Business Finance - I want my money back!

A company must think carefully about how to give shareholders an ongoing return on their investment. Regular dividends are just one way of doing it.
Dan Tuckey

A shareholder will invest in a company in the hope of making a healthy return. If we consider a share's value to be the future cash streams it will generate, then the share will only have positive worth if the shareholder can expect future cash flows. This may in fact be a long way into the future. For example, Eurotunnel floated in the mid-1980s, yet may only pay its first-ever dividend towards the end of this decade.

The most common of these flows will be dividends. Typical blue chip companies in the UK will pay an interim dividend part-way through the year to ordinary shareholders and then a final dividend once the company results have been established (ie, after the year-end). There are arguments for and against the importance of having a clear dividend strategy.

'Dividend irrelevance'

Modigliani and Miller (M&M) argued that shareholders do not worry about receiving dividends immediately. Essentially, the argument is that a share's value is the present value (PV) of all cash flows associated with that share. This PV will reflect dividends and capital growth. Any capital growth will simply reflect any expectation of increasing dividends in the future.

Here lies the key. If a company has a worthwhile project (project internal rate of return (IRR) > cost of capital), then the company should use retained earnings to fund the project. The project, having a positive net present value, will enhance shareholder wealth and therefore enhance the prospects of even bigger dividends in the future. Therefore the shareholder is better off not taking a dividend now, but taking a large dividend in the future. Example 1 illustrates this point.

It could be argued that the company should raise external funds for the project (debt or equity). However, most UK companies tend to prefer, if possible, to use retained earnings to fund such projects, since they involve neither high issue costs nor meeting external fund providers' needs (eg, justifying the reason for raising new funds through an equity issue).

Any residual cash left over after the project has been funded can be used to pay out current dividend needs. Also, if a company has no appropriate projects to invest in (project IRR < cost of capital), then all surplus cash can be paid out to shareholders. Such a 'policy' leads to significantly differing dividends per share each year (ICI follows a similar strategy).

If a shareholder needs to generate cash during a period when a company is not paying dividends (ie, it is investing in worthwhile projects), then it can be argued that the shareholder should sell some shares in order to 'create' their own dividend. The value of each share will be rising, in the anticipation of future improved dividends (because of the cash inflows the worthwhile project will generate in the future). As such the shareholder is merely realising some of this capital gain in cash before the company pays out a higher dividend in the future.

'Dividend relevance'

The counter-arguments to dividend irrelevance are based largely on a practical approach.

Preference for current income. Shareholders prefer to be paid dividends now, in order to fund their immediate cash needs. As such they will invest in companies paying 'healthy' and predictable dividends. Under the dividend irrelevance approach, it can be argued (as above) that a shareholder can sell parcels of shares to generate current income. This, however, ignores transaction costs (commissions).

Bird in the hand. A dividend 'now' is more certain than a capital gain. Therefore a company should pay high dividends now, in order to eliminate future uncertainty about returns (dividends or capital gains). This, however, overlooks the fact that the value of any share is the PV of the future cash flows (and not present or past cash flows). Unless a company can sustain future dividends, its share price may be seriously restricted.

Dividend signalling. One of the main arguments is that the payment of dividends is seen as a strong signal of future performance and hence share value (assuming at least a semi-strong efficient market). Most blue chip companies wish to pay a steadily growing dividend per share even though its earnings per share may fluctuate dramatically. If you scan a quality newspaper to compare this year's and last year's dividend for most listed companies, you will see evidence of this (even more so if you look at its history of paying dividends). If a company that has paid steadily growing dividends over many years were suddenly to alter its payment pattern, shareholders would be aggrieved. However, if the reason for such a change had been clearly signalled to the shareholders, a change in policy would not be such a shock. For example, in the late 1990s, British American Tobacco pegged its dividend in order to build up cash reserves against possible litigation in the US. It clearly explained the reason for the short-term alteration of its dividend 'policy', which was well accepted by the market.

Clientele effect. Shareholders' inclination to invest in a company will depend on whether they prefer dividend income and capital growth. For example, shareholders in British Biotech and Egg are investing for capital growth, since neither company has yet paid a dividend. However, investors in typical blue chip businesses often look for reasonable capital growth but, importantly, steady dividend growth as well. If a company were to dramatically change its dividend payout strategy, shareholders may decide to move their investment. For example, BT is currently struggling to reduce its gearing. One way it is doing this is by scrapping this year's final dividend. However, institutional investors are probably not particularly keen at the prospect. Fund managers set up funds based on certain investment criteria. For example, Perpetual High Income fund invests in successful businesses that have a high dividend payout policy. If such companies were to cancel their dividends, then the fund manager may need to consider whether that stock should still be held in its portfolio.

Personal taxation position. Shareholders often invest in companies as a result of their personal tax preferences (a continuation of the clientele effect). For example, shareholders who regularly use up their annual CGT allowance (£7,500 for 2001/02), will usually prefer a company to pay dividends. Indeed, given the UK income tax and CGT system, most shareholders tend to be in a better tax position if they receive a dividend. However, a shareholder who has yet to use their annual CGT allowance may well prefer capital gains, since they will be tax-free.

Alternative methods of returning funds to shareholders

The payment of interim and final dividends is not the only way shareholders can get returns from the company.

Scrip dividends. This is where, instead of a cash dividend, a shareholder receives extra shares. The advantage to the company is that no cash leaves the business. The shareholder will have a larger shareholding, although the market price of each share will reduce proportionately, since the scrip dividend hasn't created any wealth. An enhanced scrip dividend may encourage the shareholder to take up the offer. This is where the shareholder receives shares in lieu of a cash dividend, but to a higher monetary value.

Special dividends. This is where a single oneoff large dividend is paid to each shareholder. Many blue chip companies have considered or indeed followed this course of action. Halifax plc was under pressure (after the society was demutualised) to return excess cash to shareholders by way of a special dividend (considerable cash sums had been raised by offering shares to financial institutions on demutualisation and flotation). Halifax had struggled to find suitable acquisitions that would have used the cash fund. National Power paid a substantial special dividend to shareholders in the mid-1990s. Essentially, the argument for paying special dividends is similar to that already explored. If the company cannot get an acceptable return from its cash reserves, has excess cash reserves for its needs or is worried that a potential predator is eyeing up its cash reserves, it may return cash to the shareholders via a special dividend.

Share buybacks. An increasingly popular route for returning money to the shareholder is for the company to repurchase its own shares. This will enable a shareholder to 'cash in' their shareholding for a one-off repayment of their capital. There are three main motives for a company to pursue this course of action.

To return surplus cash to shareholders. If the company does not feel it can put cash reserves to good use (ie, to increase shareholder wealth) then cash should be returned to the shareholders. Boots has cited this as a reason for its recent share buyback strategy.

To boost reported earnings per share (eps). If the company retains the same level of underlying profitability, then reducing the number of shares in circulation will lead to a boost in the profit per ordinary share (ie, eps).

The most common reason is to attempt to reduce the company's weighted average cost of capital (WACC). This will in itself improve the value of the business, since even if the underlying business cash flows do not change, they are discounted at a lower discount rate (lower WACC), and hence shareholder wealth (PV of future cash flows) increases. In the UK, interest rates on debt have been very low for some time. Coupled with tax relief on interest payments (for profit-making companies), it could be significantly to a company's advantage to replace relatively expensive equity with cheaper debt. This assumes that a company is not operating at its optimal capital structure position (ie, debt:equity mix) in that it is 'undergeared'. In Example 2, by buying proportionately cheap debt, or simply buying back share capital and not raising further funds, the company (Whitehorse plc) would increase its debt to equity proportion. Clearly this is not an option for BT, which is so highly geared (with some £30bn of debt) that a share buyback financed by extra borrowings would be unthinkable.

Conclusion

A company needs to consider its position with reference to returning funds to shareholders. In any business stream examination, this could be a considerable point of contention.

Dan Tuckey BA ACA is a senior tutor with Financial Training Company in Wokingham. He specialises in management and business related papers.

1: Illustration of dividend irrelevance

Milner plc is considering paying a dividend now of £0.50. Alternatively, it could decide not to pay a dividend now, but instead retain funds and invest the money in a project that would give a return of 20% over one year. The shareholders' required rate of return is 15%.

PV to the shareholder of the company paying a dividend now:

1 x £0.50 = £0.50
(1 + 0.15)°

PV to the shareholder of the company paying a dividend in one year's time:

1 x £0.50 (1 + 0.20) = £0.5217
(1 + 0.15) 1

Therefore the shareholder's wealth is improved by the company retaining funds now in order to invest in a project with a superior rate of return.

2: Illustration of share buybacks

Capital structure of Whitehorse plc

Whitehorse plc has a low debt:equity ratio (D/E°). It could buy back equity from the shareholders and also replace this equity with debt (although if the equity is not replaced with debt, the effect is the same). Increasing the proportion of cheap debt to equity (ie, moving to D/E1) will pull down the WACC from WACC° to WACC1. This will increase the value of the business as a whole, since in the long term all cash flows can be 'discounted' at a lower WACC, hence increasing the company's PV.

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