The traditional view on dividends

- This is a view based on ‘a bird in the hand is worth two in the bush’ Approach, that is, the notion
that a guaranteed receipt enhances the value of the asset from which it derives.
Example: if the shares are priced at £6 before a £1 per share dividend, the price of the share will
not fall to £5 ex dividend, according to traditionalists, but perhaps to, say, £5.50.
The traditional view implies that the payment of dividends reduces the capital market’s
perceptions of the level of risk attaching to future dividends. This means that the discount rate
to be applied to expected future dividends will be lower and the market price will increase as a
result.

Who is right about dividends?

Some assumptions:

- There are frictionless capital markets, which implies that there are neither transaction costs nor
any other impediments to investors behaving in practice as they might be expected to do in
theory.
- Securities are efficiently priced in the capital market.
- Shares may be issued by businesses without any legal or administrative costs being incurred.
- Taxes, corporate and personal, do not exist.
- A feature of the UK investment scene is the increasing tendency for equities to be owned by
investing institutions.
- The situation is complicated still further by the fact that the business’s corporation tax liability
will, to a large extent, depend on what it does with any funds that it retains.
- MM’s ‘no tax’ assumption is perhaps not too significant provided that businesses show some
consistency in their dividend policy.

Other Factors

Informational content of dividends - some hold the view that the level of dividends, and perhaps more
particularly changes in the level of dividends, convey new public information about the business.

Assuming that increased dividends are seen as a positive sign, whether such a signal is meant as one or
is inadvertent probably varies from case to case.

If dividend increases are meant to act as signals, it seems reasonable to ask why the directors do not
simply issue a statement.

Incidentally, if the signalling view of dividends were correct, it would be expected that an increased
dividend would have a favourable effect on the share price in the capital market.

Clientele effect - it is widely believed that investors have a preferred habitat, that is, a type of
investment that they feel best suits them.

If there really is a clientele effect it means that a proportion of any business’s shareholders acquired
their shares because they are suited by that business’s dividend policy.

Liquidity - It has been suggested that the level of dividends paid by a particular business, at a particular
time, is largely dictated by the amount of cash available.
Pecking order theory

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 favored next, while equity financing through a new issue of shares
will come last in the list of preferences. The preference for using retained profit for investment,
combined with a firm resistance to making share issues, has implications for dividend policy.

Agency - 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 problem, 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.
Share repurchases allow the business to make significant cash distributions in a particular year without
establishing any expectations of the future level of dividends.