Are dividends important?

Firstly, dividends can be described as the amount of reserves that can be used to pay shareholders who have invested in the company (McLaney & Atrill, 2010). However, are dividends actually important? 

In finance, dividend policy has been one of the most significant topics, which gives it  considerable attention to solve the vagueness of dividends (Alzomaia & Al-Khadhiri, 2013). Theorists such as Modigliani and Miller (M&M) (1961) believed that in an efficient market dividend policies are irrelevant and have no influence on a firm’s share price and does not affect shareholder wealth. However, many financial theorists such as Myron Gordon (1963) and John Lintner (1962) have disagreed with this theory, as M&M did not take taxes and transaction costs into consideration. They have also based their proposition on perfect capital market assumptions, which clearly does not exist in the real world. Gordon and Lintner’s “bird in the hand theory” critisised M&M’s paper as they explained that investors prefer dividends in comparison to retained earnings since the stock price risk declines as dividends increase. They believe the more money the firm pays in dividends, then the more valuable it becomes.  The money that is directed to shareholders is more valuable than the money that is reinvested back into the business.

A unique solution for dividend policy does not exist, as there is strong evidence that the dividend policy is a puzzle (Black, 1976; Baker, Powell & Veit; 2002). There are many companies on the FTSE 350 that do not pay dividends. According to Smith (2013), the Chief Corporate Correspondent of the Financial Times, stated that almost 1/7 of the UK’s largest quoted companies do not pay dividends, despite shareholders searching for reliable income streams. This trend is amongst the UK’s largest quoted companies and has been increasing since 1985. As a result of the financial crisis, times have been tough and companies such as the Royal Bank of Scotland and Llyods Banking Group are not paying dividends, as they are not in the position to do so.

Furthermore, there are a lot of companies that do not pay dividends to their shareholders but are still able to create value. For example, there are many companies in the Computer Hardware industry that do not pay dividends (Financial Times, 2014). Companies such as Apple, the world’s most valuable publicly traded company had $97.6 billion in cash and securities. Apple has kept this money to spend on building data centres, buying parts for products and to pursue ambitious projects that may come along the way. Research and development (R&D) of new technological equipment is also important for Apple (Svensson, 2012). In my opinion I would say this sounds a bit greedy, doesn’t it?
 

However, times have changed and Apple has at last come into the real world and has started to invest in dividends. A commitment to this policy is able to show investor confidence with respect to future earnings and also reassures those shareholders who need income (Collins, 2013). Other companies such as Exon Mobil Corp., the world’s second largest company by market capitilisation pays £9billion in dividends annually (Svensson, 2012). Therefore, this company has been able to create further value.

As a consequence of paying dividends, it is important to consider the drawback that may be involved when distributing them. As we have experienced a tough economic climate, companies may cancel or cut the size of the dividend (Krantz, 2011).  This can be a bad sign for the investors and would decrease their confidence, thus leading them to not invest in the company. Therefore, increasing the level naturally would be more appropriate. 

So to answer this question, I believe dividends are important due to the sensitive economic environment in which we live in. We do not live in a perfect world where dividends are discarded and are not required. They can allow investors to signal credibility of their beliefs regarding the future performance of the firm in the market (Ergungor, 2004). This is important as the financial market is tough and attracting investors is crucial to raise finance to enable future success.

Is there an Optimal Capital Structure?

There is not a definite answer to this question.

According to the traditional view of capital structure, as the level of gearing increases, the cost of equity also increases and the cost of debt remains constant. This is shown in Figure 1. Although the cost of equity increases, this has an overall effect as a result of the lower cost of debt. The weighted average cost of capital (WACC) falls as gearing increases. Once a certain level of debt (not identified) is reached, then the cost of debt starts to increase because of the gearing risk. Therefore, the continuing increase of both the cost of debt and equity causes the WACC to increase (ICSA, 2009).

Figure 1. Traditional view of capital structure

(ICSA, 2009)

Point A in Figure 1 is associated with the minimum cost of capital. It is the financial managers job to come to the decision of determining the appropriate mix of debt and equity to minimise the WACC.

Theorists such as Modigliani and Miller (M&M) (1958) argued against the traditional view of capital structure and developed a proposition described as the ‘irrelevance of capital structure”. They came to the conclusion that the traditional approach is incorrect and the value of the firm depends on its assets and the operating income that has been derived from them, therefore there is no optimal structure.

There are many criticisms with M&M’s theory:

1.    They assume that the capital market is perfect.

2.    Ignore taxation

3.    Assume WACC remains constant at all levels of gearing

However, in 1961 M&M admitted that corporate tax is necessary in their analysis. This altered their conclusion dramatically. They believed that debt became cheaper, as a result of the tax relief on interest payments. They came to the conclusion that if a firm wishes to reduce its weighted average cost of capital (WACC), then it should borrow as much debt as possible which would lead to an optimal capital structure of 99.99% (Samuels, Wilkes & Brayshaw, 1998).

There are also criticisms with M&M's revised theory:

1.    Company’s capital structures are not almost entirely made up of debt.

2.  Assume perfect capital market- however we live in the real world and companies are     exposed to increased interest payments, which could lead to bankruptcy.

Moreover, changing the capital structure of companies can help to create more shareholder value. For example, Aventura Equities announced capital structure changes including a forward stock split.  The company’s CEO believes that this action creates more liquidity for their shareholders and will give the company better opportunities presented as a result of these actions. Enhancing shareholder value is their main aim, and they believe they can meet this goal by changing their capital structure (OTC Markets, 2014). 

So is there an optimal capital structure? I would say no. Given how risky a business is and depending on the circumstances, the appropriate proportion of debt and equity should be used.

Are family businesses really that important?

The answer to this question is yes as family businesses represent the most enduring business model in the world. Continuous success of family firms through generations relies on ensuring that the next generation, in which the baton will be passed on to those who are motivated to take up the challenge and who are fit for the job (Drake, 2013). 

Whether the firm is private or public, family businesses constitute a major segment of the American economic system (Dreux, 2012). The greatest part of America’s wealth lies with family owned businesses. They comprise of 80%-90% of all the business enterprises in North America (Family Firm Institute, Inc. 2014). A great example of an American family owned business is Wal-Mart. Figure 1 shows a family tree of the Waltons, who are one of the richest and most powerful families in the world, own Wal-Mart and according to Bloomberg the family controls more than 50% of the Wal-Mart Corporation. Similarly, based on Forbes’ wealth estimates they have a combined net worth of at least $150 billion. So why does this company matter?  Even though the Walton’s are building billion-dollar museums, driving million dollar cars, Wal-Mart is the country’s largest private employer and pays its employees an average of $8.81 an hour. As a consequence, this company significantly impacts the US economy as growth, increased stability and wealth can be achieved (Willett & Nudelman, 2013).

Figure 1. 

Other famous and successful family businesses include Mars Inc. which is one of the world’s largest companies as it operates in six segments: Chocolate, Petcare, Wrigley Gum and Confections, Food, Drinks, and Symbioscience (Forbes, 2011). It is the 7^th largest private company in the USA and has an income of over $15m. According the President of Mars Incorporated, the company has an objective to create long lasting, mutual benefits for all those involved in the business success. They strive to create positive social impacts, minimising environmental impacts and also create economic value. Therefore companies such as Mars help to increase the prospects of the economy. 

So how are family owned businesses financed? 

It is does not come as a surprise to me that the most popular forms of finance for family owned businesses are self-finance and debt finance. Both forms of finance do not alter the share ownership of the company and so therefore preserve family ownership and control. Though family businesses tend to steer away from equity finance in order to try and retain ownership of their business. However, there is also the case of external investors are often deterred from offering equity finance to family-owned ventures due to the limited opportunities to secure an exit. If family businesses are not able to source finance and capital then how will they grow? This is a key limitation that can affect their ability to continue in an upward track. 

Although family businesses may be successful, problems may occur in larger family firms. Family businesses that wish to obtain outside equity capital will face agency problems. This may cause conflicts, as what the family members wish to achieve may be different to what the investors wish to achieve. Therefore, this may lead to the investors not trusting the family business and their wealth, which can therefore lead to wealth constraints preventing family firms from undertaking activities that can increase growth. Other problems such as conflict between family members and believing in different values may also be a concern when making financial decisions. If a company has generations of family members involved, generational differences can occur as the younger generations can have a different view compared to the older generations. 

Therefore, to sum up family businesses around the world are very important to the global economy as they bring a lot of wealth and growth. As a result they are really important and we must not forget them.