Corporate Strategy in a Company: the Objective of Stability and Consistency - Coursework Example

?Dividend Relevance Introduction Dividend is an important issue in corporate strategy relevant to stock prices and shareholder value. When a company follows a dividend policy consistently, such policy is already discounted in the stock prices. Any significant increase or decrease in dividend is relevant in valuation. Also when dividend policy is changed by company, the causes leading to such changes are reflected by the markets facilitating realignment of the stock prices. If a company has good track record of transparency and integrity, and there are proper justifications given for the change in dividend policy, shareholders are convinced about the need to change policy. Dividend relevance The relevance of dividends in the price movement of the shares will be very high in case there is a shift in the fundamental factors governing dividend policy. ‘Agency theory posits that dividend mechanism provides an incentive for managers to reduce the costs associated with the principal/agent relationship. Distributing resources in the form of cash dividends forces managers to seek outside capital, thus causing them to reduce agency costs as they subject themselves to the scrutiny of the capital marketplace’ (Moh’d et al., 2005, p.367) The fundamental factors in this regard are profitability of the companies, the investment opportunities available to the companies for plough back of profits for the growth and management policy. Therefore, any change in the continued practice or policy is reviewed critically by the investors. In could affect the value of the shares in the following ways. 1. The existing investors sell the stocks if the change in policy impacts future dividends and is inconsistent with their investment objectives. 2. The change in policy could attract new investors if it is consistent with their investment objectives. 3. The demand and supply of stocks due to change in dividend policy will influence the market prices. The relevance (or irrelevance) of dividends on value of the stocks significantly varies in the case of other factors which determine dividend payout or rate of dividends. These factors include changes in taxation policy, composition (types) of shareholders, corporate structure and state of economy. In the case of other extraneous factors the relevance of dividend is questionable. The process of price discovery in the market is greatly vitiated in general by the interplay of these factors. Though these factors do cause price movements, the impact is very unpredictable. This leads to speculation with regard to the motives of the management of a company relating to dividend decisions. The investor community would generally be affected by these dividend decisions due to lack of access to market information or inability to interpret the information and its impact on the stock prices. There would be violent fluctuations of the stock prices in the short run which are caused not due to information content in respect of dividends, but other considerations or perceptions. The fundamental factors influencing dividend policy Profitability of company, its growth over years, the opportunities available to company for investment within company and management policy are the important factors governing dividend policies of the companies. Earnings growth The consistency and growth in payment of dividends by a company over years are discounted in the stock prices under efficient market conditions. The companies with good track record in this respect command high price/earnings multiple in valuation of their companies’ stocks. Dividend policy is, therefore, relevant to the premium in price/earnings multiple attached to the stocks. But, the recurring dividend announcements in line with the expectation of the market are not the determinants of the value of the stocks. However, when the earnings beat the expectation of the market and company increases dividends substantially or the payout ratio is increased significantly, the investors expect that the increase in dividends will be maintained in the future. Dividends in these cases are relevant for the movement of stock prices positively (or negatively as the case may be). Investment opportunities When companies have business opportunities to plough back the profits earned, companies do not pay dividends or reduce dividend payouts to shareholders. If the returns expected from such investments are perceived as attractive compared to the normal returns that could be earned by the investors from bonds or fixed income securities, the non-payment of dividend would not be viewed with a concern. On the other hand, the value of the stocks could increase by this dividend decision in view of company’s growth potential. Similarly, if a company marching on growth path through reinvestment of profits made over years suddenly decides to pay dividends, the growth potential discounted in valuation is reviewed critically. ‘The relation between the prospective yield of a capital-asset and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price’(Keynes, 1936, p.121). Dividend decision in this case could have negative impact on stock prices since it is expected that the marginal efficiency of capital employed in the business has diminished over years. Dividend equalization reserve Management policy with regard to dividend decisions is a very important factor to be considered. For example, a company with the proportion of more small shareholders would like to protect the interests of the small shareholders by paying regular dividends. To achieve this purpose and declare dividends even when the results are poor in a year, some companies maintain dividend equalization reserve. In one way this policy is relevant in valuation because, shareholders repose confidence on these companies which ensure stability in stock prices. Other factors determining dividend payout Tax treatment of dividends Taxation policies of the country lead to polarization of investors, between equity and bonds or fixed income securities and within ‘equity’ into people under income groups with more tax implications and people with lesser or no tax implications, due to incidence of tax on income and capital gains. If dividends are taxed once in the hands of company and then in the hands of investors, especially people in high income group will be affected in double taxation. In the composition of shareholders if the proportion of high income groups is larger, the interests of the minority shareholders in dividend payout may not be fulfilled. However, due to series of transactions taking place over a period of time, equilibrium in shareholder composition is reached. Under this condition dividend policy of company is fully discounted in the share prices. However, when this equilibrium is disturbed due to change in dividend policy such change might be perceived as favourable by certain section of shareholders, and become relevant in valuation. Morck (2005, p.135) stated ‘Arguments for eliminating the double taxation of dividends apply only to dividends paid by corporations to individuals. The double (and multiple) taxation of dividends paid by one firm to another – intercorporate dividends – was explicitly included in the 1930s as part of a package of tax and other policies aimed at eliminating U.S. pyramidal business groups.’ However, the moot point in this situation is the ability of the majority shareholders in influencing dividend decisions by the companies against the interest of the minority shareholders who view ‘a bird in hand worth two in the bush’ and prefer current dividends. There are also statutory regulations to protect the interests of the minority shareholders. Composition of shareholders If few firms or people own majority shares of a company, company’s dividend policy in general favours restrictions in payment of dividends due to tax implications. On the other hand, if majority of the shares are owned by small investors company should take into account the interests of these shareholders. However, increased participation of the institutional investors and their influence on the management on dividend policies cannot be ignored. Therefore, relevance of dividend in stock values varies from case to case. Corporate structure Family owned companies tend to be conservative in dividend payments. Their dependence on markets for capital needs relating to future expansion is an important criterion in dividend decisions. But, professionally managed companies which need shareholders patronage for their continuous growth and expansion prefer to formulate a consistent dividend policy to enhance their relationship with shareholders. In the later case, relevance of dividend policy on stock prices cannot be ignored. State of economy When the state of economy is bad, the companies will be cautious and conservative in dividend payments. When markets are continuously falling, dividend becomes irrelevant as it cannot reverse the situation. Extraneous factors affecting dividend decisions There are motives such as market expectations, earnings guidance, earnings management, the fear of losing management control and CEO’s personal interests for making announcement of dividends that are not really based on sound and consistent principles or policies. According to Burgstahler and Dichev (1997, p.124) there is compelling empirical evidence that earnings decreases and losses are frequently managed away and earnings are managed to meet forecasts. Dividends in most of the cases constitute as a signal to the market about the profitability or future growth of company. However, these extraneous factors with a motive on the part of the management to declare dividends do have impact on the stock prices. Sometimes it backfires with unintended consequences to the companies and shareholders. Usually, the price movements in such cases would affect the interests of shareholders negatively. In such cases there is no linear relationship between dividends and the true profitability or growth prospects. This leads to uncertainty and unpredictability in valuation and dividend relevance becomes questionable. Stock dividends and repurchase Stock dividends do not involve any cash outlay, though it is considered positive in the markets. Repurchase of shares is on rise in the recent years. It is considered superior in repayment to shareholders as it is simple and cost effective. Moreover, when the companies are willing to buy-back the shares at a price that is at par or above the prevailing market prices, it is believed that the buyback price is reasonable and based on intrinsic value of the shares. Fall in percentage of dividend paying companies Dimson et al. (2003, p.40) stated ‘Fama and French (2001) found that by the end of the 1990s, only about 50 percent of companies on the NYSE paid dividends. On Nasdaq and Amex, the proportion was much lower. In the United Kingdom, however, despite some decline since the mid-1980s, about 75 percent of all listed companies still paid dividends in 2001. In terms of market value, dividend-paying companies account for 95% of total market cap.’ There has been significant fall noticed in percentage of dividend paying companies over years. However, the relevance of dividend either to value of stocks or shareholder value cannot be underestimated. Eije and Megginson (2007, p.2; 6) stated ‘As in the United States, the fraction of European firms paying dividends declines dramatically over this period, from 91 to 62 percent of listed companies, while total real dividends paid and dividend payments as a fraction of total corporate profits increase significantly … Firm characteristics like size, firm age and being headquartered in a common law country significantly increase both the propensity to pay and amount paid. On the other hand, rapidly growing companies are less likely to begin paying dividends or to make large payments.’ Conclusion Positive dividend announcement impact the stock prices positively as it is considered a positive signal to the prospects of company in future under normal circumstances. The relevance of dividend in valuation cannot be undermined. Dividend policy is an important tool for increasing the shareholder value. Therefore, company has to formulate a suitable dividend policy in tune with the internal capital needs for growth and shareholders’ expectations with the objective of stability and consistency to enhance shareholder value. References Burgstahler, D. and Dichev, I., 1997. Earnings Management to avoid earnings decreases and losses, Journal of Accounting and Economics, 24 (1997), pp.99-126. Dimson, E., Nagel, S. and Quigley, G., Capturing the Value Premium in the UK, Financial Analysts Journal, Vol.59, No.6, Nov – Dec, 2013, pp.35-45. Eije, H. and Megginson, W., 2007. Dividend Policy in the European Union, [online] Available at: [Accessed 29 March 2013]. Keynes, J. M., 2008. The General Theory of Employment, Interest and Money, Atlantic Publishers & Distributors. Moh’d, M. A., Perry, L. G. and Rimbey, J. N., 2005. An Investigation of the Dynamic Relationship between Agency Theory and Dividend Policy, Financial Review, Vol. 30. Iss: 2, p.367-385. Morck, R., 2005. How to Eliminate Pyramidal Business Groups: The Double Taxation of Intercorporate Dividends and Other Incisive Uses of Tax Policy, National Bureau of Economic Research, Volume Title: Tax Policy and the Economy, Volume 19, Ed. Poterba, MIT Press. Read More