Introduction
Corporate Finance involves the providing of funds for a companys activities while balancing profitability and risk, in an attempt to increase its wealth and the value of stock. The three components of Corporate Finance may be categorized as; Capital Budgeting, Working Capital Management and Capital Structure.
Capital budgeting is the planning procedure used to determine whether a company should pursue long term projects and opportunities that enhance shareholder value. Various budgeting techniques are used to verify projects that will yield the most return over an applicable period of time. Working capital management ensures that a company has sufficient cash flow to meet its short-term debt obligations and operating expenses by maintaining efficient levels of current assets and current liabilities.
Capital Structure outlines the mix of debt and equity used by the company .The components that structure these two asset classes are preferred stock, common stock and bonds. Bonds are a form of debt, and they include loans which are either financed by financial institutions or investors. Whereas equity, preferred investors as well as some common shareholders receive dividends from a company's profits. Profits that a company does not distribute to its shareholders through dividend payments but instead are reserved for fund growth, acquisitions, or expansion are known as retained earnings. When analyzing a company, it is important to note this mix, as it showcases the financial health of the company. Myers (2001) states the essence of capital structure extremely simply…
The study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance real investment. Most of the research on capital structure has focused on the proportions of debt vs. equity observed on the right-hand sides of corporations' balance sheets.
In the 1930's it was a requisite by law, that company's were to disclose their financial information .A company's ability to pay dividends was a sign of its financial health. Despite the Securities and Exchange Act of 1934 and the improved transparency it brought to the industry, dividends still remain a worthwhile gauge of a company's prospects.
Generally, established, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities the company may keep the profits and reinvest them into the business.
Dividend policy refers to the decision regarding the degree of the dividend payout, the percentage of earnings paid to the stockholders in the form of dividends.
Fischer Black (1976) in his article "The Dividend Puzzle" puts forth an extremely intriguing thought;
….Why do corporations pay dividends? Why do investors pay attention to dividends? Perhaps the answers to these questions are obvious. Perhaps dividends represent a return to the investor who put his money at risk in the corporation. Perhaps corporations pay dividends to reward existing shareholders and to encourage others to buy new issues of common stock at high prices. Perhaps investors pay attention to dividends because only through dividends or the prospect of dividends do they receive a return on their investment or the chance to sell their shares at a higher price in the future.
Or perhaps the answers are not so obvious. Perhaps a corporation that pays no dividend is demonstrating confidence that it has attractive investment opportunities that might be missed if it paid dividend. If it makes this investment it may increase the value of the shares by more than the amount of the lost dividend. If that happens, its shareholders will be doubly better off. They end up with capital appreciation greater than the dividends they missed out on, and they find that they are taxed at lower effective rates on capital appreciation than dividend….
Companies draw investors whose characteristics cause them to favor a particular type of dividend policy. Diverse preferences may put pressure on the market values of the firm and therefore on the management of corporations. The dividend policy may be useful in signalling to the market, the earnings and growth opportunities prospected by the management of that particular firm. But the core apprehension which is debatable is whether the dividend policy can affect the value of the firm.
A proposition that the value of the firm was independent of its dividend policy was made by Nobel Prize winning professors, Franco Modigliani and Merton Miller (M&M) in 1961, which formed the foundational bedrock of modern corporate finance theory. Their view was that the market value of a public company is determined only by the investment and operating decisions that generate cash flows and capital structure and dividend policy are just financial decisions of dividing up operating cash flows among investors.
The M&M proposition induced so much academic thinking that experts have been producing studies of dividend policy ever since. Various researchers have come to diverse conclusions that attempt to explain investors' demand for dividends. The essence of the controversy pivots on the extent to which dividend policy affects the value of the enterprise. Apart from the M&M theory which germinated the case of 'dividend irrelevance' and sparked off the whole controversy, there are groups and people who have various views.
Dividends as a Residual
According to what can be termed as the residual theory, Dividends should only be paid when the firm has financed all its positive NPV projects. Maximization of shareholders' wealth will be achieved by identifying projects with positive NPVs and investing in them .We can look at this as a three-way split of profits: interest payments to the suppliers of debt capital, dividend payments to the shareholders and retention of after tax profits for plough-back into investment opportunities. Since the capital structure decision determines largely the level of interest payments, what remains is how the annual net of tax and interest distributable cash earnings, should be divided between dividend payments and retention for investment. The theory implies that investors prefer to have the firm retain and reinvest earnings rather than pay them out in dividends if the return on re-invested earnings exceeds the rate of return the investors could themselves obtain on other investments of comparable risks.
Let us share the following case:
Hotel A is an all-equity financed company and distributes as dividend its entire cash flow every year. The equity of the firm is valued at Rs 100,000 represented by Rs 10,000 in the cash account and Rs 90,000 in other assets which generate profits of Rs 10,000 per annum.
Assume a perfect world of no information asymmetries, no-tax, no flotation costs and zero-transaction costs
Management wishes to undertake a project that costs Rs 10,000 and that would generate income in year 2 of Rs 15,000. In this case, since the NPV is positive therefore the management decides to undertake the project
The project is financed from internal cash flows leaving no cash for dividend payment in year 1.
Year 2 will however leave the company with an extra Rs 15,000 in cash for distribution.
The above example shows that in year 1, the value of the shares was Rs 100,000 or Rs 10 per share assuming that the firm had an issued share capital of 10,000 shares. Had the amount of cash representing reserves been distributed, then the shareholders would have been Rs 10,000 better off with money to spend or re-invest but their share would have depreciated in value by
Rs 10,000 or Re 1.00 per share distributed as dividends.
Having decided not to distribute the cash still left the shareholders worth Rs 100,000 by virtue of the shares they hold. The investment decision based on a positive NPV, earned the company a further Rs 15,000 in addition to the Rs 10,000 from previous investments. Therefore it should be quite clear that the investment decision rather than the dividend distribution, left the company's shares valued at Rs 15,000 better than the scenario had management decided not to invest.
Let us now consider the case that the management of the above firm decides to distribute the dividend and also go ahead with the investment. The firm raises the capital required for the investment by an issue of stock.
As soon as the investment is undertaken, the cash from the share issue of Rs 10,000 is used up to acquire the required assets. Taking the NPV of the project to be Rs 15,000 as assumed above, the value per share would work out as
100,000 + 15,000 = Rs 10.50 per share
11000 shares
And in year 2 when an additional Rs 10,000 is earned from previous investments, the value per share would be
100,000 + 15,000 + 10,000 = Rs 11.40 per share
11,000 shares
From the above example under the assumptions taken, it should be clear that dividend policy does not affect the shareholder wealth, nor does the capital structure policy have any such effect. It is the investment policy that has a bearing on shareholders' wealth.
It is opportune here to recap the essential assumption of having a perfect capital market, that is, the firm's capital market opportunities to invest funds withheld from shareholders are no better and no worse than those available to shareholders. This implies that management is denied the ability to create wealth by adjusting the time pattern of dividend payments. Management can create value only by doing things that shareholders are incapable of doing. In a perfect market environment, shareholders who prefer for example a steady level of consumption can easily borrow on the same terms as a firm in which she holds shares. This leaves management with the responsibility of identifying opportunities for positive NPVs embodied in investment projects so as to create wealth.
This chain of reasoning brings us back to the M&M 'dividend irrelevancy hypothesis' even though the name in itself can be misleading, it is not the dividend that is irrelevant but the dividend pattern.
Arguments for dividend irrelevance - the Middle-of-the-Roaders
As mentioned in the residual theory above that if the firm cannot invest further to earn in excess of its cost of capital, it should distribute the earnings to its shareholders. M&M argue that the split between dividends and funds to be reinvested does not affect the firm's value as it is determined by the investment policy under the various assumptions explained. Miller, Black and Scholes also are in favor of this argument.
This brings us to the real world where a perfect capital market is almost unlikely. The clientele of firms, referring to persons with money to invest come in various preferences, some with low-payout demands and others with high-payout demands. M&M therefore states that changes in dividend policies from low-to-high payouts should not have a bearing on the market value of the shares, but instead on the clientele that the firm will attract. Miller, Black and Scholes argue that if all clienteles are satisfied, their demands for either high or low payouts will have no effect on prices of shares. 13…. PUT TABLE OF DIVIDENEDS OF THE TREEE COMPANIES However M&M's counter-argument to this is that the effects on the prices are attributable to the informational content of dividends with respect to future earnings rather than to the dividend itself. The shift in the clienteles questing to satisfy their preferences is what may cause prices to change. This characteristic allows firms to avoid having to identify the indifference curves of individual shareholders when establishing their investment policies. There is a strong consistency between the M&M views and those of the 'dividend irrelevance' proponents, and the 'residual theory' discussed above.
Arguments for Dividend Relevance - The Rightists and the Leftists
The dividend controversy over so many years of debate, has resulted in two extreme groups apart from the above discussed 'middle-of-the-roaders'. A conservative group, the Rightists, believe that higher dividend payouts will result in an increase in the value of the firm. The Leftists on the other hand believe that a high dividend will decrease the firm's value.
A common belief in the business and investment communities is that earnings paid out as dividends should be allotted a much higher multiplier in evaluating shares than that to undistributed earnings.14 The Rightist group argue that there seems to be a natural clientele for high-payout shares because dividends are regarded as 'spendable' income whereas capital gains are additions to capital.
Myron J Gordon and John Lintner(1959) suggested that investors see current dividends as less risky than future dividends or capital gains. Their proposition came to be known as the 'bird in the hand' argument, and suggested that the lower uncertainty attached to dividends received will result in a lower discount factor applied to the firm's earnings resulting in a higher stock value.
That said, shareholders may realise capital gains by selling stocks, whenever they feel they have not received enough returns by way of dividends. However there still remains much sympathy with the argument that investors prefer higher dividends. One reason may be because mature companies may have plenty of free cash flow but few profitable investment opportunities.
Another major departure from the perfect market scenario is the effect of taxes which, together with other imperfections is likely to interfere seriously with the idea of dividend irrelevancy. If dividends are taxed more heavily than capital gains16, then it is more advantageous to transmute dividends into capital gains. It is a growing practice that when companies make large one-off distributions to shareholders, they do so by repurchasing stocks. However this cannot be done frequently because the tax authorities may identify the scheme, deem the distribution as a dividend and tax it accordingly with the higher rates. DeAngelo (2005)Failure to recognize that MM's dividend irrelevance theorem does not apply to payout/retention decisions can cause serious mischief, a point we illustrate by revisiting Black's (1976) "dividend puzzle."
Black argues that when taxes are added to the MM framework, firms should largely eliminate payouts to stockholders,1 which they obviously do not. But the logic Black uses to generate this prediction is flawed.
1 In Black's (1976) words: (1) "Under the assumptions of the Modigliani-Miller theorem, a firm has value even if it
pays no dividends. Indeed, it has the same value it would have if it paid dividends." (2) "If this theorem is correct,
then a firm that pays a regular dividend equal to about half its normal earnings will be worth the same as an
otherwise similar firm that pays no dividends and will never pay dividends." (3) "In a world where dividends are
taxed more heavily (for most investors) than capital gains, and where capital gains are not taxed until realized, a
corporation that pays no dividends will be more attractive to taxable individual investors than a similar corporation
that pays dividends. This will tend to increase the price of the non-dividend-paying corporation's stock. Many
corporations will be tempted to eliminate dividend payments." (4) "If a corporation insists on paying out cash, it is
better off replacing some of its common stock with bonds." Although passages (1) through (3) refer to dividends
rather than total payouts, the only way to rationalize claims (3) and (4) about the tax advantages of retention (from
generating unrealized capital gains that are not taxed) is that the passages also apply to repurchases which, like
dividends, are tax-disadvantaged because they trigger immediate taxes. In all cases, including those in which payouts are taxed, optimal payout policy requires distributions that are large in present value terms; if managers actually implemented Black's suggestion to eliminate virtually all payouts, they would destroy untold amounts of stockholder wealth. For corporate finance research, a more troubling consequence of the MM irrelevance theorem is that its central lesson - that investment policy alone determines value -- has both limited our vision about the importance of payout policy and sent researchers off searching for frictions that would make payout policy matter, while it has mattered all along even in the standard (frictionless) Fisherian model.
Another argument put forward by the 'Leftist' group is that taxes on dividends have to be paid immediately whereas capital gains tax can be deferred until shares are actually sold. Apart from the distinction between income and capital gains, there is also the effect of differential rates of personal income tax and also the possibility that a company may have shareholders, both private and corporate, who are taxed under different tax regimes.
'Clientele' effect
Imperfect Capital market includes also substantial transaction costs and differential interest rates. These all interfere with the dividend irrelevancy argument based on perfect capital markets, meaning that an individual cannot adjust his dividend pattern without bearing any cost, in order to fit the preferred consumption pattern.
that investors will tend to hold stocks whose dividend policy fits their needs. Therefore shareholders may prefer companies to supply them with their desired dividend pattern thereby creating a certain demand for specific patterns. Investors are attracted to different company policies, and when the company policy changes, investors will adjust their stock holdings accordingly. As a result of this adjustment, the stock price will move. Unfortunately, this may mean that the shareholders may incur costs of adjustment. Therefore, an easily identifiable dividend pattern may avoid such costs to the shareholder. At the same time, the company may incur consequential costs in the form of missed investment opportunities or costs of raising finance due to free cash flow shortage.
A 2007 study in The Journal of Finance suggests that investors should also factor net share repurchases into the equation, through a metric called the net payout ratio. According to the authors of the study, this ratio not only identifies companies that are paying back investors, but also predicts future equity returns better than the dividend yield.
Let's crunch the numbers
To find the net payout yield, start by adding up all the cash the company spends on both dividends and share buybacks. Next, subtract its share issuances. Finally, divide the resulting number by the company's current market cap.
The ratio that you end up with represents the percent of each invested dollar that a company is returning to shareholders. This simple calculation handily allows us to adjust for shares issued through employee stock options and other forms of shareholder dilution. Some companies will spend a lot of money buying back shares just to counteract the dilutive effect of their stock compensation programs, without creating any value for shareholders.
Here are the net payout yields for a few companies in the hotel industry:
Company
Net Payout Yield (TTM)
Dividend Payments (TTM)
Net Share Repurchases (TTM)
Market Cap
Marriott International(NYSE: MAR)
(0.5%)
$16
($73)
$11,864
Intercontinental Hotels(NYSE: IHG)
2.7%
$119
$5
$4,515
Wyndham Worldwide(NYSE: WYN)
1.9%
$29
$53
$4,266
Hyatt Hotels (NYSE: H)
(2.2%)
$0
($143)
$6,543
Source: Capital IQ, a division of Standard & Poor's. Payout yield is author's calculation. All dollar figures in millions. TTM = trailing 12 months.
It's also interesting to look at the emphasis that each company puts on dividends versus stock buybacks:
How powerful is this payout?
Based on the analysis above, Intercontinental Hotel Group looks like a potential buy for investors searching the hotel industry for a stock with a solid net payout yield. As you can see from the data above, Intercontinental has made a strong commitment to returning cash to shareholders.
Keep in mind that this data only looks at trailing-12-month numbers, so it does not correct for recent changes in a company's dividend or buyback policy. While dividends tend to remain fairly stable, share buybacks can vary substantially from year to year. Investors should also look at a company's dividend payout ratio to make sure the dividend is sustainable, and examine historical buyback patterns to ensure that the buybacks aren't a one-time event. If you can build a diversified portfolio with a few of these high-yielders, healthy returns -- and plenty of cash -- are likely to follow.
Conclusions
It seems that there is no conclusion set in stone on the dividend irrelevancy controversy. Since the formulation of the M&M proposition in 1961, financial economists have been arguing about whether dividends have any effect on the long-term market value of the firm.
