BUSS3 A* Evaluation - Do You Really Have to Pay That Dividend?

Shareholders can be hard to manage and difficult to please.

On the one hand, a firm owes a debt of gratitude to shareholders for putting their money where their mouth is and backing the business with their cash.

However, shareholders – like all investors – look for a return on their shareholding. The return comes in two ways: (1) a dividend paid (in cash) out of retained profits and (2) an increase in the value of the shares (a “capital gain”).

For many quoted companies, the shareholder dividend is a permanent feature of doing business with investors. A dividend is typically paid twice each year: an interim (usually smaller) dividend paid after 6 months of the financial year; followed by a final dividend once the full results for the year are worked out.

The payment of dividends enables you (and investors) to calculate a key shareholder ratio: the dividend yield.

Dividend yield is simply the annual dividend paid divided by the average share price over the period covered. This gives a good indication of the percentage return on investment that a shareholder gains just from the dividend each year.

So, for example, an annual dividend payment of £0.50 per share for shares that were priced on average at £10.00 each would be a dividend yield of 5%.

So far, so good. But can you see a potential problem from the point of view of management?

What happens if the dividend payment becomes “expected”? Shareholders, used to getting two dividend cheques during each year, assume that the dividends will continue to flow? It creates an expectation that cash will flow out of the firm in order to finance the dividend.

What if the firm is in a situation where it has a compelling strategic need to retain that cash in the business? For example, it may wish to change the capital structure of the business and reduce the amount of debt owed (i.e. reduce gearing). Alternatively, it may have a major investment project in mind which requires substantial upfront cash payments.

In such circumstances, would it not be better to reduce or postpone the payment of dividend? After all, why pay cash out to shareholders when the firm has the potential to invest the cash for a better return or purpose?

The classic A2 business textbook response to a cut in a dividend payment would be to portray the decision as bad news for shareholders. You can see why – the dividend yield will fall and on the face of it shareholders are losing out.

But that’s not the way things often work in practice. Shareholders aren’t stupid. They can see that the value of their shareholding may gain more by retaining and reinvesting cash in their firm – provided that the business is able to generate a sufficient return on its activities.

For a business with liquidity problems and/or unsustainably high gearing, then it makes perfect sense to ask shareholders to accept a lower dividend payment whilst the finances are repaired. Such a move is often in the longer-term interests of shareholders.

So consider whether that might be an option for the BUSS3 case study firm as you dive into the case study issues and options facing management!