In 1961, two Nobel Prize winning economists – Franco Modigliani and Merton Miller (M&M) – gave us the ‘Dividend Irrelevance Theorem’. The theorem stated that in a competitive capital market dividend policy is irrelevant for the market value of the firm. In other words, the value of the shares of a company would not be affected by whether the company has a dividend payout ratio of zero, 100 percent or anything in between.
The proof of the Dividend Irrelevance Theorem was straight forward. M&M showed that if the assumptions of competitive capital markets held, an investor can create homemade dividends by selling shares and realising capital gains. The investor is therefore able to enjoy the same investment income that he or she would have received in the form of dividends. In other words, dividends and capital gains are equivalent.
The assumptions of the irrelevance theorem were very strong. A perfect capital market meant that: a) there were enough buyers and sellers in the capital market such that no one market participant could influence the market price of a financial asset (analogous to perfect competition in economics; b) markets were informationally efficient – that is, information was available at no cost to all market participants and not asymmetrically distributed; and c) there were no transaction costs such as discriminatory taxes on dividends and brokerage fees associated with the trading of financial instruments that would distort the choice between capital gains and dividends.
The assumptions of the dividend irrelevance theorem were challenged by several prominent academic critics who argued against the assumptions of the theorem. One of the most vehement critics of the M&M dividend irrelevance theorem was Myron Gordon (1962) of the University of Toronto (whom I was privileged to have as my supervisor).
Myron Gordon systematically attacked the dividend irrelevance theorem on the grounds that the assumptions lacked realism and therefore the theorem could not serve as a guide to dividend policy decisions. Over the years, the dividend irrelevance theorem has been superseded by more elegant models – although it holds its coveted place as one of the core theorems that took Finance out of the shadows of the more senior disciplines of economics and accounting[1] and turned it into a distinct academic discipline.
The recent Bank of Ghana Dividend Directive to banks and specialised deposit-taking institutions (SDIs) has got me thinking about the dividend irrelevance theorem again, and its application in the Ghanaian setting. In the directive, the Bank of Ghana has directed that all banks and SDIs desist from declaring or paying any dividends or distributing reserves to shareholders, and from making any irrevocable commitments regarding the declaration or payment of dividends to shareholders – until further notice but more specifically for 2019 and 2020.
Are dividends relevant in Ghana? Recalling the irrelevance theorem, any taxes that discriminate between dividends and capital gains will make dividends relevant. In Ghana, dividends attract a withholding and final tax of 8 percent. However, capital gains on listed equities are tax-exempt. Therefore, other things being equal, a value-maximising investor in a listed company should never take their returns in the form of dividends because of the tax penalty.
Indeed, even under the Bank of Ghana dividend directive, an investor can create home-made dividends by selling stock on the open market. Behavioural finance suggests that investors do not see dividends and capital gains as identical, and this is reflected in the fact that most investors would rather hold onto their shares and suffer the 8 percent tax on dividends instead of selling on a tax-free basis.
It is also possible that liquidity conditions might make it difficult to sell shares without sacrificing price at certain times – another violation of the competitive market assumptions of the dividend irrelevance theorem.
Therefore, barring liquidity constraints, the Bank of Ghana directive should not matter to investors in the shares of listed banks. In many markets, companies have supported their shareholders with share repurchases that guarantee price stability and liquidity to shareholders wanting to sell their shares. However, this is not an option for listed banks under the dividend directive because of the prohibition on the use of reserves for distributions to shareholders.
Having established that dividends are not an efficient distribution mechanism under our tax laws, do dividends serve any other purpose? Why do companies want to pay dividends even though they come at a tax disadvantage? Recall again that dividends are irrelevant if there is no asymmetric information.
Asymmetric information occurs if information about a company is not available at no cost to every market participant and some are better-informed than others. In a typical company with widely held shares, managers tend to know more than their shareholders because of the separation of management and ownership. Asymmetric information can depress the value of shares.
In other words, all the good and bad news about the company is not disseminated. However, dividend policy can serve as a signal of quality to the market. Therefore, dividend policy matters. High and consistently rising dividends signal good quality while low or zero dividends signal low quality. Share prices are therefore more fairly determined by investors because they incorporate more information about the quality of the firm.
Another consequence of asymmetric information is agency costs. In principal-agent terms, shareholders are the principal and management are the agent. Agency costs arise for shareholders because they cannot observe all the actions of managers and can become the victims of decisions that benefit management only, but increase the risk of loss to shareholders.
The inability to monitor management enables managers to shirk responsibilities or overconsume perks at the expense of shareholders. This is especially the case if managers have access to ‘free cash flow’. Michael Jensen (1986) argued that dividend payments create a commitment for management to make payments to shareholders, thus disengaging free cash flow from management control.
In short, dividends are a partial resolution of the agency problem. That this phenomenon exists in Ghana has been revealed in instances of free cash flow misappropriation by executives of some banks on the blind side of shareholders, resulting in the financial institution failures of 2017-19. Therefore, the payment of dividends provides a positive contribution to the efficiency of capital markets by reducing agency costs.
In conclusion, although the dividend irrelevance theorem does not obtain in the real world, its assumptions direct us to the role of dividends in markets. From a tax point of view, dividends are ‘bad’. Selling the shares of listed banks instead of receiving dividends is more tax-efficient. If investors can find liquidity, they should sell stock to create their own dividends.
However, like most decision models, there are always trade-offs. Although they are tax-inefficient, dividends perform some critical functions for the operation of competitive and efficient capital markets. They provide signals about the quality of firms to the market, thus inducing a more efficient pricing of shares. Dividends also eliminate access to ‘free cash flow’ by managers, thus resolving a costly agency problem that can affect the firm’s value negatively.
It seems, therefore, that what we lose from the Bank of Ghana Dividend Directive are the positive benefits which dividends provide for the competitiveness of capital markets. A set of rigorous conditions for the payment of dividends rather than outright prohibition enables the retention of some market benefits from dividend payments.
While indicating that dividends are prohibited for 2019 and 2020, the Bank of Ghana has also signalled that if it is satisfied the affected institutions have met the regular prudential requirements and are not relying on the additional liquidity released by regulatory reliefs provided by the Bank of Ghana, it will permit the payment of dividends. The market would benefit from more clarity on whether the directive is an outright prohibition; and if not, the specific thresholds that would enable dividends to be paid.
>>>the writer is the CEO, SEM Capital Advisors
