Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 17 Returning value to shareholders: the dividend decision 455
■
Dividends as a residual
The dividend decision is simply the obverse of the investment decision. As observed
earlier, we are examining the impact of one of the various ways in which proposed
After a long spell in the cold,
the dividend is making a come-
back.
Bankers say there is such pres-
sure on companies to hand back
cash to shareholders that some
are forsaking the lurid world of
acquisitions as a result.
Yesterday, French Connection
showed its commitment to the
dividend with a 20 per cent half-
year increase, double the rate of
earnings growth, in spite of head-
winds in the UK high streets.
Redrow, the housebuilder, also
raised its dividend by 20 per cent
and pledged to do the same for
the next three years even if the
housing market cools.
Merrill Lynch, meanwhile, said
yesterday that, for the second
month running, its monthly sur-
vey of 290 global fund managers
showed more preferred companies
to return them cash than increase
capital spending or improve bal-
ance sheets.
This represented a significant
change from 2002 and 2003,
which is as far back as Merrill’s
survey goes.
‘It’s a story that’s still gather-
ing momentum,’ says David
Bowers, Merrill’s chief global
investment strategist. ‘The econ-
omy isn’t strong enough to justi-
fy increased capex but it isn’t
really weak enough to persuade
companies to rebuild their bal-
ance sheets.’
The watershed for dividend
payments came from the US this
summer, when Microsoft risked
its long-held rating as a growth
company by agreeing to pay $32
bn in a special dividend this year,
and $44 bn in buy-backs and an
enhanced dividend over the next
four years.
Mr Bowers says the strength of
demand for dividends from US
investors is such that it has even
overridden a tax break the Bush
Administration offered compa-
nies to boost capital spending.
Bankers say the UK is far
ahead of its European counter-
parts in getting the message.
The backdrop was the period of
balance sheet repair that went on
after the dotcom collapse, which
has put much of corporate Britain
on a more sound fiscal footing.
Once again, however, there is
concern about the economic out-
look and the risk the money will
be squandered on ill-conceived
mergers and acquisitions.
In boardrooms, the debate on
what to do with cash on the bal-
ance sheet is often a tense one.
For executives, returning it to
shareholders is not necessarily
the virile growth sport they are
used to. Often, the non-executive
directors will have to fight the
shareholders’ corner.
Paul Gibbs, a banker at JP
Morgan, says it is unclear how
much cash UK companies are
giving back to their shareholders
and believes it should be more –
especially as they are not spend-
ing it on takeovers.
‘UK companies are accumulat-
ing a lot of cash and we can’t tell
where it’s going. It’s sitting on
the balance sheet, which is why
investors, quite rightly, are ask-
ing for it back,’ he says.
However, returning too much
cash to shareholders can carry
risks. It is all very well for com-
panies to liquidate their cash bal-
ances to please investors but not
if that jeopardises their ability to
compete on the global stage.
The dividend, after all, symbolis-
es a more parochial era of busi-
ness, when companies steered a
steadier path, and shareholders
were more interested in total
return than surging capital values.
Justin Urquhart Stewart, a
director at Seven Investment
Management, worries that
today’s business leaders may not
be equipped for such an era.
‘There’s been a management
trend to buy things. The fear I
have is that it’s a different style
of management to run a business
that’s a cash cow,’ he said.
That style of management also
involves executives whose pay
packets are often linked to rising
share prices more than the divi-
dend or total shareholder returns.
Over the long-term, the com-
pounding of dividends has pro-
duced steadier value for
shareholders than the vagaries
of capital appreciation, he says.
Dividends might not look as
alluring in the shop window but
at least they keep you warm
when winter sets in.
Source: Henry Tricks, Financial Times, 15 September
2004.
Self-assessment activity 17.3
How can dividend policy damage shareholder interests when no external financing is
available?
(Answer in Appendix A at the back of the book)
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456 Part V Strategic financial decisions
investment may be financed. Divicut is a case where the company is forced to retain
funds through lack of alternative financing options. With the explicit assumption that
the firm is capital-rationed with access only to internal sources of finance, we can illus-
trate the residual theory of dividends.
This argues that dividends should be paid only when there are no further worth-
while investment opportunities. Having decided on the optimal set of investment
projects, and determined the required amount of financing, the firm should distribute
to shareholders only those funds not required for investment financing. This idea is
shown graphically in Figure 17.2, using the marginal efficiency of investment (MEI)
model. The MEI traces out the rate of return on the last invested, and thus shows
investment opportunities ranked in declining order of attractiveness.
With free cash flow of there is scope for dividend payments. The limit of
worthwhile new investment is at X, where the return on the last unit of investment is
equal to the minimum required return The company can now make residual divi-
dend payments of However, if the free cash flow is only distribution would
impose an opportunity cost on shareholders. The whole cash flow should be reinvest-
ed, but it falls short of the finance required to support the optimal programme. The
shortfall is which could only be plugged by external financing if available.E
1
X,
OE
1
,XE
0
.
k
e
.
OE
0
,
£1
Optimal investment
level
k
e
=
R
Marginal
efficiency of
investment
(MEI)
Amount of funds
0
E
1
X
E
0
k
e
Rate of return (%)
Figure 17.2
Dividends as a residual
Self-assessment activity 17.4
What dividend, if any, should the firm pay in the following situation? Earnings are
per cent.
Project Required outlay IRR
A 18%
B 16%
C 14%
D 10%
(Answer in Appendix A at the back of the book)
£200,000
£700,000
£400,000
£300,000
£1 million, k
e
12
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Chapter 17 Returning value to shareholders: the dividend decision 457
■
External equity financing: yet more Divicut
We now consider the case where the firm has access to external financing. Rather than
use earnings retention to finance investment, the firm may make a rights issue of
shares, i.e. offer existing shareholders the right to buy new shares in proportion to their
present holdings. If they all exercise their rights, the existing balance of control is
unchanged, i.e. everyone ends up holding the same share of the firm. To sustain the
irrelevance conclusion, we need to show that shareholder wealth is unaffected by
choice of financing method, retention or new issues.
Consider the case where Divicut contemplates a one-off dividend cut to finance a
project that requires a cash outlay of and offers perpetual earnings of p.a.
The shares are not yet quoted ex-dividend. The options are to:
1 Retain the earnings.
2 Pay the dividend out of earnings and then recoup the cash via a rights issue.
The project itself is worthwhile, since its NPV is:
The implications for shareholder wealth of each financing alternative are respec-
tively:
1 If the dividend is passed, the value of shareholder wealth is:
Retention therefore benefits Divicut’s shareholders, since now is exchanged
for a dividend stream with present value of
2 If a rights issue is used to recoup the required capital, the wealth of shareholders is:
Shareholders’ wealth is unaffected if they subscribe for the new shares, anticipating
the higher future stream of dividends implied by the new venture. The attraction of the
rights issue to some people is that it offers a choice between further investment in the
company and an alternative use of capital (although this second option may be irra-
tional if accurately measures the opportunity cost of capital). Either way, in practice,
companies often ensure they obtain the required funds by employing specialist finan-
cial institutions to underwrite such issues as seen in Chapter 16.
■ Summary
This section has demonstrated that dividends are relevant to company valuation in the
absence of external financing, but only in the sense that, if the company has better invest-
ment opportunities than its shareholders, payment of dividends prevents worthwhile
investment. With external financing, however, in a perfect capital market, dividends
k
e
1£1,000 £10,000 £2,0002 £1,000 £12,000
£1,000
£1,000
0.1
£200
0.1
£1,000
1amount subscribed for new shares2
1PV of dividends from new projects2
W
o
1dividend in year 02 1PV of dividends from existing projects2
£2,000.
£1,000
0
£1,000
0.1
£200
0.1
1£10,000 £2,0002 £12,000
1PV of dividends from new projects2
W
o
1dividend in year 02 1PV of dividends from existing projects2
1W
o
2
NPV £1,000
£200
0.1
£1,000 £2,000 £1,000
£200£1,000,
CFAI_C17.QXD 10/28/05 5:16 PM Page 457
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458 Part V Strategic financial decisions
become totally irrelevant since dividend payment no longer precludes worthwhile
investment. The firm can simply recoup the required finance via a rights issue.
In the next section, we begin to unpick some of the assumptions underpinning the
irrelevance theory and consider the implications of doing so.
17.5 OBJECTIONS TO DIVIDEND IRRELEVANCE
This section examines some of the arguments advanced against the irrelevance theory.
Financial managers should weigh up several important considerations before deciding
upon the appropriate dividend payout policy:
■ To what extent do shareholders rely on dividend income?
■ Are nearer-in-time dividends less risky than future dividends?
■ Do market imperfections lead companies to adopt policies that attract a particular
clientèle of investors?
■ Would investors accept a rights issue?
■ How does taxation affect dividend policy?
Let us deal with these questions in turn.
■ Do shareholders rely on dividend income to support expenditure?
Shareholders who require a steady and reliable stream of income from dividends may
be concerned by a sudden change in dividend policy, especially a dividend cut, albeit
to finance worthwhile projects. Some groups of shareholders may well have a marked
preference for current income: for example, the elderly, and institutions such as pension
funds, which depend on a stable flow of income to meet their largely predictable lia-
bilities. However, in an efficient capital market, such shareholders should be no worse
off after a dividend cut, since the value of their holdings will rise on the news of the
new investment. They can realise some or all of their gains, thus converting capital into
income. The capital released is called a ‘home-made dividend’. (This is similar to the
‘equity release schemes’ whereby UK home-owners extract some of the value locked up
in their homes.) A worked example is given in the appendix to this chapter.
There are several criticisms of the validity of the home-made dividends mechanism.
Even in the absence of market imperfections, the investor is forced to incur the incon-
venience of making the required portfolio adjustments. Allowing for brokerage and
other transactions costs, the net benefits of the project for the income-seeking investor
are reduced. Also, if capital gains are taxed, the enforced share sale may trigger a tax
liability. In the case of only marginally attractive projects, these effects may be suffi-
cient to more than offset the benefits of the project, at least for some investors.
Conversely, it can be argued that payment of a dividend to investors who then incur
brokerage fees in reinvesting their income is equally disadvantageous.
■ Are future dividends seen as more risky by shareholders?
The practical limitations on the unfettered ability to home-make dividends were spelt out
by Myron Gordon (1963) in a ringing attack on MM’s irrelevance conclusion. However,
Gordon extended his critique of MM to argue that $1 of dividend now is valued more
highly than $1 of retained earnings because investors regard the (albeit higher) future
stream of dividends stemming from a new project as carrying a higher level of risk. In
other words, investors prefer what Gordon called an ‘early resolution of uncertainty’.
Gordon was, in effect, arguing that shareholders evaluate future expected dividends
using a set of rising discount rates. If present dividends are reduced to allow greater
investment, thus shifting the dividend pattern into the future, company value will fall.
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Chapter 17 Returning value to shareholders: the dividend decision 459
Keane (1974) refined Gordon’s position by suggesting that it is secondary whether,
in fact, future dividends are more risky than near ones. If investors perceive them to
be riskier, a policy of higher retentions, while not actually increasing risk, may
unfavourably alter investor attitudes. In capital markets where full information is not
released about investment projects, investors’ subjective risk assessments may result
in low payout companies being valued at a discount compared to high payout com-
panies: that is, investors’ imperfect perceptions of risk may lead them to undervalue
the future dividend stream generated by retentions.
The ‘bird-in-the-hand fallacy’
If the firm’s dividend policy does alter the perceived riskiness of the expected dividend
flow, there may be an optimal dividend policy that trades off the beneficial effects of an
enhanced growth rate against the adverse impact of increased perceived risk, so as to
maximise the market value. However, advocates of dividend irrelevance argue that
Gordon’s analysis is inherently fallacious. More distant dividends are more risky only
if they stem from inherently riskier investment projects. Risk will already have been
catered for by discounting cash flows at a suitably risk-adjusted rate. To deflate future
dividends for risk further would involve double-counting. There is no reason why risk
necessarily increases with time – a model based on this supposition incorporates the
‘bird-in-the-hand fallacy’. According to MM (1961), dividend policy remains a ‘mere
detail’ once a firm’s investment policy, and its inherent business risks, is made known.
Self-assessment activity 17.5
Why is Gordon’s ‘early resolution of uncertainty’ argument in favour of paying early divi-
dends logically flawed?
(Answer in Appendix A at the back of the book)
■ Market imperfections and the clientèle effect
The extent to which investors are willing and able to home-make dividends, and thus
adjust the company’s actual dividend pattern to suit their own personal desired con-
sumption plans, depends on the degree of imperfection in the capital market. In prac-
tice, numerous impediments, especially when aggregated, may significantly offset the
benefits of exploiting a profitable project. Some of these have already been mentioned,
but the main ones are as follows:
■ Brokerage costs incurred when shares are sold.
■ Other transaction costs incurred, e.g. the costs of searching out the cheapest bro-
kerage facilities.
■ The loss in interest incurred in waiting for settlement.
■ The problem of indivisibilities, whereby investors may be unable to sell the precise
number of shares required, forcing them to deal in sub-optimal batch sizes.
■ The sheer inconvenience of being forced to alter one’s portfolio.
■ Share sales may trigger a Capital Gains Tax liability.
■ If the company is relatively small, its shares may lack marketability, requiring a sig-
nificant dealing spread and hence a leakage of shareholder capital.
■ If the company is unquoted, it may be difficult or impossible to find a buyer for the
shares.
Under such imperfections, maximising firm value may not be the unique desire of
all shareholders; the pattern of receipt of wealth may become equally or more impor-
tant. Some shareholders may actively prefer companies that offer dividend flows
CFAI_C17.QXD 10/28/05 5:16 PM Page 459
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460 Part V Strategic financial decisions
which correspond to their desired consumption, perhaps being prepared to pay a pre-
mium to hold these shares. In this way, they avoid having to make their own adjust-
ments. The vehicle for aiding such investors is to provide a stable and known dividend
stream. Shareholders can then perceive the nature of the likely future dividend pattern
and decide whether or not the company’s policy meets their requirements. In other
words, the company attracts, and attempts to cater for, a clientèle of shareholders.
However, such a policy has costs, including the benefits forgone from projects that
have to be passed over, the costs of borrowing if debt finance is used, and/or the
issue expenses of a rights issue if external financing is employed. The implications for
control if rights are not fully exercised by the existing shareholders may be another
problem.
The key difficulty facing the financial manager is lack of knowledge of shareholder
preferences, without which it is difficult to balance the two sets of costs.
Table 17.2
Rawdon plc
■ 1m shares have been issued in the past ■
■
Market price per share is ■ Rawdon’s
■ Current company
■ Proposed investment
■ The project has a perpetual life.
■ Terms of rights issue:
One share for every five held, i.e. 200,000 new shares.
Purchase price
Issue costs: 5% of
Net
proceeds £950,000
gross receipts 10.05 £1 m2 £50,000.
gross proceeds £1 m£5:
outlay £950,000
earnings £1 m 1EPS £12
value £5 m£5
k
e
20%
Self-assessment activity 17.6
What is meant by a shareholder clientèle? Which shareholders are most likely to prefer
near-in-time dividends?
(Answer in Appendix A at the back of the book)
■ Problems with rights issues: Rawdon plc
In addition to the effect of a rights issue on share price, discussed in Chapter 16, the
costs of making rights issues can be substantial, and will affect the required return on
new investment. Among the costs are the administrative expenses, the costs of print-
ing brochures and circulation to shareholders, and also the underwriters’ fees. The
impact of these costs is examined using the case of Rawdon plc, whose details are
shown in Table 17.2.
Although Rawdon’s shareholders require a return of 20 per cent, the new project
has to offer a return of over 20 per cent. This is because some of the finance raised by
the share issue is required to meet the costs of the issue, but the holders of those shares
will nevertheless demand a return. Total share capital is now million, and earn-
ings of million are now required to generate a 20 per cent return overall.
However, the required increase in earnings of million must be generated by an
investment of necessitating a return of per cent.
Rawdon’s required return on this project is:
Normally required return
11 % issue costs2
k
e
11 c2
0.2
11 0.052
0.211, i.e. 21.1%
1£0.2 m>£0.95 m2 21.1£950,000,
£0.2
£1.2
£6
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Chapter 17 Returning value to shareholders: the dividend decision 461
However, the problem of transactions costs may operate in another direction. Some
shareholders, when paid a dividend, may incur some reinvestment costs. The higher
the proportion of investors who wish to reinvest, either in the same or in another com-
pany, the greater the total saving of brokerage and other fees enjoyed by shareholders
when the company retains earnings. Hence, the greater is the attraction of retained
earnings to finance investment.
Bearing in mind the impact on share price, the announcement of a rights issue is not
always greeted with delight. The shareholder is forced either to take up or sell the
rights in order to avoid losing money (even sale of rights will result in brokerage fees),
and thus incur the inconvenience involved. If the market takes a dim view of the pro-
posed use of the capital raised (for example, if the funds are required to finance a
takeover whose benefits look distinctly speculative), the share price may fall. But it is
important to realise that this would be a consequence of a faulty investment decision rather
than of the financing decision itself.
■ The impact of taxation
In many economies, the tax treatment of dividend income and realised capital gains dif-
fers, either via differential tax rates or via different levels of exemption allowed, or both.
In such regimes, the theoretical equivalence between dividends and retention becomes
further distorted. Typically, tax on capital gains is lower than tax on income from divi-
dends. In some countries there is no tax on capital gains. Some shareholders might pre-
fer ‘home-made dividends’ (i.e. selling shares) when the rate of Capital Gains Tax
(CGT) is lower than the marginal rate of Income Tax applied to dividends. Others may
prefer dividend payments because their Income Tax liability (plus any reinvestment
costs) is lower than CGT payments.
In addition to considerations of personal taxation, where the financial manager has lit-
tle way of knowing the particular tax positions of shareholders (a major exception to this
is the case of institutional investors), complications may also be imposed by the corporate
tax system. In an imputation tax system, shareholders receive dividend income net of
basic rate tax, while the rate of tax applied to corporate profits is designed to include an
element of personal tax, thus making the distribution of dividends tax-neutral.
There are so many different tax regimes operated throughout the world, that it is
difficult to generalise about the effect of taxation on dividend policy. However, the fol-
lowing simple example captures the flavour of some of the issues.
Barlow plc
Barlow plc is financed entirely by equity and its future cash flows have present value
of million at the start of 2006. During 2006, it earns million – for simplicity,
we assume that all transactions are in cash, so it now holds cash of Profits are
taxed at 30 per cent so Barlow must set aside million for tax payments, leaving
available for distribution. According to the EMH, the firm
will be valued at
Should Barlow distribute or retain? The answer depends on three factors:
■ shareholders’ marginal rates of tax.
■ the relative rate of tax on dividends vs. tax on capital gains.
■ The nature of the tax regime.
Under a classical tax system, profits are taxed twice if distributed, once simply as
profit tax, and secondly, as income tax paid by investors. Imagine the firm makes a full
distribution. Consider two rates of investor income tax:
(i) if investors pay tax at 10%, income tax is and the total tax
charge is (or 37% of pre-tax earnings).1£30 m £7 m2 £37 m
110% £70 m2 £7 m,
1£500 m £70 m2 £570 m.
170% £100 m2 £70 m
£30
£100 m.
£100£500
classical tax system
A system where dividends are
effectively taxed twice – the
firm pays profits tax and then
investors pay income tax on
any dividend payment
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462 Part V Strategic financial decisions
(ii) if investors pay tax at 50%, income tax is and the total
tax charge is (or 65% of pre-tax earnings).
It looks better to retain in the second case, but the decision also depends on the rate
of capital gains tax (CGT).
Assume the CGT rate is 20 per cent. If we also assume that the firm invests in zero-
NPV projects (unlikely, but a necessary assumption to strip out the effect of the invest-
ment decision), the value of the firm will have risen from million at start-year to
million at end-year. The CGT payable is thus Along
with the profits tax, the total tax payable is
Obviously, shareholders paying income tax at 50 per cent would prefer retention
and vice versa.
Under an imputation tax system, the relative attractiveness of distribution and
retention depends not only on the relative tax rates, but also on whether there is full
or partial imputation.
With full imputation, investors get full credit for corporate profits tax already paid.
In case (i) above, the investor would face no further tax on income and may even
get a tax rebate, depending on the tax regime, because the rate of corporate tax exceeds
the rate of personal tax.
In case (ii), the investor obtains credit for the corporate tax already paid, and thus
faces an additional income tax charge of With
these particular figures, investors would be indifferent between distribution and
retention.
With partial imputation, it is less clear-cut–the relative desirability of distribution
and retention depends on the degree of imputation, as well as the respective tax
rates.
Current UK rates
Under the present UK system of partial imputation, income from dividends and capi-
tal gains are taxed at the same rate, depending on the amount involved. But while there
is no apparent discrimination in favour of either form of income, the threshold at which the taxes
are payable are different.
Income tax on dividends
Dividends are paid net of tax, assumed payable at 10 per cent, thus generating a tax
credit. Current (2005–6) UK income tax rates applicable to gross dividend income are:
10% for gross (i.e. including, the tax credit at 10%)
dividend income of
and at 40% where total income exceeds
As the tax is applied to gross incomes, investors in the starting rate band of income
pay no further tax, taxpayers in the basic rate bracket pay a further 10 per cent, and
those in the higher rate band pay a further 32.5 per cent (to make their overall charge
40 per cent). Income tax becomes payable at incomes above but dividends are
treated as the top slice of income, thus bearing the highest rate of tax.
Capital Gains Tax
1 Gains above the threshold are taxed as if additional income at the following
rates:
– up to the starting rate limit 10%
– between and higher rate threshold 20%
– above the higher rate threshold 40%
1£32,4002£2,090
1£2,0902
£8,500
£4,895
£32,400.
£2,090–£32,400,
150% 30%2 £70 m £14 m.
1£30 m £14 m2 £44 m.
120% £70 m2 £14 m.£570
£500
1£30 m £35 m2 £65 m
150% £70 m2 £35 m,
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Chapter 17 Returning value to shareholders: the dividend decision 463
2 Gains up to 5.4.1998 are inflation-indexed, but indexation is frozen from that date.
3 Tapering relief applies on non-business assets as follows:
100% of gain chargeable for assets owned for 2 years or less
95% 3 years
60% 10 years or more.
■ The tax irrelevance thesis
Some argue that, under perfect capital markets, the question of relative tax rates is
irrelevant because of arbitrage. Zero/low rate taxpayers prefer to hold shares in
firms with high payouts, and those with high marginal rates of tax prefer low pay-
out firms. The process of tax-driven arbitrage would lead each group to bid up the
share prices of the firms whose distribution policy suits their own particular tax
positions, until in equilibrium, post-tax rates of return are equalised. This means
there is no share price advantage to be obtained from following a particular divi-
dend policy.
Elton and Gruber (1970) noted the importance of marginal tax brackets in deter-
mining the return required by shareholders. They defined the cost of using retained
earnings as ‘that rate which makes a firm’s marginal shareholders indifferent
between earnings being retained or paid out in the form of dividends’. Under differ-
ential tax treatments of dividend income and capital gains, the cost of using retained
earnings is a function of the shareholder’s marginal tax bracket. We might also expect
companies whose shareholders incur high rates of income tax to exhibit low payout
rates. Such a relationship between corporate dividend policy and shareholder tax
brackets would support the notion of tax ‘clientèles’, whereby companies seek to tai-
lor their payout policies to the tax situation of particular shareholders. Elton and
Gruber’s empirical work seemed to indicate that firms attract rational clientèles –
shareholders gravitate to companies whose distribution policy is compatible with their per-
sonal tax situations.
T
tapering down to:
T
17.6 THE INFORMATION CONTENT OF DIVIDENDS:
DIVIDEND SMOOTHING
Possibly the most important consideration for corporate financial decision-makers
when framing dividend policy is the information-processing capacity of the market.
Any dividend declaration can be interpreted by the market in a variety of ways. In an
uncertain world, information regarding a company’s prospects is neither generally
available nor costless to acquire. Managers possess more information about the com-
pany’s trading position than is available to investors as a whole. This so-called infor-
mation asymmetry may mean that the announcement of a new or changed company
policy may be interpreted by the market as a signal conveying particular information
about a company’s prospects, as in the Deutsche Telecom case overleaf.
For example, the decision to pay an unexpectedly high dividend may be seized
upon as evidence of greater expected dividend-paying capacity in the future. It may
be taken as guaranteeing an ability to sustain at least the higher declared dividend and
probably more. As a result, the financial manager should consider carefully how the
market is likely to decode the signals contained in the dividend decision, and the like-
ly consequences for share price.
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464 Part V Strategic financial decisions
Company finance directors (FDs) are well aware of the signalling power of divi-
dends and their capacity to influence share price. This awareness is implied by the
recent earnings and dividend record of BAA plc, shown in Table 17.3.
BAA’s EPS figures have increased by 70 per cent over the past dozen years, but
erratically, whereas the profile of dividend increases has been more regular. This
‘smoothing’ of dividends can be found among many other firms and has been identi-
fied empirically. Lintner (1956) showed that companies appear to raise dividends only
on the basis of reported earnings increases that they expect to be sustainable in the
Table 17.3
BAA plc: dividend
smoothing
*
Year EPS (p) % increase DPS (p) % increase
1993 20.90 13.8 8.00 10.3
1994 23.50 11.2 9.00 11.2
1995 27.20 11.6 10.125 12.5
1996 30.40 11.2 11.25 11.1
1997 28.30 (9.3) 12.40 10.2
1998 26.30 (6.9) 13.65 10.1
1999 37.50 42.6 15.00 9.9
2000 24.20 (35.5) 16.35 9.0
2001 37.70 55.8 17.70 8.3
2002 15.60 (41.3) 18.30 3.4
2003 35.30 262.8 19.00 3.8
2004 35.50 0.6 20.00 5.3
Average 24.4 8.8
Range: max 262.8 12.5
min (41.3) 3.4
304.1 15.9
Note: figures for the years 2001–2004 are not totally comparable will
those for 1993–2000 due to adoption of new Accounting Standards.
*
Deutsche Telekom: dividend resumption
signals recovery
FT
Deutsche Telekom has completed
its journey towards normality by
announcing an out of the norm
dividend. That marks a fitting
end to its recovery from its recent
debt-ridden past. Admittedly, the
fact that Telekom’s likely divi-
dend looks high for the sector
mainly reflects the stinginess of
its peers.
But at least, the dividend yield-
ing about 4 per cent offers some
reassurance that the German
operator itself believes in the
sustainability of recent cash gen-
eration. True, dividends would at
most only amount to ;2.6 bn,
against next year’s targeted free
cash flow of ;7.5 bn – ;8 bn before
discretionary expenditures. But
Telekom has already announced
it intends to spend up to ;6.9 bn
in 2005 on buying back its inter-
net subsidiary T-Online, as well
as acquiring additional spectrum
and regional networks in the US.
If debt is to be kept constant rela-
tive to underlying earnings, it will
need to have quite a solid year.
Fortunately, Telekom’s recent
operating performance looks
healthy enough. Cost savings are
starting to feed through, the US
business continues to grow and
margins in German mobile have
recovered. Some doubts remain
over the sustainability of these
trends, while revenues at the fixed
line business, Telekom’s main
cash-cow, continue to decline.
Increased efficiency is unlikely to
offset top-line pressures for ever
and Telekom’s plans for innova-
tive bundled offerings remain
rather vague. But, at least com-
pared with the broader market, its
shares retain some attractions.
Source: Lex column, Financial Times, 11 November
2004.
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