Dividend Policy- Don't Rock the Boat

Dividend wealth is an interesting topic for conversation when it comes to rewarding shareholder investment.  My original thoughts on dividends were that such insignificant figures would make little difference regarding fluctuations.  This was before I was made to realise the scale of investment made in companies from insurance and pension funds.  It’s a crazy concept that the future of our retirement is massively dependent on the dividend policy of these huge companies.

There are arguments, when considering NPV that would recommend company profits would be better investing in ventures with a positive rating.  Such ventures would be claimed to raise the value of a company, thus boosting shareholder wealth.  Only residual cash left from profitable ventures would be repaid as dividends using this concept.

Modigliani & Miller echo such sentiments, claiming that dividend policy has no effect on company value.

In reality however, it can rarely be seen that dividend policy has no effect on company value.  Of course, in a ideal world where humans are rational, the understanding that dividends may be low due to a high level of invest activity which would boost their wealth.

Unfortunately, humans are very irrational and such fluctuations would likely lead to a mass exodus.  If several shareholder looked to sell their shares at the same time, the share price would fall.  Although M&M’s idea is theoretically true, in the real world dividends play a huge role.

Looking at the BP Gulf of Mexico oil spill, the announcement that BP would be halving their dividend payment resulted in panic from UK pension funds, fearing such a decrease could cost the UK millions in the long run.  Although not the only factor, BP’s share price suffered badly as a result of this announcement.

It can therefore be seen that shareholders, being the irrational, over-emotional being that they are crave stability.  A constant, un-fluctuating dividend yield is met favourably, thus companies have reacted to this by attempting to maintain a steady dividend payout, regardless of good or poor performance. 

Although investors may look on such a decision favourably, I would consider it a bit of a shame that shareholders are so insistent at focussing on their short term gains, that they cannot see the bigger picture- that maybe a company’s surplus cash could be put to better use, which would eventually lead to an increase in their own wealth.  To ask shareholder to think long term is quite possibly too much of a revolutionary step I fear. 

Captial Structure: Is there an optimal level?

Optimal capital structures are an interesting (and complicated) area of research.  Personally, I’m quite a fan of the traditional view.  At the risk of sounding like a grumpy old man; back in the day, people seemed to be more sensible.  What happened to the days of companies having a concern for their levels of debt?  Of course, debt is cheap but debt is also constant.  What the good times are here, having a cheap source of capital is great... but what about the bad times?

The traditional approach considered the idea that although debt was cheap, WACC would only decrease to a certain point, where the financial risk was considered to be too high, thus seeing WACC decrease as equity was used as a source of capital.  The optimal capital structure was seen as a delicate balancing act.  ‘Was’ being the key word...

It seems in current times, or at least before 2007, shareholders were content with the risk involved in taking on massive amounts of debt because of the returns they were seeing.  Satisfied that they were maximising shareholder wealth, companies were happy to take on more and more debt.  Then came the point when the ‘credit crunch’ sunk its teeth into a bloated and unsuspecting world.  Suddenly debt finance became impossible as banks collectively panicked over their enormous shortfalls from carelessly loaning out money to any person that could ‘walk and chew gum at the same time’.  Companies like PC World that based their short term cash flow forecasts under the assumption of acquiring cheap debt struggled for survival, and shareholder wealth was obliterated.  Oh for the good old days.

A reason for this blasé attitude appears to stem from the research of Modigliani & Millar (1958), who suggested there was no optimal capital structure, and company value is based on business risk.  The assumptions made in this study were rightfully torn apart by academics, who found the idea of assuming no tax to be laughable.  With nothing being ‘certain but death and taxes’, I’m inclined to agree with the academics.  After a rethink, which included tax, it was found that debt was a significantly cheaper source of capital which would lead to company value being improved if this emphasis on debt was used.

Of course, humans seem to crave an excuse to do something if they can justify it, thus the loading on of debt became almost commonplace.  After the deregulation, which stems from the 1980’s, banks took this opportunity to greater levels which has finally resulted in the chaos we see today.  Only after such a major failure has any action been taken to rectify this, with the introduction of Basel III as an attempt to rectify this problem. 

Personally, although you cannot deny the benefits of debt, the level we have allowed our businesses, governments and ourselves to become reliant on debt is ridiculous.  It is a damning assessment to look at our inability to be sensible and level headed.  As soon as the banks were deregulated, greed seemed to override common sense.  Is there an optimal capital structure?  Most definitely.  Are we anywhere near it?  Looking at the mess we’re in after our love affair with debt, probably not.  Oh for the good old days...