Dividends: Relevant or not?

Dividend Policy is the determination of the distribution of profits generated by the company to its shareholders (Arnold, 2013). This is usually done in the form of dividends and is often paid out twice a year, one after the publication of interim results and the other after the year end.  However, companies are under no obligation to do so.

Dividend Policy has sparked much debate with some authors arguing dividends are essential in maintaining company value and others deeming them irrelevant to the firm’s value and consequently shareholder wealth. The Norwegian oil and gas producer, Statoil, recently announced that it would be continuing its dividend policy despite a drop in operating income (Bloomberg, 2015), caused by falling oil and gas prices. Therefore, I will be considering whether it is really necessary for Statoil to maintain its dividend policy during these tough business conditions. 

The two opposing arguments of dividend policy are briefly presented below:

·         Miller and Modigliani (1961) proposed that in a perfect world (and in turn making many assumptions) dividend policy is irrelevant to shareholder wealth. They argued that a company’s investment policy determines the valuation of a company, as investment decisions are responsible for the company’s future profitability.

·         Whereas, Gordon (1959) contended this by presenting the ‘bird in the hand’ theory – that investors prefer to receive a dividend payment now as future capital gains are uncertain. Therefore, if dividends are the preferred choice for shareholders, dividend policy has a role in determining the value of a company.

Last month, Statoil announced that its 4^th quarter net operating income was NK 9bn, significantly lower than its forecasted income of NK 26.3bn (Bloomberg, 2015). The newly appointed CEO, Eldar Saetre attributed this to the recent drop in oil and gas prices, which he believes to have fallen by approximately 10%. Eldar says Statoil are taking steps to combat this problem and improve their position by cutting capital expenditure by $2bn (Bloomberg, 2015). However, he confirmed that Statoil will not cut their dividend and are ‘highly committed’ to their policy. The dividend will remain at a flat rate for the next 3 years which he thinks reflects the current market environment but continues to offer a competitive rate (Bloomberg, 2015).

It could be argued that Statoil are maintaining their dividend policy despite these tough business conditions as they believe the value of their company could otherwise be negatively impacted. As mentioned before, the ‘bird in the hand’ theory presented by Gordon (1959) suggests that dividends are preferable to capital gains because of their unpredictable nature. Investors favour dividends as it means they receive cash now rather than leaving their money tied up in uncertain investments. Therefore, the dividend policy of a company will influence its market value (Gordon, 1959). For example, if Statoil decided to reduce its dividend payment, investors may decide to sell their shares and buy stocks in another company paying a higher dividend which would cause Statoil’s share price to deteriorate.

This relates to the informational content of dividends. As investors don’t have access to internal information an asymmetry of information exists (Arnold, 2013). Shareholders see dividends as providing them with information regarding a company’s performance and future prospects. A high dividend will signal good news to the investor, whereas a declining dividend can indicate that directors have a pessimistic view of the company’s future (Arnold, 2013). Also, Baker, Powell and Veit (2002) suggest that firms that decrease cash dividends should experience negative price reactions. Therefore, Statoil obviously do not want investors to lose confidence in the future of their shares, therefore have decided to maintain their dividend despite the drop in income.

Conversely, a criticism of this thought is that high dividends could indicate a lack of positive NPV investment projects and therefore lower future returns for shareholders (Watson & Head, 2013). However, Statoil insist they are continuing to invest in a high quality portfolio and have approved many projects in recent years and still have upcoming projects planned (Bloomberg, 2015) which suggests that the high dividend payment is not covering up for a lack of future investment projects – good news for investors!

As shown in the table below, Statoil have maintained their cash dividend at NK 1.80 per share since quarter 1 of 2014.

Quarter	Cash dividend (NOK)	Announcement date	Payment date
1Q 2014	1.8	29.04.2014	05.09.2014
2Q 2014	1.8	25.07.2014	05.12.2014
3Q 2014	1.8	29.10.2014	05.03.2015
4Q 2014	1.8	06.02.2015	04.06.2015

(Dividend figures sourced from - http://www.statoil.com/en/InvestorCentre/Share/DividendPolicy/Pages/DividendAmounts.aspx)

This appears to be the right approach for Statoil as the graph constructed below shows that their share price has remained reasonably steady over the past six months, indicating that shareholders on the whole are happy with the decision and have not chosen to invest elsewhere.

 

(Share price figures sourced from - http://www.statoil.com/en/investorcentre/share/pages/historicshareprices.aspx)

However, Reuters (2015) reported that analysts have suggested that Statoil should reduce or even suspend their quarterly dividend, warning that the low oil prices are draining its cash. Statoil have already had to sell some of their assets to cover their spending.

When following the argument of Miller and Modigliani it could be claimed that Statoil’s share price would not have been affected if they had chosen to reduce or even suspend their dividend as dividend policy has no beneficial impact on shareholder wealth (Baker et al., 2002). The timing of dividend payments is irrelevant and investing in projects with positive NPVs is of greater concern in securing future success. Miller and Modigliani (1961) conclude that share valuation is independent of the level of dividend paid by the company.

Miller and Modigliani suggested that investors who are rational, are indifferent to whether they receive capital gains or dividends on their shares. What is most important is that the company maximises its value by adopting an optimal investment policy – investing in all projects with a positive NPV (Watson & Head, 2013). Saetre, the CEO, emphasised that project quality must remain high (Reuters, 2015), indicating that Statoil are adopting a good investment policy. Therefore, it could be concluded that it is not necessary that Statoil continue to maintain their divided policy and should instead focus on investments to secure future value for the company.

However, it must be noted that the theory is based on many assumptions; Miller and Modigliani frame their paper on a perfect capital market with rational investors (Baker et al, 2002). And also assume no transaction costs or taxes – in reality we live in a very different world!

To conclude, I agree with the idea proposed by Miller and Modigliani that investment decisions are key to a company’s profitability and these will be essential to Statoil in improving their future income. However, as Baker et al (2002) argue, market imperfections such as information asymmetries, agency problems and transactions costs to name but a few, may make the dividend decision relevant. Therefore, I can most identify with the ideas of Gordon (1959) in the case of Statoil, as failing to pay a dividend may result in investors losing confidence in the business and exiting, which would ultimately leave Statoil in a worse position.

I believe companies should aim to provide a stable dividend with stable growth as this is most likely to be sustainable in the future. This conservative approach allows managers to set dividends at a low enough level to ensure they can maintain future pay-outs but should also provide shareholder satisfaction so they don’t look elsewhere for higher returns – the perfect balance!

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

Baker, H.K., Powell, G.E. & Veit, E.T. (2002). Revisiting the dividend puzzle – Do all the pieces now fit?, Review of Financial Economics, 11(4), 241-261. Doi: 10.1016/S1058-3300(02)00044-7

Bloomberg. (2015, February 6). Statoil CEO Says `Highly Committed' to Dividend Policy. Bloomberg. Retrieved from http://www.bloomberg.com

Gordon, M.J. (1959). Dividends, earnings and stock prices. Review of Economics and Statistics, 41(2), 99-105. Retrieved from JSTOR http://www.jstor.org

Miller, M.H. & Modigliani, F. (1961). Dividend Policy, Growth and the Valuation of Shares. Journal of Business, 34 (4), 411-433. Retrieved from JSTOR http://www.jstor.org

Reuters. (2015, January 8). UPDATE 1-Statoil CEO sticks to dividend policy despite low oil prices. Reuters. Retrieved from http://uk.reuters.com

Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.

 

Capital Structure – Is it possible to create the optimal capital structure?

As discussed previously, the main aim of a company is to maximise shareholder wealth. With this in mind, is it possible to achieve increased wealth for shareholders by changing the company’s capital structure? In simple terms, a firm can choose to finance their business through a mixture of debt and equity, but to what ratio? This is an issue I will explore, using current examples to highlight the different choices and preferences of certain businesses.

The optimal capital structure debate centres on the question of whether a company can minimise its cost of capital by adopting a particular combination of debt and equity finance. Companies seek a lower WACC as this is a fundamental determinant of market value; cost of capital is used as the discount rate in investment appraisal decisions (Watson & Head, 2013). Therefore, it is an important figure as it can determine a company’s strategic option set, in effect influencing future cash flows of the firm.

Norwegian oil producer, Det Norske Oljeselskap ASA, is currently trying to create an optimal capital structure (Holter, 2015) in order to restore wealth to shareholders. This is because share price has deteriorated over the past year as shown in the graph i have constructed below. A net loss of $287m was reported in the fourth quarter due to the significant drop in oil prices recently (Holter, 2015), causing the company to consider both sources of financing. CEO Karl Johnny Hesvik said the company would be able to raise more debt and may also issue new shares (Holter, 2015).

(Share price figures sourced from https://uk.finance.yahoo.com/q/hp?s=DETNOR.OL&b=9&a=03&c=2014&e=10&d=03&f=2015&g=w)

However, equity and debt both have their benefits and drawbacks. Firstly, issuing shares on the stock exchange can result in relatively hefty transactions costs. Equity finance is also considered highly risky; investors have no guarantee of either dividend payments or capital gains. They are also ranked lowest on the creditor hierarchy should the company go into liquidation (Watson & Head, 2013). Due to these uncertainties faced by the investor, a higher return is demanded to compensate for the risk taken, increasing the cost of equity capital.

Contrastingly, lenders require a lower rate of return than ordinary shareholders, due to finance providers having secure claims on income (interest payments) and in liquidation (Arnold, 2013). Moreover, further benefits include the tax advantage and much lower transaction costs than issuing shares (Arnold, 2013). Therefore, debt is a much cheaper source of finance than equity.

Taking these factors into consideration, you would assume maximising shareholder wealth through capital structure is simple – just load up on debt as it has a lower cost than equity. Job done!!

But why then do companies continue to finance through issuing shares? For example, last week the UK furniture chain DFS returned to the stock market after privatisation in 2004 (BBC News, 2015). DFS are seeking to expand internationally and view floating on the stock exchange as a valuable way of securing finance, expecting to raise £105m by floating 25% of the private equity-owned company (Monaghan, 2015). They plan to use the capital raised to reduce their current debt and provide access to a lower cost of financing (Chapman, 2015). This highlights the issue of acceptable levels of gearing, which companies must take into account when considering their capital structure.

Increasing levels of debt can increase risks. Although debt decreases WACC as it’s a cheaper source of finance, the cost of equity actually increases as shareholders will demand higher returns for the risks they are taking (Arnold, 2013). Investors view increased gearing as risky as the financial risks a business takes are amplified and the risk of financial distress and ultimately liquidation increase. Therefore WACC will increase, reducing the value of the company and shareholder wealth (Arnold, 2013).

I believe DFS may have wanted to reduce their levels of risk and financial distress by issuing shares on the stock exchange- a period of expansion could mean uncertain times ahead for the company. So a reduction in debt and therefore interest payments will be beneficial and DFS will also be under no obligation to pay shareholders dividends. However, DFS have been cautious and set their share price at the lower end of the market range, this reduces the value of the company to £543.2m, despite initially valuing the company at £585m (Chapman, 2015). This could reflect the fact that there is still debt in the balance sheet and investors may be weary of this.

Nevertheless, Nobel Prize winners Miller and Modigliani (1958) suggested that a company’s capital structure has no impact on the WACC and value of a firm. Thus, advising that no optimal structure exists. Miller and Modigliani (1958) argued that as the cost of equity rises with the level of gearing, the increase is exactly offset by the cost of debt being lower, constant and a larger proportion of the capital structure. This implies that both Det Norske and DFS could choose to load up on debt and their WACC would remain the same, despite investor’s worries of financial distress.

But their theory was widely criticised for being based on many assumptions such as perfect efficient markets existing, no tax and also no costs of financial distress (Miller & Modigliani, 1958). They later published updated versions that took into account the effect of tax (1963) and financial distress (1971) and their theory dramatically changed, suggesting an optimal structure was possible.

To conclude, I believe that an optimal capital structure does exist. However, there is not one set combination, I think it will vary from company to company depending on investors and managerial preferences. The current economic climate and situation of the business will also influence this structure. For example, since the financial crisis many managers have become more cautious of the level of borrowing their firm undertakes (Arnold, 2013) and I believe this is the case with DFS, choosing to source finance through equity rather than debt. As the dramatic drop in oil prices and industry conditions will influence Det Norske’s choice of future capital structuring.

Furthermore, companies are beginning to consider alternative methods of finance that managers perceive to involve less risk. BBC News reported that many Northern Irish start-up firms were choosing to by- pass the banks to finance start-ups and expansions and instead favour methods such as Crowdfunding, with 4% of the UK's small business funding coming from this source last year (BBC News, 2015). These new emerging methods may be preferred by investors as they see crowdfunding as lower risk than lending from the bank.

 

References

Arnold, G. (2013). Corporate Financial Management. (5^th ed.), Harlow: Pearson.

BBC News. (2015, March 6). Furniture chain DFS returns to stock market. BBC News. Retrieved from http://www.bbc.co.uk/news/business

BBC News. (2015, March 8). Alan Watts: NI start-up firms 'bypassing banks' says leading entrepreneur. BBC News. Retrieved from http://www.bbc.co.uk/news/business

Chapman, M. (2015, March 6). DFS valuation drops £40m as it sets share price at lower end of range. Retail Week. Retrieved from http://www.retail-week.com

Holter, M. (2015, February 25). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Bloomberg. Retrieved from http://www.bloomberg.com

Miller, M.H. & Modigliani, F. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48(3), 261-297. Retrieved from JSTOR http://www.jstor.org 

Monaghan, A. (2015, February 6). DFS Furniture to float on stock market. The Guardian. Retrieved from http://www.theguardian.com
Watson, D. & Head, A. (2013). Corporate Finance: Principles and Practice. (6^TH ed.), Harlow: Pearson.