Analyse the theoretical, empirical and practical factors which influence the dividend policy of listed companies.

To what extent is the dividend policy of one FTSE 100 NON-FINANCIAL company of your choice consistent with the theoretical and empirical evidence you have analysed.

Introduction There are different ways of paying dividends. A company has the option of paying their dividends in cash, which means that profits are paid out to the stockholders biannual in cash. This form of dividends is the most common one. Another option that firms have at their disposal is the payment of dividends in stock. This means that existing stockholders are issues more stock instead of cash dividends. A third option is the stock split, which is similar to the stock dividend. This particular method of frequently used when the overall aim is to lower the market price of a firms stock by increasing the number of shares held by each shareholder. A last method is for a company to repurchase the stock from its investors. This particular strategy is common when a hostile takeover is to be fended off. Various theories exist explaining dividend payout policy. There are theories which approach the argument from a tax point, from an agency cost point, from the point of asymmetric information which is signaling as well as theories which explain dividend policy using behavioral explanations. Other approaches include risk as a determining factor as well as cash flow, growth, taxes, price earning rations and further variables. Other academic studies approach the point from an empirical point of view creating studies that test theories by applying them to real life scenarios. A further approach is that researchers survey managers working for corporations in order to better understand the factors which to them are the deciding factors in determining a firms dividend policy and payout. Generally, profits have long been viewed as the main indicator giving information about a companys ability to pay dividends. However, it is interesting to note that Black (1976) concluded his study with the statement that we do not know what a corporation is to do about their dividends. In order to explore the issue, this essay is going to look at different factors and theories influencing dividend policy decision. It will also look at the case of Vodafone and how the discussed theories may apply. Mueller (1972) introduced the concept of a life cycle for a firm which is the basis for the life cycle theory of dividends. According to this research, firms face an agency problem within their company structure. The issue is that managers of a firm need to make a decision on whether they want or should maximize shareholder value or pursue company growth for the companys benefit, which would mean an overinvestment in assets from the shareholders view. According to him, the optimal dividend policy for a value maximizing firm is to retain all earnings in the rapid growth phase and pay out 100 percent of the earnings when corporate maturity has been reached. This is an important proposition which will need to be remembered throughout the essay.

Research

There are a number of theories explaining how it is that dividend payout strategies are formulated. It is important to gain understanding of the different motives may be behind dividend payout policies. With 1

the help of this understanding, it is then possible to analyse a companys dividend policy and also make assumption on what the motivators for the chosen payout policy may be. One common theory on dividend payout is the residual theory of dividend policy. The essence hereby is that a firm will only pay dividends out of residual earnings, which means the dividends are paid from the earnings that are left over after all possible and suitable investment projects with a positive NVP are exhausted. This approach assumes that the main priority for a firm is to finance investment projects. This means that in this scenario, investment and growth are higher priorities than dividend payments. The process of paying dividends is treated as a passive process. The reason behind this is that management assumes that the wealth of the firm and shareholders will be maximized by investing in successful projects rather than paying out the profits to shareholders. This means that managers main focus if to seek out and invest into projects which are likely to increase the firms value after a thorough risk and return analysis. Dividends are only paid should there be earnings left over after all investments are finished. The motivation behind this dividend policy is that the need to raise new capital be it from debt or equity is reduced which in turn minimizes associated issues as well as floatation costs. Also, by pursuing a high retention policy, a firm is likely to avoid a dilution of ownership control since no new shareholders and investors are needed to provide the operating capital. Such a policy is likely to facilitate a rapid growth at a higher rate. Some shareholders, as discussed below, will prefer this approach to dividends since taxation may be such that dividends are taxed higher than capital gains and thus investors may prefer capital gain in order to maximize their personal benefit. The dividend irrelevancy theory proposes that the dividend policy of a firm has no effect on the market value or cost of capital of a firm. Miller and Modigliani (1961) assert that dividend policy is a passive residual which is contingent on a companys need for investment funds. In their view, there is no difference should a company decide to pay out dividends to the shareholders or retain earnings internally. This means that managers do not need to worry about the right dividend policy since the optimal dividend policy does not exist. The assumptions behind this model are that in perfect capital markets, there are no taxes, be it personal or corporate. There are no transaction costs on securities, investors are rational and information is symmetrical, which means that all investors are able to access the same information and are all sharing the same expectations about a firms future with the managers. The model also assumes that the investment policy of the firm is fixed and not related to the dividend policy chosen. The bird in the hand theory, mainly developed by Lintner (1962) and Gordon (1963) focuses on the fact that investors are perceived as averse to risk and would prefer dividend payments now rather than capital gains later. The dividends paid now are perceived as a more certain return on investment than future capital gains for the investors. Gordon pointed out that it is precisely the present day payout that resolves the uncertainty investors face. The preference is for a certain, steady and defined income now rather than uncertain, larger capital gains in the future. The value of the firms shares is increased since both Gordon and Lintner assume that investors would discount the companys dividend stream at a lower rate of return. This model was opposed by Miller and Modigliani since they maintained that the required rate of return or cost or capital were all not contingent on dividend policy. In their view, risk is a function of a companys investment policy rather than dividend policy. The reason why it is irrelevant for shareholders whether they are paid dividends or retain shares that provide capital gains since investors will purchase more stock from the company with the dividend money anyway. The dividend signaling theory proposes that in a real life scenario dividend policy may have a real effect on share prices. Increased dividend payments will result in higher share prices and a fall in 2

dividends will conversely decrease the share price. This observation lead to the conclusion that Miller and Modiglianis model is incorrect and the investors do prefer present day dividends to future capital gains. In this view, the dividend payment is interpreted as a signal for shareholders and investors about the earnings a company is expecting to have in the future. Higher dividend payments are viewed as a positive signal signaling a positive forecast for the future which will result in a higher share prices. A decrease in dividend payments, on the other hand, is viewed as a negative sign and the projection of future earnings and is likely to result in a lower share price consequently. To this point, Brav, Graham, Harvey and Michaely (2004) conducted a survey of 384 financial executives and confirmed Lintners (1956) proposition that managers will only increase dividends when it is likely that strong earnings will be sustainable in the future. On the other hand, empirical literature has little proof for the assumption that changes in dividend payout are signaling future increases in earnings. In fact, Nissim and Ziv (2001) conclude that changes in dividend policy may be interpreted as a signal for future abnormal profits. Benartzi, Grullon, Michaely, and Thaler (2003) find no evidence indeed that changes in dividend payout signal an increase in earnings in the future. This issue highlights the fact that there is no consistency between theory and practice. Lintners (1956) classic study of ways in which US managers arrive at dividend decisions was the first that inquired into the perceptions that corporate managers had concerning dividend policy and dividends themselves. For this, this study is to be considered a piece of work which is approaching the problem from a behavioral point of view. Linter discovered 15 different factors which has an influence on dividend decisions. Hereafter, he proceeded to interview managers of 28 high ranking industrial organizations. This lead him to conclude that changes in the earnings of the company is the main factor that leads to payment ratios that are not in line with the target ratios set by the company. Further, he stated that instead of drastic changes to the amount of cash that was paid as dividend, firms tended to periodically and partially adjust their payment ratios in the direction of the target payout ratio. He believed that this was the case since he assumed that managers were aiming at providing a steady stream of dividends for the shareholders, which he assumed would be preferable to a highly fluctuating dividend payout system. Ultimately, this means that managers attempt to smooth out dividend payments in the short run to avoid great fluctuations in the dividend payout shareholders receive. Using the information available, Lintner developed a compact mathematical model which allowed him to test his theory. In tests, Lintner arrived at the conclusions that this model explained 85 percent of dividend changes undertaken in a year. Further, he discovered that his model worked not only for a short period of time in which his study was conducted, but was applicable to longer time periods also. This means that according to him, dividend payouts are determined by the current year earnings as well as the dividends paid the previous year. Further studies such as of Fama and Babiak (1968) confirmed Lintners results. The clientele effect is describes the impact on the stock prices a change in the dividend policy would have which would be caused by investors reacting to a change in dividend payouts. Miller and Modigliani (1961) for example, state that it is indeed possible that a clientele effect is linked to the distribution of dividends. However, they also state that if the payout ratio is matched exactly to the investors preferences, then the situation is in fact identical with the case of a perfect market in which dividends and capital gains are not relevant to investors. Consequently, investors will chose to invest in firms which have their preferred payout ratios. Even if it is impossible to attain ones preferred payout ratio using one stock only, investors are capable of building portfolios that will provide them with their desired payout ratio. The authors point out that although it seems plausible for investors to prefer capital gains over dividend policy due to the high taxation on dividends, this is in actual fact not 3

the case. This is due to the fact that frequently, stock is being held by charitable organizations, retired people with a low income and foundations. Alternatively, stock is held by organizations that pay lower taxes on dividends such as insurance companies. This means that ultimately often investors are in favor of a dividend policy, even though it may seem counterintuitive. A study conducted by Farrar and Selwyn (1967) point out that dividends and capital gains were subject to different levels of taxation. Combined with the fact that investors will be subject to different levels of taxation depending on their income, it is clear that the clientele is diverse and will have different preferences in terms of payout policy. All of the investors will be attempt and maximize net returns for themselves. The company always has a choice between distributing profits using dividends or an increase in capital gain for the investors, who could sell of a part of their stock and thus sharing in the profits. Both forms of income for the investor are taxed at different levels. If the capital gains tax is smaller than the tax on dividends it is clear that the investors will prefer capital gains for any given level of profits, interest rates or debt level. Sine in most cases the dividend is taxed more than capital gains, Farrar and Selwyn conclude that firms should not pay dividends since their investors would always prefer capital gains. Brennan, (1970) who developed on Farrar and Selwyns model, however, arrived at an entirely different conclusion. He states that for any given risk level, investors will demand a higher return on stock, including higher expected dividend yields which is the result of the higher taxation applied to dividends as compared to capital gains. Ultimately, this means that lower returns before taxes are acceptable to investors, in the stocks that pay lower dividends and provide higher capital gains. In analyzing Vodafones strategy, it is important to find out if the payouts have increased steadily over time. It is equally necessary to determine if the payouts are sustainable. A further question that needs to be addressed is whether there is room to increase the dividends in the future. According to Company REFS Vodafone has a 5.9 percent yield. Historically speaking, the five year annualized growth rate of a dividend per share is 12.3 percent and the diluted earnings per share are 12.3 percent also (Capital IQ 24.8.2010), which is precisely what is ideal a one to one ratio for the long term dividend and earnings growth rates. In addition to this, Vodafone is part of the Mergent Dividend Achievers Index which indicates that the company has been raising its dividend payouts for the past five years. The company has 4.4 billion pounds in cash available to payout the 4.1 billion pound annual dividends. In addition to this, the company also has sufficient funds in order to cover payments to its creditors. In summary, this means that Vodafones balance sheet is in stable condition. Also, Vodafones long term debt has more than doubled in the time span from 2005 to now. However, the financial burden of interest rates has but only increased by 50 percent which is an indicator of the fact that Vodafone has been able to secure cheaper loans in recent times. Since the scheduled dividend payouts are sufficiently covered by profits as well as cash flows, it appears that in the least, Vodafones dividend policies are sustainable. The future target is a seven percent growth rate in terms of dividend payouts until the year 2013 which signals that the company is confident in the fact that its cash resources will also be enough to carry this burden. A reason for this confidence is that it is expecting significant payments from dividends itself it owns 45 percent of Verizon and even though the company has not been paying dividends recently but rather paying off debts, it is expected to pay dividends starting 2012. This would increase Vodafones free cash flow significantly which could easily translate into dividend payout growth. Analyzing trailing yields of competitors, they range from 5.1 percent for the BT group and 6.4 percent for AT&T. This means that Vodafone is securely covering the middle ground with 5.5 percent. This means that there is little pressure to adjust its dividend payments following internal or external pressure due to competition. Consulting the 4

companys financial history for the past 5 years, it is clear that the dividend payout ratio has been improving over that period of time, with the current ratio being around 40 (ft.com). If one is to look at the Financial Times Top 100 Company Vodafone one notices that for the fiscal year of 2010 it has raised it dividend by about seven percent which in effect means a dividend of 8.31 pence per share. The company has also announced that it is planning to raise its annual dividend by a further seven percent over the next three years with the target of having a return of at least 10.18 pence per share for its shareholders by 2013. This indicates that Vodafone is pursuing a progressive dividend policy. The increase in dividends is designed as a signal which is to communicate to shareholders and potential shareholders that the company is expecting to increase its cash earnings in the foreseeable future which will be reflected by the dividend payments. Putting this in the theoretical context, it is clear that Vodafone is an example that supports Lintners theory. The policy is clearly designed as a signal, an act of communication between the firm and its shareholders. It is also clear that Vodafone is convinced just like Lintner and others that investors prefer a dividend now to potential capital gain in the future. This means that empirically, Miller and Modiglianis proposition is again not finding any proof using this as case study. Farrar and Selwyn (1967) also seem to be incorrect in describing the clientele effect. It is clear that investors prefer to have a dividend now. Brennan seems to be more correct concerning this empirical case since he too is of the opinion that present day dividends are of a higher value to the investors. In fact, looking back on Vodafones fiscal history, it is clear that the companys approach is successful as since the announcement of the increase in dividends the stock price has been ever increasing and reuters.com suggests to buy stock from the company. This means that in a real world, Miller and Modiglianis theory does not stand and that the stock price, that is the value of the firm, is in fact connected to its dividend policy and not just to its investment decisions. If one is to follow Muellers concept of a dividend life cycle, this would mean that Vodafone has reached a level of maturity which is probably correct if one is to consult its overwhelming market share in many mobile phone markets across the globe where is it constantly among the market leaders. Conclusion Ultimately, the theoretical discussion highlights the multitude of approaches to a dividend policy. Lintner argues that dividends today are always going to be preferred by shareholders than potential capital gains in the future. Miller and Modigliani are of the opinion that there is no difference between opting for a dividend payment or en earnings retention policy and some of the literature describing the clientele effect is of the opinion that it may indeed be better to invest in future capital gains in order to maximize the benefits and value for the investor. Surely, the life cycle of a firm has an effect on the dividend policy pursued. Dividend policy, therefore, is contingent upon the stage at which the company is within this circle as well as the signals that the company wants to send to its investors, which is aptly illustrated by the Vodafone case. It is evident from the literature that an approach providing the optimal dividend policy is still unavailable. There are many fragments to dividend policy decision making. One if the most important aspects hereby is probably the fact that the investor market is very fragmented. Many of the investors pursue different agendas and different dividend policies maximize the personal benefit of different investors. Taxation, an important aspect to consider, is different depending on the nature of the investor and his particular tax situation. However, it is also crucial to bear in mind that managers may be pursuing different agendas and that the profit maximization for the shareholder is not a high priority. This aptly illustrates the agency problem which is associated with dividend policy decisions. It has also become clear that there is a difference between theories and imperial studies which sometimes tend to arrive at opposite conclusions creating a rift between theory and practice which has yet to be overcome. Ultimately, it is clear that the subject 5

requires further investigation and there is still much scope for future research that may resolve the issues presently at hand.

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Bibliography
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