Dividend Policy

This week is about dividend policy. Dividend policy is decision of the proportion of profit share to shareholders-generally periodically. There are some theories analyzing dividend policy. One of them is Miller and Modigliani’s dividend irrelevancy proposition. It claims that dividend policy is not relevant to shareholder wealth, basing on rigid assumptions such as no taxes, no transaction costs, all investors knowing all relevant information, all investors can borrow and lend at the same interest rate etc. Another is dividends as a residual. It assumes that it is so expensive to raise external finance. Earnings are the sole source to invest. Basing on this, dividend policy can influence on shareholder wealth deeply. However, in the real world, it is not simple as the two theories. In the real world, dividend policy is influenced by many factors and designing dividend policy is complicated. There are some elements which influence on the dividend policy, such as clientele effects, taxation, dividend as conveyors of information, agency theory, uncertainty, potential of firm etc.

Royal Dutch Shell plc, generally called as Shell, is an Anglo-Dutch multinational oil and gas company and is one of the six oil and gas companies. According to Yahoo Finance (2013), since 2011, the board of Royal Dutch Shell plc decided increased their dividend slightly. From 2011 to 2012, interim dividend increased to $ 0.43 per ordinary share and it increased by about 2.3% than the previous year. In 2013 the board expects that the first quarter interim dividend will be improved to $ 0.45 per ordinary share and it improves by over 4.7% than the same quarter in the previous year. In addition, Royal Dutch Shell plc offers dividends in cash and scrip dividends for shareholders. (Source from Yahoo Finance)

In the case, in my opinion, there are some reasons why the manager decided a slightly and stable increase of dividend policy. First of all, the company creates a large number of free cash flow. According to CEO of the company, Peter Voser, from 2009 to 2012, he said that their company achieved the aim which increased by 80% of cash flow. (Yahoo Finance, 2013) this makes more capability to return for shareholders. In addition, According to dividends as conveyors of information, dividends appear to act as a significant conveyor of information about companies. Shell plc utilizes the stable and slightly increase dividend policy to express that directors view the earning of company and the future of the company with optimistic. I think it is benefit to attractive for shareholders’ investment. And during the good earnings of Shell time, the company avoids paying high return for shareholders. This can avoid losing effects of predictability and stability cherished by shareholders when the company falls into bad earnings time. Meanwhile, according to clientele effects, different shareholders prefer different a dividend pattern. Basing on Arnold (2005), pension funds, trust funds and insurance companies prefer to invest the company which has a stable dividend policy. Thus Shell’s dividend policy will attract to institutional investor. On the other hand, Shell adopts dividend in cash and scrip dividend. This can decrease the number of cash leaving company and make the company keep more cash flow. Thus Shell chooses this dividend policy.

Capital Structure

Capital Structure

This blog will introduce capital structure of companies. The company pursue maximizing shareholder’s’ wealth and company value. By decreasing the weighted average cost of capital (WACC), companies can improve shareholder’s wealth and company value. Debt is a lower cost than equity. Meanwhile, debt can reduce taxable profit. Thus by increasing proportion of debt in the whole capital, WACC will decrease. In other words, improving gearing ratio will create more company value. However, with increase of gearing ratio, the company will have high risk of financial distress. Meanwhile shareholder will require high return. In addition, the company also face business risk. Hence, managers should choose a suitable proportion of equity and debt, in order to build optimal capital. On the other hand, according the theory of Modigliani and Millar, it claims the total value of any company is independent of its capital structure. Thus there is no optimal structure. However, this theory is established under many assumptions such as there is no taxation, there are no costs of financial distress and liquidation, individuals can borrow as cheaply as corporations. Because the assumptions are rigid, I think it is difficult to implement.

Li Ning is a famous company in China which run sport clothes. Its CEO, Li Ning was an outstanding gymnast. On January 2013, this company issue 241 million dollars of bond. The company increase its gearing ratio again. Last year, it has raised 120 million dollars by bond. In fact, since 2008 the company has adjusted its capital structure in order to occupy market share. In 2008, china holds Olympic Games. Li Ning represents Chinese people lighted final Olympic flame. Li Ning catches this marketing opportunity and expands a number of its shops in China. To achieve this, in 2008 the company’s gearing ratio increased to 52%. (Li Ning Annual Report, 2009) Compared its competitor, Anta’s gearing is 10% in 2008. (Anta Annual Report, 2009)Within five years, Li Ning company has been utilizing this capital structure which is high gearing. However, these years the economic is slump and purchasing power keep low. Thus Li Ning makes a large number of inventory with its sharp expand. This leads its cash flow became intense. To remit this, Li Ning has to issue bonds again in 2013. (Financial Times, 2013)

In this case, in order to extend sharply, manager adopts capital structure with high gearing. This capital structure is low raising cost and reduces taxable profit. And it is effective to expand. Li Ning’ shops have exceeded Adidas in China. However, the manager may pay less to its shortcomings or the manager may prefer to high risk, and this leads to the company value decrease. Because economic slumps and expand is sharp, there are large stores and intensive cash flow. These make business risk and financial risk. Meanwhile, clothes retailer is sensitive for general level of economic activities. Thus the capital structure increases risk of financial distress. Furthermore, such high risk makes shareholders require high return, but it cannot be satisfied. As a result, from 2011 to 2013, its share price decreases from about 17 HK Dollar to almost 4.8 HK dollar. (Business Week, 2013) this decreases company value.

Therefore managers should balance proportion of equity and debts in capital structure, according to their industries and aims. Also how to find the good point which balances risk, develop and cost is a challenge for managers.