2-1 Introduction

Dividend policy has drawn due attention from various researchers. One of the most famous studies in this respect is Miller and Modigliani hypothesis (1961), which asserted that the cash dividend policy is not important because it has no effect on the company’s value, and as such it does not affect the company owners’ wealth. This is due to the fact that companies follow a Residual Dividend Policy which is based on reinvestment of corporate profits in the available investment opportunities (Van Horne 1983; Arnold 2008) with positive net present value and distribution the surplus cash as a cash dividend to shareholders.

The above hypothesis aroused a lot of controversy on the part of researchers. However, the most important study that opposed it is that of Partington (1985) which claims that the companies do not follow – in practice – the residual dividend approach as the dividend decisions taken independently from the investment policy. Right now, controversies continue among researchers based on the subject without arriving at any decisive results

This chapter will study the public dividend policy to shareholders, which is considered to be one of the most important financial decisions, in view of its direct relationship to shareholders and financing decisions and investment in the company. The chapter will also cover the alternatives to be addressed consisting of general dividend policy and theories that linked the cash dividend policy with the company market value, and therefore the company owners’ wealth in addition to the share dividend policy and buying back policy, besides the cash dividend policy and its relationship with the investment policy

2-2 General Dividend Policy

The Company Board suggests distribute dividend to shareholders in an annual meeting (Watson and Head 2004). The main interest is to suggest acceptance and secure fair dividend for shareholders consistent with the rate of dividend decided by the company management. Therefore, in preparing dividend distribution, the mangers do not look only for current year profit, but they, instead, will look for the future earnings expected, and hence for the ability of the company to maintain a stable rate of dividend taking into consideration the systematic growth of this ratio. On their part, the investors are aware of this truth, and they look for a profit increase in a positive vision expecting throughout a stability of the future dividend. When the company achieves high profits for a particular year and do not expect the same level of profit for next years, they will make normal dividend and give additional dividend so as not to disappoint the investors hopes in the future. The profits are then divided into two dividends, a normal and an incremental dividend, to make notification to investors that this type of dividend is unexpected and would not continue in the future (Levy and Sarnat 1994).

There are several alternatives for the profits dividend. The company may either distribute the profits in the form of regular cash dividends, or it may distribute profits in the form of shares dividends to shareholders. However, the above two types may be distributed at the same time. Besides that, shareholders can also obtain profits when the company tends to repurchase its shares, and considers the regular cash dividend as something quite common (Broyles 2003).

The percentage of the profits distributed by the company is typically governed by several considerations. In addition to the law which prohibits the distribution of profits unless the company achieves a profit after deducting reserves, the contracts of the bonds, in case the company issues these bonds, often prevents companies from increasing the proportion of cash dividend on a certain level to secure the rights of bondholders (Watson and Head 2004).

Thus, the general dividend policy may well looked upon on the basis of differentiating between the cash dividends and the shares dividend through capitalization of profits, or through buying back the company’s shares. This is due to the fact that the investment policy is fixed. The company will thus detain profits to finance capital spending on growth and expansion or debt repayment, or extinguish the bonds if any, and distribute the remaining cash as a cash dividend, and also to finance any deficit in capital spending by issuing new shares or through outside borrowing. The company could detain the necessary funds to finance capital expenditure and re-buy part of the shares issued and distribute the remaining as a cash dividend.

These alternatives will not affect the company’s value, and therefore the wealth of shareholders, if the company is operating in market characterized by ideal, efficiency and depth (Merton and Modigliani 1961; Black and Scholes 1974; Peter 1996). In case such characteristics are absent of the market, one can expect arguments about the impact of dividend policy, particularly cash, on the value of the company, and therefore the wealth of shareholders. The second group (Gordon 1959; Blume 1980; Dyl and Weigand 1998; Koch and Shenoy 1999) believes that increasing the percentage of cash dividends would increase the company’s value, thus increasing the shareholders’ wealth, while the third group (Litzenberger and Ramaswamy 1979; Blume 1980; Litzenberger and Ramaswamy 1982; Ang and Peterson 1985) believes that increasing the percentage of cash dividend will lead to a decline in the value of the company, thereby reducing the wealth of shareholders. These groups together with their theories will be discussed when dealing with the policy of cash dividend.

The profits will be transferred to return earnings account, which is used for purposes determined by the board and the approval of the General Assembly of the company. This account is usually used to maintain a stable dividend amount of cash dividends (a systematically dividend policy). During the years where the company cannot meet the amount of normal dividend, they will tend to the return earnings account to insure any deficit. The General Assembly of the company has full authority to use this account for normal or abnormal cash dividend in whole or in part. It could also be used for company repurchase share, or for capitalization this account and distribution of share dividends to shareholders. On their part, shareholders can obtain their profits through a set of policies that can be combined in a single year, but it often takes one of the following alternatives(Watson and Head 2004):

• A cash dividend policy
• Shares dividend policy
• Buying back shares policy

2-3 Cash Dividend Policy

The impact of cash dividend policy on current prices of the company shares is considered to be very important, not only for policy makers, but also for investors, portfolio managers, and economists interested in the performance of capital markets (Watson and Head 2004). The questions to be raised here are: Can managers maximize the wealth of the owners of the company through a particular dividend policy? (Lumby and Jones 1999) Are the companies with high dividend sold with premium? Should the shares of companies that retain their profits or distribute a percentage of its profits, be sold as well in a lesser price? The fact is that these questions were, and still are, the subjects of many applied studies. Until now, there seems no consensus on the answers to these questions. The reason is the presence of other relevant factors that affect the market value of the shares that enable us to measure the impact of dividend policy on profits alone. This means that researchers did not so far prepare both proper and adequate tests and studies to distinguish between different hypotheses.

The arguments among researchers about the dividend policy focus on that part of the cash dividend to be distributed to shareholders and its impact on the company’s value and therefore the wealth of the owners of the company. Miller and Modigliani (1961) see that the cash dividend does not affect the value of the company, as the company’s value will not be affected by how earned profits are divided; but rather affected by the ability to achieve profits. Thus, there is no point in thinking of how to divide profits between dividends and return earnings, while thinking must be directed towards maximizing these profits through the optimal investment policy as the way by which the cookie is divided will not lead to increase its size.

In the opinion of others (