Chapter 12 • The dividend decision
shareholders. This would not suggest great confidence in the future on the part of
the directors.)
Assuming that increased dividends are seen as a positive sign, whether such a
signal is meant as one or is inadvertent probably varies from case to case. Certainly, a
typical tactic of an unwilling target business’s management in a takeover battle is
to increase its dividend level; perhaps this is a deliberate signal to inspire the share-
holders’ confidence in the business’s future.
If dividend increases are meant to act as signals, it seems reasonable to ask why the
directors do not simply issue a statement. Surely a statement would be much less
ambiguous than an increased dividend. Perhaps the directors feel that actions speak
louder than words.
Incidentally, if the signalling view of dividends were correct, it would be expected
that an increased dividend would have a favourable effect on the share price in the
capital market. Such a phenomenon would represent a further piece of evidence that
the capital market is not efficient in the strong form (see Chapter 9), because it implies
that information available to the directors may not be impounded in the share price.Clientele effect
It is widely believed that investors have a preferred habitat, that is, a type of investment
that they feel best suits them. In the context of dividends, their preference might well
be dictated by their individual tax position. A person with a high marginal income tax
rate might well be attracted to shares where dividend payouts are low. On the other
hand, an investor such as a pension fund that is tax exempt, but which needs regular
cash receipts so that it can meet payments to pensioners, might prefer to hold shares
in businesses whose dividend payments are relatively high. Such an investor could, of
course, generate cash by selling shares, but this would involve brokers’ fees and such
like, which obviously are best avoided.
If there really is a clientele effect it means that a proportion of any business’s share-
holders acquired their shares because they are suited by that business’s dividend pol-
icy. If there is inconsistency in the policy on dividends, many investors would be put
off the shares as they would not know whether the levels of dividends would suit their
preferences or not. The lack of popularity of the shares would have an adverse effect
on their price and, therefore, on the cost of capital. Even if a particular business were
to be fairly consistent in its dividend policy, but then undertook a major change, those
of its shareholders who particularly liked the previous dividend policy (this might be
all of them) would probably seek to move to the shares of a business with a dividend
policy more acceptable to them. While it might well be the case that a new clientele
would find the dividend policy attractive, the friction caused by one set of investors
selling to a new set of investors would have a net adverse effect on the shareholders.
Not only this, but the uncertainty in the minds of investors that the change may pre-
cipitate, as to how consistent the dividend policy was likely to be in future, could also
have a dampening effect on the share price.Liquidity
It has been suggested that the level of dividends paid by a particular business, at a
particular time, is largely dictated by the amount of cash available. Certainly this is
what MM suggest should be the case. On the other hand, if failure to pay a dividend