Dividend decisions are to some extent influenced by
investing and financing decisions as a company has the choice to not pay
dividends and keep wealth in the company or to take wealth out the company and
pay dividends. Therefore if the company has nothing attractive to invest in then the
extra money should go to the shareholders so they invest when the company needs
them too or the money could be kept to finance the business and keep money back
in a high interest account so it is there when it is needed.
Dividend payments made by UK-quoted companies is normally
twice a year and are out of accumulated distributable profits and not out of
capital. So companies that have made a loss can pay dividends if they wish but
can only be paid out of the previous years realised profits. This is in order
to provide protection for creditors by stopping shareholders looking to remove funds
from the firm and removing the capital that was originally provided by the
shareholders. The determination of what proportion of profits should be paid to
shareholders should aim to maximise shareholders wealth and can only do so if
the new share price of the company plus the dividend is equal to or higher than
the previous year’s share price (Porterfield, 1965).
However Modigliani and Miller (1961) argued that dividend
policy is irrelevant to share prices and is determined by future earning
potential based on the availability of projects with positive NPV’s. Their
assumptions that were made for this to be true included no taxes, no transaction
costs and investors can borrow and lend at the same interest rates. Given these
assumptions dividend policy can become irrelevant and wealth is created by
positive NPV projects that will increase share price and therefore increase
shareholder wealth. They argued that dividends simply represent a residual
payment and after a company has invested in all available positive NPV
projects, then any earnings left over should be paid out in dividends and if no
surplus the market value of a company should still rise to reflect the future
increasing returns. However if using this theory and dividends are paid regularly
then does this mean the company are in trouble as they have no wealth creating
projects to invest in?
Nevertheless the traditional view supported by Linter (1956) and Gordon (1959) suggests that investors prefer dividends over capital gains because of the uncertainty of future gains so would rather have the money now than leave it tied up in uncertain investments. This conflicts with M&M's (1961) theory as if investors prefer dividends then this would influence the market value of the company as a company that pays low dividends to investors may sell their shares in favour of a company that pays larger dividends. This would cause the share price to go down for the company so meeting short term expectation may be better for the company than looking at long term value growth.
The importance of dividend payments are also evident to
shareholders as they see a high dividend payment as good news and a low one as
bad news which in reality could be the opposite causing asymmetric information
to be signalled to the market. As investors do see dividends as information
(Pettit, 1972) management of the company should communicate effectively if the
dividends are reduced in order for it not to be detrimental to the share price
and thus shareholder wealth.
Clientele effects argues that shareholders are not
indifferent to dividends versus capital gains as they need a regular income as
some shareholders may require a regular income in order to meet liabilities.
M&M believe that this shouldn’t be the case as shareholders can create
their own income by selling shares but this doesn’t take into account the
implications this has in terms if transaction costs, how time consuming this
would be and the tax implications this would incur. M&M ignored tax yet
investors are attracted to companies that best suit their needs in terms of tax
as dependending on their income tax levels they would prefer either dividends or
capital gains.
Agency problems also exist within the payment of
dividends as shareholders and management are separate individuals with
different aims. Firms have been known to pay out high dividends shortly after issuing
shares to raise funds for investment and is seen as an indication the dividend shouldn’t
have been paid in the first place. It is also inefficient practice as shareholders are taxed on
dividends and issuing shares is costly both of which erode shareholder wealth. However
this could also be beneficial to the shareholders as if the dividend is higher,
then the amount of retained profit available to managers is lower therefore forces
managers to justify their investments as they would require funds to be raised
eternally.
Lloyds bank is an example of a company that rewards its shareholder
‘s with dividends as before the financial crisis they had a record of being one
of the highest dividend paying stock in the UK, paying out just over half of its
profit in 2005 and 2006. However since the credit crisis hit the bank has not
made a pay-out which reflected the crisis that they were in. The pre-tax
profits that Lloyds have made this year has strengthened their plan to pay its
first dividend since it was rescued, this supports the importance that
companies place on paying dividends to shareholders to signal how well the company
is doing. Restarting these dividends is seen as a key prerequisite for Britain
to sell any of its remaining stakes to retail investors with possibly handing
out to shareholders more than half its future earnings
Finally, dividends are considered an indicator of a successful company
as they are essentially paid out of the previous year’s profits, the director’s
view of the coming year and the financial strength/ liquidity of the business.
Therefore if companies don’t want to see the market value of their company drop
regardless of dividend payments they need to make sure this is communicated
effectively and is justified to their shareholders. In reality, most companies
aim to provide stable dividends with stable growth and even in time of fluctuating
profits they will try to maintain the level of dividends paid as a result of
signalling to the market.
