Dividend Theories

Lecture 11 discusses dividend policy. Dividend relevance theory was proposed by Lintner (1956) and Gordon (1959). They suggested that investors are generally risk adverse and would rather have dividends as appose to capital gains because of uncertainty (‘Bird-in-the-hand’ argument). Where future gains are uncertain, investors would rather have the money now than leave it tied up in uncertain investments. Therefore as investors prefer dividends, the dividend policy will influence the market value of the company.

According to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders. Empirical studies fail to provide conclusive evidence in support of the dividend relevance argument. In practice, however, the actions of both financial managers and shareholders tend to support the belief that there is some connection between dividend policy and share price. (Frankfurter, 2003)

Conversely, Modigliani and Miller showed algebraically that dividend policy did not matter. They argued that as long as the firm was realising the returns expected by the market, it did not matter whether that return came back to the shareholder now as dividends, or reinvested. The clientele effect argues that shareholders are not indifferent to dividends vs. capital gains. (Myers, 2010) This could be because some shareholders require a regular income (dividends) to meet liabilities. On the other hand, M&M (1961) suggested that the shareholder can create their own dividend by selling their shares when cash is needed. (Booth and Cleary, 2010) However, this would be time consuming for the shareholder and possible issues could be that there would be control implications and transaction costs involved. Their argument that dividend policy is irrelevant to a company’s market value and therefore shareholder wealth is based on the assumption that perfect capital markets exist and there are no taxes or transaction costs.

However, in reality, where perfect markets do not exist and tax and transaction costs do, M&M’s views are unrealistic. (Watson and Head, 2003)

Research suggests that dividends are important to both investors and companies. Moreover, if dividends do not remain stable or increase in the long run, the value of shareholders investment will not be seen as returned or maximised, plus performance and reputation of the business may be doubted, potentially leading to a decrease in market value of the company and therefore shareholder value destruction. (Gillet, Lapointe and Raimbourg, 2008)

M&M argue that changes in dividend policies from low-to-high pay-outs, for example, should not have a bearing on the market value of the shares, but rather on the clientele that the firm will attract. Looking at this from the other end, Miller, Black and Scholes (1974) argue that if clients are satisfied, their demand for high or low pay-outs will have no effect on prices of shares. In the real markets, studies have however shown that large changes in dividends do affect share prices. (Gitman, 2011) M&M’s counter argument to this is that the effects on the prices are attributable to the informational content of dividends with respect to future earnings rather than to the dividend itself.

Marks & Spencer was the first British retailer to publish pre-tax profits of over £1 billion in 1998. (BBC, 1998) However, a few years later it plunged into crisis which lasted for several years. They publish £millions loss and lost their entire market share. Simply, they got the branding wrong; they copied the catwalks in Milan and changed the target market, and ignored their main customer base. This resulted in a multi-million pound refurbishment throughout the whole company. In 2001, their profits recovered somewhat and they recovered some of its market share, but it was soon evident that problems remained. However, their dividend pay-out policy remained exactly the same. It remained the same during their good years, their bad years and also their recovering years. The fluctuation in profits would not be apparent looking at their dividend. They drew on reserves to pay the dividend. They did this because it was the dividend that said something about marks and spencer. If they had massively slashed the dividend, which might have been expected, it would have affected the attractiveness to invest in their company.

In conclusion, there are many different factors that will influence the decisions of management with regard to dividends. Although offering high dividends to investors may satisfy them in the short term, future performance must be considered as it may not be possible to continue with such high payments, especially if the financing of future projects is threatened by the fact that money was spent on issuing dividends.