Evidence has also suggested that the marginal tax rates on dividends are normally higher than on capital gains and that capital gains tax can be defer by reinvestment of the proceeds. Why then should companies pay dividend by following the rightists view? The following are some of the reason why companies pay dividends:
¢Some investors require a steady stream of income. It can be argued that they can have this by selling shares; but because of transaction costs, it is preferable for them to have a stream of income instead. ¢Other investors are required to spend money out of income and not capital; as such they cannot sell shares and will thus require some dividend payments to meet maintenance requirements. ¢Also that investors may prefer some money now than wait to receive it the future because of the time value of money; a dollar today is greater than a dollar tomorrow. ¢To reduce agency costs that arises because of the separation of management and ownership. Management may want to build an empire through the accumulation of cash, which creates conflict by pursuing objectives that do not maximize shareholders value but increases managerial perquisite consumption.
¢Also shareholders may require dividend in order to prevent management from accumulating too much cash that they can expend on projects with negative NPVs, if they do not find lucrative investment opportunities. ¢Some investors, like pension funds, do not pay tax on dividends so the tax argument is irrelevant to them; as such they will require dividend payout. ¢Companies also pay dividend for signaling purposes. That is that management has confidence in the investment opportunities of the company and the future sustainability of dividend payout.
¢Companies are also normally viewed favorably through share price increase when they increase dividend or announce dividend for the first time. Those that decrease dividend may experience a fall in share price. ¢Companies also pay dividend to attract different clientele of investors that fall in different tax brackets or for portfolio diversification. Those that fall within a lower tax bracket are paid dividends; those on higher tax brackets are given other payout options that are tax efficient. Dividends can be paid in the form of cash, property or stock. The advantages of cash dividend are:
¢Earnings they are highly liquid for investors, which they can use as they see fit. The other types are less liquid. ¢Companies that consistently pay cash dividends demonstrate a sense of stability and investor respond by paying premiums for the stocks of such companies. ¢Cash dividends enable investors to reap some benefits from their investment without selling their stocks; thus it encourages long-term ownership of the stocks, especially for investors that require steady streams of cash. ¢When a company pays regular cash dividends its limits the amount of losses investor may incur in the event of a downturn as some of the investment had been recouped earlier on. Disadvantages of cash dividends are:
¢Decrease in retained earnings that the company can use for growth and investment opportunities ¢Cash dividends are taxed immediately, where as the tax on the others can be defer until the stocks are sold or cash is withdrawn from the investment property. ¢Also the tax on cash dividend is relatively higher.
¢Shareholders will expect the company to continue paying cash dividends; if the company faces cash flow problems or wants to invest in lucrative opportunities then the company would be encountering a dilemma. ¢Dividends are also normally taxed twice; first as corporate tax and then as dividend income.
2) The most important issues confronting the FPL Group in May 1994 were: ¢The adverse ratings from analysts. ¢The possibility of the company not being able to maintain its dividend policy. ¢The companys stock price had fallen by 19.6% with the S&P Electric Utilities Index fallen by 22.1%; the companys share price fell by more than 6% in one day in May 5. ¢Negotiations between the company and the Florida Municipal Power Agency which was ordered by the Federal Energy Regulatory Commission; this intercession was as a result of the litigation brought on the company by the agency claiming that the company violated the NEPA Act of 1992 by denying the agency access to its utility transmission system.
¢Threat of competition if the Florida Public Service Commission considered retail wheeling. The company would then lose some of its market share. At that it was the largest utility company in Florida but the fourth largest in the country. Retail wheeling allowed companies in other states to provide utility in other states. ¢Rising interest rates and the possibility of an increase in the companys beta; this may result in a downgrade of its debt ratings by Standard and Poor. ¢Shareholders may not ratify the companys auditors or approve the proposed compensation plan.
3) The dividend payout ratio of the company = cash dividend/net income = 461,639/428,749 = 1.0767 = 107.67% Or dividend payout = dividends per share/earnings per share = 2.47/2.30 = 1.0739 = 107.39%. For comparative purposes, the dividend payout ratio of the company before extraordinary items = 2.47/2.75 = 89.82%. As per exhibit 7, the company had the highest payout ratio in the industry. From the perspective of the company, its then dividend payout ratio was inappropriate because it was not sustainable given the increased risks faced by the company and the systemic risk in the market in addition to the issues highlighted in (2) above. Without adjustment for extraordinary items, the company had the highest payout ratio as per Exhibit 9. The company should decide on a lower payout ratio and invest the rest on positive NPVs projects. It can decide to reduce its dividend payout to at least the industry average of 82.9%.
4) For the individual investors and others who held 51.9% of the companys stock, a reduction in the payout ratio should not affect their value; this is because most of the payout was going into taxes. A reduction in cash dividend would lead to capital appreciation. If cash dividend would be replaced by stock dividend the company could still have enough cash flow to pursue growth strategies and these shareholders would be better-off. Thus the payout ratio was inappropriate to them. For the institutional investors that owned 36.9% of the companys stock, they would prefer a higher dividend payout ratio since tax on dividend do not affect them.
Thus this payout ratio was appropriate for them. They may even expect an increase in the payout ratio; because a bird in hand is worth two in the bush to them. For the ESOP investors that were using the stocks as a retirement savings plan, the payout would be appropriate based on whether the employees were retired or on active duty. Those on active duty would prefer a low payout so less tax and high capital appreciation; those that were already retired would prefer more payout because their marginal tax rate would then be lower and they require steady streams of cash flows for sustenance and maintenance purposes. The insiders (officers and Directors) would prefer a low payout as they would have been earning high salaries already; as such the payout ratio is inappropriate for them.
5) The majority of the firms investors (63.1%) would prefer a lower dividend payout ratio. Thus the effect of a dividend cut would not affect them and in effect not having a substantial effect in the share price. These investors would therefore likely hold their shares. Institutional investors may bale out and invest in other companies that would then have higher payout ratios, like Texas utilities. This bale out would lead the share price to fall. Thus a reduction in the dividend payout would affect the share price further; it was falling anyway so the company should just as much do the right thing now to cut the dividend and use the cash to invest in positive NPVs projects or repurchase the stocks at the lower share prices and hold them in their treasury. If the company would be able to identify enough positive NPVs, its share price would bounce back. Thus the recommendation is to hold.