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Home > Corporate Governance Best Practice > Reinvesting in the Company versus Rewarding Investors with Distributions

Corporate Governance Best Practice

Reinvesting in the Company versus Rewarding Investors with Distributions

by Ruth Bender

Executive Summary

  • Dividend payouts will always depend on having sufficient retained profits and cash.

  • Companies should invest in growth if doing so will generate a return above the cost of capital, as this will increase stockholder value. If there are no value-enhancing investments, surplus cash should be returned to stockholders.

  • Stockholder expectations will drive dividend policy, and changes to that policy should be signaled clearly to investors.

Introduction

Stockholders gain value from their investments in two ways—either by receiving dividends or by realizing a capital gain. Dividend policy is determined directly by a company’s board, which has to decide whether to make a payout or to reinvest.

Although many factors underlie the dividend decision, there is one basic rule: If there are investment opportunities where the expected return exceeds the company’s cost of capital, value will be created by making the investment and it should be done. If there are insufficient value-creating opportunities, the surplus cash should be distributed to stockholders.

Therefore, the question to ask when considering reinvestment versus distribution to investors should be: Will this create stockholder value?

Dividend Policy

Companies that pay dividends try to increase the absolute level of dividend each year in order to meet investor expectations.

Two numbers are relevant to understanding dividend policy: The level of the annual dividend (which may in practice be paid in quarterly or semi-annual installments), and the dividend payout ratio (the dividend for the year as a percentage of after-tax income). Stockholders are concerned with the absolute level of dividend they receive, but will also have an eye on the dividend payout ratio.

If the payout ratio is kept constant, then, as profits grow, the absolute level of dividend will become progressively larger. However, volatility in profits would mean volatility in payouts, and this is unsatisfactory to investors. Accordingly, most companies have a more flexible attitude to the payout ratio, aiming to smooth the distribution, increasing dividends annually but not exactly in line with the change in profits.1 This is particularly relevant in cyclical industries, where a progressive dividend implies a changing payout ratio over the cycle.

Drivers of Dividend Policy

Two fundamentals underlie a company’s ability to pay dividends to its stockholders—is there enough cash, and are there enough profits?

The issue of cash is a universal one: if a company does not have sufficient liquidity to manage its operations in the way it needs to, it would be foolish to deplete cash resources by making payouts. As to whether there are sufficient profits, this is often a legal issue, and so specific to a particular jurisdiction. However, a general rule is that dividends should only be paid out of realized retained profits.

Moving beyond these fundamentals, a key issue for management to consider is the business of the company. Companies in different industries, or at different stages of their life cycle, have different cash needs and investment opportunities, and these will drive dividend policy.

Investors in an early-stage business have different expectations from those investing in a mature business. The early-stage business has low (if any) profits but high growth potential, and the investor will be seeking a capital gain. That gain will come from growing the business, which is likely to involve considerable investment along the way. So for these types of business, paying a dividend would reduce the growth potential; investors would not, therefore, expect a high payout.

In a mature company there are fewer investment opportunities and so less growth is expected. To obtain the required returns, stockholders will expect a large dividend. Indeed, if a company with no clear investment opportunities were to retain profits rather than paying them out as dividends, stockholders could rightly query the executives’ motives in doing so as this is not a value-creating strategy.

In determining their dividend policy, boards also need to ensure that the capital structure of the business is sound. Because debt is a cheaper form of finance than equity, companies generally want a proportion of their finance to be debt. However, too much debt will drive a business to bankruptcy. Accordingly, the dividend decision has to be consistent with the financing policy—a riskier business will have more equity in its capital structure, and it is unlikely that a company that is equity-financed would pay out a large dividend. Table 1 illustrates this.

Table 1. Financing and dividend policy over the business life cycle. (Source: Bender and Ward, 2009)

Stage of life cycle
Launch Growth Maturity Decline
Capital required to support value-enhancing growth Very high High Medium Negative
Main source of finance for the business Equity (venture capital) Equity Equity and debt Debt
Dividend policy Nil Nil or low Substantial 100% payout

For an early-stage operation there is no point in paying a dividend, as this would deplete the company’s much needed cash resources, and the only source of replacement funds would be the same stockholders that are receiving the dividend. However, as the business gains the traction to use more debt-based instruments, a higher payout to stockholders can be made. For declining business there will be few, if any, value-enhancing investment opportunities, so the dividend payout should be as great as cash flow allows, probably paying out previously retained profits.

A further consideration in deciding dividend policy is the tax situation of the company and its investors. In many jurisdictions, investors are taxed more highly on dividends than on capital gains, which means that they might prefer to receive value by selling their shares in the market at a time of their choosing (or selling them to the company in a buyback) rather than taking this highly taxed income. Also, in some jurisdictions companies can face a tax penalty for paying dividends.

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Further reading

Books:

  • Bender, Ruth, and Keith Ward. Corporate Financial Strategy. 3rd ed. Oxford: Butterworth-Heinemann, 2009.
  • Ross, Stephen A., Randolph W. Westerfield, and Bradford D. Jordan. Fundamentals of Corporate Finance. 8th ed. New York: McGraw-Hill Higher Education, 2008.

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