Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 17 Returning value to shareholders: the dividend decision 465

long term. In a survey of 179 Finance Directors of large quoted companies conducted

by 3i (1993), 43 per cent said that the single most important factor influencing divi-

dend policy was prospective long-term profit growth, while 93 per cent agreed with

the statement that ‘dividend policy should follow the long-term trend in earnings’.

When dividend increases lag behind increases in EPS, the payout ratio falls and vice

versa. However, average payout ratios have risen in recent years, owing to a number

of factors:

1 Increasing corporate profits.

2 Hence, increased confidence in companies’ ability to sustain dividends.

3 The increasing pressures exerted by the ever-more powerful institutional investors,

especially the tax-exempt funds.

4 The use of pre-emptive dividend increases to ward off takeover raiders.

5 The tax changes of 1988, which largely removed the tax discrimination for higher-

rate taxpayers in favour of retentions.

So do companies ever cut dividends? Obviously, in adversity, dividend cuts are

forced on firms in order to preserve cash. In the 3i survey, 55 per cent of FDs agreed

with the statement that ‘any cut in dividend payout sends adverse signals to the mar-

ket and should be avoided’. Dividend-cutting is far more common in the USA than in

the UK. Empirical work by Ghosh and Woolridge (1989) suggests that even when this

was motivated by the need to conserve funds for investment purposes, shareholders

suffered significant capital losses, despite the merits claimed for the proposed invest-

ments. In the UK, it is almost unheard of (almost - but remember the Monsoon case at

the start of the chapter) for companies to cut dividends to finance investment – the

dividend payment-plus-rights issue is invariably the preferred alternative. In the 3i

survey, one FD said that ‘a dividend cut is a sign of fundamental management failure

– when management fails and the Board should change’.

17.7 ALTERNATIVES TO CASH DIVIDENDS

The motive for cutting a dividend is to save cash outflows. This suggests that liquidity

considerations are another influence on the dividend decision. This section discusses

how firms that wish to preserve liquidity can still offer ‘dividends’, and also how firms

can cope with excessive liquidity. Alternatives to cash dividends are thus divided into

those that preserve liquidity and those that reduce liquidity.

■ Liquidity-saving alternatives

(i) Scrip dividends

Most major companies offer shareholders scrip dividends. This is an opportunity to

receive new shares instead of a cash dividend payment. It has certain advantages for

both the shareholder and the company.

From the firm’s point of view, the scrip alternative preserves liquidity, which may

be important at a time of cash shortage and/or high borrowing costs, although it could

face a higher level of cash outflows if shareholders revert to preference for cash in the

future. With more shares issued, the company’s reported financial gearing may fall,

possibly enhancing borrowing capacity. In this respect, the scrip dividend resembles a

mini-rights issue.

For shareholders wishing to expand their holdings, the scrip is a cheap way into the

company as it avoids dealing fees and Stamp Duty. A scrip dividend has no tax advan-

tages for shareholders as it is treated as income for tax purposes.

In an efficient capital market, there is no dilution effect on the share price, because

it would have fallen anyway with a cash dividend because of the ‘ex-dividend effect’.

CFAI_C17.QXD 10/28/05 5:16 PM Page 465

466 Part V Strategic financial decisions

However, if the additional capital retained is expected to be used wisely, the share

price may be maintained or may even rise, giving shareholders who elect for the scrip

dividend access to higher future dividends and capital gains. As a result, there may be

a longer-term tax advantage for shareholders. However, most of these effects are mar-

ginal. Perhaps the main benefit of a scrip dividend is that, by giving shareholders a

choice, it makes the shares more attractive to a wider clientèle.

(ii) Enhanced scrip dividends

To overcome the low take-up rate of scrip dividends, in 1993, several companies with

chronic liquidity problems began to offer ‘enhanced scrip dividends’ (ESDs). The first

was BAT Industries (www.bat.com), which announced a scrip alternative 50 per cent

above the equivalent cash dividend, designed to be so generous that shareholders

could not refuse. BAT declared a 22.6p final dividend, and then, later that month,

offered an ESD alternative of 33.9p. Had all of BAT’s shareholders taken up the ESD,

the cash saving would have been million.

The ESD mechanism is a rights issue in disguise. To the extent that shareholders

take the scrip alternative, the company is left with as much cash as if it had paid a cash

dividend and then clawed it back from the same shareholders via a rights issue. As

with a rights issue, the number of shares issued will rise. Finally, because the scrip is

voluntary, the control of shareholders taking cash is diluted.

£423

Self-assessment activity 17.7

How many shares would an investor receive in lieu of cash dividends of if offered:

(i) a pro rata scrip alternative?

(ii) an ESD of 20%?

Share price is

(Answer in Appendix A at the back of the book)

£20.

£1,000

Due to tax changes enacted in 1997, some firms experienced a sharp rise in the take-

up rate of scrips – e.g. some 20 per cent of Boots plc’s dividend outflow was in scrip

form. This was unpalatable to firms that were concerned about the effect on the total

number of shares issued by the company, e.g. it reduced the scope for any future rights

issue.

In April 1998, GKN plc (www.gkn.plc) responded to this problem by withdrawing

its scrip dividend scheme because ‘recent changes in tax legislation affecting institu-

tional shareholders make it more likely that a scrip dividend could lead to the issue of

large numbers of new shares which, we believe, is not in shareholders’ best interests’.

Instead, GKN introduced its Dividend Re-investment Plan (DRIP) as from May 1998,

whereby shareholders can purchase existing shares of equivalent value to the cash div-

idend at a preferential dealing cost (0.5 per cent of the dividend displaced). Many

firms now offer similar facilities.

Liquidity-reducing alternatives

The dividend decision is contorted by the case of companies with too much cash.

As an alternative to paying cash dividends, the facility to repurchase shares, sub-

ject to shareholders’ approval, was introduced in the UK by the 1981 Companies

Act. It resulted from pressure from the small firms lobby, concerned that low mar-

ketability of unquoted firms’ equity was hampering their development. Certain

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Chapter 17 Returning value to shareholders: the dividend decision 467

conditions were stipulated, designed principally to safeguard the position of

creditors, and further restrictions were imposed by the Stock Exchange and the

Takeover Panel, aimed at reducing the risk of market-rigging during takeover bat-

tles. The first major company to mount a buy-back was GEC in 1984, ostensibly to

raise the EPS of the remaining shares. A component of Marks and Spencer’s

defence package against a takeover bid in 2004 was share repurchase, designed to

raise the cost of the bid.

The Bank of England (1988) cited five possible reasons for repurchases:

■ To return surplus cash to shareholders.

■ To increase underlying share value.

■ To support share price during periods of temporary weakness.

■ To achieve or maintain a target capital structure.

■ To prevent or inhibit unwelcome takeover bids.

The hoped-for increase in share price works through the effect on EPS. A company

may attempt a buy-back when it has a cash surplus beyond what it needs to finance

normal business operations. This situation is assumed in Table 17.4, which shows the

before-and-after situation of a company sitting on a cash pile of million earning

interest at 5 per cent. It buys in 20 million shares at 180p, above the market price of

172p, the discrepancy being due to the required premium and the costs of buying the

shares. The total buy-back cost is therefore million, on which the company will

lose interest income.

In the UK (unlike the USA), when a company buys back shares it has to cancel

them. This suggests a problem with buy-backs – directors may buy in shares and

might subsequently have to make a rights issue, the costs of which are far higher than

those involved in repurchasing shares. US evidence suggests a strong signalling effect,

whereby executives can express confidence in their firms by investing in equity. Yet

there remains a strong suspicion in the UK that such messages are likely to be decod-

ed adversely. To many observers, buy-backs are tantamount to an admission of man-

agerial failure, signalling lack of confidence in their ability to identify and exploit

wealth-creating projects.

However, investment expenditure is rarely a continuous process and small buy-

backs may be a useful way of investing temporary cash surpluses, with the benefi-

cial effects on EPS and share price providing a platform for a subsequent rights

issue if development funds are needed. In addition, buy-backs may be a useful

alternative to paying higher but unsustainable dividends, while preserving choice

for investors.

£36

£100

Table 17.4

Analysis of a share

repurchase

Before After

Trading profit 200.00 200.00

Interest income at 5% 5.00 3.20

Pre-tax profit 205.00 203.20

Tax at 30% (61.50) (60.96)

Profits available for shareholders 143.50 142.24

Number of shares in issue 500 m 480 m

EPS (p) 28.70 29.63

P:E Ratio 6:1 6:1

Share price (p) 172 178

Cash balances 100.00 64.00

1£m2

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468 Part V Strategic financial decisions

Rosy view of share buybacks ignores paucity

of investment opportunities

First some good news: the under-

performing company whose

shares you have reluctantly been

holding has just announced a

share buyback.

So relax and watch the share

price rise, comfortable in the

knowledge there is a ready buyer

for at least part of your stake.

The problem is that this can be

a rose-tinted view of buybacks.

The practice, nevertheless, shows

few signs of losing its attraction

for investors.

A Merrill Lynch survey last

month found for the first time

that a majority of global fund

managers surveyed wanted cash

generated by companies returned

to shareholders through increased

share buybacks or dividends.

Continued

Self-assessment activity 17.8

Suggest some arguments against share repurchases.

(Answer in Appendix A at the back of the book)

Vodafone yesterday announced

an aggressive doubling of its div-

idend and a further increase in

its share buy-back programme in

a firm sign that the mobile oper-

ator has listened to shareholder

demands to increase its cash

payouts.

The company’s interim divi-

dend per share increased to

1.91p compared with 0.95p last

time and it said it expected to

double its full-year dividend,

also. The increases will take its

dividend pay-outs for the finan-

cial year to ($5.2 bn), giv-

ing it a healthy dividend yield –

based on yesterday’s share price

close – of about 3 per cent. The

mobile operator also raised its

share buy-back programme from

Vodafone reported a 6 per cent

rise in underlying group turnover

to for the six months to

the end of September as the

mobile operator continued to add

new users across its global cus-

tomer base.

The growth, slightly ahead of

consensus expectations, was

driven by 7.4 m customer addi-

tions in the first half, taking its

global proportionate customer

base to 146.7m.

The bigger-than-expected hike

in Vodafone’s dividend under-

lined the company’s continued

ability to deliver strong free cash-

flow. For the first six months, free

cash-flow across the group was

a 7 per cent decline on

the same period last year, partly

reflecting increased investment

in building its 3G network. Over

the period, the company deliv-

ered a pre-tax profit on ordinary

activities before exceptionals of

Group earnings before inter-

est, tax, depreciation and amorti-

sation (ebitda) were 6 per cent

higher at

Arun Sarin, chief executive,

said the increased pay-outs

would still give Vodafone free-

dom to pursue acquisition oppor-

tunities in the future and still

maintain its coveted A credit

rating.

He said he would ‘not be sur-

prised’ if Vodafone made an

acquisition in eastern Europe

over the next 12 months.

Mr Sarin expected to gain con-

trol of SFR, the French mobile

arm majority owned by French

media group Vivendi, in the long

term.

Ebitda margins across the

group were down to 39.7 per cent

compared with 40.5 per cent last

time as as sterling strengthened

over the period. Vodafone said it

expected ebitda margins to be

‘broadly stable’ between now and

the financial year ending March

2006.

At the end of September

Vodafone had 11.5 m higher

spending users on its Live con-

tent portal. The number of users

of its mobile datacard had more

than doubled to 323.000.

The revenue growth target for

the remainder of the financial

year rose to 10 per cent from

high single digits. For the year

to the end of March 2006, the

company expects high single-

digit growth in customers and

revenues.

Source: Robert Budden, Financial Times,

17 November 2004.

£8.3 bn.

£5.4 bn.

£4.3 bn,

£16.8 bn

£4 bn.£3 bn

£2.8 bn

Vodafone doubles its dividend pay-out

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Chapter 17 Returning value to shareholders: the dividend decision 469

‘With investors at the moment,

it’s a case of “show me the

money”,’ said David Bowers, chief

global investment strategist at

Merrill Lynch.

‘Many of them have given up

believing in global economic

growth, so if nothing better can

be done with the corporate cash,

they want it back,’ he said.

‘It’s the first time fund man-

agers have turned negative on

profits since April 2001. There’s a

veritable collapse in expectations;

they are abandoning corporate

earnings and focusing on cash.’

Certainly, shares in Germany’s

T-Online rose sharply this month

amid speculation that its parent

company, Deutsche Telekom, could

buy out minority shareholders in

the internet provider. The specula-

tion was spurred by management

changes at both companies, seen

as precipitating closer ties.

French retailer Carrefour

raised its investors’ spirits with

plans to revive its lacklustre stock

price, which has underperformed

sector peers this year amid wor-

ries over its sales and earnings

outlook. The company plans ;1 bn

of disposals and has pledged to

return cash to shareholders by

raising its dividend and buying

back shares.

Novartis, the cash-rich Swiss

drugmaker, launched plans last

month to buy back up to another

SFr3 bn of its own

shares. The scheme won approval

shortly after the company com-

pleted a SFr4 bn share repurchase

programme that began in 2002.

The company’s aim is to cancel

the shares it buys back and it

intends to reduce its share capital

next year by an amount correspon-

ding to the shares then repur-

chased under the new programme.

Daniel Vasella, Novartis chair-

man and chief executive, said at

the time that launching the new

share buyback programme

enabled the company to continue

returning surplus liquidity to

shareholders, ‘which is a result of

our dynamic organic growth and

robust free cashflow’.

Germany’s BASF, the world’s

biggest chemicals company by

sales, also plans to continue a

share buyback programme. It is

to repurchase of shares,

on top of the it bought in

the first six months of the year.

Not all repurchases run so

smoothly, however. An ill-judged

buyback by ABB, the Swiss-

Swedish engineering group, left

the company with a weakened

balance sheet and net debt of

$4.1 bn in 2001.

More recently, Switzerland’s

Ciba Speciality Chemicals called

a halt to its share buyback

programme, after buying up more

than 3 m shares. However, the 3m

shares represented only about 4

per cent of Ciba’s capitalisation.

The company said it stopped the

programme because of a lack of

interest by institutional investors

in selling their Ciba shares back

to the company. Ciba shares fell

about 15 per cent over the course

of the buyback.

Sharon Bell, regional strategist

at Goldman Sachs, has advice

about the impact of buybacks on

broader equity markets.

‘Do not expect share buybacks

to support equities,’ she says. ‘We

do not believe that share buy-

backs will be sufficient to lift the

European equity market. First

there is simply not enough money

to make a significant difference

and second, and more important,

share buybacks act as a signal

that no growth is available.’

Ms Bell says that while com-

pany balance sheets were rea-

sonably strong and cashflow

generation was high, companies

had been reluctant to use the

extra cash to invest in their own

businesses.

‘Returning funds to sharehold-

ers through dividends or share

buybacks has remained popular,

even as economies have recovered.

But what may be good for an indi-

vidual stock may not support

equities in aggregate.

‘For one thing, buyback pro-

grammes indicate a general lack

of growth opportunities.’

Source: Michael Morgan, Financial Times,

11 September 2004.

;300 m

;500 m

1;1.95 bn2

Cable and Wireless

Signalling confidence is a risky busi-

ness. Shares in Cable and Wireless

have been victims of overblown expec-

tations for much of this year. That

helps explain the enthusiastic market

reaction to the share buyback

of Britain’s second largest telecoms

operator, accompanied by yet another

restructuring package and a fairly

solid set of interim results.

Returning cash via share buybacks,

rather than a sharper dividend rise,

looks shrewd. The buyback, stretching

into C&W’s next fiscal year, signals

confidence without actually setting

Continued

£250 m

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470 Part V Strategic financial decisions

17.8 THE DIVIDEND PUZZLE

At a practical level, we encounter a dilemma known as the ‘dividend puzzle’. Dividend

cuts are undesirable, yet dividend payments may not always be in the best interests of

shareholders. For example, under many tax regimes, dividends are immediately

taxed, while the tax on capital gains can be deferred indefinitely. Dividend distribution

may force a firm subsequently to issue equity or debt instruments which incurs issue

costs and interferes with gearing ratios (see Chapter 18). However, markets do react

favourably to news of unexpectedly high dividend increases despite the acknowledged

costs of dividends. The message conveyed by firms when raising dividends seems to be:

Despite the cash flow costs of dividend payments, we are prepared to pay higher divi-

dends because we are confident of our ability to withstand these costs and at least to

maintain these higher disbursements.

■ The case for a stable dividend policy

Astute financial managers appreciate that different shareholders have different needs.

A financial institution reliant on a stream of income to match its stream of liabilities will

prefer stable dividends, while a ‘gross fund’ (i.e. one exempt from tax on its income)

will prefer shares that offer a high level of dividends. The private individual in the

40 per cent tax bracket will prefer capital gains, at least up to the exemption limit

(2005–06), while the old-age pensioner with a relatively short time horizon is likely to

seek income rather than capital appreciation.

Given the wide diffusion of shareholdings, it is almost impossible for most financial

managers to begin to assess the needs of all their shareholders. This is a powerful argu-

ment for a stable dividend policy, e.g. the application of a fairly constant rate of divi-

dend increase, implying that dividends rise at the same rate as corporate post-tax

earnings, subject perhaps to the proviso that dividends should not be allowed to fall,

unless earnings suffer a serious reverse. This will enable shareholders to gravitate

towards companies whose payout policies suit their particular income needs and tax

positions. In this way, companies can expect to build up a clientèle of shareholders

attracted by a particular dividend pattern. Hardly surprising, then, that 75 per cent of

FDs in the 3i survey said that ‘Companies should aim for a consistent payout ratio.’

£8,500

too high a hurdle for the future. It will

also improve balance-sheet efficiency,

given C&W has net cash of

(excluding about in unfunded

pension liabilities).

Closing the London head office as

part of the latest round of cost cuts

should sustain C&W’s recovery, by

boosting its long-suffering UK busi-

nesses. As George Bernard Shaw put

it, if you can’t get rid of the skeleton

in your closet, you’d best teach it to

dance. Unfortunately, prospects of a

jazzy performance in the UK remain

uncertain, with pricing pressures in

C&W’s business-centric legacy units

continuing and targets for direct

broadband access customers looking

ambitious.

In the short term, its Caribbean arm

could also suffer more than expected if

the region’s economic recovery slows

after hurricane Ivan. For now, limited

visibility is likely to put a cap on its

shares’ rebound.

Source: Lex Column, Financial Times, 11 November 2004.

£400 m

£1.4 bn

Self-assessment activity 17.9

Rehearse the arguments in favour of a stable dividend policy.

(Answer in Appendix A at the back of the book)

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Chapter 17 Returning value to shareholders: the dividend decision 471

17.9 CONCLUSIONS

What advice can be offered to practising financial managers? We suggest the following

guidelines:

1 Remember the capacity of ill-advised dividend decisions to inflict damage. In view

of the market’s often savage reaction to dividend cuts, managers should operate a

safe dividend cover, allowing sufficient payout flexibility should earnings decline.

This suggests a commitment to a clientèle of shareholders who have come to expect

a particular dividend policy from their company. This, in turn, suggests a long-term

payout ratio sufficient to satisfy shareholder needs, but also generating sufficient

internal funds to finance ‘normal’ investment requirements. Any ‘abnormal’ financ-

ing needs can be met by selling securities, rather than by dividend cuts. In the long

term, it seems prudent to minimise reliance on external finance, but not to the extent

of building up a ‘cash mountain’. This may merely signal to the financial world that

the company has run out of acceptable investment projects. If there is no worth-

while alternative use of capital, then dividends should be paid.

2 If an alteration in dividend policy is proposed, the firm should minimise the shock

effect of an unanticipated dividend cut, e.g. by explaining in advance the firm’s

investment programme and its financing needs.

3 In an efficient capital market, the dividend announcement, ‘good’ or ‘bad’, will be

immediately impounded into share price in an unbiased fashion. News of higher

Silicon Valley is starting to return cash to investors

When Dell, the US computer

maker, said this month that it was

buying back its shares at a faster

rate and had set aside another

$10 bn for repurchases,

it echoed an increasingly share-

holder-friendly message from the

technology industry.

Criticised for hoarding too

much cash, technology companies

are at last starting to share more

with their investors – though not

fast enough to deal with the tor-

rent of riches they have been pro-

ducing recently.

But the message of slowing

growth is getting through. ‘High

tech companies are getting mature

– it’s time for them to start looking

at ways to distribute more cash,’

said Bill Watkins, chief executive

of hardware group Seagate

Technologies.

His message is echoed in the

increase in share repurchases by

technology companies. In 2000,

the cash they raised from selling

shares to investors (net of repur-

chases) was equivalent to 22 per

cent of operating cashflow, accord-

ing to Sanford C Bernstein; by the

third quarter of last year that

position had flipped, with net

repurchases equalling 22 per cent

of cashflow instead.

The number of companies pay-

ing dividends has also jumped by

60 per cent since 2002. Despite

the increase in distributions,

though, the industry’s cash moun-

tain has continued to pile up. By

last year, cash holdings had risen

steadily to 27 per cent of tech

companies’ total assets, roughly

double the level at the start of the

1990s, according to Bernstein.

Stock market incentives may

encourage a faster adjustment in

thinking at tech companies than

has been apparent so far.

Over the past year, the shares

of technology companies that pay

dividends have out-performed

those that do not by 10 per cent,

according to Steve Milunovich,

strategist at Merrill Lynch.

But the Wall St message does

not seem to have been loud or

clear enough for many. Stock

market inefficiencies are still

encouraging many companies to

hold more cash than they need,

according to Rick Sherlund, soft-

ware analyst at Goldman Sachs.

The interest income from cash

holdings boosts earnings, yet tech-

nology investors, accustomed to

studying revenue growth rather

than balance sheets, may not have

adjusted their thinking as growth

rates have slowed.

The shares of US software com-

panies currently trade at 22.3

times estimated earnings for

2006, said Mr Sherlund. Strip out

the effects of cash holdings, and

the multiple falls to 19.4 times. A

different tool kit for measuring

tech companies, which looks at

performance excluding cash, is

needed, he added.

Until then, Silicon Valley’s

attitude to cash is likely to con-

tinue to adjust as it has so far –

slowly.

Source: Richard Waters, Financial Times, 14 March

2005.

1;7.4 bn2

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472 Part V Strategic financial decisions

dividends will lead to a higher share price because it conveys the information that

management believes there is a strong likelihood of higher future earnings and div-

idends. In view of this, many observers argue that the primary role of dividend pol-

icy should be to communicate information to a security market otherwise starved

of hard financial data about future company prospects and intrinsic value, while

pursuing a year-by-year distribution rate that does not violate the interests of the

existing clientèle of shareholders.

4 While it is impossible to be definitive in this area, the box lists the circumstances in

which shareholders are likely to prefer dividends to retention and hence, when a

dividend increase may raise share price.

5 Finally, the dividend decision is ‘only’ a financing decision, in so far as paying a div-

idend may necessitate alternative arrangements for financing investment projects.

There can be few companies (at least, quoted ones) for which dividends have con-

strained really worthwhile investment. For most companies, it is often sensible to

adopt a modest target payout ratio. It is not wise to pay large dividends and then

have to incur the costs of raising equity from the very same shareholders.

Dividends are likely to be higher:

■ The greater the shareholders’ reliance on current income.

■ The more difficult it is to generate home-made dividends.

■ The greater the impact of imperfections, e.g. brokerage fees.

■ The lower are income taxes compared to capital gains taxes.

■ The lower the costs of a rights issue.

■ The greater the ease of reinvestment by shareholders.

■ The more often that past dividend increases have heralded subsequent earnings and divi-

dend increases.

We have reviewed the competing arguments regarding the relative desirability of pay-

ing out dividends to shareholders and retaining funds to finance investment, resulting

in capital gains.

Key points

■ The market value of a company ultimately depends on its dividend-paying capacity.

■ The irrelevance or residual theory of dividends argues that, under perfect capital

market conditions, an alteration in the pattern of dividend payouts has no impact

on company value, once the effect of the investment decision is removed.

■ If retentions are used to finance worthwhile investment, company value increases,

both for one-off retentions and for sustained retention to finance an ongoing invest-

ment programme.

■ Failure to retain profits can damage shareholder interests if the company has better

investment opportunities than shareholders, unless outside capital sources are

available and utilised.

■ Dividend irrelevance implies that shareholders are indifferent between dividends

and capital gains, because the latter can be converted into income.

SUMMARY

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Chapter 17 Returning value to shareholders: the dividend decision 473