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)