7.3 Dividend Policy Theories (Prelude)

So far, we have asked numerous questions concerning capital structure (the financing decision) and related matters, and we failed to resolve them. First, we illustrated that although leverage reduces net income, it potentially enhances Earnings Per Share (EPS)  and Return on Equity (ROE); we noted, in this connection that increased leverage poses a greater risk of bankruptcy and, accordingly, will reflect itself in a higher yield-to-maturity for its debt, and a higher equity discount rate, which via the Dividend Discount Model (DDM), will result in a lower share price. Implicit in all this is the notion that little or no leverage is not desirable either, as no EPS and ROE benefits will be produced.

Having satisfactorily arrived at these relationships, we nonetheless could not answer whether there is a universal solution to the notion of “optimal” leverage; the ideal level of leverage depends on industry and firm characteristics, including the stability of operating earnings. Other factors may also come into play, such as management and shareholder risk profiles.

We then posed the question as to whether leverage matters at all in light of the possibility that investors can manipulate a firm’s leverage to suit their own needs by utilizing “homemade leverage,” which alternatively reduces or amplifies the firm’s ex-ante degree of leverage. An argument was made that leverage is not important at all; rather the firm’s valuation is a function of the size and volatility of its operating earnings and not its Net Income (NI), EPS, or ROE. These arguments are attributable to Modigliani and Miller’s (“M&M”) groundbreaking research. (Their arguments were also based on very restrictive assumptions including the absence of taxes and flotation costs.)

Next, we posed the question as to whether dividends matter whatsoever – does paying, or not paying, dividends positively or negatively affect a firm’s valuation?  Clearly, dividends affect a firm’s ability to grow its (internal) equity in that dividends paid reduce retained earnings, causing the firm to rely, in part, on more expensive external equity for growth. It would thus appear that dividends indeed matter to some extent! On the other hand, it is argued that dividends are only paid if the firm can find no acceptable capital projects, i.e., investments whose prospective returns exceed the firm’s hurdle rate. We shall present some classic pro and con arguments concerning the subject of the “relevance” of dividends next.

In short, firms will pay cash dividends when they perceive a bright future cash flow outlook and reduce or eliminate dividends when the future is gloomy. In any case, erratic dividend payments make investors queasy, with negative stock valuation implications. If the firm needs cash to fuel growth, it may not pay any dividends. Paying dividends may indicate that the firm has no positive internal capital budgeting investment options.