Why Pay Dividends, Relevant or Irrelevant?

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.