Are dividends relevant in the search for shareholder value?!

To recap on previous blogs shareholder value has been considered in terms of investment and finance decisions. Now however dividend decisions must be considered after all these three topics are all closely interlinked… if the company decides not to pay a dividend, it opts to retain the cash within the company which subsequently means they don’t have to borrow additional capital in order to invest in new value adding projects. So, if value has been created it is only right it is returned to those it was created for – the shareholders? This sparks the discussion as to whether companies should prioritise shareholder wealth over that of its stakeholders or even the society?

Adopting the stance of Modigliani & Millar (1961) on dividend theory the timing of the dividend is deemed irrelevant and dividends should be paid as an investment residual when all other positive NPV projects have been invested in. M&M suggested managers should place priority on investing in good projects which in turn increase share price rather than worrying about paying out dividends as both options will have the same outcome in terms of shareholder wealth maximisation. However their theory was based on numerous assumptions including that there is no tax, no transaction costs and that interest rates remain constant, which unfortunately is not the case in reality!

For investors a dividend is often used as an indicator of how well a company is doing, which before this week I thought to be an appropriate measure. However after this week’s lecture it was highlighted that dividends must merely be paid out of residual profits. It does not state that these profits have to have been yielded in this year. Therefore a company in financial difficulty could still pay out a large dividend to its shareholders from residual profits made in previous years when the company was prospering and so disguising the current financial position of the company.

Linking in with my pervious blog on the global financial crisis companies often choose to suspend dividends in times of financial strain or uncertainty. Recently Thomas Cook announced that it would be suspending its dividend payments as it works to ‘rebuild the balance sheet’ (BBC, 2011). Another company struggling to cope in the recession is Mothercare, with store closures, job losses and now the suspension of its dividend (The Telegraph, 2012).

Apple has announced plans to pay its first dividend since 1995 to put to use some of its $95 billion cash pile (BBC, 2012). This is perhaps an example of how M&M suggested that the timing of the dividend is irrelevant as even though Apple has never paid a dividend until now I would still consider the company as being successful.

An alternate view by Linter (1956) uses the ‘bird in hand’ theory to argue dividend relevance. He suggested that investors prefer to receive a dividend rather than having the uncertainty of whether the company has invested their money into positive investments. In this view not paying dividends will lead to a destruction of shareholder wealth as shareholders will no longer purchase their shares and share price will decrease.

In conclusion, it would seem from a company perspective dividends are regarded as relevant as firms spend much time deciding on the level of dividend they pay out. From the theory discussed this week it would seem stable dividends are what companies aim for, this is often due to high dividends being unsustainable in the long run and for fear of losing investors’ confidence if dividends are set too low.