Dividend Policy – To pay or not to pay

For as long as there have been dividends there have been questions raised regarding their relevance and necessity to shareholders. Managers face a difficult decision when deciding what proportion of profits should be retained within the company for future growth and what amount should be paid out to shareholders in the form of dividends.

There are a number of solutions to the issue all that can have direct effects on share value and shareholder wealth.  Managers may choose to pay out a high volume of profits, nicely lining the pockets of shareholders, hopefully increasing share price?


Or could this demonstrate that the firm has a lack of potential, positive NPV projects in which to invest and therefore has no better use for the capital that to distribute it amongst shareholders. Such an impression could possibly have a negative effect on share price. 

Modigliani and Miller (1961) argue that dividends are irrelevant in determining share value. The authors believe that share price is based upon the forecasted growth and availability of positive NPV projects.  Unfortunately for the proposition to be accurate there are several conditions that must be made, for example, there are no taxes, there are no costs associated with buying and selling shares etc.

If Modigliani and Miller's theory were true then if a company that produces consistently high dividends every year were, to one year, simply declare that all cash was being retained and therefore no dividend was being distributed, the share price wouldn’t even flinch due to the irrelevance of dividends...

One of the major dividend issues reported in the media recently was BP’s decision not to pay a dividend for three of the four quarters during 2010. The company usually pays dividends consistently every quarter of the year, however in 2010 this pattern was broken. In June 2010 the decision came to ‘suspend its quarterly dividend as part of its commitments to compensate victims of the Gulf oil spill’ (ABC, 2010) .


The direct effect of a potential dividend cut was evidently reflected in the company's share price:

Share in BP fell 6 percent on Wednesday as investors saw it increasingly likely the oil major would suspend dividend payments under the US political pressure due to its oil spill in the Gulf of Mexico (Reteurs, 2010). 

 

This demonstrates the relevance of dividends and the effect it can have on share value, constructing an argument opposing that of Modigliani and Miller (1961).

However, in retaliation only recently Apple declared 'it would pay a quarterly dividend of $2.65 per share from July' (BBC News, 2012). This will be the first dividend the firm has produced since 1995, however, this doesn't seem to have had much of an impact on the growth of company's share price...

The Apple case suggests that dividends may not be so relevant with creating value as the firm has achieved significant growth since 1995 despite never distributing a dividend.

However, I feel the more traditional outlook on the significance of dividend policy provides a more accurate picture of how the distribution/retention of dividends can affect shareholder value.

Shareholders might require a dividend to reassure them that the company is performing well; reducing a dividend to re-invest in future projects could have adverse effects on share price. Shareholders that aren’t receiving a frequent cash return on their investment may choose to sell up and purchase shares in company that produces strong, consistent dividends. In this circumstance obviously dividend policy has had an effect on share value and is therefore very relevant in contributing to shareholder wealth, counteracting the former argument outlined by Modigliani and Miller (1961).

Like most things in business then dividend policy is another complex decision to be made by managers, constantly weighing up the opportunity costs of their firm’s capital. Several things can affect dividend policy, for example: changes in the market, the firm’s financial position, clientele effects etc.

One of the other approaches toward dividend policy that I consider to be reasonably suitable it to treat dividends as a residual. This approach ensures that all future positive NPV investment projects receive the retained capital required and after all channels of investment that encourage future growth are exhausted then the residual capital should be distributed through dividends. During a boom or period of financial success I believe this approach would be favourable as the future investment opportunities receive the capital required and shareholders receive a dividend. The knowledge of further investment in positive NPV projects is also likely to drive up the share price. 

You have both a bird in the hand AND two in the bush.

However, this method typically produces a fluctuating dividend that can often discourage shareholders.

Producing consistently stable dividends year-on-year is usually considered an important factor with regards to dividend policy as it suggests financial stability and translates the least amount of risk to shareholders. Furthermore, producing consistent dividends can help companies safeguard themselves by producing the same dividend regardless of financial success; managers can retain capital from years of significant profitability and then potentially use this capital to pay dividends if they were to make a loss the consecutive year. 


This blog demonstrates yet another issue managers must take into account when determining the best ways to enhance shareholder wealth.

To pay or not to pay, that is the question.

Sources used:
Bergin, T. (2010) 'BP shares drop as dividend cut seen more likely', Reuters [Online]. Available at: http://uk.reuters.com/article/2010/06/09/uk-bp-shares-idUKTRE65838Q20100609 (Accessed: 26/04/12).

ABC (2010) 'BP: No dividend to be paid this year', ABC Website [Online]. Available at: http://abclocal.go.com/ktrk/story?section=news/national_world&id=7501374 (Accessed: 26/04/12).

Roberts, D. & Pratley, N. (2010) 'BP Dividend - To pay or not to pay', The Guardian Website [Online]. Available at: http://www.guardian.co.uk/business/2010/jun/10/bp-dividends-for-and-against (Accessed: 26/04/12).

BBC News (2012) 'Apple to pay dividend and buy back shares', BBC News Website [Online]. Available at: http://www.bbc.co.uk/news/business-17434328 (Accessed: 26/04/12).

Capital Structure and the three bears

Throughout previous weeks a theme that has been common throughout some of these blogs is the idea of maximising shareholder wealth. It has been made apparent, throughout this weeks lecture that utilising capital structure can be an effective method of contributing to this objective.

Capital structure can be defined as the method at which a firm finances its operations and growth by using different sources of capital. For example, one of my previous blogs covers the idea of equity vs. debt, well; capital structure is the method at which managers use both of these capital sources to achieve their optimal capital structure.

Traditionally it was believed that simply increasing the gearing of a firm, i.e. the debt would be most beneficial as this would produce the cheapest rate of borrowed funds, creating the lowest WACC and therefore enhancing shareholder wealth. Debt is considered cheaper than equity due to the fact that: lenders usually expect lower rates of return than shareholders, debt can actually be paid off before the business’ profits are taxed, resulting in less tax being paid by the firm and finally, the transaction costs associated with debt are usually less expensive than those incurred by equity.

However, unfortunately raising capital through debt does have its disadvantages. As gearing increases, so do the annual interest repayments and unlike dividends, firms are required by law, to pay the interest. As a result, interest repayments that get too large can result in a firm being unable to pay dividends to shareholders, lowering shareholder wealth and opposing the aim of optimising capital structure in the first place. In more extreme scenarios firms may have to enter liquidation to pay off their debts and could even end up having to declare bankruptcy!

There is a way of achieving this optimal debt to equity ratio; if the gearing is too low then the benefits of low cost borrowing are lost, whereas if debt is too high then the company could be deemed a very risky investment.

The idea reminds me of the story Goldilocks and the three bears, it’s all about finding that perfect bowl of porridge…

However, finding the optimal capital structure can be difficult, particularly if your firm is largely affected by changes in the market. For example, if a firm has a capital structure that relies heavily on debt, it can often find itself in trouble during times of turmoil.

Companies with this sort of capital structure have been hit worse by the economic recession. As stated previously, companies that raise capital through debt must pay their interest repayments regardless of their financial performance whereas companies that have raised finance through equity can choose to avoid paying out dividends, retaining the capital to sustain future operations and growth.

Many companies that have been hit hard by the recession have found themselves struggling to pay interest repayments on their debt. One of the largest UK companies to buckle under the weight of their debt as a result of the recession was Woolworths. In November 2008 the high-street chain went into administration after struggling to cope with repayments of its £385million of debt (BBC News, 2008). The firm had been described as a “lame duck” by the BBC, a term usually used to refer to politicians that were known to be in their final term of office. Woolworths had been losing market share to intense competition over the previous years and a vicious cocktail of declining sales and heavy debt repayments were the cause of its demise.

In its final days, the 'company had tried to sell itself for the nominal price of £1' (BBC News, 2008) with the new owner taking on the company's huge debt. Unfortunately, the desperate plea for someone to inject life back into the firm, fell on deaf ears.

Perhaps if the firm had re-structured its capital, taken a more equity focused approach it would’ve been able to weather the storm of this recession. Retaining any cash reserves, withholding dividend payments until things began to look up.

Although, are shareholders likely to hold onto shares that aren’t offering any returns? What use is holding equity in a firm that’s bleeding market share? Ridiculed by the media as a “lame duck”, hardly screams great investment. Maybe then this end was unavoidable for Woolworths; a strategic re-structure of capital may simply have delayed the inevitable. 

Sources used;

BBC News (2008) 'Woolworths set for administration', The BBC News Website. [Online]. Available at: http://news.bbc.co.uk/1/hi/7751064.stm (Accessed: 01/04/12).