The report will be focussed on a global scale. Within my report I will introduce the significance of the dividend puzzle relating it to the current economic crisis. I will then identify my current issue. In order to answer my current issue i will analyse the strengths and weaknesses of dividend distribution and retention as well as providing case studies that demonstrate points mentioned in the above analysis. I will conclude by answering my current issue. I will outline limitations to my report and areas of further research.
Significance of dividend Puzzle and Current Economic Condition
The dividend puzzle was established by Fisher Black (1979). It asks the question: 'why do companies use dividends the most expensive form of returning cash to shareholders of the company?'(Black, F. 1996) When answering this puzzle we must consider current economic conditions. Usually, there is not a huge variation in overall dividend payment trends from year-to-year. This changed afte r September 2008, when the near collapse of the financial industry after Lehman Brothers' bankruptcy resulted in huge cuts in dividend payments. Even the steadiest companies followed suit. For instance, General Electric slashed payments by nearly $9bn and Pfizer cut $4.3bn. 2009 turned out to be record year in terms of dividend cuts in the US (Van Duyn, A. 2009). Dividend retention was a sensible response by companies seeking to conserve cash as it is not a legal obligation for firms to distribute dividends. The future performance of companies was uncertain due to the economic crisis. Hence, a consequence of the banking crisis encouraged companies to conserve cash due to fear of bankruptcy which was experienced by Lehman Brothers. Thus my current issue is: Will companies retain or distribute dividends in current economic crisis?
Advantages of dividend retention
Evidence suggests firms will have more investment opportunities. This is because there will be more earnings to finance those investments (Kim, J. and Jang, S.S. 2009). This decision can be argued to have the potential to create more wealth for shareholders once the economic crisis is over as more wealth will be reinvested in the company to generate increased profits distributed to shareholders in future.
In 2009, financials in the S&P 500 index paid out $18bn in dividends, representing just over 9 per cent of the total pay-outs made by all companies included in the S&P 500, according to Standard & Poor's (Van Duyn, A. 2009). The majority of companies deciding to retain dividends demonstrates a sensible response in a period where growth of capital for firms was difficult. Hence cash is conserved and according to the Miller and Mogdigliani (1961) dividend policy is irrelevant (Arnold, G. 2008). Therefore, even if the proportion of dividends were to reduce or be a zero dividend policy the share price will not move. Thus shareholder will be unconcerned whether dividends are distributed or retained.
Disadvantages of dividend retention
The severity of the economic downturn appears to have a direct link to dividend retention, for example, the number of FTSE 100 companies scrapping their dividends leapt from 13 during 2008 to 48 since the start of 2009 (Lawlor, A. 2009). This demonstrates how companies feared the worse. Hence dividends retention increased due to the uncertainty they will be able to generate capital in the foreseeable period. Evidence suggests banking and finance sectors will be hardest hit as most dividend cuts are coming from within the FTSE 100 (Lawlor, A. 2009). The fact that "most dividend cuts are coming from within the FTSE 100 " suggests that when firms fear the worse in the market, for instance the London Stock Exchange which trades the FTSE 100, companies will follow suit which explains why dividend retention increased during 2008.
Dividend retention is generally viewed as undesirable, for instance, the barrage of high-profile dividend cuts and passes dealt another blow to investor confidence and placed a keystone of UK investment culture on shaky ground. Amid a backdrop of depreciating asset values and near-zero deposit rates, income has become increasingly important to investors (Lawlor, A. 2009). This emphasizes to a large extent dividend distribution was pivotal to shareholders during a period of uncertain personal income. This is why people were shell shocked" because shareholders were misled about Aviva realistic performance during the economic downturn. Hence, dividend retention come under fire when shares in Aviva fell 33 per cent to 189.9p (Felsted, A. (2009).
Case Study: dividend retention
First National Community Bank, announced that its Board of Directors voted to suspend payment of the Company's quarterly dividend indefinitely in an effort to conserve capital
in 2010. This demonstrates that the Board viewed this action as a strength during the economic downturn. It was vital where expectation future revenue was dire. Which impacts the health and stability of many businesses whom they serve. According to Lombardi, chief executive, suspending the $0.02 per share dividend will save the Company approximately $1.3 million (2010. Suspends Dividend Payments to Conserve Capital). The board acted in the best interest of the shareholder, because the reinvestment of cash is more likely to save the company from insolvency and administration which would appear disastrous for the shareholders who owns the company. Hence, the reinvestment of cash could be reinvested for opportunities for the company to potentially create more profits to be distributed as dividends in the future for shareholders.
Advantages of dividend distribution
It is a form of signaling positive information from well informed managers to poorly informed shareholders in capital markets, charachterised by asymmetric information. Thus dividends are a source of information to investors indicating a firms sustainable level of income. If a firm is not distributing dividends it suggests that the company is not performing well (Arnold, G. 2008). This explains why oil companies have typically been defensive in terms of sustaining dividend payments during downturns (Lawlor, A. 2009). This was a similar case in Ahold, the Dutch retailer, which planned to return EUR500m ($683m) to shareholders in 2010 to deliberately signal confidence despite a reported 8 per cent fall in fourth-quarter profit (Steen, M. 2010). This demonstrates that distributing dividends signals positive information to shareholders despite the economic downturn, to ensure shareholders maintain confidence and investment within the company.
Banks could achieve several things by shifting more profits to dividends. First, it is a way to prop up consumption. Therefore dividend payments might as well get spent in the economy because consumption for goods and services creates demand for jobs. Second, it is a way of rewarding shareholders who stuck with the banks (Van Duyn, A. 2010). This conveys how the economy would be better off by increased demand from consumption and the creation of assurance by shareholders from being rewarded ensures they continue to invest their money in companies listed on the stock exchange. Which eventually enhances the companies capital preventing liquidity shortfall, cash shortages and be financially distressed.
Researchers have proposed that dividend payments are associated with lower risk. Firms that distribute dividends benefit from increased monitoring that result from accessing capital markets more frequently (Van Duyn, A. 2010). This illustrates the incentive for firms to distribute dividends because of the advantage from external forces monitoring their operations in the capital markets. Hence they will be encouraged to distribute dividends as they can address to their investors that the company is affiliated with lower risk which will appeal to prospective investors who will be skeptical to invest in a company during the economic crisis.
Disadvantages of dividend distribution
Paying dividends imposes costs on the company as well as Investors In the form of taxes paid by shareholders and foregone profitable Investment opportunities (Arnold, G. 2008).
Therefore, this will deter companies considering dividend distribution particularly during tough economic conditions where the raising of capital and profits are tremendously difficult.
Dividend payment reduces management's flexibility because it takes money out of management's control and puts it in the hands of investors
(Blau, M.B. and Fuller, P.K. 2008). This is because shareholders ultimately own the business thus they have control to an extent in deciding how their capital should be utilised. Thus if they disagree that their funds are not utilised appropriately they will oppose the proposal which will reduce managements flexibility of ultimately running the company in the interest of shareholders. Also, during the economic crisis it can be argued that shareholders will become more skeptical on proposal made by management due to the fear the venture may not be worth while generating future profits.
A company cannot pay dividends to shareholders without it affecting its market value. This is because money that a company pays out to shareholders is money that is no longer part of the asset base of the corporation. It's money that can no longer be used to reinvest and grow the company. Thus there is a reduction in the company's "wealth" which is reflected in a downward adjustment in the stock price (3 Dividend Myths Exposed. 2009).
It may not always be in the best interest of shareholders, for example, dividend distribution may force a firm to subsequently issue debt Instrument which incur costs and interfere with the gearing ratio (Pike, R. and Neale, B. 2009). This demonstrates a negative implication by deterring companies paying dividends during the economic downturn. It can be argued companies will try to minimise unnecessary finance costs during challenging conditions where repayment can be difficult thus dividend distribution will be avoided.
Case Study distribution
Capita Registrars in 2010 found that dividend payments from companies listed on the main market of the London Stock Exchange - excluding investment companies - fell by 15 per cent to £56.9bn in 2009. Between 2007 and 2008, dividend payments had risen 7 per cent. The above statistics demonstrate the severity of the economic downturn impacting dividend distribution, whereas it appeared to be greater before the economic downturn began. The reduction in 2009 reflected a flurry of dividend cancellations and cuts as the financial crisis forced companies to conserve cash. The above actions demonstrated the strengths which would be attained if companies retained dividends. This is because the future performance of the company was uncertain hence dividend retention was appropriate in order to conserve cash. The decline in overall payments would have been much worse had it not been for five companies that accounted for £26.9bn of dividend payments between them: BP, Royal Dutch Shell, HSBC, Vodafone and GlaxoSmithKline (Jones, A. 2010).
Conclusion - are firms distributing or retaining cash in current economic crisis?
Yes, firms are still continuing to distribute dividends despite the above weaknesses discussed associated with dividend distribution. 2010 is looking like an encouraging year for dividend payments, for example, in January 2010 96 companies raised or initiated dividends, the highest number since October 2008. In contrast, just 17 companies cut or omitted dividends, the lowest number since October 2007. And February promises to deliver even more increases. February is typically a big month for dividends. In each of the last five years, more companies raised their payouts in February than in any other month. The first seven trading days of February featured 39 dividend hikes (New year paying dividends, 2010). According to Capita Registrars dividend payments by Britain's larger listed companies will increase by 5 per cent in 2010 as profit growth persuades managers to stop accumulating cash (Salih, C. 2010) The fact that dividend distribution is improving suggests reflects to an extent
that the economy across the globe is improving.
Limitations of approach and further research
Evidence suggests the likelihood of paying dividends is positively related to firms characteristics such as profitability, firm size, life-cycle stage, and the dividend payout ratio of the preceding year. According to Denis and Osobov, 2008 the payment of dividends is positively related to profitability. Profitable firms generally have lower financial distress costs and larger free cash flows, hence they are more likely to pay dividends than less profitable firms (Kim, J. and Jang, S.S. 2009). This emphasises that despite the economic crisis a firm will also be affected by the above characteristics which will judge whether they should distribute dividends. Therefore, a wider spectrum should be considered for further researched to determine whether a firm will retain or distribute dividends
2033 words
