Financial Shareholder Policy

The corporate dividend policy and its usefulness in regards to increasing the shareholder value has been a topic of discussion since last few decades and it is one of the very few aspects of corporate financial policy where the gap between the academics and the practitioners is significantly large enough to attract attention. The academic consensus is that dividends really don't matter very much whereas according to practitioners it is the other way around (MM, 1961). According to the academics, the market does not, and should not be expected to fluctuate the stock prices for firms depending on whether the firm adopts to generous dividend policies or no dividend. The practitioners from corporate and investment banks on the other hand, insists that a firm's dividend policy matters a great deal evidenced by examples of companies whose price collapsed after passing a regular dividend; or whose price jumped after announcing a resumption of regular dividends (Allen, 2004).

Here we will try to evaluate both sides of the argument in order to reconcile these conflicting views. In particular, it is important to understand as why according to the practitioners, in the face of all this evidence of price gyrations in response to dividend announcements, a firm's dividend policy really doesn't make much difference. The practitioner's view is an optical illusion similar to phenomenon of a stick under water being seen as a bent one. The dividends although don't really affect the value of the shares, however may seem to the investors as fluctuating factor for the stock price. There have been academic studies in support of the argument where it has been explained as why, as a matter of economic theory, no relation between dividends and value should be expected (AER, 1989). A very well known article entitled Dividends, Growth and the Valuation of Shares, written by famous Nobel laureates Miller and Modigliani provides empirical evidence in support of the proposition. In the article it has been argued that part of the feeling that there should be a dividend effect was caused by an imprecise use of words. If a firm pays out a dividend, the money to pay the dividend must come from somewhere as the uses of funds must equal sources of funds. The proposition argued that if the firm's investment spending remains constant, then paying out more dividends requires extra funds from bank loans or outside flotation of bonds or stocks. A firm's choice of dividend policy, given its investment policy is thus really a choice of financing strategy.

MM Proposition

The proposition stated by Miller and Modigliani says that the dividend policy affects only the allocation between ordinary income and capital gains, and has no effect on the total gain to shareholders. The proposition rests on several assumptionscapital markets are perfect, there is no asymmetry of information, no tax or transaction costs, no changes to the business composition or capital structure, and managers seek to maximize shareholder value. Under these simplified conditions, the logical conclusion is that changes in dividend policy have no economic implications.

The proposition can be illustrated with an example ( fig 1). Let's take an example firm in Japan, which holds no debt and has 90 billion in business assets. It has decided to pay out 10 billion in cash to shareholders. As the total assets are 100 billion and 100 million shares have been issued, the initial share price is 1,000. If the company pays out a cash dividend of 10 billion, the ex-dividend share price will drop to 900. But in this situation, the shareholders are not worse off because they have received 100 in cash. Let's suppose that the company then makes a public offering at 900 per share, raising 10 billion and restoring total assets to 100 billion. The total outstanding shares in that case would have increased, but the share price remains at 900, and new and current shareholders are neither better nor worse off than before. In an alternative scenario, if a share repurchase is done instead of the cash dividend, certain details may change, but the economic outcome for shareholders remains unchanged. Thus under these simplified conditions, dividend policy affects only the allocation between income gains and capital gains, and has no effect on the total value received by shareholders. Moreover, even if the company could freely increase capital so as to boost dividends, the higher dividend would still be meaningless to shareholders. Thus the M-M proposition proves that the dividend policy has little if any economic effect.

Ultimately, to say that dividends do not matter under is simply to say that one clientele is as good as the other. In sum, the position forces to believe that the general impression that dividends are terribly important is basically a confusion of the firm's dividend policy with its investment policy. Given the firm's investment policy- the dividend decision can be seen as essentially a decision about financing strategy (Harris, 1986). A firm can continue to pay its stockholders higher dividends while maintaining capital spending, if it is prepared to sell off more of the firm to outsiders. The above argument is reinforced by a real life example that appeared in the Wall Street Journal (March 4, 1982, p. 20) after RCA cut its dividend for the first time since it began payouts in 1937. According to the Journal reporter: According to John Reidy, analyst at Drexel Burham Lambert, the cut was a sound management decision. He noted to consider liquidating some of RCA's assets. RCA recently put its Hertz Rental car unit up for sale. Analysts said a cut could have been prevented if a buyer had been found.. If one wonders as why RCA didn't just pay out the Hertz shares as a dividend, it can be assumed that, perhaps that would have made it all too obvious that for stockholders, a dividend payment is merely putting money in one's pockets by taking it out of another.

If one argues that in cases where there had been no significant increase in current cash flow (or at least none that the market had been told about), and yet the price still jumped up when a dividend boost was announced, the MM proponents would argue that the changes in stock prices happened due to the so called dividend optical illusion .There are even cases where the stock price followed the dividends despite an earnings move in the opposite direction (Chen, 2004). The announcement of a decrease in accounting earnings, but an increase in its dividend, has resulted in its share price increase. All these examples depict a picture as if the dividend policy matter even when they do not. To understand the source of the illusion, a second article can be referred. The article in question was entitled Rational Expectations and the Theory of Price Movements and was written by John F. Muth, Indiana University, which was recognized as one of the most important and influential papers written in economics in the twentieth century. The central notion of the paper is basically a simple one, however its development and elaboration is complicated and subtle. According to the rational expectations approach, what matters in economics, and especially in policy making in economics, is often not so much what actually happens as the difference between what actually happens and what was expected to happen.

Figure 1 - MM proposition (source: Makita, 2005)

To explain the above statement, let's take an example scenario. If a firm is expected to make a quarterly dividend statement in near future, as the date of announcement approaches, the market decides what dividend to expect, based on its estimates of the firm's earnings, investment opportunities, and financing plans, which are in turn based on information the market has about the state of the economy, the industry, the firm's past dividend decisions, the recent decisions of other similar firms, changes in the tax trade offs, and so on. If the actual announced dividend is just what the market expected, there may be no price movement at all, even if the amount of dividend announced is larger than the previous one. It was expected by the market to be larger and so was fully discounted long back. However if the announced dividend is higher than the market expected, the market will start rethinking its appraisal. The real world financial markets starts to wonder as what the management means by that. In such a scenario, the response would likely to be: As it's not sure yet as what the firm's earnings really are, but given what is known about the firm's investment opportunities, management is certainly behaving the way one would expect them to behave if they had turned in better earnings than one had been thinking they would. And, since it is the earnings as sources of funds and not the dividend as one particular use of funds that concern the market, one should expect upward price revisions even though no earnings figure was actually announced-just a dividend payment that was higher than expected. The same follows for the alternative case as well. It is a well known fact that when a firm cuts or passes a dividend unexpectedly, it results in a crash in its price. Any clarification from the management that all was really well for the long pull and that this was just a way of redeploying cash to more profitable uses would of no avail. The following comments in the Wall Street Journal (February 18, 1982, p. 36) on the decision by AT&T to hold its payout to $1.35 per share neatly illustrate the interaction between the market's expectations of earnings and the firm's dividend decisions that give rise to the dividend illusion. Many analysts had expected an increase of 10 cents or more in the quarterly rate. . . .Apparently investors were disappointed that the dividend wasn't raised. AT&T was the most active stock . . . yesterday, down $1.125. The above discussion summarizes that unexpected dividend actions in a world of rational expectations provide the market with clues about unexpected changes in earnings. These in turn trigger the price movements that look like-but only look like-responses to the dividends themselves.

However in the real world, shareholders traditionally seek higher dividends, while companies regard dividend policy with caution (Lintner, 1996). Moreover, it has been observed that the announcements of dividend hikes and share repurchases are often favorably received by the market, seemingly contradicting the MM dividend irrelevance proposition. The next question comes to mind is that why does not dividend policy and actual share prices always conform to standard theory? The reason behind the inconsistency may arise because the assumptions oversimplify the situation. In the real world, asymmetry of information exists and release of private information concealed in the dividend policy announcement will cause the share price to respond accordingly. Moreover, managers of the firms do not necessarily seek to maximize shareholder value at all times. Should they do anything to damage shareholder value, it will quickly be reflected in the share price. To address such concerns not covered by the MM proposition, we will discuss two hypotheses belowthe signaling hypothesis and free cash flow hypothesisand show that dividend policy can indeed affect share price.

Signaling Hypothesis

Let's consider the case when a company pays cash dividends to its shareholders. As the investors cannot be as informed or knowledgeable of the company as management (due to the presence information asymmetries), they generally assume that management can better predict future earnings. Moreover, investors tend to favor a dividend increase by the firm and frown on dividend cuts (Chen, 2002). On the other hand, the higher management of the firm generally tends to appease shareholders by maintaining dividends even when performance declines. Under such a scenario, an increase in dividend can mean two commitments from managementfirstly, the increased dividend will be maintained over the long term, and second, that earnings will grow to sustain the increased dividend to the shareholders. Thus the increase in dividend is perceived by the shareholders as a signal from the management that they are confident about their earning predictions in future which ultimately results in increase in share price. Conversely, when a dividend cut is announced without explaining any appropriate reason , it signals to investors that management predicts earnings will deteriorate to the point that dividends cannot be sustained, ultimately resulting a southward movement of share price (Chen, 2002). In this way, changes in the dividend payout serve as a signal of predicted earnings, thereby impacting share prices. Investors have seen to respond to share buy-back announcements as signals as well. As there exists information asymmetries in the real world, investors predict that a share repurchase generally means that shares are currently undervalued, while on the other hand the issuance of new shares signals that the shares are overvalued. Thus the obvious result of a share buy-back announcement is an increase in share price. The signaling hypothesis discussed above is based on information asymmetries between managers and investors in the real world situation. The investors interpret changes in dividend policy (cash dividends and share repurchases) as signals regarding information not yet made public, causing the share prices to fluctuate accordingly.

Free Cash Flow Hypothesis

The cash earned from the business can be either invested back to the business or can be saved to increase the company cash holding. If the company decides to hold the cash, the managers in the firm enjoy considerable discretion, and may not necessarily try to maximize shareholder value. The cash reserve can be used for multiple purposes which may not be in the best interest of the shareholders. Such happenings are generally described as agency problem arising due to conflict of interest between the shareholders and the manager whereby the manager in charge of the corporate uses the cash to serve other stakeholders or ownself. The large financial slack may induce managers to neglect their duties or invest in unproductive projects. Such problems are particularly serious at companies with large cash flow, excess funds, and limited growth options. If the market suspects that the financial slack is being squandered, it will result in southward movement of the stock price (Xing, 2004). To reverse the market perception, the management needs to convince the investors that the excess cash has been deployed in productive projects with positive cash flows. The best way to reverse the market perception is such a scenario is by returning capital to shareholders, either by increasing the dividend or repurchasing shares otherwise the cash reach companies may become a target for acquisition.

Both of the above described hypotheses have got some implications for shareholders regarding the dividend policy of the firm. As both the hypotheses suggest that dividend hikes and share repurchases tend to boost share prices, there is enough reason to believe why shareholders have traditionally welcomed dividend hikes and spurned dividend cuts. However there is difference in meaning between the two hypotheses in regards to dividends and share buy-back. Under the signaling hypothesis, a cash dividend contains private information from management regarding the earnings predictions, whereas a share buy back contains private information regarding the current valuation of the firm in the market. As a result, the investors are provided with new information from dividend policy changes, and the share reacts accordingly.

On the other hand, under the cash flow hypothesis, an increase in the dividend as well as share buy back help alleviate the agency problem. Here the management signals its commitment to deploy the financial slack to positive cash flow projects. The impact of reduction in cash holdings is particularly important at companies with a large financial slack and limited growth opportunities. Thus the management can make a choice as how to return cash to shareholders depending on what information it seeks to convey to the market. If the management is confident enough in its future earnings predictions, but believes that the information is not fully reflected in the share price, the likely action is a dividend increase. On the other hand, if management believes that the current share price is fundamentally undervalued and there exists some acquirers in the market, the likely action is a share buy back. It can be stated that the companies with excess funds, strong cash flow, and deeply discounted share prices are particularly vulnerable to hostile takeovers. To remove the discount, a large dividend increase or massive share repurchase is effective because either action demonstrates to the market that management is aggressively tackling the agency problem (Mendelson, 1986).

Dividend policy has the potential to provide shareholders insight on management's views on earnings trends and current share prices, as well as its stance on financial slack. These whole set of information is vital in valuing the company and assessing the management which ultimately gets reflected in the share price. The shareholders need to act in a way that does not diminish the information value of dividend policy. Shareholders can enhance the information value of the company's dividend policy by reacting predictablythat is, applauding a dividend increase, and condemning a decrease (Chen, 2002). It should be noted that the investors demand for a fixed dividend payout ratio. However for the company, the payout ratio target should be a long-term priority, while dividend stability should be a short-term priority. Recent surveys suggest that managers observe this distinction when deciding dividend policy (Xing, 2004). It is also observed that, unless shareholders strongly insist on higher dividends, managers are likely to set the payout ratio target considerably below the achievable long-term level. The low payout ratio causes the financial slack to grow, exacerbating the cash flow problem.

It can be concluded that the dividend policy may not be an effective management tool and may not even be completely under the control of management in a world of rational expectations, however there are other things such as firm's investment decisions one engineering, production, personnel, marketing, and research that do matter and over which the management should have more control. These decisions are in what economists call the real side of the business, and they generate the firm's current and future cash flows.


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