To Pay or Not to Pay - That is the Question

With apologies to the Bard.

When it comes to allocating after-tax profits, the directors of firms have two choices. They can pay the money to the firm’s shareholders in the form of dividends or they can keep the money to be reinvested to foster future growth. In theory, if the rate of return that a firm can generate with the funds exceeds the rate of return that a shareholder can obtain on an alternate investment, the shareholder would desire the funds to be reinvested. Again, in theory, a firm’s board of directors will structure dividend policy in the best interests of the shareholders. A few recent news articles offer illustrations.

British Petroleum, faced with billions of dollars in damages from its ongoing Gulf of Mexico problems has cancelled their dividends to conserve cash, thus reducing the need to borrow. An increase in debt makes the shares a more risky investment. Thus, cancelling the dividend was in the best interest of current shareholders, even though it reduced their current income. Click here for the Financial Times article.

The Ford Motor Company, who along with the other two big US automakers cancelled dividends on both common and preferred stock to conserve cash during the credit crisis. Ford was the only one of the three that did not require emergency loans from the government. Now that Ford’s sales and profits have increased, they are in a position to reinstate the dividend. Again, the board did what was best for the shareholders. Click here for the Reuters article.

In a different application of dividend policy, Yahoo! has recently announced a $3 billion buyback of outstanding shares. Suppose that a company’s shares are trading at $100 and they pay a $5 dividend. The investor receives a 5% return. Unfortunately, this dividend is taxable in the hands of the investor. Suppose instead that the firm uses the cash to purchase its own shares on the market. A reduction of outstanding shares by 5% increases the value of the remaining shares by 5%. This 5% increase in share price is not immediately taxable in the hands of the shareholder. Click here for the Bloomberg article.

Unfortunately, there are occasions when a board does not act in the best interest of shareholders. When a company has a large amount of cash on hand and invests those funds in treasury bills yielding less than 2% interest, shareholders are worse off. If the company paid that money out shareholders would then be able to reinvest those funds in shares that yielded more than 2%. Such is the case with Sears Canada. Click here for the Globe and Mail article.

For more on dividend policy see, for example:
Fundamentals of Corporate Finance, Richard A. Brealey, Stewart C. Myers et al., McGraw-Hill Ryerson