Dividends

I have never really put much though into the issue of paying dividends, simply because I have believed it to be pretty straightforward process. An investor buys shares in a company and in return they receive a large pay out (dividends), simple yes? Regrettably not, after this weeks lecture I have once again had my eyes opened to the complex and arduous task companies face when dealing with issues of paying dividends.

Research carried out suggest that investors use dividend signals to assess a companies performance, and that stock returns are positively correlated by dividend fluctuations (Asquith & Mullins 1983 and Aharony & Swary 1980). Having said that it seems to me too presumption to assume that a change in a company’s dividend level means that there has been a change in performance or profitability?

I accept that in certain scenarios a decrease in dividends may lead to a lack of investor confidence, and that investors would argue that dividends are preferable to capital gains because of the fear of uncertainty. However this can be due to a miss-guided feeling that their future investment may get tied up in uncertain projects. Unfortunately we do not live in a ‘perfect world’, and managers are in possession of sensitive operational information that is not always made accessible to investors for fear company investment plans are made public knowledge. Whilst I understand that a degree of secrecy is needed, I do believe that there needs to be a bit of ‘give and take’ on both sides. Whilst investors do get to find out such information in annual reports, as they make a beeline to the page that is most concerning for them, I can’t help but think that there is a lack of trust between the two camps.

One reason for retaining residual income is to reinvest in future investments, investments that in the long-term will create higher returns and maximisation shareholder wealth. However if such projects are not fully communicated to shareholders carefully they can have an adverse affect. Due to this lack of insider information all investors can do is look to dividend levels to access company performance, with the basic assumption being: high dividend = good

                             low dividend = bad

However as discussed above, it’s not all black and which and in reality the reverse many be true: 

high dividend = lack of good investments and thus lower future investment returns.

low dividend = indication of attractive investments made and future prospects.

It could be argued that investors are too short sighted and that managers jeopardise potential long-term profit gains in favour of high dividend returns. Which in return contradicts the concept of shareholder maximisation when it is in fact the very same people who are preventing companies from doing so. It makes me think of the saying ‘all good things come to those who wait’ and questions whether there can ever be a happy medium. In order for companies to give high dividends they need to have made good investments in the first place. I do feel that in this case investors seem to hold the higher ground and can leverage their options to move their stocks to another company where higher dividends are being paid.

One way of dealing with this is for companies to offer a steady dividend return, that way they can attract the right ‘clientele’ to their company. In order for this to work however the dividend policy needs to remain constant, changes would drive the clientele away to companies that were better able to fulfil their needs, and destroy shareholder value. This lack of fluctuation with the dividend level would reduce the problem of communicating with shareholders and give clarification to shareholders that the company was progressing rather than sending them into a fear of uncertainty.

However the view presented by Miller and Modigliani (1961), suggested that the value of the company was created and secured through investment decisions and not dividend decisions. Therefore rationally shareholders wouldn’t care if their return on investment was made through capital gains or dividends and rejects the ‘bird in the hand’ argument that dividends offer certainty rather than uncertainty of capital gains.

What is clear is there doesn’t seem to be a right or wrong dividend policy. It seems to be a very situational opinion and one that is very dependent on each individual company and the needs and expectations of shareholders. I do believe a constant level seems to offer a sense of certainty but we do not live in certain times and companies don’t operate in certain markets, therefore I think fluctuations are both unavoidable and part and parcel of the securing investor finance and investing in future long-term opportunities.

Capital Structure

The discussion of an optimal capital structure has been around for a while, with theorists themselves not being able to agree what is best for companies. On one hand, Myers (1977) would argue that a company financed through debt, looks risky to investors, which may affect their future growth options. Where-as Jensen and Meckling (1976) argue that firms not taking advantage debt finance may be losing a competitive advantage over other companies. Therefore what is the best option?

Debt finance has always been a popular choice as it is cheaper than equity; this is due to lenders requiring a lower rate of return than ordinary shareholders. Plus there are tax benefits to debt finance, but what happens when a company becomes overloaded with debt?? Without a doubt, rarely do we look at a company’s financial statements without seeing they have a substantial amount of long-term loans. Heck one of the most important financial ratios we are taught is gearing, but whilst debt is seen as a reasonable and advantageous way of financing the business there does come a point when enough is enough. Conceptually a company should load up on debt until there comes a time when debt becomes equal to or more than equity. Once this occurs the benefits of debt finance become less sweet as further costs are incurred and the company runs the risk of becoming ‘Financially distressed’.

What does financially distressed mean for a company? Well, due to the company becoming increasingly risky because they are highly geared, lenders expect high interest for the loans they are proving and Banks etc. start raising interest on current debt due to their fear of defaulting on the payments. All in all to me it sounds like a very tricky and messy situation, a situation whereby companies get sucked into a vicious circle of borrowing to pay off debts whilst sustaining further debt. Certainly doesn’t sound like an ideal situation to me!

It is important to remember that companies are trying to create and maintain shareholder maximisation but I think extreme debt finance is a sure way of destroying value, as companies look less and less likely to offer good strong future prospects. It doesn’t matter if profits are high or low, interest has to be paid regardless. If we think back to a time when we have ever been in debt, even if it’s to our parents, it still hangs around like a dark cloud and doesn’t disappear until it is paid. . . and that is without interest.

So maybe being financed solely through equity doesn’t sound like such a bad idea. For a start it has the huge advantage of releasing the ball and chain and having the freedom to choose whether or not to pay dividends or retain and reinvest the money.

Those companies that were financed predominately/ fully through equity would have been rejoicing that they had when the economic crisis hit. The good years had seen companies load up on cheap debt to finance their business activities, but when 2008 hit these companies were left with the bad years, when all they could do was stand back and watch interest rates rocket and scratch their hands thinking of a strategy to get them out this mess.

Unfortunately thought, equity finance isn’t all its cracked up to be. Just like debt finance, equity comes at a cost. Instead of using loans to finance business activities a company uses shares instead, the catch being that shareholders can demand higher rates of return the more risky the project looks. Whilst bondholders have a built in level of security, shareholders don’t therefore they have to take precautionary actions to protect their investments.

It is understandable why companies try and chase the ideal of an ‘optimal capital structure’, surely the benefits of a mixed financed approach will be in the company’s best interest? But surely is theorist can’t decide whether there is such a thing as an ‘optimal capital structure’ then companies shouldn’t waste their time and resources trying to achieve the impossible? There are industry norms set, so investors can determine and set aside those companies with the most potential and less risk.

I think there is the issue of companies becoming too reliant on debt, with the worse case scenario of being insolvency. If the 2008 economic crash taught us anything, it is that loading up solely on high levels of debt finance is not the way forward. I agree that strategically debt finance can offer a competitive advantage and create shareholder value, but its whether companies can stop themselves from becoming too greedy and tipping the scales in the wrong direction. Maybe what is meant by optimal capital structure is a company keeping within the boundaries of finance and avoiding extremes therefore taking the advantages offering from debt finance but not becoming too highly geared and incurring financial distress costs.