The Dividend Debate

This week 27% of Barclays shareholders 'revolted' over decisions made in favour of using their firm's spare cash, to pay top managers' bonuses, rather than dividends. Alison Carnworth, chair of the bank's remuneration committee, talked about in the future attaining a 'balance of rewards between shareholders and employees'. The fact of the matter is that Barclays CEO Bob Diamond and Chris Lucas, finance director had been awarded bonuses close to the maximum defined by the bank even though the share price was down by a third, dividends had stagnated and profits have fallen. You can see why the shareholders are angry, shouldn't bonuses be paid based on good stewardship? As far as the dividend issue, they may, or may not have had the accumulated profits to pay them but that's a separate issue, as is the subject of the bonus, deserved or not. Barclays shareholders are having trouble separating the two.

When it comes to the issue of enhancing shareholder wealth, each company will have its own dividend policy; loans, bonds and preference shares may impose restrictions limiting company control. Warren Buffet talked about 'the circumstances under which earnings should be retained and under which they should be distributed'. Allocation of this capital he said was 'crucial'. But what does the dividend policy say about a company? It anything.

Dividend decisions can be logical and almost predictable and if all else is constant, may be able to add or subtract value. Patterns emerge which give an indication of firm performance to the outside world. As a shareholder, would I be happy with steady increases year on year, volatile movements in an unpredictable fashion or to accept what ever remains following positive NPV projects? Or, would I prefer that no dividends were paid (through choice) and all monies reinvested, after all surely the share price would reflect any added value. Or would it?

In 1961 Modigliani and Miller developed the 'dividend irrelevancy proposition' and like their work on capital structure it requires certain assumptions to be made.  The basic idea is that regardless of the dividend payout, large, small or not at all, the share price would remain unaffected and therefore becomes irrelevant. What would M&M have made of the Barclays fiasco? None of their assumptions covered banker's bonuses  surprisingly, but what they did assert is that whether a shareholder receives rewards in the shape of dividends or not, value is enhanced purely through the firm's acceptance of positive NPV projects alone. In a year where the choice is made to invest in positive NPV projects, rather than pay dividends, liquidation of (some) shares would provide income required by the shareholder (instead of the dividend payout) and the sale price would reflect value added by the projects and create a 'homemade dividend'. In the real world of course the transaction would incur charges.

Assuming I'm the shareholder, would I rather the company invested in positive NPV projects, returned cash to me or kept it on their balance sheet? Am I an independent investor or a pension fund? What is my investment motive? It is long term or short term? What level of tax payer am I and am I expecting a return from a regular dividend or through a capital gain? The opposing view of the residual approach would be for a company to target a particular group. Sounds plausible, almost common sense since multi million pound organisations seldom do anything without a well thought out strategy. The 'horse' is built for the 'course' so to speak.

An unexpected change in dividend pattern is regarded as a sign of how the directors view the future prospects of the firm. A potential investor may make investment decisions based on historical dividend patterns, depending on their requirements, should they need regular predictable amounts or as and when payouts. It is this change in pattern which leads to changes in share price because it's taken as a reflection of the results of the last year, the director's view of the future and the strength of the business. In short it's a bit of a PR exercise.

Where the decision is taken to reinvest profits, rather than pay out dividends, this can be viewed as increasing the perceived risk level due to the future uncertainty of dividend payments, thereby reducing the share price. An alternative approach would be to pay out all funds to shareholders then issue new shares in order to raise funds for investment. There doesn't seem to be a perfect way to return cash to shareholders, this is one of the many decisions faced by managers who need to act with the company's best interests at heart. Almost a by-product of the decision making as far a dividends goes is, do dividend decisions affect share price? There is no one categorical answer, simply evidence to show both opinions therefore when I next make my big investment decision, I will consider all of the above but most importantly, I will ask myself as the shareholder, what are my requirements and expectations and if the firm can fulfil them, then that's the investment I'll go for.          


Sources: FT, Arnold, BBC News Website

Optimal Capital Structure

WACC (or Weighted Average Cost of Capital) can be used as an investment tool when deciding whether to invest in a given project. If the return on the project is higher than the WACC the company is creating value, if the return is lower than the WACC, the company is shedding value. Organisations apply hurdle rates to projects they consider, this is the minimum rate of return required by an investor or manager on a given project, the higher the risk, the higher the hurdle rate.

The capital structure (or how a company funds its operations and growth) of a business is a critical decision for a company, should the business be funded through debt or through equity? Or what proportion of each? Debt financing usually offers the lowest cost of finance because it is tax deductible however as the company's debt increases, so does the risk.  The optimal capital structure will allow an organisation to maximise its value through an acceptable cost of capital and risk level. A company's debt to equity ratio will provide a picture of how risky the company is.

A company more heavily financed by debt will be more risky. Peacocks has been described as having an 'unsustainable capital structure' (J Pope of KPMG) which lead to their sale out of administration to Edinburgh Wollen Mill in February this year after being unable to secure refunding of £240m of its £750m debt.

During its expansion, Peacocks floated on the stock market but the CEO Richard Kirk was unhappy with the valuation and lead a management buy out with backing from financial institutions including Goldman Sachs. It is this debt which is at the centre of the problem. Peacocks had suffered from tough economic conditions and the banks refused to provide further working capital. In April 2010, the stores appeared to have made a profit of £27m but this was reduced to a pre tax loss of £56m after bank loans and overdrafts.

The relationship between debt and a company's capital structure is complex, it can both increase and decrease a company's WACC because although a higher proportion debt decreases the WACC because its cheaper than equity, it also increases the WACC because shareholders want more returns for a higher level of risk. The question is, can the way a company is financed add more value for shareholders? And if it can, what is an acceptable risk level? Interest and repayments back to lenders won't go away, profits do. If a company doesn't make a profit, it has the option to withhold dividend payments, not so with repayments. Shareholders appreciate a certain level of risk, they respond to it through the market, the question is how much is too much?

The discussion surrounding an optimal capital structure is not a new one. It is widely acknowledged that the balance of gearing has an impact on the overall value of an organisation however, Modigliani and Millar (1958) argue that a company's capital structure has no impact on the WACC and therefore no optimal structure exists because the company is valued on risk alone.  One of the flaws in the argument is the assumption that no taxation exists. That's like saying Santa doesn't exist, it's just not true. Thankfully in 1963 M&M updated their theory to include tax (but not Santa).

It seems to me that compromise is the only option, with a reasonable compromise being the point before shareholders want higher returns because of increased debt and the resulting increased risk.  It's a bit like tightrope walking, one push and you're off!





BBC News website, Arnold