Dividends vs Capital Gains

Dividends vs Capital Gains

Companies giving high dividends are somewhat of a controversial topic. There are several debates on whether companies giving dividends are performing well - or whether they are simply signalling to attract investors. In today’s blog I will discuss whether investors would prefer capital gains (therefore meaning dividends are irrelevant) or whether investors value dividends.

In the UK companies pay out 2 dividends throughout their financial year. The first is an interim dividend which is paid half way through the year and is generally the smallest dividend of the two. The second dividend is after their company accounts have been published and is usually larger than the first dividend. According to Porterfield, a company’s dividend policy should aim to maximise shareholder wealth – otherwise what is the point?

Dividends and retained profits are decided by the investment and financing decisions of a company (Watson & Head). They are only payable through any retained profits the company may have whether this be recent profits or historical. Realistically a company should only pay dividends if it creates more wealth. Porterfield created a model for analysing dividend payments which suggested that dividends only create higher shareholder wealth when ‘the cash dividend paid to shareholders’ + ‘the expected ex dividend share price’ > ‘market price before the dividend was announced’.

Just how important are dividends?

The most common theory in relation to dividends is the dividend irrelevance theory. This is derived from Modigliani and Millar’s capital irrelevance and suggests that under perfect market conditions shareholders are indifferent to whether they receive returns on dividends or capital gains (Brennan & Thakor, 1990).  They also argued that share price is determined by future earning potential and not what is paid in dividends now which therefore results in share value being determined in their investment policy – and not the level of dividend paid out. M&M argued that shareholders are more interested in a company who invests in projects with a positive Net Present Value (NPV) and therefore increasing the market value of their shares. Therefore by doing this the company is increasing its wealth generation thus increasing the shareholders capital gains. This results in shareholders not being concerned about any dividends as they are gaining by other means. Is this true in reality?


Bird in the hand…



An alternate theory is the ‘Bird in the Hand’ theory. This idea suggests that investors actually are interested in dividends as they are more certain than capital gains. In other words, dividends are a ‘sure thing’ whereas the future share price of a company is not, therefore due to the certainty of these dividends a company would increase the firm value (Baker et al, 2002). However, Bhattacharya argues that the riskiness of a projects cash flows affects a firms risk and an increase in dividends now will result in a drop in the stocks ex-dividend price. Therefore overall the counter-argument suggests that by increasing the dividend today will not increase a firms value.



Tax Preference Policy



Alternatively, there is the tax preference policy. Capital gains are taxed at a lower rate than dividends so this is an important factor for investors to take into consideration. Therefore based on this, this could assist with M&M Dividend Irrelevance theory if investors are worried about paying higher taxes on dividends.


Centrica


Centrica's dividends have increased continuously over the past 5 years, however their share price has not reflected this and has been extremely volatile throughout the same period, thus supporting Modigliani and Millars theory that they aren't related. Furthermore the current share price has reacted to market information which would suggest it is at a price determined by future earning potential (share price has dropped in correlation with P.E Ratio of the industry, thus suggesting that due to the market having less confidence in the industry, share price has followed). Therefore this example supports M&M's theory.



Overall…



In conclusion the existing theories appear to suggest that overall investors prefer capital gains as opposed to dividends, with the only problem being the uncertainty of the capital gains on share price. With M&M’s dividend irrelevance theory I appreciate that this theory is based on ‘perfect market conditions’ (which is another debated topic and relates to my previous post of EMH whereby investors question how efficient the market is) and therefore cannot be solely relied on for a thorough conclusion. With the addition of the Tax Preference Policy, my personal opinion is that investors would prefer capital gains as they pay less tax and they are gaining on their investment, but as suggested in the ‘bird in the hand’ theory, capital gains are less certain. Personally I would be indifferent if I received the same returns over a 5 year period from dividends as I would to capital gains, as long as there was a gain overall. My opinion therefore coincides with M&M so I would deem that theory to be most correct whereby under perfect market conditions shareholders are indifferent to whether they receive returns on dividends or capital gains

References

- Baker, H. K., Powell, G. E., & Veit, E. T. (2002). Revisiting managerial perspectives on dividend policy. Journal of Economics and Finance, 26(3), 267-283. Retrieved from http://search.proquest.com/docview/215589529?accountid=12860

- Brennan, M.J. & Thakor, A.V., (1990). Shareholder Preferences and Dividend Policy. The Journal of Finance. 45 (4), pp.993-1018

- Investopedia, https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/reporting-of-stockholders-equity-12/dividend-policy-80/investor-preferences-364-8369/ retrieved 24/11/14

-Watson. D, Head. A, (2013), Corporate Finance: Principles and Practice, 6th Ed, Chapter 10, pp 317-347