Is shareholder wealth impacted by changing a company's dividend policy?

As discussed in my previous blogs generally the sole guiding objective of a company is to maximise shareholder wealth - by changing a company's dividend policy will this impact shareholder wealth? A dividend policy is the strategy a company uses when determining the proportion of profits to be paid out to shareholders. Typically this is done twice a year with an interim and final year dividend however companies are under no obligation to do so. I have learned during lectures that there are many factors which need to be considered when determining a company’s dividend policy which I will discuss throughout this blog. Recently two oil companies - Eni and Statoil - made announcements surrounding their dividends providing a good opportunity to compare the impact this has had on each company. Eni, an Italian oil company, announced last week (13^th March) its plans to axe its spending following the oil price crash by cutting its dividend along with selling billions of dollars of assets (Financial Times, 2015). In contrast, Norwegian oil company Statoil did the opposite - announcing their intentions on 5^th February 2015 that they were “highly committed” to maintaining their dividend policy despite the difficult trading environment and competitors cutting their dividends (Bloomberg, 2015).

Will this change impact shareholder wealth?
 

No - says Miller and Modigliani (1961), referred to as M&M, who claim that dividends are irrelevant to a company’s value; instead this is determined by a company’s investment policy (Miller & Modigliani, 1961). Essentially they believe investment decisions are what determines a companies future earnings potential which is what impacts the share price and shareholder wealth. Therefore M&M argue that dividends represent a residual payment and should only be distributed if there is cash left over after investing in all possible projects with a positive NPV. Likewise if there is no cash left over, a dividend would not be paid and as a result, over the years, we would see highly fluctuating dividends. This suggests that companies should be focusing on their investment policy rather than spending time altering their dividend policy as it has no impact on shareholder wealth. 

Following M&M’s theory, when Eni announced they were cutting the dividend I would expect the company’s share price to remain relatively stable. However following the announcement of the dividend cut Eni's share price fell by 7% (Figure 1) which goes against M&M’s theory and suggests that a company’s dividend policy does impact value and shareholder wealth. CEO of Eni, Claudio Descalzi, stated that this decision was made with the aim of building a more robust company which will be capable of facing the challenging business environment with the lower oil prices. This implies that the company is focusing on long-term sustainable growth and hopefully wealth will be restored in the future as a result of this.

Figure 1: Eni Share Price (London Stock Exchange, 2015)

Looking at Statoil's share price this also goes against M&M's theory. Following their announcement to maintain their dividend policy their share price increased (Figure 2). Again this suggests that by altering the dividend policy it does impact value and shareholder wealth. 
 

Figure 2: Statoil Share Price (London Stock Exchange, 2015)

 

However, common to M&M’s theories, this theory was also based on a set of unrealistic assumptions. For example they assumed perfect capital markets where there is no transaction costs and no tax - which world do they live in?!

There are many theories and factors which oppose the views of M&M, including those listed below which will be discussed in more detail:

• Gordon's (1962) "bird in the hand argument"
• Clientele Effect
• Taxation
• Signalling

 

Gordon’s (1962) “bird in the hand” argument suggests that investors would prefer dividends now rather than company's retaining cash to allow possible, uncertain gains in the future (Gordon, 1962). This implies that because the future is unpredictable, investors would prefer a pay-out now rather than having it tied up in uncertain investments which may not provide a return. Given that Eni are cutting dividends to retain cash it could result in shareholders withdrawing from the company to seek alternative investments which are paying dividends. Consequently the share price would decrease leading to a reduction in shareholder wealth, thus suggesting that a companies dividend policy does in fact impact shareholder wealth.

Another theory opposing M&M's view is the clientele effect which suggests that shareholders are attracted to certain types of dividend policies (Jain & Chu, 2014) and therefore implies that a company’s dividend policy does affect value. For example pension companies seek constant, stable dividends and so whether an investor chooses to invest in a company is likely to be determined by the dividend policy and whether it suits their needs. This implies that companies need to understand the preferences of their shareholders in order to keep them happy, prevent them from selling their shares and to attract new investors. With Eni making the decision to cut their dividends, if shareholders require a stable income it may result in them selling their shares as it no longer meets their needs which will have a negative impact on value and shareholder wealth. It could be argued that the opposite will happen to Statoil. Given that they are maintaining their dividend it could suggest that they understand the needs of their investors. By announcing their dividend intentions it will reassure investors as they know it will continue to meet their preferences but may also attract new investor’s seeking a stable dividend thus increasing shareholder wealth.

Clientele theory is reinforced by taxation (bearing in mind that M&M assumed no taxes) as investors who are subject to paying lower tax prefer dividends whereas those subject to higher tax prefer lower dividends or capital gains (Jain & Chu, 2014). This further suggests that certain investors are attracted to particular companies depending on their dividend policy and reinforces that changing the policy could decrease shareholder wealth. Therefore companies must carefully consider the affects which changing their dividend policy could have.

Another factor which suggests a company's dividend policy affects shareholder wealth is the concept of signalling. Signalling gives investors an idea about the expected future performance of a company (Karpavičius, 2014). This is based around the idea of information asymmetry as investors don’t have access to internal information and so depending on a company’s decision regarding dividend pay-outs it can signal to investors how well the company is expected to perform in the future. For example, if high dividends are paid this signals good news to the market that the company is optimistic about the future which is likely to see an increase in the company's share price. Likewise if lower dividends are paid, or cut as in Eni's case, it suggests the company may be struggling and are concerned about the future performance of the company. Therefore dividends can be seen as an information transferring mechanism from inside a company to the market place. With Eni announcing the dividend cut, this theory suggests that the company may be concerned about the future due to the current difficult trading environment as a result of the oil price crash. Following the announcement the share price dropped. In contrast, by maintaining their dividend Statoil are signalling to investors that they are optimistic about the future, this was met with an increased share price. The concept of signalling clearly suggests that dividends are significant determinants of a company’s share price and therefore a company's policy does impact shareholder wealth.

 
To conclude, whilst I agree with M&M's theory that a company's investment decisions are essential to a company's profitability, as demonstrated with Eni and Statoil, I believe that a company’s dividend policy does have a significant impact on a company’s share value and therefore does affect shareholder wealth. Whilst there is no obvious way for a company to determine their policy I believe this is something that will be established over time and as discussed throughout this blog there are many factors which a company must consider when making decisions in relation to dividends. For example they should understand the preferences of their current shareholders and consider how they will react to significant changes in dividends. Personally, I think company's should aim to have a stable dividend policy with consistent pay-outs and stable growth as I believe this will retain investors as well as attracting new ones.

 

References

Bloomberg (2015). Statoil CEO Says `Highly Committed' to Dividend Policy. Retrieved 16^th March 2015, from http://www.bloomberg.com/news/videos/2015-02-06/statoil-ceo-says-highly-committed-to-dividend-policy

London Stock Exchange (2015). ENI. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/international-markets/indices/company-summary.html?symbol=ENI&market=MTA

London Stock Exchange (2015). STATOIL ASA STATOIL ORD SHS. Retrieved 16th March 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary-chart.html?fourWayKey=NO0010096985NONOKEQS

Financial Times (2015). Eni to cut dividend and suspend share buyback. Retrieved 16^th March 2015, from http://www.ft.com/cms/s/0/c6ff2624-c994-11e4-b2ef-00144feab7de.html#axzz3UXyAnaFA

Gordon, M. J. (1962). The savings investment and valuation of a corporation. The Review of Economics and Statistics, 44(1), 37-51. Retrieved from http://www.jstor.org/

Jain, P. & Chu, Q. C. (2014). Dividend clienteles: A global investigation. Review of Quantitative Finance and Accounting, 42(3), 509-534. doi:10.1007/s11156-013-0351-2

Karpavičius, S. (2014). Dividends: Relevance, rigidity, and signaling. The Journal of Corporate Finance, 25, 289-312. doi:10.1016/j.jcorpfin.2013.12.014 

Miller, M. H. & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433. doi:10.1086/294442

 

Can a company's capital structure maximise shareholder wealth?

The capital structure of a company is how it finances its activities - usually through a combination of both debt and equity. Last week it was announced that Norwegian oil producer, Det Norske Oljeselskap ASA (Det Norske), was reviewing their funding options in order to create the optimal capital structure to increase the cash flow it needs for new projects whilst doing this at the lowest cost to shareholders (Bloomberg, 2015). Hersvik, CEO of Det Norske, has noted that the company is able to raise more debt and may also issue more shares - but how should they decide the proportion of debt and equity? Does an optimal capital structure exist? And can this increase shareholder wealth?

The weighted average cost of capital (WACC) is a way of calculating the costs of a company’s capital sources, both debt and equity, which determines the lowest rate of return needed on an investment to satisfy investors (Reilly & Wecker, 1973). This allows a company to determine which investments they can afford and therefore defines the company’s strategic option set as it acts as a hurdle rate for investment appraisal. As a result companies generally seek a low WACC (Watson & Head, 2013), allowing them to pursue more projects which maximise shareholder wealth. The recent oil price crash has reduced Det Norske's cash flows which are needed as they are wanting to take on new projects. By reducing the WACC it will allow the company to invest in these new projects as the company will require a lower rate of return. At first glance, you may think the decision is easy for Det Norske - increase debt as it is cheaper than equity, therefore lowers the WACC thus increasing their scope of possible investments which could increase shareholder wealth.

Decision made?! Not quite.

Whilst increasing debt does decrease the WACC as it is a cheaper source of finance, the traditional view of capital structure suggests that there becomes a point where a company can have too much debt. After this point it starts to become more costly, thus suggesting there is an optimal capital structure (Brusov et al, 2011). Essentially, debt finance is cheaper as lenders require a lower rate of return in comparison to ordinary shareholders. This is because, due to uncertainties and no guarantee of receiving dividends or capital gains, they often demand a higher return to compensate for the risks they are taking, thus increasing the cost of equity. Furthermore the transaction costs associated with raising debt are generally less than those involved in issuing shares and paying dividends and debt interest can be offset with pre-tax profits - reducing the overall tax bill for a company. However the traditional view suggests that there becomes a point where the cost of equity will start to increase as shareholders demand higher returns for the risks they are taking as highly geared companies are seen as risky investments. So it is at this point where a company achieves their optimal capital structure - before the level of debt causes the cost of equity to rise. I take the view that up until this point it seems logical to take on more debt as it is cheaper. However after this point, if a company continues to take on more debt the risk of financial distress increases along with the possibility of liquidation (this concept is summarised in Figure 1). As a result the WACC will increase thus reducing company value and shareholder wealth. Therefore if a company is above or below the optimal level, they are destroying shareholder value. It appears that Hersvik supports this traditional view as he clearly suggests there is an optimal capital structure and he is aiming to achieve it.

Gearing levels, cost of finance and risk of financial distress (Adapted from Arnold, 2012)

 

Whilst Hersvik has noted that the company is able to raise more debt and the equity ratio requirement of 25% has been removed, the company reported a net loss of $287m which could provide problems when trying to raise more debt. Lenders are likely to require higher returns meaning higher interest rates, thus increasing the cost of debt. Furthermore the company will not benefit from being able to offset the debt interest with pre-tax profit. Having said this, it is likely that raising debt will still be significantly cheaper than the costs associated with issuing shares. In addition, due to the current situation and issues Det Norske is facing with the oil price crash this will increase the risk of financial distress and shareholders will demand higher returns to compensate for the risks they are taking, increasing the cost of equity. This demonstrates how there is a fairly complex relationship between debt and a company's capital structure.

An alternative view, which significantly differs from the traditional view, was taken by Nobel Prize winners Modigliani and Miller (1958) who suggested that company value is independent of its capital structure. Instead, the value of a company is entirely dependent on business risk (Modigliani & Miller, 1958). Essentially this view suggests that no matter how much companies play around with their capital structure, it will not change the WACC, thus no optimal capital structure exists. Therefore Modigliani and Miller (1958) would argue that Hersvik's is wasting his time in aiming to achieve an optimal capital structure as such a thing does not exist. The theory behind this was that as the levels of debt increased, the cost of equity would also increase leaving the WACC the same. This suggests that Det Norske should focus on making good investments rather than altering their capital structure as cash flows generated from operations is the only way to increase company value and maximise shareholder wealth. However, in order to make this theory work in practice a set of unrealistic assumptions were made which have been heavily criticised. For example, they assumed that there is no taxation, as discussed above - debt receives a tax benefit, and they assumed there are no costs of financial distress and liquidation when in reality businesses clearly face the costs associated with these for example bankruptcy costs.

These criticisms led to Modigliani and Millar (1963) reviewing their theory to include tax. This dramatically changed their conclusions where they suggested that companies should be highly geared because of the measurable tax benefit (Modigliani & Millar, 1963). Therefore as the companies gearing increased, the WACC would decrease due to the tax benefit of debt. This would suggest that Det Norske should scrap the idea of raising finance through equity, load-up heavily on debt which would result in WACC being at its lowest and company value at its highest. Therefore, the theory now suggested that in fact there was an optimal capital structure - being highly geared. Clearly I would not recommend this for Det Norske or any company as it does not take into account the risk of financial distress which in reality does exist and will have a negative effect on a company’s value. By heavily increasing debt levels shareholders will demand higher returns to compensate for the risks they are taking, lenders will require higher interest rates and it is highly unlikely that potential investors will be attracted to the business.

To conclude, I personally believe that an optimal capital structure does exist as it seems logical that there becomes a point where having too much debt causes the cost of equity to increase as shareholders become worried. I also believe that when a company achieves such a structure it will increase shareholder wealth as they are able to broaden their strategic option set, thus increasing their scope for investments. In addition, I take the view that there is no generic ideal combination of the structure but that this varies depending on the company, the industry and the economic climate. It is impossible for me to predict what decisions Det Norske will make in terms of their capital structure but I think it is crucial they consider the benefits and drawbacks of both equity and debt finance as well as the business risks they are currently facing and how shareholders will react to the decisions they make. It will be interesting to see what decisions they make and whether they believe they were able to achieve their optimal capital structure.

References

Arnold, G. (2012). Corporate financial management. New York: Pearson.

Bloomberg (2015). Billionaire Roekke’s Det Norske Reviews Funding as Oil Drops. Retrieved 3^rd March 2015 from http://www.bloomberg.com/news/articles/2015-02-25/billionaire-roekke-s-det-norske-reviews-funding-amid-oil-drop

Brusov, P., Filatova, T., Orehova, N. & Brusova, N. (2011). Weighted average cost of capital in the theory of modigliani-miller, modified for a finite lifetime company. Applied Financial Economics, 21(11), 815-824. doi:10.1080/09603107.2010.537635

Modigliani, F. & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261-297. Retrieved from http://search.proquest.com/?accountid=12860

Modigliani, F. & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. The American Economic Review, 53(3), 433-443. Retrieved from http://www.jstor.org/

Reilly, R. R. & Wecker, W. E. (1973). On the weighted average cost of capital. Journal of Financial and Quantitative Analysis, 8(1), 123-126. doi:10.2307/2329754

Watson, D. & Head, A. (2013). Corporate finance: Principles and practice. New York: Pearson.