Other factorsis interpreted adversely by the capital market, the best interests of shareholders’
wealth might be advanced by making sure that cash is available, perhaps by borrow-
ing, or even by passing up otherwise beneficial investment opportunities.Pecking order theory
In Chapter 11 we saw that a combination of factors might lead to businesses seeking
to raise funds in the following order of preference:1 Retained profit
2 Debt
3 Equity issue, only as a last resort.This implies that, where the business has funds built up from profitable trading that it
can dip into for investment purposes, it will tend to do so. If there are insufficient
investment funds available from retained profit, debt financing will be favoured next,
while equity financing through a new issue of shares will come last in the list of pref-
erences. The preference for using retained profit for investment, combined with a firm
resistance to making share issues, has implications for dividend policy. According
to the pecking order theory, businesses may be less likely to pay dividends when
they have profitable (positive NPV) investment opportunities, as predicted by MM.
If they have surplus cash, businesses would be likely to hold on to it rather than pay
dividends, in contradiction to MM. Also, if they need more investment finance, they
are more likely to borrow than to make a new share issue, again in contrast to what
MM predict.Agency
The theoretical principles of dividend decisions are clear, according to MM. If the
business cannot identify profitable (positive NPV) investments, it should return any
residual cash to the shareholders and let them use it more advantageously than it can
on their behalf. In an effort to expand their empire, however, the directors may choose
to make disadvantageous investments. Thus there is the danger that the agency prob-
lem of the separation of the ownership of the business from the directors can lead to
agency costs to be borne by the owners – the shareholders.
In short, the agency problem could lead to dividends that are less than those that it
would be in the shareholders’ best interests to receive. As ever with the agency prob-
lem, the shareholders often do not have the necessary information that could lead
them to make a reasoned challenge to the directors’ dividend decision.Share repurchase
One way for a business to transfer funds to shareholders is for it to buy back shares
from individual shareholders, either through the Stock Exchange or by making direct
contact with them. We should be clear that, in essence, this has the same overall effect
on the business as would a dividend payment involving an equal amount of cash. The
effect on shareholders is very different, and this is a major advantage. Shareholders
who want to withdraw part or all of their stake in the business (sell part or all of their
shares to the business) can do so to the extent that they wish; those that do not wish