Dividend Policy

In keeping with the main theme of my previous blog posts (shareholder wealth), this post will concentrate on the topic of dividend policy. Many companies are faced with the dilemma of deciding the size of dividend that should be issued or if any dividend should be issued at all rather than retaining funds within the business to help fund future projects for example. From the point of view of the shareholder, wealth can be created from capital gains (an increase in value of the shares owned) or from receiving dividends per share owned by the shareholder.

The 'bird in the hand theory' developed by Linter and Gordon suggests that investors prefer dividends to capital gains as a form of creating shareholder wealth due the uncertainty associated with future capital gains in comparison to the definite gain associated with receiving a dividend. This theory suggests that companies offering high dividends will benefit from a rise in value of their shares as investors will seek to purchase shares in companies offering high dividends and sell shares that offer low or no dividends. Due to the lack of internal information available to investors, the issuing of dividends can be used by investors as a parameter to determine the performance of a company, assuming that a company offering high dividends is performing well and vice-versa.  But is this general assumption accurate? Not necessarily. A company issuing high dividends may be doing so due to a lack of potential future attractive investments being available which in turn could have a detrimental effect on future investment returns. On the other hand, a company offering low or no dividends may have chosen this strategy in order to allocate funds to finance promising investments rather than raising finance externally. These investments could in time prove to bode very well for future returns for the investor. This demonstrates that the size of dividend offered is not sufficient to judge the performance of a company.

A recent example in the news regarding the dividend policy of a company is that of Apple, who announced their first dividend payment since 1995. One may ask why it has taken so long for a company which has recently been dubbed 'the world's most valuable company' to issue dividends to its shareholders? However, it is important to note the meteoric rise in Apple's share value over the past ten years from $10 to over $600. Investors in Apple may not have had the luxury of regular dividends but there is no doubt of the capital gains associated with investing with the company, particularly early investors. This example also contradicts the theory by Linter and Gordon who suggested that companies may suffer from a decrease in share value if they do not issue dividends. Does the case of Apple suggest that dividend payments are not as significant as previously thought when considering shareholder value maximization? It certainly could be argued that way, although I don't believe that this is a typical example as Apple is an extraordinary company. One could argue that if Apple did pay dividends regularly over the past 15 years or so that they may not have been in a position to expand as rapidly as they have done. This goes back to the argument that a company offering no or low dividends may be doing so in order to allocate funds to finance future projects. Either way, I was an Apple shareholder I know I think the news of a proposed dividend would merely be the icing on the cake in comparison to the substantial increase in share value over recent years!

In conclusion, the decision to offer dividends is obviously a contentious topic for the top management of a company and there are many different factors that will ultimately influence the decision. Although offering high dividends to investors may please them in the short term, consideration of future performance must be taken into account as it may not be possible to maintain these high levels of payment, which might become expected, especially if the financing of future projects is jeopardised by the fact that money was spent on issuing dividends.

Capital structure

The balance between debt and ordinary share capital can have an significant influence over the wealth created for shareholders by the company in question. By altering the capital structure of a firm, wealth can be created. Capital structure refers to the level of debt in relation to ordinary share capital (Arnold 2008). Generally speaking it is cheaper to finance a company by using debt finance rather than raising equity finance. This is because lenders of debt finance typically expect lower returns to that of shareholders. Other advantages of using debt finance include the ability to offset any interest from borrowing against pre-tax profits, allowing the company to reduce their tax bill. Another advantage is avoiding the high costs associated with raising equity finance as mentioned in my previous blog concerning raising capital. The capital structure of a company is concerned with the level of gearing a company possesses. By this we mean the proportion of debt in the capital structure of a company (Arnold 2008). So if a there as so many clear advantages associated with using debt finance why do companies often want to reduce their level of gearing and avoid too much of their capital coming from debt? As with most things, there are disadvantages as well as advantages! One main disadvantage with using debt finance in comparison to equity finance is that if the company in question happens to find itself in a period of financial distress due to poor performance for example, they will still be obliged to pay back money borrowed from lenders at the agreed rate. This is all well and good if they are in a position to do so, however if they are heavily financed by debt this may prove to be a big concern. On the other hand, a company which has been financed heavily with equity finance will find itself in a position where it has no obligation to pay dividends to shareholders if they find that they are not in a position to do so and therefore can retain the money within the company, helping them during this time of uncertainty.

It seems that during the recent times of the global financial crisis, the importance of capital structure has become even more prevalent. Many companies have found themselves in a position of financial uncertainty, and restructuring their finances has become a clear focus to them to try and alleviate the problems that have arisen. A recent example of a company which has altered it's capital structure is that of EuroTunnel. The operator of the channel tunnel has found itself returning to profit this year and has decided to buy back some of it's debt to reduce interest repayments. By reducing it's level of gearing it is hoped that the company will have a more appropriate capital structure to cope better with any problems that may arise in future years. The company was able to do this due to record levels of passengers in 2011. In my opinion, the decision to alter the capital of the structure of the company following a successful year is a wise one as it will hopefully allow them to cope better in the future if passenger levels drop again for whatever reason.

As mentioned before, the effects of the global recession have been a strong incentive for many companies to re-consider the capital structure of the firm. Getting the balance right between debt and equity can ultimately decide the fate of the company. I think the move by EuroTunnel to alter the capital structure of the firm whilst in a position to do so was a very good one and shows a level of long-term vision being held by the directors. Despite not being obliged to pay shareholder dividends during rough times, surely the chance of keeping the company solvent should be of paramount importance to any set of directors, with the hope of dividends being available in future years when the company becomes more prosperous.