Business finance : theory and practice

Chapter 12
The dividend decision
Objectives
In this chapter we shall deal with the following:
‘ the nature of dividends
‘ the theoretical position of dividends as residuals
‘ the Miller and Modigliani view that the pattern of dividends is irrelevant to
the value of shares (and WACC)
‘ the traditional view of dividends
‘ the evidence on dividends
12.1 Introduction
Dividends are payments made by businesses to their shareholders. They seem to be
viewed by both the directors and the shareholders as the equivalent of an interest payment
that would be made to a lender; a compensation for the shareholders’ delaying
consumption. Dividends are also seen as a distribution of the business’s recent profits
to its owners, the shareholders.
A share, like any other economic asset (that is, an asset whose value is not wholly
or partly derived from sentiment or emotion), is valued on the basis of future cash
flows expected to arise from it. Unless a takeover, liquidation or share repurchase is
seen as a possibility, the only possible cash flows likely to arise from a share are dividends.
So it would seem that anticipated dividends are usually the only determinant
of share prices and hence of the cost of equity capital.
It would, therefore, appear that the directors would best promote the shareholders’
welfare by paying as large a dividend as the law will allow in any particular
circumstances.
This attitude begs several questions, however. Is it logical that directors can
enhance the value of the business’s shares simply by deciding to pay a larger dividend;
can value be created quite so simply? What if the business has advantageous
new investment opportunities; would it be beneficial to shareholders for the business
to fail to pay a dividend in order to keep sufficient finance available with which to
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