Corporate Dividend Policy
1 Introduction
The fundamental role of the financial manager is to maximise shareholders wealth. Since, in theory, the value of shares is heavily dependent on future expected dividends, it is important to consider the dividend policy of the company and the effect this may have on shareholders expectations.
2 Dividend irrelevance
Modigliani and Miller argued that the level of dividend is irrelevant and that is simply the level of profits that matters. Their logic was that it is the level of earnings that determines the dividends that the company is able to pay, but that the company has the choice as to how much to distribute as dividend and how much to retain for expansion of the company.
A large dividend will result in little future growth whereas a smaller dividend (and therefore more retention) will result in more growth in future dividend. It is expected future dividends that determine the share price and therefore the shareholders should be indifferent between the alternatives outlined above.
As a result, the company should focus on improving earnings rather than worry about the level of dividends to be paid.
3 Practical influences on dividend policy
Despite the above, shareholders are affected by the dividend policy of the company for various reasons:
the signalling effect
If a company reduces a dividend then there is a danger that it will worry the shareholders, even if it results from increased retention and not from a fall in earnings. The danger is that whatever information is given to shareholders about the reasons, their immediate reaction might be to assume that the company is performing badly. If this is their reaction then they will reduce their future expectations with an adverse affect on the share price. Similarly an increase in the dividend payment may serve to increase their future expectations even if it results simply from a reduction in retention rather than an increase in earning.
liquidity preference
Some shareholders invest for income and others for capital growth. If they require income then they will choose to invest in companies that have a record of high dividend payments whereas if they prefer growth then they will choose companies that have a record of lower dividends but more retention and expansion.
If, for example, an investor requires income and has therefore chosen a company paying high dividends, they are going to be unhappy if the company changes its policy and starts to retain a higher proportion of earnings.
Modigliani and Miller counter this by saying that since the expansion should increase the share price then shareholders needing cash can always sell some of the shares to recoup the fall in dividends. This is fine in theory, but ignores transaction costs and also the fact that shareholders can argue that their company should pay them their cash directly and not ‘force’ them to start selling shares.
taxation
As stated already, the basic choice is between high dividends with low capital growth, or low dividends with high capital growth.
Dividend income is taxed differently from capital gains and therefore the tax position of the investors can influence their preference.
4 Practical dividend policy
In practice there is a tendency for companies to do two things in relation to dividends:
to aim for a steady pattern of dividends
e.g. to have a policy of increasing dividends by 5% p.a.. This enables investors to choose the companies whose dividend policy they prefer, and avoids the signalling problem.
Clearly, the company can only maintain 5% growth in the long-term provided that they can achieve the same earnings growth. Therefore they follow a policy that they think is achievable and trust that years where earning grow in excess of 5% will fund years where earnings grow at less than 5%. They do however leave themselves open to a dramatic ‘signalling’ problem if they ever are forced to deviate from their stated policy.
scrip dividends
a very common practice in recent years has been to offer investors the choice between taking dividends in cash or in shares. This overcomes the ‘liquidity preference’ problem by allowing each shareholder to choose whichever is best for them.