This week I am discussing the hot topic of dividends and whether or not it is beneficial for a shareholder to receive dividends or not.
It seems that there are two simple options that a shareholder has when deciding if they would like to be paid dividends or not: Would I like to receive payments twice a year regardless of share price movements? Or would I like to be guaranteed that my shares will increase in value over time continually, with no payments made? In the end all of this can be summarised using divided relevance theory and dividend irrelevance theory.
Just the same as last week (capital structure blog) Modigliani and Miller have a rather different and controversial approach to dividend payments. In their 1961 paper M&M argued the case of “Dividend Irrelevance” and claimed that a rational investor should be indifferent to receiving dividends or increasing wealth through capital gains. They argued the case that the best way to maximise market value is through a company’s investment policy and investing in positive NPV projects. In turn this should theoretically increase positive NPV cash flow, which should increase the share price and finally increase the shareholder wealth. Modigliani and Miller made it clear that they do not discourage companies from giving shareholders dividends, however it should only be the residual money after all possible NPV projects have been invested in.
However, once again good old M&M have made some very major assumptions. Surprise, surprise! Just like they did on their 1958 paper on capital structure they have made the assumptions that there are perfect capital markets with no transaction costs involved and that there are no tax implications regarding dividend payments or on capital gains. To me this is majorly alarming that they have not considered the implications that tax would have on the shareholder. One reason being that if a dividend payment to the shareholder took them into the next tax bracket than they would have been in ordinarily, it would make the shareholder worse off than if they had increased in wealth through increased share price and through capital gain!
There is also the “bird in the hand” theory (also known as dividend relevance theory), which is discussed by Linter (1956) and Gordon (1959-1962). This is the idea that shareholders see dividends as more desirable than capital gains, mainly because of uncertainty. This uncertainty lies in the fact that future gains are not guaranteed and shareholders would much rather have money paid in the present than have to worry about their investment being tied up in an uncertain investment. From a personal point of view I know that I would much rather have dividend payments than have to wait and see what the outcome of investments are, as I am generally not a risk taker and I am certainly not patient. But maybe that’s just me?
The payment of dividends can also act as a “signalling effect” for investors, as high dividend payments can represent good news and low dividends represent bad news. So it could be beneficial for a company to pay out higher dividends even if they are not performing greatly in a financial sense, as it could entice potential investors to invest, which would in turn increase the share price. Personally I see this method of increasing market value very short sited as it would not take long for investors and shareholders to realise how the company is actually performing and the share price would decrease back to the correct level.
On the flip side investors may see high dividends as a negative, as they may believe that this is due to there not being many future investments and no room for growth in the future!
From a personal point of view if I was a shareholder or a company then I would always rather have dividend payments than increased wealth through the share price of a company. Maybe this is just because I am a student and current finances are not brilliant, but I have always had the attitude that having current cash is more beneficial than having slightly more down the line.
From a company’s perspective, I agree with Modigliani and Miller to some extent that it does not matter what the dividend policy is, however I believe that complete transparency with the shareholders is key to increasing the market value!
Feel free to leave any comments fellow bloggers!...