10 - The use of dividend policy

In this weekly blogger it will explore dividend policy.  There is a question, what is dividend policy? Dividend policy is to determine the proportion of profits that paid out to shareholders. Shareholders usually buy share from stock market, and the share of the company usually pay out dividend periodically. Most of people think that the reason why companies need to pay dividend back to shareholder is to return money back to shareholder to maximise their wealth.

However, this is an interesting question to everyone. Do a company want to maximise shareholder wealth? The answer is yes, but they may have other purposes when paying dividends, such as to keep shareholders buying their shares. Indeed, there are two different situations that the company may face, which are obtain attractive investments and a project that difficult to obtain or too expensive. If a company is paying a small amount of dividend which represents the company is using the amount of money to invest into a project. On the other hand, if a company is paying a huge amount of dividend to shareholders, it may be a signal that the company does not have any project to invest to.

When a company decide to pay a dividend, what do they need to consider? Modigliani & Millar (1961) suggest that company should determine by investment policy, not the amount of earning distributed, which means the amount of paying dividend has no effect to company value. The dividends represent a residual payment and therefore it is irrelevant to pay more dividends when the company try to increase their value.  However, Modigliani & Millar assumption only applies in a perfect capital markets, no issue cost for securities and no tax.

Looking at a warehouse club company Costco, the announcement that Costco will spend 3 billion USD to pay a special dividend to shareholder, as higher tax rates that may kick in come January, from this announcement Costco share price rose 6.3% dramatically.

It can be seen that Costco is based on a tax issue to raise dividend to shareholder, which cannot apply Modigliani & Millar (1961) assumption. However, the amount of the dividend, a low dividend is considered bad news to the company. Costco spent $3 billion on special $7 dividend per share, which demonstrates this is a good new to Costco as they have performed well previous year. Through this action it will display an unstable dividend compare to last few years, it will lead investors who aims for short team may intend to sell their shares when the company drop their amount of dividend in times. Therefore to all companies are willing to pay dividend should be stabilize their dividend in order to lost potential investors.