Notes on dividend policy for a company in Benco’s position

In theory, companies should make all investments available to them that increase shareholder value (i.e., all positive NPV investments, when discounted at the shareholders‟ opportunity cost of capital). Any funds remaining after undertaking such investments should be distributed to shareholders as dividends so that the shareholders can invest them as they see fit. The dividend decision is, therefore, a residual decision. As a company’s share price is the PV of its future dividends, shareholders should be indifferent about how the PV is made up (i.e., the size of each year’s dividend).

One point of view is that individual shareholders who dislike a particular dividend policy can adjust the cash flows to suit their own needs. They can do this by „creating‟ dividends through the sale of shares or conversely they can buy more shares to cancel the effect of dividends. One drawback to this strategy, however, is the question of transaction costs in the real world. However, in practice, Benco’s dividend policy will be affected by a number of other issues than purely its own investment policy.

Dividend signaling. In reality, shareholders do not have perfect information concerning the future prospects of the company, so the pattern of dividend payments actually functions as a key indicator of likely future performance (increased dividends is taken as a signal of confidence which causes estimates of future earnings to increase, so increasing the share price, and vice versa). This supports the argument for the relevance of dividend policy and the need for a stable (and increasing) dividend pay-out.

Preference for current income (as displayed by certain of the private shareholders referred to by Director B). This implies that many shareholders will prefer companies which pay regular dividends and will, therefore, value their shares more highly.

Clientele effect. Investors may be attracted to firms by their dividend policy, for example, because it suits their particular tax position. Major changes in dividend policy may well upset particular clienteles who may then sell their shares, so pushing down the share price. While this may be off-set by other clientele buying the shares and boosting the share price, the climate of uncertainty concerning long-term dividend policy often depresses the share price.

Cash. Shortage of cash can affect dividend policy, although money may be borrowed to fund a dividend payment to avoid negative signaling effects. In summary, companies should establish a dividend policy which is stable, which sets a stable, rising dividend per share, and which sets the dividend at a level below anticipated earnings to provide for new investment (avoiding the need for new share issue) and to provide a cushion if an unexpected fall in earnings is experienced. Excess earnings over investment needs and normal dividends can be returned to shareholders via a special dividend or used to repurchase the firm’s shares.

Addressing the issue of differing shareholder preferences Director A‟s comments reflect the dividend valuation model but overlook the issues of both the funds available to a company and the investment calls on the company in any given year. Furthermore, Modigliani and Miller showed that, in the absence of taxes and transaction costs, dividends are irrelevant to the value of a company. In principle, it does not matter when dividends occur, provided that their PV is maximised. Furthermore, transaction costs somewhat undermine the director’s comments on raising new finance.

Director B’s comments are illustrative of the clientele effect as discussed above.

The way in which a company will try to address the issue of differing preferences of different groups shareholders depends on the current mix of shareholders (which the company must remain aware of at all times), what other similar companies do, and the effect that changes in dividend payout have had on the share prices of similar companies in the past. It is vital that the company makes clear to shareholders what its long-term dividend policy is, why any changes in dividend policy are being made and what the likely effect will be on shareholder value of any future proposed investments.

In reality, the aspirations of the new management team may mitigate against the family shareholders‟ desire for dividend payments as required and so the only way ahead is to communicate a planned, long-term dividend policy even if this means driving away those family shareholders.

The relationship between a company’s dividend policy and the „agency problem‟ This is apparent in the way that managers/directors do not necessarily act in the best interests of shareholders. Shareholders may seek to keep some control over their money by insisting on high pay-out ratios (in line with Director A‟s comments), thereby forcing managers/directors wanting new funds for investments to justify why the investment is sound. However, there is an agency cost here in the form of the cost of the new share issue. Managers/directors may, therefore, be motivated to adopt a low dividend pay-out policy which circumvents this need to justify projects by creating retained earnings which can be used to fund new projects. Even if they do this, however, there may still be an agency cost for shareholders in that managers may invest in empire building projects rather than in those that maximise shareholder wealth. In addition, an over-reliance on retentions can lead to dividend cuts which upset shareholders, depress the share price and increase the cost of equity.