Dividend Policy (Part II) – the implications for shareholder wealth

Retained earnings are a major source of finance to many companies, and the amount paid out as dividends will have a direct effect on the retained earnings balance, thus the value of the company. Many of the economic theories examined in this article have already been discussed in Dividend Policy – which is the best policy?. The purpose of this article is provide a more detailed explanation as to how these theories suggest that a company’s dividend policy impacts directly or indirectly on the wealth of shareholders.

Shareholders take a risk by investing in a company, and therefore expect to be compensated for this. The annual return earned by shareholders is typically made up by a combination of dividends and capital gains (profits made on share values). However there is a potential conflict between dividends and retained earnings – the higher the dividend pay out, the less funding available for further investment in or by the company. It is generally accepted that Directors should follow a dividend policy that will maximise shareholder wealth, however there are numerous arguments regarding the relationship between dividends and shareholder wealth.

There are commonly two schools of thought regarding the impact of dividends on shareholder wealth:

  1. Dividends are irrelevant in determining shareholder wealth.
  2. Dividends are relevant in determining shareholder wealth, split further into:
    1. Paying larger dividends
    2. Paying smaller or no dividends

Perfect Capital Market

In a perfect capital market, nothing would be able to affect the share price; there would be no transaction costs, no taxation, all information would be freely available (strong form efficient), everyone would be able to lend and borrow at the same risk free rate, and shareholders would be indifferent between dividends and capital gains. Whilst this is considered the ideal market, it does not exist and therefore there are limitations – discussed later in this article.

Irrelevancy Arguments

Miller and Modigliani propose that a company has two options: (1) retain earnings to invest, and (2) pay out dividends and raise funds through new shares and borrowing to invest. They argue that in a perfect capital market, shareholders will be indifferent between the two policies as their wealth will be unchanged, therefore suggesting that dividends are irrelevant to shareholder wealth.

Example. – M&M’s perfect capital market

Balance sheet at market values:

Assets                         190

Cash                           110                            Shares      300

                                    300                                                300


The company has 100 shares, thus the share price is £3 per share. The company needs £110 to fund an investment that has a NPV of £10.

Option 1 – retain earnings and invest in project

The value of the company will increase by £10 if the project is taken, thus the share price will increase:

Equity:                                           £300 + £10                  = £3.10 per share

Shares:                                                300

If the shareholders require a cash return they can sell some shares and create a ‘home made dividend’.

Option 2 – pay £110 dividend and issue £110 of new shares

The market value of the company after the dividend will fall to:                       £300 – £110 = £190

But will increase with the addition of the NPV from investing in the project:   £190 + £ 10 = £200

The share price at this point will be:                                                                                     £200 / 100 = £   2

The market value of the company after issuing the new shares will be:                           £200 + £110 = £310

The number of new shares issued                                                                                       £110 / £2.00 = £ 55

Therefore the shares price is now                                                                                     (£310 / (100 + 55)) = £2

The amount of dividends paid to original shareholders is                                                   £110 / 100      = £1.10

The shareholders wealth has remained the same                                                                                        £3.10

Shareholders have bought shares for £2 each and in a perfect capital market that would be the fair price.


Another theory supporting the irrelevancy of dividends to shareholder wealth is the residual earnings theory. This theory suggests that a company should take all projects that yield a positive NPV*, and that only then should any left over earnings be paid out as dividends. This theory therefore suggests that it is in fact the projects that a company invests in that affects shareholder wealth, rather than the dividend policy itself.

*for more information on how to calculate NPV, see my article on ‘Investment Appraisal, Part I: Payback Periods, ARR, NPV and IRR’

Relevancy Arguments

There are however a number of arguments in support of the relationship between dividends and shareholder wealth. These can be further split into two categories; those for high dividend pay out, and those for low pay out.

High Dividend Payout Arguments

Gordon (1959) provides support for a high dividend pay out, as he found that the dividend payout ratio is positively related to the P/E ratio. Therefore, if the dividend payout ratio is high, this will increase the P/E ratio, which will cause the share price to rise and consequently increase capital gains.

Another theory to support high dividend pay out is the ‘bird in hand’ theory. This theory suggests that because dividends are certain i.e. cash is absolute, shareholders prefer returns in dividends over capital gains as these are much more risky due to constantly fluctuating share prices, and cannot be guaranteed.

The Signalling Effect is a well-established principle in corporate finance whereby due to information asymmetry i.e. managers of a company have the ‘inside scoop’ on a company, the dividend pay out is seen as an indicator to the market of the success of the company. Therefore, a high dividend pay out signals to the market that the company has been successful, which increases confidence in the company and thus may increase share prices (thus capital gains).

On the other hand, an argument for low dividend pay out is based on tax rates. If the tax rates on dividends are higher than those on capital gains, shareholders will prefer an increase in capital gains to minimise their tax liabilities.

Limitations of the Capital Market

Many of the models used to explain the relationship between dividends and shareholder wealth are based on a perfect capital market. However there are a number of market imperfections.

The perfect capital market assumes that there is no tax, but in reality shareholders income is taxed immediately – UK dividends are received net of 10% tax, and similarly capital gains are taxed as soon as they are realised.

The perfect capital market also assumes there are no transaction costs, but in reality this is not the case. Issuing costs mean that retained earnings are cheaper to use to finance investments than issuing new shares. It may also be hard for shareholders receiving higher capital gains than dividends to make ‘home made dividends’ if the costs of selling shares are too high.

Finally, the perfect capital market assumes that shareholders have no preference between dividends and capital gains. However, different shareholders have different requirements i.e. high or low dividends for different reasons e.g. current cash requirements, tax position, short/long term investment prospects etc. shareholders are therefore attracted to companies with dividend policies that suit their requirements. Companies should therefore not change their dividend policy, as this may be detrimental to the aims of the investors.

According to the Clientele Effect, different shareholders have different dividend requirements – some prefer high dividends, and some prefer low. This could be due to;

  • Current cash requirements
  • Current tax position
  • Current wealth v future wealth

Shareholders are attracted to the company which the dividend policy that best suits their requirements. Therefore, the company should not change its dividend policy as this would be detrimental to its current shareholders.

Dividends in Practice

  • Shareholders can vote to decrease the amount of dividend received, but cannot vote to increase it.
  • Directors decide on the level of dividends.
  • Loan covenants may restrict payments.
  • Dividends have to be paid out of profit.
  • Dividends may be in the form of new shares (bonus share).

Lintner found that manager’s perceive that shareholders prefer a stead stream of dividends to a volatile one, thus they make adjustments towards the target each year.

Example. – Lintner

A company aims for a 50% pay out, and makes a partial adjustment of 30% towards this target each year. The EPS is £4 and the latest dividend was £1.50. Calculate the next dividend.


Target dividend                                              £4.00 x 50% =            £2.00

Existing dividend                                                                                (£1.50)

Full increase                                                                                      £0.50

Partial increase                                              £0.50 x 30%                £0.15

New dividend                                                 £1.50 + £0.15              £1.65

Featured image courtesy of http://www.bancaemercati.com/sito/wp-content/uploads/2015/03/Il-fattore-dividendi_.jpg


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