Chapter 37
CAPITAL STRUCTURE POLICIES : Distribution in practice: dividends and share buy-backs


Within the framework of equilibrium market theory, dividend policy has little importance. The shareholder is indifferent about receiving a dividend and letting the company reinvest the cash in assets that will earn the rate of return he requires. His wealth is the same in either case.

Signalling theory interprets dividends as information communicated by managers to investors about future earnings. A rise in the dividend signals good news; a cut signals bad news.

Agency theory interprets dividends as a means of mitigating conflicts between owners and managers. Paying a dividend reduces the amount of cash that managers are able to invest without much control on the part of shareholders. On the other hand, paying a dividend aggravates conflicts between owners and lenders when the amount of that dividend is significant.

All things considered, dividend policy should be judged on the basis of the company's marginal rate of return on capital employed. If that rate is above the weighted average cost of capital, the dividend can be low or nil because the company is creating value when it reinvests its earnings. If the marginal rate of return is below the cost of capital, shareholders are better off if the company distributes all its earnings to them.

As long as the company has opportunities to invest at a satisfactory return, managers set a target dividend payout ratio that will be higher or lower depending on whether the company has reached maturity or is still growing. Fluctuations in net earnings can be smoothed over in the per-share dividend so that it does not move erratically and send the wrong signal to investors.

The reader should not forget that, to some extent, dividend policy determines the composition of the shareholder body: paying no dividends leads to low loyalty on the part of shareholders, who must regularly sell shares to meet their needs for cash.

A capital decrease can take the form of either a reduction in the par value of all shares via distribution to shareholders of the corresponding amount of cash, or by a buy-back of shares in which shareholders are free to participate or not, as they see fit.

A capital decrease may be undertaken for several different purposes: to return funds to shareholders when managers are unable to find investment projects meeting the shareholders' return requirements; to signal an undervalued share price; as an indirect means of increasing the percentage of control held by shareholders that do not take part in the buy-back; or to distribute cash to shareholders at a lower tax cost than by paying a dividend.

The reduction in equity capital produces an increase in earnings per share if the reciprocal of the share's P/E ratio is higher than the after-tax interest rate paid on incremental debt (or foregone on short-term investments). But make no mistake, this has only a remote association with value creation.

Debt-financed capital decreases are economically sound when they allow equity capital to be reallocated away from companies that have reached maturity and achieved predictable cash flows towards newer companies that are still growing. They are a means of preventing overinvestment and haphazard diversification. However, they lead to value creation only if one or more of the following hold: the added debt burden forces managers to achieve better performance; the shares are bought back at a price below their true value; or the funds returned to shareholders would have earned less than the cost of capital if kept in the company.