Financial economists have, for decades, debated on the effect of the dividend policy under uncertain conditions on a firm's valuation. Whilst Miller and Modigliani (MM) aver that the capitalisation rate on shares is unrelated to a firm's dividend policy, other traditionalists rebut this proposition and recommend theories of valuation wherein capitalisation rates and share prices are reliant on a firm's dividend policy.
Jackson plc, after substantial investment and reorganization, is currently profitable and professionally managed. It is consequently contemplating restarting, (after seven years), of dividend payments. The board's initial deliberations on dividend payment led to disagreement on specific issues, viz. (a) urgent introduction of a stable dividend policy, (b) the irrelevance of dividends to shareholders and (c) dividends being payable only when there are no alternative investment opportunities that exceed shareholder expectations.
The traditional view on dividend policy supports a higher payout ratio as dividends connote lesser risks than potential capital gains. The risk-return principle implies that less risky dividend paying shares will also provide lower required rates of return. The correct evaluation and weighing of available risk return trade-offs is integral to the creation of a robust shareholder wealth maximisation plan.
Stability of dividends is considered to be a desirable management policy as shareholders value stability more than fluctuating returns. Whilst a stable dividend policy stabilises the market share price in the long run, it runs the danger of seriously affecting investor sentiment when it is changed without due cause. The significant advantages of dividend stability include investor preference for current income, the resolution of investor uncertainty, raising additional finances and requirements of institutional investors. Dividend stability can be maintained with the application of constant dividend rates, constant dividend payouts or a combination of both. Some companies achieve constant dividends through the maintenance of a constant 'payout ratio' of dividends to earnings.
In the case of Jackson plc, dividends are planned to be reintroduced without delay and the formulation of such policy will help in the establishment of the company's stability factor and its financial standing amongst all the stakeholders.
MM (1961) established that the market value of a firm in a perfect environment is unrelated to its dividend policy if (a) the firm's fixed investment policy is known by investors, (b) individuals are able to trade in securities without any cost implications, (c) there are no corporate or personal income taxes, (d) there is no existence of asymmetric information, and (e) there are no agency costs between external investors and managers.
A dividend paying firm will need to raise external finances for its investment plans. MM's bedrock model of dividend policy and shareholder wealth independence indicates that when firms disburse dividends, their advantages are compensated by external funding. In such circumstances, shareholder wealth comprising of dividends and terminal values of share prices stay unchanged, and the share price adjusts by the quantum of distributed dividend. MM also affirm that their theory of dividend irrelevance is unaffected by the firm's raising external financing through the issuing of debt instead of shares.
Certain dividend theories criticise MM assumptions, particularly those concerning symmetrical information flow between managers and investors. The agency cost reasoning of dividends contradicts its supposition that shareholders interests are aligned with those of managers. The dissimilarity in taxation treatment of (short-term and long-term) capital gains and dividends has also led to differing views on the impact of dividends on the market valuation of firms. The tax advantage of capital gains over dividends leads to the favouring of a low payout ratio, a policy that can result in tax savings for the shareholders.
In the instant case, it would be practical for Jackson's board to argue that the dividend policy is irrelevant to the firm's valuation. This is because of the company's ability to augment its long-term stability and standing by leveraging its optimum debt and equity and thereby ensuring constant terminal valuations.
Gordon's model states that the market share value of a firm equals the present value of the infinite stream of dividends receivable against its share. The model's major assumptions are similar to those of MM. Gordon however concludes, on the adaption of causal assumptions to reality, that the share value is also affected by dividend policy when return (r) equals cost of capital (k). Rational investors being risk averse prefer near dividends to future ones.
Professor Walter argues that the chosen dividend policies often chosen nearly always influence the enterprise value. Walter's model clearly reveals the significance of correlation between r and k in establishing of dividend policy for maximisation of shareholder wealth. In other words, if r is more than k the firm should finance investments with earnings, if r is less than k all its earnings should be distributed, and if r equals k it should be indifferent to the financing decision.
Firms should consequently pay dividends only when investment opportunities that give returns that are greater than that required by shareholders are not available. In the case of Jackson plc, this possibility is unlikely in the near future because of the available investment opportunities for deployment of the firm's profits. The firm, depending on the need to fund investment opportunities, can follow different dividend policies. In light of such analysis the formulation of Jackson's dividend policy should take account of low, medium or high dividend alternatives with appropriate time-frames, in accordance with liquidity, profitability and legal restrictions. The major considerations in this case concern (a) adequacy of appropriate investment opportunities, (b) profitability, and (c) sound management.
It is thus recommended that Jackson plc's dividend policy should entail restarting dividends, albeit at a low level, for reinstatement of stability and financial standing amongst its stakeholders. The firm should, in subsequent years, (in line with the conventional behaviour of firms), distribute relatively low dividends and deploy the available cash surpluses towards appropriate investment opportunities. Such a strategy will not only further wealth maximisation of shareholders and meet their dividend expectations but will also assist in sustaining the firm's terminal share valuations in line with MM theory of dividend irrelevance.
