If the investments decision is not attractive to the investor, investor would focus on the other decision – dividend policy. “Dividend Policy is the determination of the proportion of profits paid out to shareholders.” (Arnold ,2008) It is important that firms should have a right level of dividend to the shareholder every time. For example, firms may pay dividends at higher level, same level, lower level or not pay dividends.
Managers have the responsibility to formulate the best dividend policy for both side of corporate and shareholder. Dividend is used to protect the creditors that preventing the shareholders to remove funds from the firm. Therefore, even the firms have loss this year, they may still pay dividends in order to satisfy shareholder to remain investment to the firms. According to Porterfield (1965), dividend policy should aim to maximize shareholders wealth which Porterfield point out that dividend payment only under the situation that new share price is higher than previous share price.
However, Modigliani & Millar (M&M) (1961) argue that if a few assumptions can be made, dividend policy is irrelevant to share price. The share prices are determined by future earning potential, not dividends paid now. Therefore, M&M point out that the share value is determined by investment policy, not by the amount of earning distributed. It means that dividend is only a residual after all the positive net present value (NPV) project investment and earnings are left over. (Arnold, 2008) It is because the market value would rise to reflect future increasing returns due to all positive NPV project that maximize share price of the firms.
Nevertheless, Linter (1956) and Gordon (1959) argue that dividend policy is relevant to the share value. They claim that investors prefer to receive dividend rather than invest the same amount of dividend into the uncertain investments. Investors do not access internal information. Therefore, dividend is the only way to let them know the performance of firms well or not. Arnold (2008) argues that shareholders are interested in whether the firms pay dividends or capital gains. They need regular income such as retired people prefer a high and steady income likes pension funds.
Commerzbank in Frankfurt plans to raise capital to $15.6 billion for repaying a major chunk of state on this Wednesday. Commerzbank shareholders can join mandatory convertible bond in a book-building exercise. This strategy will phase out silent participations as eligible core capital. Therefore, it will reduce annual coupon payments of 9% the bank has to make on the silent participations if it makes a profit under German accounting standards. It will increase when it pays a dividend to shareholder. However, SoFFin from the German Financial Market will enhance corporate actions to maintain its minority in 25% of profit.(The Wall Street Journal, 2011)
By M&M theory, Commerzbank’s policy is profitable strategy for those shareholders, Commerzbank try to reduce annual coupon payments to maximize market price of banks. As the result, shareholders can gain since there is an increase of share price. However, in my opinion, Commerzbanks should not rush to raise capital. Although this strategy would significantly improve the capital structure of banks that make a profit under German accounting standards, there are still a lot of risk factors about it such as the financial market is uncertain about Portugal bailout. Thus, banks cannot predict the consequences of raise capital. Also, as the argument by Linter(1956) and Gordon(1959), in this unpredictable environment, shareholders would prefer to receive dividend rather than Commerzbank use the same amount of money to raise capital.
Those arguments of dividend policy have existed for decades. Firms might choose rather “M&M policy” or “Linter and Gordon policy” or others. It would have different results at the end. However, as I have mentioned in last week blog post, in the real world, there would not have those assumption by M&M, like no taxes, no transaction costs or borrow and lend at the same interest rate. It is because it would not happen. Otherwise, the set up of government and stock market exchange would be useless since we can also assume there would not have any fraud or tax evasion in this financial world to establish M&M assumption.
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