Dividend policy and firm value
The dividend decision is an integral part of the firm's strategic financing decision. It essentially involves a firm's directors deciding how much of the firm's earnings, after interest and taxes (EAIT), should be distributed to the firm's ordinary shareholders in return for their investment in the firm, and how much should be retained to finance future growth and development. (Sterk and Vandenberg 2004 441-55)The objective of the firm's dividend decision, like all financial decisions, should be the maximisation of shareholder wealth. If an optimal dividend policy does exist then clearly managers should concern themselves with its determination; if it does not, then any dividend policy will do, as one policy will be equal to another. It should be noted that the dividend decision and dividend policy relate only to ordinary share capital. (Asquith and Mullins 2003 77-96)The payment of preference share dividends is not considered part of a firm's dividend policy, as the level of, or method of calculating, the preference dividend is fixed in advance by the terms and conditions of the original preference share offer. Once a dividend policy has been formulated, setting out the amount and timing, etc. of dividend payments, it should be followed with stability and consistency as its guiding principles. As we shall discuss later, changes to a firm's dividend policy can be interpreted in various ways by the financial markets, sometimes with dramatic consequences for the firm's share price. You will note that the dividend decision is made at the level of the firm's most senior managers - at board of director level. It is the directors who will decide the amount and timing of dividend payments. Under UK company law the directors cannot be compelled to recommend a dividend and shareholders cannot vote themselves a higher dividend than that recommended by the directors. (Bajaj and Vijh 2004 193)Payment of dividendsIn the UK, in common with many other countries, dividends are usually paid to shareholders twice a year. An interim payment is made half-way through the financial year, with a final payment being made after the end of the financial year. Dividends are paid to the shareholders listed on a firm's Share Register on a specified date, known as the Record Date. (Sterk and Vandenberg 2004 441-55) In the stock market, shares of listed companies are traded on what is known as either a cum-dividend or ex-dividend basis. A listed company's shares are traded cum-dividend for a period after the company announces its results, interim and final. When the shares are trading cum-dividend, buyers of the shares will be entitled to
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receive the dividend payment. When the shares are trading ex-dividend, buyers will not be entitled to receive a dividend payment. This explains why (assuming the absence of any other relevant factors) there is usually a drop in a share's price, roughly equivalent to the value of the dividend per share, when the share goes ex-dividend. (Impson 2005 422-27)For instance, distributing capital or certain types of reserves (e.g. share premium account) as dividends is prohibited by company law. The determination of distributable profits is set out in a detailed code of statutory regulations. For public and private companies, the Companies Act 2003 defines distributable profits as: 'accumulated realised profits, so far as not previously utilised by distribution or capitalisation, less accumulated realised losses, so far as not previously written off in a reduction or reorganisation of capital duly made'. These legal restrictions on the payments of dividends are necessary to maintain the capital of a company and to protect the rights and claims of creditors. The relevance (or irrelevance) of dividend policy to the value of the firm has been one of the most widely researched topics in finance and accounting. Arguments have been advanced on all sides of the issue. Given the inability to structure a single conceptual relationship between dividend policy and the value of the firm, empirical studies of the relationship between dividends and firm value have taken on increased importance. Previous studies have used either short-run measures of stock price or risk-adjusted returns to measure firm value. (Jose and Stevens 2004 652)Dividend announcement studies have examined the immediate reaction of the firm’s stock price to a dividend announcement to determine if the stock price falls by more or less than the amount of the dividend. Findings from announcement studies suggest that investors discount dividends. Other studies have tested for the relationship between risk-adjusted returns and dividend yield. Using short-run holding periods, these studies have found that investors require higher risk-adjusted returns from higher dividend yield stocks. While there are controversies over the short-run measures and assumptions of asset pricing models relating returns to firm value, the empirical findings have consistently suggested that higher dividend commitments lower the value of the firm. (Bernstein 2005 4-15)Multiple Measures of Dividend PolicyDividend \"policy\" implies a conscious management of dividend distributions over time. Surveys indicate that managers tend to focus on the payout ratio in the long run, but smooth dividends in the short run. (Baker et al 2004 1-8) In the longer run, the level of the firm's average payout ratio captures the firm's commitment to the level of dividend distribution out
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of earnings. However, over time the firm need not adhere to the same short-run payout ratio to accomplish the longer-run objective unless earnings are stable. If dividends per share are consciously smoothed relative to earnings, the firm's payout ratio will be volatile. The greater the volatility in the payout ratio, the greater the smoothing of dividends. The volatility of dividends around their trend reflects the inherent dividend stability aspects of the policy. (Woolridge 2002 237-47)Measures of the average payout ratio (APOR), dividend stability around the dividend time trend (R2LDPS), and payout ratio volatility (SDPOR) are used to represent the firm's policy with respect to dividend levels, stability, and smoothing. The dividend payment In practical terms a firm's dividend payment is important to its shareholders. It is part of the return which shareholders receive for their investment in the firm. The dividend payment is also a favoured method by which shareholders and investors estimate a firm's share value, where the value of a share is equal to the present value of the expected future dividend payments - the dividend valuation model Notice the tendency for the final dividend to be significantly greater than the interim - this is the common, financially prudent, approach adopted by most company boards. (Michaely 2005 573)Clearly directors will wish to be certain of how a company has performed for the year overall, before committing valuable cash resources to a dividend payment. Shareholders, depending upon the individual company's articles of association, may have the right to receive dividends in the form of fully paid ordinary shares instead of cash, if they so elect. Under such a plan shareholders can, if they wish, use the entire cash dividend to buy additional shares of the company in the market, usually at a competitive dealing rate. (Christie 2004 459-80)Dividend coverThe dividend cover ratio indicates the vulnerability, or the margin of safety, of dividend payments to a drop in earnings. Notwithstanding the abolition of ACT, tax credits will continue to be available to individual shareholders resident for tax purposes in the UK, although the amount of the tax credit will be reduced to one-ninth of the amount of the net, or cash dividend - equivalent to 10 per cent of the gross dividend. Lower and basic rate taxpayers, as before 6 April 2006, will have no farther liability to tax on their dividends. Higher rate tax payers will, as before, be able to offset the tax credit against their liability to tax on the gross dividend. UK resident individual shareholders who are not liable to income tax in respect of the dividend will not generally be entitled to reclaim any part of the tax credit. Tax credits are no longer available to UK pension funds. (Baker et al 2003 78-84)Under legislation introduced in the Finance
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(No. 2) Act 2005, UK pension funds are not entitled to reclaim the tax credits on dividends paid to them by a company. Similarly, after 6 April 2006 tax credits in respect of dividends paid, which constitutes the income of a charity or venture capital trust, will not be repaid. There is some speculation that, in the future, companies may increase their dividend distributions to compensate these investing institutions for the loss of their tax credits. (Miller 2003 1031)Over time many theories on dividend policy, often controversial ones, have emerged. The central area of controversy has, and continues to be, concerned with whether or not there is a real connection between dividend policy and the market value of the firm. In this section we will review the following main theories of dividend policy:1 the residual theory of dividend policy;2 dividend irrelevancy theory;3 the bird-in-the-hand theory;4 dividend signalling theory;5 the dividend clientele effect;6 agency cost theory.
The residual theory of dividend policyThe essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed. Recall from the previous chapter that, according to Myers' Pecking Order Theory, managers will prefer to utilise retained earnings as the primary source of investment financing, before resorting to issuing debt or equity. Retained earnings are the most important source of financing for most companies. (Ang 2003) They are a cheaper source of finance than making a fresh issue of equity due to expensive equity issue costs (e.g. advertising, brokerage and underwriting fees). The existence of these issue costs - which are examples of real world market imperfections it is suggested by some theorists, would lead companies to favour using retained earnings to finance investment projects rather than making a fresh equity issue. This implies a residual approach to dividend policy, as the first claim on retained earnings will be the financing of investment projects. With a residual dividend policy, the primary focus of the firm's management is indeed on investment, not dividends. Dividend policy becomes irrelevant; it is treated as a passive, rather than an active, decision variable. (Crutchley 2004 36-46)The view of management in this case is that the value of the firm and the wealth of its shareholders will be maximised by investing earnings in appropriate investment projects, rather than paying them out as dividends to shareholders. Thus managers will actively seek out, and invest the firms earnings in, all acceptable (in terms of risk and return) investment projects, which are expected to
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increase the value of the firm. Dividends will only be paid when retained earnings exceed the funds required to finance suitable investment projects. Conversely, when the total investment funds required exceed retained earnings, no dividend will be paid. (Sterk and Vandenberg 2004 441-55)Dividend irrelevancy theoryDividend irrelevancy theory asserts that a firm's dividend policy has no effect on its market value or its cost of capital. As we discussed in the preceding section, dividend irrelevancy is implied by the residual theory, which suggests that dividends should only be paid if funds are available after all positive NPV projects have been financed. (Ofer and Thakor 2003 365) The theory of dividend irrelevancy was perhaps most elegantly argued by its chief proponents, Modigliani and Miller (usually referred to as M&M) in their seminal paper in 1961. In the same manner in which they argued for capital structure irrelevancy M&M assert that the value of a firm is primarily determined by its ability to generate earnings from its investments and by its level of business and financial risk. They argue that dividend policy is a 'passive residual' which is determined by a firm's need for investment funds. According to M&M's irrelevancy theory, it therefore does not matter how a firm divides its earnings between dividend payments to shareholders and internal retentions. In the M&M view the dividend decision is one over which managers need not agonise, trying to find the optimal dividend policy, because an optimal dividend policy does not exist. M&M built their dividend irrelevancy theory on a range of key assumptions, similar to those on which they based their theory of capital structure irrelevancy. For example they assumed:• Perfect capital markets, that is, there are no taxes (corporate or personal), no transaction costs on securities, investors are rational, information is symmetrical - all investors have access to the same information and share the same expectations about the firm's future as its managers. (Miller and Scholes 2002 1118)• The firm's investment policy is fixed and is independent of its dividend policy. You may consider that the theory can be dismissed because the underlying assumptions are simplistic and idealistic. However, as M&M themselves argued, all economic theories are based on simplifying assumptions, and it is not their lack of realism which matters but the ability of the theory itself to stand up to empirical testing. The model's robustness can be tested by introducing real-world factors and observing their effect. (Peterson and Benesh 2003 449-53)Dividend signalling theoryIn practice, changes in a firm's dividend policy can be observed to have an effect on its share price - an increase in dividends producing a increase in share price and a reduction in dividends
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producing a decrease in share price. This pattern led many observers to conclude, contrary to M&M's model, that shareholders do indeed prefer dividends to future capital gains. Needless to say M&M disagreed. (Crutchley 2004 36-46) M&M suggested that the change in share price following a change in dividend payment is due to the informational content of the dividend payment, rather than the dividend payment itself. In other words, the change in dividend payment is to be interpreted as a signal to shareholders and investors about the future earnings prospects of the firm. Generally a rise in dividend payment is viewed as a positive signal, conveying positive information about a firm's future earnings prospects resulting in an increase in share price. Conversely a reduction in dividend payment is viewed as a negative signal about future earnings prospects, resulting in a decrease in share price. As we discussed in relation to capital structure in the previous chapter, signalling theory argues that shareholders and the investing community understand these issues; that managers have more information about a firm's future prospects (information asymmetry) and use dividend and financing policy to signal this information to their less well-informed shareholders and investors. (Soter et al 2005 4-15)The dividend clientele effectThe dividend clientele effect is a feature of M&M's dividend irrelevancy theory. In relation to dividend policy, M&M argued for the existence of a clientele effect, where the nature of a firm's dividend policy will attract a particular clientele of shareholders. Investors who prefer income to capital growth will be attracted to companies with high dividend payout policies and vice versa. For example, many charities, pension funds and retired senior citizens, have a need for a stable, regular income to meet their operating expenses and other financial commitments. (Barclay et al 2005 4-19) With regard to charities (and also other institutions such as universities which receive endowments and legacies) often the terms and conditions of endowments will prohibit a charity's trustees from spending the capital sum endowed. The capital endowment therefore has to be invested, in perpetuity, to generate income. In such circumstances, investing in high dividend paying companies has its appeal. In contrast, other groups of investors who (perhaps for taxation reasons, where an investor's capital gains may be taxed at a lower rate than the investor's income) may prefer capital growth to income will be attracted to firms with high earnings retention and low dividend payout policies. In the main, the existence, or otherwise, of investor clienteles is generally considered to have no effect on an individual firm's share value. Any sudden and dramatic change of policy is
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likely to cause a similar, sudden and dramatic shift in its shareholder clientele and possibly in its share price. Shareholders and investors who find the new policy meets their needs will be attracted to the firm. Any existing shareholders who no longer find the policy suitable will sell their shares. (Healy 2004 149)Growth stageDividend policy is likely to be influenced by a company's growth stage. For example, a young, rapidly growing company is likely to have a high demand for development finance. In such circumstances dividend payments may be strictly limited or even deferred until the company reaches a mature growth stage. (Benartzi et al 2005 1007)Ownership structureA firm's dividend policy may be driven by its ownership structure. Normally in small firms, where owners and managers are one and the same, dividend payouts tend to be very low, or even non-existent. (Crutchley 2004 36-46) Whereas large, quoted public companies tend to pay out significant proportions of their earnings as dividends in small firms, the values and preferences of a closely knit, small group of owner-managers will exert a more direct influence on dividend policy. It is also interesting to note that, almost without exception, when private companies become public their dividend payouts increase. (Ofer and Thakor 2003 365)Shareholder expectationsShareholder clienteles that have become accustomed to receiving stable, and possibly increasing, dividends will reasonably expect a similar pattern of dividend payments to continue in the future. Any sudden reduction or reversal of such a policy is likely to incur the wrath of these shareholders, perhaps even prompting them to dispose of their shares and causing the share price to fall. (Pruitt and Gitman 2004 409-30)Share repurchases schemesIn the UK the ability of a company to repurchase its shares became legal following the introduction of the 1981 Companies Act. However, it is only in recent years that the practice of initiating share repurchase, or buyback, schemes has become a very popular way for companies (mainly in the UK and in the US), which have accumulated substantial balances of surplus cash, to return some of this cash to their shareholders. (Easterbrook 2003 650-58)Market signallingSimilar to dividend signalling, share repurchases can be used to signal information about the company's future prospects to the financial markets. For example, by initiating a share repurchase, directors, who have inside knowledge about the company, may be trying to convince the financial markets that the company's share are undervalued. For example, when Rio Tinto (the largest mining company in the world and listed on both the UK and Australian stock markets) announced in January 2006 a plan to buy back up to 10 per cent of its share capital,
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the company's chairman publicly stated that: 'We consider that buying back shares, particularly in current market conditions, should achieve earnings per share improvement for the shareholders of both companies and enhance the underlying value of those shares which remain outstanding.'(Rozeff 2007 249-58)SummaryAt this stage it would be helpful to try and summarise the various views on dividend policy. Miller and Modigliani (M&M) have demonstrated that, assuming perfect capital market conditions, a firm's dividend decision is irrelevant; dividend policy has no influence on share value. (Ofer and Thakor 2003 365) Therefore, in a perfect market, it does not matter whether a firm has a dividend policy or not. In the real world, market imperfections, such as taxation and transaction costs, do exist. Expensive equity issue costs (e.g. underwriting and brokerage fees) would induce firms to use internally generated funds, that is, retentions, to finance positive NPV investments, rather than make a fresh equity issue. This, some theorists argue, leads to a residual approach to dividend policy. Earnings will be primarily used to fund investments; dividends will be paid from any earnings remaining after all suitable investments have been funded. (Ghosh and Woolridge 2004 281-94)In addition, investors who, because of their individual financial circumstances, prefer steady income to capital growth or vice versa, create a clientele effect - a firm will attract the investor clientele to which its dividend policy most appeals. But the existence of clientele groupings is generally considered irrelevant. (Smirlock and Marshall 2003 1659-67)It is argued that clienteles have no effect on an individual firm's share value as long as there are enough shares widely available in the capital markets to satisfy the needs of various clienteles. A firm's share value may also be affected by other market imperfections such as information asymmetry, where the information content or signalling effect of dividends seems to be relevant. (Ofer and Thakor 2003 365) Therefore a firm's management should be wary of making any sudden and dramatic changes, particularly reductions, to a firm's dividend policy, as this will probably also cause a sudden and dramatic change in its shareholder clientele and probably its share price. The available evidence would suggest that a firm maintains a stable and consistent dividend policy over time. (Rozeff 2007 249-58)The mainstream, modem agency cost view of dividend policy argues for the valuable role of dividend policy in helping to resolve the agency problem, reducing agency costs, and thus in enhancing shareholder value. Agency cost theory would imply that firms adopt high dividend payout policies; after all suitable investment projects have been financed. (Benesh et
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al 2003 131-40) Although the jury is still out on dividend policy, and there is no general consensus on the relationship between dividend policy and share value, the empirical evidence available would seem to suggest that, at least in practical terms, dividend policy is highly relevant to corporate managers, shareholders and investors, particularly the large institutional investors. (Farrelly 2003 62-74)It would only seem logical therefore that this behavioural aspect of dividend policy is recognised by a firm's managers in the formulation of its own dividend policy. It is intriguing that, over twenty years later, and despite voluminous academic research, the two basic questions posed by Fisher Black, in his famous article 'The Dividend Puzzle' in 1976: (1) Why do corporations pay dividends? And (2) why do investors pay attention to dividends? Still remain without definitive answers.
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