LEARNING OBJECTIVES • Explain the rationale and conclusion of the ideas of Modigliani and Miller’s dividend irrelevancy hypothesis, as well as the concept of dividends as a residual Describe the influence of particular dividend policies attracting different ‘clients’ as shareholders, the effect of taxation and the importance of dividends as a signalling device Outline the hypothesis that dividends received now, or in the near future, have much more value than those in the far future, because of the resolution of uncertainty and the exceptionally high discount rate applied to more distant dividends Discuss the impact of agency theory on the dividend decision Discuss the role of scrip dividends and share repurchase

DEFINING THE PROBLEM Dividend policy is the determination of the proportion of profits paid out to shareholders – usually periodically. Can shareholder wealth be enhanced by altering the pattern of dividends not the size of dividends overall? We assume: (a) the underlying investment opportunities and returns on business investment are constant (b) the extra value that may be created by changing the capital structure is constant

MODIGLIANI AND MILLER’S DIVIDEND IRRELEVANCY PROPOSITION Dividend policy is irrelevant to share value – Modigliani and Miller (1961) 1 There are no taxes 2 There are no transaction costs; for example: 3 All investors can borrow and lend at the same interest rate 4 All investors have free access to all relevant information investors face no brokerage costs when buying or selling shares companies can issue shares with no transaction costs

DIVIDENDS AS A RESIDUAL Imagine the raising of external finance is impossible. Dividends should only be paid when the firm has financed all its positive NPV projects. 1 If cash flow is retained and invested within the firm at less than kE , shareholder wealth is destroyed; therefore it is better to raise the dividend pay-out rate. 2 If retained earnings are insufficient to fund all positive NPV projects, shareholder value is lost, and it would be beneficial to lower the dividend. What about the world in which we live? There are transaction costs to contend with.

CLIENTELE EFFECTS There may be a natural clientele for shares which pay out a high proportion of earnings and another clientele for shares which have a low pay-out rate. Pressure on the management to produce a stable and consistent dividend policy. Inconsistency would result in a lack of popularity with any client group.

OTHER INFLUENCES ON DIVIDEND POLICY • Taxation Dividends as conveyors of information Resolution of uncertainty Owner control (Agency theory)

SHARE BUY-BACKS AND SPECIAL DIVIDENDS SCRIP DIVIDENDS A scrip dividend gives shareholders an opportunity to receive additional shares in proportion to their existing holding instead of the normal cash dividend. Advantages: 1 Cash does not leave the company 2 Advanced corporation tax (ACT) does not have to be paid SHARE BUY-BACKS AND SPECIAL DIVIDENDS An alternative way to return money, held within the company, to the owners.

THE ARGUMENTS Question 1 Can shareholder wealth be increased by changing the pattern of dividends over a period of years? Question 2 Is a steady, stable dividend growth rate better than one which varies from year to year depending on the firm’s internal need for funds? Forces promoting a low pay-out tax systems; some clienteles; Forces promoting a high pay-out high growth potential of the firm; some clienteles; instability of underlying earnings; owner control (agency theory); management desire to avoid the uncertainty (‘bird-in-the-hand’); risk of a future dividend cut; signalling. liquidity . THE DIVIDEND DECISION Force promoting a fluctuating Forces promoting stable dividend dividend clientele preferences; dividend as a residual: signalling; positive NPV project owner control (agency theory); availability takes precedence. management desire to avoid the risk of a future dividend cut; stability raises credit standing for debt issues. Exhibit 19.8 The forces pulling management in the dividend decision