Plekhanov Russian Economic Academy

Profit for distribution: 140.000

Company’s shareholders obtain the best of both words. They can invest the

?140.000 received as dividends to earn a higher rate of return than the company could earn for them; and the ?210.000 retained by the company is reinvested to shareholders’ advantage. Shareholders’ wealth is optimized, and the dividend paid is simply the residual profit after investment policy has been approved.

If companies look upon dividend policy as what remains after investments are decided then the search for an optimum dividend policy is pointless. Shareholders wanting dividends can always make them for themselves by selling some of their shares.

Further support for the ‘residual’ theory of dividends, and the argument that the change in dividend policy does not affect share values, was advanced by Modigliani and Miller in 1961. They contended that in a perfect market the increase in total value of a company after it has accepted an investment projects is the same, whether internal or external finance is used.

One deficiency in the Modigliani and Miller hypothesis, however, is that they ignore costs associated with an issue of shares, which can be quite considerable.

1. Costs Associated with Dividend Policy

Capital floatation costs are a deterrent substituting external finance for retained earnings but there are other costs affected by the dividend decision.

If shareholders are left to make their own dividends by selling some shares, this involves brokerage and other selling costs that, on a small number of shares, can be extremely an economic. In addition, if they have to be sold during a period of low share price, capital losses may be suffered.

Another important factor is taxation. First, when the company distributes dividend it has to pay an advance installment of corporation tax (ACT), currently one quarter of the amount paid. But the offset against mainstream liability to pay corporation tax will be delayed by at least one year. Indeed, if the company does not currently pay this type of tax, the delay in setting off ACT will be even longer, and this will tend to restrain extravagant dividend distributions.

Second, from the investors’ viewpoint profitability invested retained earnings should increase share values, enabling shareholders to create their own dividends. Selling shares creates a liability to capital gains tax, currently 20%, 23% or 40%, but subject to a fairly generous exemption limit. By comparison, dividends in the hands of shareholders attract higher rate of income tax (up to 40%). Thus higher-rate taxpayers may prefer comparatively low dividend payouts to minimize their tax burden.

Third, financial institutions confuse the taxation picture even more, through their major holdings in the shares of quoted companies. They are able to set off dividends received against dividends paid for tax purpose but some may be liable to capital gains tax if they sell shares to make dividends.

The effect of taxation on dividend decision is difficult to analyse.

It may be argued that companies attract investors who can match their personal taxation regimes to company’s dividend policy, and that those who don’t join a particular ‘taxation club’ will invest elsewhere. If this were true, however, a change in company’s dividend policy would probably not find favour with its shareholders clientele. And would consequently affect share values, which seem to support the argument that dividend policy matters.

2. Other Arguments Supporting the Relevance of Dividend Policy.

Activity:

As a potential investor, how would you react to the following questions? a. Would you prefer cash dividends now, against the promise of future, perhaps uncertain, dividends? b. Would you prefer a stable, growing dividend to one that fluctuates in sympathy with company’s investment needs? c. If a company, in whose shares you invest, increases or decreases its dividend, would it change your personal investment policy?In answer in question (a) you probably opted for cash now rather than cash you may never see. The future is uncertain and most people take much convincing that it is in their interests to postpone income. Although the equity shareholder by definition is the risk-bearer, he is also entitled to a reasonable resolution of dividend prospects to compensate for the additional risk he carries. An investor will almost certainty pay higher price for earlier rather than later dividends.

In question (b), in definition, a fluctuating dividend is more risky than a stable dividend. Investors will pay more for stability, especially if it is linked with steady growth. Research has shown that, in general, dividends follow a pattern of stability with growth. Maintenance

of the previous year’s dividend is the first consideration, with growth added when directors feel that a higher plateau of profitability has been consolidated.