7.5 Some Further Dividend Policy Issues
- Information Content – Stock prices tend to rise upon unexpected dividend increase announcements; alternatively, a dividend cut may be a sign of financial distress and result in a sharp price decline if unexpected. There have been instances where companies have announced huge losses, but maintained the dividends, rather than decreasing it in order to preserve cash. In doing so, management is signaling that they have high expectations for future earnings prospects. In light of this, stock prices have been known to remain steady.
- Clientele Effect – Investors may be said to gravitate to companies whose capital (and operating) policies match up with their own risk profiles and financial requirements. Companies with high/low payouts attract different investors. If high dividend firms are in short supply, market forces will bid up the price; low dividend firms may find it valuation-advantageous to increase its dividend. While payout is irrelevant, the clientele effect affects value; there is a competitive market for dividends.
- Residual Theory – Due to flotation costs, firms wish to minimize frequency of new issues. This argues for reducing payouts and having high internal reinvestment. Dividends may be paid from what is left over after internal needs, while maintaining its desired debt ratio. This requires projecting future needs – before having to resort to external financing. If requirements exceed projected inflows, then dividends may be reduced or eliminated.