In earlier years of corporate finance dividend policy
referred to whether a firm should retain its earnings or pay its shareholders a
cash dividend, addressing the frequency of payments and if the company decides
to pay, then how much. However in today’s
society dividend policy has gone beyond this scope to include such issues as
whether to distribute cash via share repurchase, or through specially
designated rather than regular dividends and how to maintain and improve the
value of its shares and stocks in the market.
(Hussainey, 2011).
Miller and Modigliani (1961) proposed that dividend policy
is irrelevant to shareholders and that share price was determined by future
earning potential not the dividends paid arguing that share value is determined
by investment policy and not the amount of earnings distributed. However they did make a few assumptions which
cannot be applied in the modern day stock market; they assume that there exist
a perfect capital market that is no transaction costs or tax, free and costless
access to information about the market, that investors are rational and that
they value securities based on the value of discounted future cash flow to
investors and that there is certainty about the investment policy of the firm.
Is a bird in the hand really worth more than two in the
bush? Bird in the hand theory takes a more traditional view of dividend policy;
theorists such as Gordon and Shapiro (1956) and Linter (1961) argue that in a
world of uncertainty investors would tend to prefer dividends to retained
earnings. They highlight that management
continue to pay dividends in order to send a signal about the firm’s future
prospects, what kind of signal does it send when you stop paying them
altogether like Lloyds did in 2008?!
Agency cost is the cost of the conflict of interest that
exists between management and shareholder (Ross et al., 2008) this arises when manages
act in their own self-interest rather than on behalf of the shareholders who
own the firm. This is contrary to the
assumptions of Miller and Modigliani (1961) who assumed that managers are
perfect agents for shareholders and that no conflict ever exists between
them. Managers conduct certain activities
that can be costly to shareholders, in the case of Lloyds it was an unnecessarily
high compensation package awarded to António
Horta-Osório, the boss of Lloyds to the tune of £11.5million in pay and
share bonuses. (The Guardian, 2015)
Lloyds announced in February that they will be preparing to
pay a dividend for the first time since its taxpayer-funded bail out in 2008, a
victory for its 3million shareholders! (BBC News, 2015) Lloyds share
price has risen significantly as a result of the banks successful turnaround,
with the share price the chief executive will receive being valued at 78p in
comparison to the 35p they were worth in 2008.
After discussing dividend policy theories, it’s vital to
look at how seven years without dividends has affected Lloyds share price and
try and answer the million dollar question.. who was right? Miller and
Modigliani or the traditional theorists?
Source Yahoo Finance
Looking at the share price in the chart above you can see
that after Lloyds announced they would not be paying out dividends share price
plummeted!! Whilst some of the dip can be attributed to the economic recession
it seems obvious that Lloyds investors are consistent with the traditional view
of dividend policy, they would rather have a bird in their hand than two in the
bush! However, if you look at dividends
from Miller and Modigliani’s point of view you could argue that Lloyds invested
their earnings and had no retained earnings left to pay dividends, but since they’ve recorded a loss between 2010
and 2013.. it doesn’t seem likely!
Miller and Modigliani also suggest that the clientele effect
exists, referring to the tendency for investors to hold stocks which are in
line with their dividend payment preferences.
Lloyds share price could have decreased due to its clientele being
investors you preferred dividend pay outs , however share price has remained steady year
on year since 2008 with no mention of dividends, could this mean that Lloyds may
have attracted a new type of clientele? They may have obtained investors who
prefer for funds to be reinvested, so now they have decided to pay out dividends
it will be interesting to see if this changes the clientele of their investors
and if share value increases.
We can see from the chart below that since rumours first
circulated that Lloyds would be paying out dividends their share price has
increased. This could be due to the
announcement of their 2014 profits and investment plans, which may have instilled faith in investors
at the potential future earnings of Lloyds or it could be as a result of
attracting a new clientele of investors who wish to receive dividend pay outs.
Source Yahoo Finance
Overall, I would argue that in the case of Lloyds their
dividend policy has significantly affected their share price, therefore Miller
and Modigliani’s theory seems less relevant whilst a traditional theory could
be deemed more applicable. It will be
interesting to see if Lloyd’s new dividend policy will increase their share
value in the future and if the investors who preferred retained earnings will
sell their shares!
References
BBC News. (2015, February 27). BBC News - Lloyds Banking Group to resume dividend payments. Retrieved from http://www.bbc.co.uk/news/business-31655343
Gordon, M. J., & Shapiro, E. (1956). Capital Equipment Analysis: The Required Rate of Profit. Management Science, 3, 102-110. doi:10.1287/mnsc.3.1.102
Hussainey, K., Mgbame, C. O., & Chijoke-Mgbame, A. M. (2011). Dividend policy and share price volatility: UK evidence. The Journal of Risk Finance, 12(1), 57-68. doi:10.1108/15265941111100076
Lintner, J. (1962). Dividends, earnings, leverage, stock prices and supply of capital to corporations. Journal of Economics, 64, 243-269.
Miller, M. H., & Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of Shares. Journal of Business, 34, 411-433. doi:10.1086/294442
Ross, S. A., & Ross, S. A. (2008). Modern financial management. Boston: McGraw-Hill/Irwin.
The Guardian. (2015, February 27). Lloyds pays boss £11.5m and resumes dividend after seven years | Business | The Guardian. Retrieved from http://www.theguardian.com/business/2015/feb/27/lloyds-pays-antonio-horta-osorio-11m-resumes-dividend-after-six-years
Yahoo finance. (2015, March 6). LLOYDS BANKING GRP Share Price Chart | LLOY.L - Yahoo! UK & Ireland Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=LLOY.L#symbol=LLOY.L;range=1d
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