Introduction
Despite the fact that many companies have different policies on dividend payments; dividend payment still remains one of the most controversial issues in corporate finance (Investopedia 2011, p. 1). This issue is brought to the fore by the fact that companies such as Microsoft Corporation (despite its success over the years) and other similar companies completely fail to pay dividends to their shareholders while other companies pay handsome dividends in a consistent manner (Investopedia 2010, p. 6). In fact, giant corporations like Google have more than half their assets invested in the money markets but don’t pay any dividends to their shareholders (Investopedia 2010, p. 6). Nonetheless, it is an undisputed fact that dividend payments affect company shareholders in various ways.
One of the most common issues pegged to managerial policies regarding dividend payment is tax benefits but other proverbial issues articulating dividend payment are income flow, shareholder preferences, capital gains and the likes (Investopedia 2011, p. 1). All in all, existing literature tends to shy away from exploring reasons why some companies find it quite useful to pay dividends while others totally refrain from it. In most cases, many companies hold the belief that excessive liquidity enables them to generate more returns than companies that choose to pay dividends. Some successful companies such as Google or Apple (for example) don’t care much about dividend payments because their stocks are already in high demand and it is a well-known fact that struggling companies use dividend payments to make their stocks more attractive (Investopedia 2011, p. 1).
However, this study does not seek to dig deeper into the reasons why companies don’t pay dividends but rather, why they do. In other words, this study seeks to carry out a comprehensive analysis of why companies choose to pay dividends in the long run as opposed to not paying dividends at all. Considering many empirical studies have been undertaken to explain this puzzle, this study will borrow from existing principles and rules explaining dividend payments in most corporations. In this manner, we will understand the implications of dividend payment on the overall company strategy formulation process and in close relation, we will also comprehend how the option to pay dividends affects problem-solving as a managerial responsibility and how it helps in complimenting managerial decisions. Comprehensively, in spite of the fact that some companies choose not to pay dividends, this study will be skewed to the reasons why companies pay dividends as opposed to why they don’t.
Company’s Financial Wellbeing and Brand Awareness
For many years, most companies have upheld a dividend payment policy because it is believed that it is a show of surety to its investors that the company’s future financial wellbeing is guaranteed (Kennan 2011, p. 3). To some extent, investors are also assured of their current savings when investing in shares and so they are guaranteed a safe place to keep their money. Some companies are also very tactful, in that, they use dividend payment as a tool to attract more investors because consistent dividend payment is often seen as a show of stability for the company and therefore many investors are bound to believe companies that pay dividends are very stable. This may however not be true (Kennan 2011, p. 3).
Nonetheless, it is a well-known fact that an increase or decrease in dividend distribution is bound to affect the overall price of the securities in question (Kennan 2011, p. 3). Obviously, this is bound to affect a company’s financial well being. To attest to this fact, companies that have been seen to distribute dividends to their shareholders in a consistent manner are never affected by a decrease in dividend payment (Kennan 2011, p. 3). In contrast, such companies are likely to be positively affected by an increase in the payment of dividends; or when they choose to have some other form of alternative dividend payment. Comparatively, companies which have never in their history issued out dividends are often perceived positively when they choose to do so. This brings us to another important reason why companies strive to pay out their dividends; brand awareness.
Brand Awareness is often achieved by many companies through dividend payment. Most of the time, this is part of a company’s grand marketing plan to improve the company’s brand name, market activities, career prospects, portfolio, credibility and such like parameters. Dividend payment is therefore a unique marketing strategy adopted by most companies especially because it transcends across various operational departments to improve their overall performances. For example, in the human resource department, dividend payments are bound to increase a company’s image in the marketplace while high-performing employees are bound to be strongly grounded in the organization as new ones are likely to be eventually attracted to such companies. A company’s financial standing is therefore likely to be greatly improved in regional charts and in some cases, such rankings prove quite beneficial for rapidly growing companies because they are able to appear in influential financial magazines such as Forbes, CRISIL, Fortune 500 and the likes. Such a positive image is not only bound to attract investors or highly qualified and educated staff; it is equally bound to boost employee morale (from top to bottom managerial level hierarchy). Such strategies are often very useful to start-up companies because they are in great need of an image boost.
Separation of Ownership and Management
For many years, most companies have found themselves at loggerheads regarding the role management and shareholders play in running a company’s operations. To solve this dispute, many companies have chosen to issue dividends as a dispute-solving mechanism. According to Feldstein (1979, p. 4) “dividends are a signal of the sustainable income of the corporation: management selects a dividend policy to communicate the level and growth of real income because conventional accounting reports are inadequate guides to current income and future prospects”. When analyzed closely, companies which pay out dividends prove to their shareholders and the general public that they are capable of generating profits because they are able to afford paying dividends in the first place. For instance, a small business owner would be delighted to be constantly getting cashback from his/her business. Later, such funds can be used to expand the business, reinvested or saved; whichever way the owner may choose. However, the lesson to be learnt here is that the ability of the business owner to have the option of using the excess cash in whatever manner is a show of confidence on the business and a representation that the business is performing well.
In addition, in light of today’s increasing business malpractices, through fraudulent accounting procedures, company managers can show their shareholders that business profits are real and not manufactured by a board of CPAs in a theoretical manner. However, what is easily observed as an issue of contention between managers and shareholders is the need for a balance between the interests of both. Dividend payments act as a critical tool for striking this balance. In times where companies make excess profits, some may choose to pay out dividends to cater for the interests of the shareholders and retain some money for expansionary ventures (which is in the interests of management). Most of the time, many companies often choose to split such earnings in the middle to cater for managers and shareholders (Feldstein 1979, p. 5). A balance between the interests of the shareholders and managers is therefore easily stroked in this manner.
Through the Auerbach-Bradford-King theory (cited in Feldstein 1979) we see that when companies consistently pay out dividends, their actions should be comprehended from a more elaborate and dynamic point of view (even though high dividend payments seem to be a high cost method of communicating such a thought). However, when companies take such drastic actions, in addition to incurring high taxes, they are rubbishing any fears held by shareholders regarding how they utilize excess company profits (Feldstein 1979, p. 6). This is true because many investors are of the opinion that managers often misuse financial profits by undertaking poor investments or compensating themselves in form of high compensation perks (Feldstein 1979, p. 6).
Feldstein (1979) further explains that “If investors would prefer dividends to retained earnings because of this distrust, it is hard to understand why there is no pressure for a 100 percent dividend payout” (p. 4). Other researchers and authors such as Auerbach (1979), Bradford (1979) and King (1977) (through the Auerbach-Bradford-King theory)
have consistently argued that when companies pay dividends to their shareholders, in a consistent manner, they improve shareholder equilibrium because the value shareholders get per dollar (or pound) is normally more than what the company would get when the money is allocated as part of retained earnings. In other words, it is proposed that companies should pay out dividends when the value of retained earnings capitalizes the penalty the company would pay in form of taxes when paying out dividends (Feldstein 1979, p. 6).
However, the Auerbach-Bradford-King theory does not lack its shortcomings because it fails to stand true when the value of shares is less or equal to the value derived from holding the money as retained earnings. Another problem observed with the Auerbach-Bradford-King theory is that it purports that shareholders cannot be paid in any other way apart from dividends. This assumption is obviously controversial because it precludes the possibility of a given company being bought off by another or the possibility of a given company acquiring more shares through the utilization of retained earnings. Another problem with the theory as explicitly stated by Feldstein (1979, p. 7) is that “any payout rate is consistent with equilibrium and therefore gives no reason for the observed stability of the payout rate over time for individual companies and for the aggregate”. However, as we will see in this study, the payout rate is rather determinant and does not easily respond to the fluctuations in dividend payment which a company may record in any given year. Nonetheless, the Auerbach-Bradford-King theory can hold true in the face of this contention if it is supported by some form of affiliated signalling explanation. Upon critically analyzing the Auerbach-Bradford-King theory, we can conclude that the theory’s biggest problem lies in its assumption that shareholders have the same tax rate. This is obviously not true because different shareholders fall in different tax brackets.
Expansion Risks
Many people would agree that it is not necessary for companies to pay out high dividends to their shareholders because it makes more sense for a company to use money set aside for paying dividends and finance expansionary ventures (Luo 1999, p. 38). However, the truth of the matter is that such monies are usually wasted in failed acquisitions, unviable business ventures and the likes. In turn, this implies a lot of business risks for both the company and shareholders. In most cases, companies that don’t pay dividends usually allocate dividend funds as part of retained earnings to be later used for financing future expansionary projects. In turn, this is likely to increase a company’s expansion rate, faster than the expected natural rate. This obviously poses a danger to the company and shareholders alike because such rapid expansion is likely to reduce the value of securities being traded at a given time because there is an increased risk involved during a rapid expansion (Feldstein 1979, p. 6). In this manner, we can be able to understand why many companies adopt a shareholder-risk-aversion technique which enables them avert such pre-empted dangers.
In most cases, companies would prefer to pay dividends to maximize the value of their shares because in this way, they can attract both taxable investors and untaxed investors. Untaxed investors are like pension schemes, non-profit organizations and such like institutions while taxable investors are the ordinary individual investors, public limited companies and the likes.
The above analysis is true because taxable individuals normally invest their share dividends in companies that pay no dividends but non-taxable investors would rather invest their money in companies that don’t retain their money as profits (in line with their non-profit making nature). In such a manner, both taxable and non-taxable investors would regard their investments as very unique (though uncertain) and therefore the share value of the company will be maximized if the company brings on board both categories of investors. However, Feldstein (1979, p. 10) notes that there is an exception, in that: “Only in the special case of little or no uncertainty of a limited ability to diversify risks, can the equilibrium be of the segmented-market form”.
Lack of a Viable Investment Portfolio
In most cases, investors are often driven by the desire to get higher returns by investing in company shares as opposed to a risk-free venture. Because of this motive, most companies are usually faced with the challenge of looking for the most viable investment portfolio to accommodate shareholder interests. Sometimes, a company may be required to generate investment returns at the rate of 8% or above (for example) as a basic requirement before it considers using money in any given investment portfolio. This action normally has its own implications as is explained by (Michael 2011, p. 5) who affirms that:
“each time a company has surplus cash in its account, it should consider new investment projects to create more value for investors. If the company fails to produce value (at 8%), investors will gradually sell the company’s shares to buy another one and the company’s stock value will eventually drop”.
However, some situations may arise whereby the company has surplus money in its coffers but doesn’t see any viable investment portfolios it can invest this money to give it returns of up to 8%. This is the time when companies choose to issue dividends to maximize their dividend payment expectation. This normally works when the shareholder, having been issued with dividends, goes out to look for viable platforms of investment to maximize their shareholder value expectation of 8%. In other words, the responsibility of generating returns of more than 8% shifts from the company to the shareholders. This is the most logical alternative companies normally have when the money market fails to generate returns of more than 8% (in this case) (Michael 2011, p. 5).
In some cases, when the markets are poorly performing or when there is very little room for any excess capital investments, many companies opt to pay dividends as a method to get rid of excess cash. However, companies which fail to pay dividends should not be assumed to be poorly performing (as people would like to believe) because most of the time, companies which have very little room for expansion pay the most dividends and this explains why companies experiencing stunted growth pay the highest dividends (Kennan 2011, p. 3).
Discipline
It is a little known fact but researchers have noted that dividend payment is normally used by some company managers as a disciplinary tool to check their managerial actions and positively influence their decision making ability (Investopedia 2010). Investopedia (2010) further attests to this fact by stating that: “Holding on to profits may lead to excessive executive compensation, sloppy management, and unproductive use of assets” (p. 6). Further studies point out the fact that most managers are likely to erode shareholder value when they hold on to large amounts of cash because the chances that they may overpay or fail to effectively negotiate for new acquisition is high (Investopedia 2010). In fact, it has been affirmed that companies which pay dividends to shareholders are very efficient in the manner in which they utilize company resources but those which fail to do so are rather sloppy and ineffective (Investopedia 2010). In today’s century, many managers have noted this fact and are using dividend payment as a tool to streamline resource utilization because it enables them properly use their capital resources (Investopedia 2010). Investopedia (2010) further explains that “Let’s face it; managers can be awfully creative when it comes to making earnings look good but with dividend obligations to meet twice a year, manipulation becomes that much more challenging” (p. 11).
Conclusion
Dividend payment is normally a debatable issue for most companies but frankly, it largely represents the public responsibility by managers to its shareholders. From this study, we can deduce the fact that most companies pay out their dividends (or not) depending on the stage of growth they are in. Companies that pay out dividends are majorly experiencing slow stages of growth but companies that fail to pay high dividends are probably experiencing high growth. These factors withstanding, we conclude that dividend payment is normally used as a managerial tool by most companies to improve their brand image and improve the overall attractiveness of the firm (with regards to investor activities). We can also conclude that dividend payment is normally used by some managers as a tool to improve resource allocation and efficiency in the organization. Upon analyzing existing literature we also find out that dividend payment is used by most companies to draw the line between shareholder and management responsibilities, in addition to minimizing expansionary risks during periods of growth. Comprehensively, we can conclude that these are the major reasons why companies choose to pay dividends to their shareholders.
References
Auerbach, A. (1979) Wealth Maximization and the Cost of Capital. Quarterly Journal of Economics, 93(8), 43-46.
Bradford, D. (1979) The Incidence and Allocation Effect to a Tax on Corporate Distributions. NBER Working Paper, 349(5), 1-5.
Feldstein, M. (1979) Why Do Companies Pay Dividends. Web.
Investopedia (2010) Why dividends Matter. Web.
Investopedia. (2011) How And Why Do Companies Pay Dividends? Web.
Kennan, M. (2011) Why do Companies Pay Dividends. Web.
King, M. (1977) Public Policy and the Corporation. London, Chapman and Hall, Ltd.
Luo, Y. (1999) Entry and Cooperative Strategies in International Business Expansion. London, Greenwood Publishing Group.