduction

BP PLC is the market leader in the business of exploration and production, of gas, power, and the business of refining and marketing chemicals. The exploration and production activities of the company include oil and natural gas exploration and field development and production. These activities are mainly upstream activities for the company. There are also midstream activities which involve transporting of pipelines and processing of natural gas. The gas and power activities of the company include the marketing and trading of the natural gas, the liquefied natural gas and the power. It also includes the development of international opportunities that investigate gas resources and involvement in the select power projects. The activities of refining and marketing of chemicals are associated with the downstream activities of the British Petroleum Plc.

BP PLC has been earning huge amount of profits over the years out of which it retains some and distributes the remaining of the profits to its shareholders. Dividends are a way to give the shareholders a reward for their investments in the company shares. The company pays to its shareholders dividends on a quarterly basis and in the form of cash only. However, for the sake of understanding the figures have been used from the annual statements and all figures are as per day on which the financial accounts were prepared i.e. end of every fiscal year (31st December of each year).

What do firms do with profits?

Once a company makes a profit, the management of the company has to decide regarding the usage of its profits. They could either continue to retain its profits within the company as reinvestment or retained earnings, or they could pay out the profits to the shareholders of the company in the form of dividends. But once the company decides on to pay dividends for sure, they have to establish a permanent dividend policy, which may in turn impact the investors and perceptions of the company in the financial markets. The decision has to be based on the situation of the company currently and in the future. The decision of management will also depend on the preferences of investors and potential investors.

Factors affecting dividend policies

There are several ways in which a company can decide to give its shareholders their right to dividends. However, the dividend policies of the companies are majorly influenced by two important factors: sector in which the company is operating and the nature of an individual company. The first factor includes the analysis of the industrial sector within which the company operates. The companies operating in industries that require huge amounts of long-term reinvestment are found to have lower payout ratios in as they require higher levels of investment in the future for business expansion. The companies operating in industries that involve high business risk, or are associated with large cyclical swings in the level of profit tend to pay lower dividends and thus have lower payout ratios. This is majorly done to avoid the risk of having to reduce dividend payments in the near future. This view was associated by Rozeff (1986) in a paper that had a detail description on how the companies determine their payout ratios. The second factor that affects the companies in deciding their dividend policies is the nature of the company and its individual characteristics. A company which has already reached the mature stage of its life cycle has to choose to adopt a high payout ratio as it will require a minor reinvestment. On the other hand, a company which has a high level of bank borrowings in comparison to the rest of the companies in its sector has to pay lower levels of dividends in response to the high level of interest rates. This will help the firm to meet its interest commitments.

Based on the above factors that are taken into in to consideration, we can say that BP PLC is a company that is highly cyclical in nature and it involves huge business risk. Thus, it should have a lower payout ratio. However, there is a need to look at the table below and comment on the type of dividend policy that is experienced by this company under study: BP Plc.

Types of dividend policies

There are a number of dividend policies or payout policies that a company can adopt for its shareholders. Each policy has its own advantages as well as its own disadvantages. The first policy that a company can adopt is a fixed percentage payout ratio policy. In this, the company pays out a fixed percentage of net profits as dividends to shareholders. It maintains a constant payout ratio every year. The advantages of this type of policy are that from the company's point of view, it is relatively very easy to operate. It even sends a clear signal to the investors about the level of the company's performance. However, the disadvantage for the company is that it can impose a constraint on the amount of funds that are available for the company to retain for the purpose of reinvestment. This type of the dividend policy is not suitable for companies with very volatile profits and the shareholders thus cannot receive a stable dividend payment.

The second policy regarding dividend payments that a company can follow is a zero dividend policy. In this type of policy, the company can decide not to pay any dividend at all. This type of extreme policy is likely to be highly beneficial for a small minority of investors. However, this can be totally unacceptable to the majority of the shareholders. This policy is very easy to operate by the company and it will result in not incurring the administration costs associated with the dividend payments. A zero dividend policy will help the company to reinvest all of the profits. This will be very attractive to investors who prefer capital gains over dividends and are considerate about the personal tax payments. Given that the majority of ordinary shareholders are mainly the institutional investors (the one who will only rely on dividend payments for their income), a zero dividend policy is likely to be a disadvantageous policy on an ongoing basis for the company. A zero dividend policy is majorly adopted by the new companies which require investments to establish and thus they make sure that they put large amounts of reinvestment in the very first few years of their existence. Many companies who are new in the industry make sure that they do not immediately start paying the dividends to its shareholders as they keep the amount of profits for reinvestment in profitable projects for the company's expansion. The third type of the dividend policy that a company can adopt is constant or steadily increasing dividend in the years of the company's existence. A company can choose to pay a constant or a steadily increasing dividend in two ways: first is in money terms and second in the real terms in which the effects of inflation is totally removed.

A constant or an increasing dividend in money terms results in a falling or rising dividend in the real terms. This will depend on the level of inflation or deflation in an economy. This type of dividend policy in the real terms will always result in the increasing dividends in the money terms. However, in both the type of policies, dividends increase in line with the long-term sustainable earnings. It is very important for the company to avoid the volatility in the dividend payments. In doing so, the company can help to maintain a share price which is very stable.however, the cuts in dividend payments will send the signal or the justification to the markets. It is usually meant for the financial weakness of the company and can result in downward pressure on the company's stable share price. The disadvantage of keeping such a type of dividend policy is that investors can expect continuity in the dividend payments indefinitely. This can cause a major problem when the companies aspire to reduce the dividend payments for fund reinvestment or for the sake of financial prudence. The companies experiencing increases in the profit tend need to be cautious about the dividend increase due to the reaction of the market in case of a dividend cut. A twenty per cent increase in the profits can rarely lead to a twenty per cent increase in the dividends. This is supported by the fact that a certain level of the company's profit will be rarely equal to the amount of cash which will be ultimately used for making the dividend payments. The companies tend to make sure that the increase in the dividends is done slowly over time in order to reflect the new profit level of the company, when they are very confident that the new level of the profit is sustainable for the company.

The following figure shows the alternative three policies and its impact:

Based on the above table, we can say that if a company follows Modigillani Millar irrelevance theory then there is no impact on the DPS and EPs of the company. However increasing dividends over period of time or bird in the hand payout policy, then the stock price will increase over time and the cost of equity will fall. Decreasing payout policy or zero dividend payout policy leads to tax advantage for the company. In this case, the cost of equity will rise whereas the share price will increase. The following figure illustrates the above fact.


The above table shows the dividend payments made by the BP Plc over the period of five years. From 2007 to 2009, the dividend payments made by company in money terms has been increasing. However, the amount of dividends paid in the year 2010 and 2011 was constant. The company pays the dividends on a quarterly basis, but in the year 2010 the company paid the dividends only for two quarters. The reason for this was the oil spill incident that took place in the Gulf of Mexico in the year 2010. This led to the company stop the dividend payments in order to recover the loss made because of the oil spill. This resulted in the fall in the share price in the year 2010. However, the company started making the dividend payments in the year 2011 to make their investors happy.

Source: BP PLC. Website

The above chart shows the dividend payout ratio with respect to the market share price for the year 2007 to 2011. The dividend payout has shown an increasing trend from 2007 to 2009. The decrease in the ratio happened in the year 2010 and again the increasing momentum was gained in the year 2011. Based on this, we can analyze that the company follows the third type of dividend policy that is constant or steadily increasing dividend policy. This is because the payout ratio is increasing steadily. It was only in the year 2010 that because of the oil spill incident that the dividend payout ratio became negative as the company experienced a loss.

Alternatives to cash dividends

However, there are some alternative ways in which the company can pay rewards to its shareholders. In addition to paying cash dividends, there are a number of other ways in which companies can provide their shareholders a reward for their investment in the company shares. The first method is the scrip dividends. This involves an offer of additional equity shares to equity investors, in proportion to their existing shareholding. This can be used as a partial or a total alternative to a cash dividend. In this case, the shareholders are usually given a choice of taking either the declared cash dividend or the scrip alternative. This allows the shareholders to choose the alternative that best suits their liquidity position as well as their tax position. BP Plc has been paying scrip dividends to its shareholders on a regular basis. The major advantage with the paying of a scrip dividend is that this allows the company to keep the cash that could have been paid out in the form of cash dividends. From a personal taxation point of view of the investors, the scrip dividend received is treated same as the income where the tax is deemed to have been paid at the basic rate of the personal income tax. However, the scrip dividends are not attractive to investors who are exempted from paying the tax on the dividends as they are not able to reclaim the tax which is deemed to have been paid otherwise. Sometimes the issue of a scrip can be increased which mean that the value of the scrip dividend will be in excess of the cash dividend. This will be a good alternative as it will make a more attractive choice to shareholders. If the increment will be more than the fifteen percent of the cash alternative though, the shareholders are very much liable to pay the additional tax out of their pockets.

The next possible advantage that is related with the paying of a scrip dividend is that it allows the company to decrease its gearing ratio marginally. The company should note that in the case of an efficient capital market, the market share price of the company will not be suppressed since the scrip dividend hardly replaces a cash dividend which could have caused the market share price of the company to fall.
Quarter Results and
dividend
announced Reference
share price announced Dividend paid Reference share price per
ordinary share
(US$) Reference
share price
per ADS
(US$)4Q 11 07-Feb-12 21-Feb-12 30-Mar-12 $7.746 $47.223



3Q 11 25-Oct-11 08-Nov-11 19-Dec-11 $7.257 $44.245


2Q 11 26-Jul-11 09-Aug-11 20-Sep-11 $6.818 $41.572


1Q 11 27-Apr-11 17-May-11 28-Jun-11 $7.217 $44.002

4Q 10 01-Feb-11 15-Feb-11 28-Mar-11 $7.658 $46.687

Source: BP Plc. website
The company BP Plc. has not seen a long history of scrip dividends. It has started so in the year 2011 onwards. This has been the other way by which the company has been returning cash to the shareholders.

The other way that can be used as a cash dividend alternative is the share repurchase. This is another way to return the excess cash to shareholders. The share repurchases are increasingly becoming a very common way of returning value to the ordinary shareholders in the United Kingdom. This type of policy is followed by the number of leading companies in recent years in United Kingdom. The BP Amoco did two share repurchases in the year 2000 that amounted to 1993 million pounds in total. The main advantage to the investors or the owners of the company in the case of a share repurchase is that the shareholders receive surplus funds from the company which the investors can use more effectively. The other benefit to a company of a share repurchase is that the shares repurchase increases the value of the remaining existing shares in the capital market. In addition to this, the return on capital employed will increase as the capital employed will be reduced by repurchasing the shares from the market. The earnings per share (EPS) of the company will also increase. The company has to make sure that this has to be balanced against the increasing gearing ratio as it has been argued that it will lead to the increase in financial risk which is negligible and the value of the shares and the company will increase leaving the cost of equity unchanged.

Source: Stocknod
The above table taken from the BP Plc. official website gives the history of the company's repurchases. The company has begun its repurchases from 2000 and had extended it to the year 2008. The toal repurchases done by the company since 2000 was $51070 million. This amount of cash was returned to the shareholders in the form of repurchases.

Conclusion
BP Plc. has been following the dividend policy of steadily increasing dividends. It has been following this for the five years of the period under study. The payout ratio has been increasing except for the year 2010 due to the oil spill incident. The company has been following the bird in the hand policy as a result of which the cost of equity has been decreasing but the market price has been increasing. 
Appendix

Source: FT.com

Source: Stocknod

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