Dividend payments for shareholders who put their money at risk in the corporation are a very significant financial issue and directly relative to any joint- stock corporation's existence and performance and shareholders' benefit as well. Basically, after-tax profits are divided into two parts: a part is retained for reinvestment and a dividend part is distributed to shareholders to use elsewhere. Thus, to make a decision of paying dividends, all of corporations need to consider very carefully on many aspects such as if the corporation should retain earnings instead of paying dividends? If not to pay, whether this behavior will affect negatively to the corporation? If paying, how the dividend method (high or low) is suitable and the reasons why corporations pay dividends? …
To be relative to dividend payments, up to now, there are many different arguments for and against dividends. However, with this essay's scope, we will only glance through arguments against dividends and spend mainly time to focus on arguments for dividends.
1. Arguments against Dividends:
First of all, according to an important 1961 paper by Miler and Modigliani (MM), if a few assumptions can be made, dividend policy is irrelevant to share value. The determinant of value is the availability of projects with positive NPVs; and the pattern of dividends makes no difference to the acceptance of these. The share price would not move if the firm declared either a zero dividend policy or a policy of high near-term dividends. The conditions under which this was held to be true included:
There are no taxes.
There are no transaction costs. For example, investors face no brokerage costs when buying or selling shares or firms can issue shares with no transaction costs.
All investors can borrow and lend at the same interest rate.
All investors have free access to all relevant information.
Investors are indifferent between dividends and capital gains.
(Glen Arnold, Corporate Financial Management - page 841)
Moreover, other economic analysts also think that an income can be achieved by individuals adjusting their personal portfolios to reflect their own preferences. For instance, investors looking for a stable and secure flow of income are more likely to invest in bonds in which interest payments don't change, rather than a dividend-paying stock in which value can change very fast. Because their interest payments will not change, those who own bonds do not care about a particular firm's dividend policy.
Secondly, there is another argument pointing out that little to no dividend payout is more favorable for investors. Supporters of this argument show that taxation on a dividend is much higher than on a capital gain. The argument against dividends is based on the belief that a firm reinvesting funds rather than paying them out as dividends will increase the value of the firm as a whole and consequently increase the market value of the stock. According to the proponents of the no dividend policy, a firm's alternatives to paying out excess cash as dividends are the following: undertaking more projects, repurchasing the firm's own shares, acquiring new firms and profitable assets, and reinvesting in financial assets.
2. Arguments for Dividends: Contrary to the arguments against dividends, there are some typical arguments for dividends as follows:
Firstly, as we already knew, all investors, taxable individuals and untaxed institutions like pension funds and nonprofit organizations …, generally invest for the purpose of making money. Dividends are an opportunity for shareholders to earn a return on their investment and they also often want to receive earnings as faster as better and the situation is especially true when a corporation has debt outstanding. Because if profits are retained or limited for one reason or another, it will dispirit investors and obviously investors will sell the companies' shares they are holding massively. As a result, this will leads to a drop in the corporation's stock price and the most obvious is that there is not any corporation like this.
Secondly, although there are some disadvantages when a corporation pursues a steady and consistent dividend policy such as the corporation can miss good investment chances for new projects which will increase its value in the future or risks about finance can lead to the loss of the company's control authorities. However, the corporations' advantage maintaining a record of consistent and stable dividend payments are that investors usually have a tendency to think that it is a good signal of the sustainable income stream and therefore the corporation is a less risky investment. This is so easy to understand because "dividend changes may tell investors more about what the managers really think than they can find out from other sources". (Fischer Black, The Dividend Puzzle - page 10)
Thirdly, after the beginning and fast growth stage of any corporation, the corporation's growth speed often will be slow down and eventually have matured to the point where there is minimal rooms for capital reinvestment because the corporations should pay the cash out as a dividend instead of holding large cash reserves to avoid investments in projects which have the net present value (NPV) not good. In addition, when a corporation announces high dividend payments, this will pressure the corporation into doing more dynamically, creatively and effectively and this will contribute to sack bad staffs and managers to enhance the corporation's competitive ability. Therefore, it helps the corporations to attract many professional and large prospective investors as well as many international and internal credit agencies. As a result, the corporation's share price will increase and create good conditions for issuing new shares. In this case, the expense of paying dividends is the same as marketing, advertising and PR expense which is very necessary for any corporation in the world.
Last but not least, dividends are required because of the separation of ownership and management. Therefore, retention of large number profit will incite behavior by managers that does not maximize shareholder value. Managers acquire control over corporate resources either from outside contributions of debt or equity capital, or from profit retentions. From an agency theory, one advantage of contributed capital is that it comes with additional checks, because rational suppliers of outside capital will not be forthcoming with funds at attractive prices if they believe that managers' policies merit low valuations. Accordingly, potential agency problems are higher when a corporation's capital is largely earned, since the more a corporation is self-financed through retained earnings, the less it is subject to the ongoing discipline of capital markets. Overall, the results support the theory that corporations pay dividends to reduce the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
From these above arguments, we can see that in the fact dividend policies affect corporations' value and share price. Because, in case, the corporations which want to cut down dividend payments should provide enough information and explain clearly to their investors about the new coming projects as well as necessary financial demands to do those projects and this will help to minimize the unpredictable consequences from a sudden dividend cut.
THE REASONS WHY FIRMS REPURCHASE THEIR SHARES?
Although, stock price awareness and dividends are the two most common ways for investors to earn a return on their investment in the corporations, there are other useful methods for corporations to share their earnings with shareholders. With the essay's scope, we will spend time to mention one of those methods: share buybacks. We will glance through the mechanics of a share buyback and what it means for shareholders before discussing this method.
1. The Meaning of Buybacks:
Instead of using a firm's earnings to pay dividends, a firm can buy whole or a part of shares issued by itself. When selling back the shares to the firms, shareholders will receive a number of money from those firms and they no longer hold those share ownership. For this, the number of outstanding shares on the market will reduce and the relative ownership stake of each investor will increase. However, share buybacks do not share profits for all shareholders just like dividend payments by cash therefore share repurchases must be publicized clearly and widely. A corporation can buy back its share by one of two main ways:
Tender Offer
The corporation can offer a tender to their shareholders, the tender offer will stipulate both the number of shares the corporation wants to repurchase and the price frame they can accept. When investors agree to the offer, they will confirm the number of shares they want along with the price they can pay. Once the corporation has collected all of the offers, it will find the right mix to buy back the shares at the lowest cost.
Open Market
The second way is that a company can repurchase shares from the open market at the market price, just like an individual investor. When this happens, it is often perceived by the market as a positive signal about the corporation's prospects in the future and it usually causes the share price to shoot up.
2. What the corporation's motivations are when buying back the shares?
Firstly, all managers of the corporations will answer that a buyback is the best usage of capital at a particular time if you ask them because they always do not see any better investment than in themselves. Although this statement is not often right. And after all, the target of a corporation's managers is to maximize return for shareholders and this generally will increases shareholder value. Furthermore, there are still other good reasons that drive firms to buy back their shares. For instance, managers feel the market has discounted the corporation's share price too much. A stock price can be fluctuated very fast by the market for many reasons such as weaker-then-expected earnings results or just a poor overall economic climate... Therefore, when a firm spends millions of dollars buying up its own shares, it often says management believes that the market has gone too far in discounting the shares.
Secondly, another reason a corporation might pursue a buyback is only to improve its financial ratios. This motivation rises questionable. There is a problem with the management if reducing the number of shares is not done in an endeavor to create more value for shareholders but rather make financial ratios look better. Nevertheless, the improvement of its financial ratios in the process may just be a byproduct of a good corporate decision if a corporation's motivation for initiating a buyback program is good so how this happens. First of all, share repurchases will decrease the number of shares outstanding and once a corporation buys its shares, it often keeps them as treasury shares, and reduces the number of shares outstanding in the process. In addition, repurchases also reduce the assets on the balance sheet. A consequence of this, return on assets (ROA) will increases actually because assets are reduced and at the same time return on equity (ROE) also increases because there is less outstanding equity. In summary, the market sees higher ROA and ROE as positives. (Refer to the following Balance Sheet) For more detail, now let's discuss the following example: assume that a corporation buys back one million shares at $15 per share for a total cash expense of $15 million.
As we can see from the above table, the corporation's cash has been decreased from $20 million to $5 million. Because cash is also an asset, the total assets of the corporation will reduce from $50 million before the repurchase to $35 million after the repurchase. As a result, this will lead to an increase in its ROA, even if earnings have not changed. Before the buyback, its ROA was 4% ($2 million/$50 million) but after the buyback, ROA increases to 5.71% ($2 million/$35 million). A similar impact can be looked at the EPS number, which increases from $0.20 ($2 million/10 million shares) to $0.22 ($2 million/9 million shares). Moreover, the repurchase also enhances the corporation's price-earnings ratio (P/E) which is one of the most well-known and often-used measures of value. Based on the P/E ratio, we can see that the corporation is now less value than it was prior to the repurchase though in reality earnings was no change.
Thirdly, a firm also may buy back it shares because it wants to reduce the dilution often caused by generous employee stock option plans (ESOP). Companies in bull markets and strong economies often have to compete to retain personnel and ESOPs and other compensation. Share options have the opposite effect of share buybacks. In the above example, a change in the number of outstanding shares can impact on significant financial measures such as EPS and P/E. In the case of dilution, it weakens the financial appearance of the company. We can see more clearly through the previous example under the assumption that the shares in the company had increased by one million then its EPS would have fallen to $0.18 per share from $0.20 per share. After years of useful stock option programs, a company may feel the demands to buy back shares to avoid excessive dilution.
Finally, a share buyback is similar to a dividend payment because the company is distributing money to investors. However, an important advantage of buybacks over dividends is that they often were taxed at the lower capital-gains tax rate in some countries, whereas dividends are taxed at ordinary income tax rates.
Are share buybacks good or bad? The question may not have a definitive answer. If a stock is under its value and a repurchase truly represents the best possible investment for a company, the buyback can be seen as a positive sign for shareholders. Otherwise, a company should consider carefully if it only uses buybacks to improve ratios, provides short-term relief to a weak stock price or to escape from under excessive dilution. (Cory Janssen, A breakdown of stock buybacks).
