Is there a trade-off between present cash dividends and future capital gains?

There is always controversy around corporate dividend policy, which is really challenging for the directors and financial manager of a company. Since different investors have different views on present cash dividends and future capital gains, it also brings up the controversy around the effect of dividends on share price：whether it is relevant to dividend policy or not.

Representative of one standpoint is two Noble Laureates, Modigliani & Millar (1961), who states that investors don't really choose between future gains and cash dividends, i.e. dividend policy irrelevance. They believe that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm.

However, M & M’s arguments are based on some assumptions such as no transaction costs, no taxes, everyone has free access to all relevant information, etc., which is often not the case in reality. There are always transaction costs and time cost for every investor who sells and purchases stocks. And income tax is at 10%, 23% and 40% while capital gains are taxed at 35% in Britain.

These bring up another standpoint, which people like James E. Walter and Myron J. Gordon believe, that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share, i.e. relevance of dividend policy. They have the following reasons.

Clientele effect suggests the company should not change its dividend policy substantially as some of its investors (its established clientele) decide to sell the security due to the change. Since investors are attracted to a particular kind of security, changes in dividend policy will obey their current preference.

Investors don’t have access to internal information thus they see dividends as signals of the company’s performance and future prospects. High dividend suggests good news while low dividend indicates bad news. Though in reality these might not be true since there’s a trade-off between dividends and attractive investments, the market tend to be short-sighted and irrational.

Uncertainty of future gains is another concern. Thus, Investors would rather have the money now than leave it tied up in uncertain investments, i.e. they prefer stable or higher dividends. There are other reasons such as owner control (agency theory), management desire to avoid the risk of a future dividend cut, stability raises credit standing for debt issues, etc.

What is the preferred distribution method of companies nowadays? The liability strategies group of Deutsche Bank once undertook a survey upon this issue. They started by asking companies which distribution methods they had employed over the last five years. Respondents could select more than one option. Figure 1 provides an overview of the responses for those firms that employed at least one of the methods.

Figure 1:  Distribution Methods

Regular cash dividends are clearly the preferred distribution mechanism, employed by 93% of all respondents, followed by share repurchases which have been employed by 39% of all firms. As for which factors firms take into account when deciding on the choice among regular dividends, special dividends, and share repurchases, they undertook the survey further. Figure 2 lists five possible factors together with the number of respondents ranking these factors as important or very important, corresponding to a 4 or 5 on a scale ranging from 0 to 5.

Figure 2:  Factors Determining the Method of Distribution

None of the factors receive overwhelming support, but they all receive moderate support. The signal sent to capital markets is considered to be important by 39% of the survey participants, followed by the flexibility, which is listed as being important by 36% of the participants. Tax efficiency, attractiveness to investors, and accounting implications follow with 31%, 30% and 29% of the firms ranking these factors at the high end of the scale. These suggest relevance of dividend policy.

Let us see contemporary issues for instance. On May 8^th BT announced news that it has completed a transformational year with a 15 percent rise in its annual dividend. We can see a sharp rise of share value (+10.80, +2.87%) on the very day from Figure 3. Higher dividend is a signal of good news which suggests better performance and prospects of the company and strengthens investors’ confidence.

Figure 3:  stock price of BT Group (BT.A:LSE)

Crowdfunding

An inherent problem that entrepreneurs might encounter at the beginning of their entrepreneurial initiative is to attract outside capital, given the lack of collateral and sufficient cash flows and the presence of significant information asymmetry with investors. More recently, some entrepreneurs have started to rely on the Internet to directly seek financial help from the general public instead of approaching financial investors such as business angels, banks or venture capital funds. This technique, called crowdfunding. 

In simple terms, crowdfunding is the financing of a project or a venture by a group of individuals instead of professional parties (like, for instance, banks, venture capitalists or business angels). In theory, individuals already finance investments indirectly through their savings, since banks act as intermediary between those who have and those who need money. In contrast, crowdfunding occurs without any intermediary: entrepreneurs “tap the crowd” by raising the money directly from individuals. The typical mode of communication is through the Internet. Crowdfunding projects can range greatly in both goal and magnitude, from small artistic projects to entrepreneurs seeking hundreds of thousands of dollars in seed capital as an alternative to traditional venture capital investment. 

In this week seminar, we are required to have a group work to propose a plan to collect fundings from the public. Our group attempted to sell record pens. After the discussion, the first step is to calculate the cost of this programme, which involves raw material, staff costs, transportation costs, administration costs and advertisement expanses. Then we decided to make a market research to find out what kind of group are interested in record pens. It can be found that record pens may be welcomed by international students and some multinational corporations. Therefore, the next plan is to advertise among these groups. In order to motivate individuals to fund for this project, our team has make a preferential policy for those who have invested for our company. The preferential policy is when an individual invests £50, we reward £60 after sell one dozen of record pens (suppose the price is £10 and the cost of one record pen is £4 so that £50 can produce twelve record pens, hence the total cost is £48 and the total profit is £72, our company still earn £12 after reward individuals for £60). This policy can attract more individuals to invest because they can also earn extra 10 pounds. By adopting crowdfunding, some small enterprises do not need consider the high interest rate if they borrow money from banks, which benefits the company reducing the operating cost. However, the teacher pointed out that the plan must consider technical costs due to the fact it might record noises when people are writing and this can affect the sound quality if the pen is recording.

There are several reasons for corporations to adopt crowdfunding. Firstly, companies make use of the crowd mainly for costreduction reasons. By participating in the product design and improvement, users contribute to creating value for the company. Moreover, this allows the company to reduce the length of new product development as well as its costs, have a better customer acceptance, and increase the customers’ perception of product newness. Within the crowdfunding activities, consumers and individuals provide needed capital to the company to make its investments such as acquire new assets or pay employees.

Besides, crowds may at times be more efficient. According to Brabham (2008), the efficiency of crowds in solving problems of companies is related to its composition; the more diverse it is, the more efficient it can be. In other terms, members of the crowd may build up their own solution using others’ suggestions and hence end up having better solutions overall. While crowdfunding can be useful for companies seeking solutions to their problems, it can also provide valuable signals on the market potential of a product they wish to launch. At times the use of crowdfunding can be seen as an excuse to generate hype around a new product in order to create a marketing campaign in which consumers are able to participate. 

In the meantime, several platforms have emerged that help intermediate between crowdfunders and individuals with a project. Sellaban accounted for one of the most famous crowdfunding companies, launched in 2006, it acts as intermediary between new music bands and their fans, who can invest in the production of a band’s first CD. In exchange, investors obtain rewards, like a free copy of the CD or benefits from its sales. In roughly three years, the company raised more than US$ 3 million from individuals in order to promote new artists. In total, almost 4,000 artists received support from more than 65,000 investors.