Chapter 12 • The dividend decision
another, more preferred, one. In either case, the effect of changes in dividend policy
seems likely to lead to lower share prices and higher costs of capital.
All of this seems to imply that liquidity may not be a particularly important factor
in the dividend decision, and that businesses will make sure that sufficient cash is
available for the dividend, one way or another.Traditional view
lDividend decision – a vital one for shareholder wealth effect.
lShareholders value a dividend more highly than the equivalent amount re-
tained in the business.Modigliani and Miller (MM) view
lDividends should be paid only where the business cannot use the available
funds at least as effectively as shareholders can on their own account, that is,
invest in all projects with a positive NPV when discounted at the shareholders’
opportunity cost of capital.
lOnly funds remaining after investing should be paid as dividend – dividend
is residual.
lShare price is the PV of future dividends – shareholders will be indifferent as
to how the PV is made up (size of each year’s dividend). If paying less this
year leads to more in later years such that PV (and share price) is increased,
shareholders’ wealth will be enhanced.
lIndividual shareholders can adjust the business’s dividend payments to meet
their own needs.
lIf no (or low) dividend and they need funds, they can sell some shares to
generate a cash inflow from the shares (homemade dividends).
lIf they prefer not to receive a dividend from the business, they can buy
more shares with the cash from a dividend and, thereby, leave the invest-
ment intact.Practical issues
lDividend levels might signal information – high dividends could imply con-
fidence in the future of the business. Possibly an illogical argument – why not
make a statement instead? On the other hand what appears to be signalling
might be investors reassessing their underestimations of projections of the
business’s future.
lClientele effect – investors are attracted to particular shares because of divi-
dend policy, perhaps because of their personal tax positions or need for regu-
lar cash inflows.
lThe relative costs of raising funds (issue costs) – same as for gearing decision:
lEquity from retained profit – virtually nothing.
lEquity from rights or public issue – very expensive.