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. 

Investment Appraisal

Investment appraisal appears to merge two of the most important issues in the world of business finance; planning and shareholder wealth. An interesting thing about investment appraisal is the reliance on figures that are at best speculative. Can there be any real value to a practise that relies on estimation and assumption? Can the reliance on these tools actually create risk?

Some techniques used, such as payback period and accounting rate of return may provide insight into if/when the project can be profitable. The assumptions however compromise the techniques in their simplistic nature; rarely will a business' cashflow be so constant as to make payback period a reliable tool. The same issue can be said regarding accounting rate of return, with the use of profitability being far too easy to manipulate.

Despite it's obvious flaws, the considerations that are made involving time value of money are of great use to anyone considering an investment. If a business could be deemed to be marginally successful based on the current value of money, the risk of inflation diminishing any potential profits is far too significant not to consider.

Net present value (NPV) is also to analyse which objectives will generate shareholder wealth through goal congruence. If the calculated NPV figure is positive, it is recommended that investment should be made. The calculation of NPV has been criticised as being too complicated. As much as this may be the case, the evidence of it's use over many decades suggests that the benefits that can be reaped from this tool is such that the complications are justified.

The big debate revolves around whether people can deem the estimates made in investment appraisal to be accurate enough to trust. Personally, I would suggest that estimations in their very definition should not be trusted as absolute fact. Of course the estimation is, in successful investments, based on a great deal of market research which adds far more value and reliability to this tool. Based on the amount of research, and the fact that the people making these appraisals for multinational companies are making obscene amounts of money, the world of investment appraisal is a tool that companies would be foolish not to use. As always, it's a case of 'fail to plan, plan to fail'.