The cost of equity is heavily influenced by the corporation’s dividend policy. When a company makes a profit, that profit technically belongs to the owners of the company, which are the stockholders. So, a company has two choices regarding what they can do with those profits:
They can distribute them to the shareholders in equal payments per share of stock as dividends.
They can reinvest them into the company as retained earnings.
In either case, those dividends are going to increase the value of the shareholders, so for investors, in theory, it shouldn’t matter what the company’s dividend policy is. Either the retained earnings go to increase the book value of the company, or they increase the income of the shareholders, both in equal values.
This idea that dividend policy shouldn’t influence investor preference, yet does, is called the dividend puzzle, which evolved from the Modigliani-Miller Theorem. This theorem states that, in an efficient market, a corporation’s capital structure won’t influence firm value. This is just in theory, though, as the choice of dividend policy will change the costs associated with capital structure, as well as the marginal returns associated with using those retained earnings to grow the company.
Increased book value by retaining earnings doesn’t necessarily translate into increased share price. Retained earnings do not remain a stagnant value and do not necessarily generate additional income or value over time.
Since corporations do not always have a use for retained earnings, the value of dividends will depend on the context of share price (for the investor) as well as total corporate book value (for the corporation deciding on their dividend policy). That’s where the study of dividend policy comes from — what approach to dividends will optimize corporate capital structure and maximize shareholder returns.
When deciding on dividend policy, corporations have a few options available to them:
Preferred cumulative dividends: Corporations have no choice but to pay these dividends eventually, so the influence of cumulative preferred shares of stock on capital structure must be anticipated even before issuing those shares. After the dividends are issued, the corporation has only the choice to either pay them now or delay payment and pay them using earnings later.
Even if the company doesn’t turn a profit one year, cumulative dividends are guaranteed and must be paid later. Delayed dividend payments are considered dividends in arrears until they’re paid, but they must always be paid eventually unless the company goes out of business and uses all the funds generated from liquidation to pay their debts. These dividends always take priority, right after making all debt payments.
Preferred noncumulative dividends: These dividends will be paid after the cumulative shares get all their money first. Noncumulative preferred dividends are paid in a similar manner as cumulative dividends and are “guaranteed” in the sense that they are paid anytime the company makes profits.
However, if the company operates at a loss one year, these dividends won’t necessarily be paid. If these dividends aren’t declared (a term that means the official allocation of profits to pay a dividend, though the dividend hasn’t yet been paid), then they will be forfeited. In other words, use it or lose it. Like cumulative shares, these dividends have a guaranteed cost of capital assuming that the corporation is successful.
Common dividends: Common dividends have no guarantee. If any money remains after a company pays all its debt payments, the preferred shareholders get their dividends, the company determines its requirements for retained earnings, and then the common shareholders get the scraps as common dividends. The role of these dividends on the capital structure of a corporation will vary depending on how these dividends are managed.
These dividends are easily the most flexible of dividends because they’re not guaranteed, which gives management the ability to most effectively determine whether to use profits to fund future projects and lower the costs of capital from equity.
Using common dividends in this manner can even increase equity capital funding in the future by attracting investors via increased total value compared to the total number of shares outstanding for which investors might receive dividends thereby providing higher dividends per share.
Retained earnings: Retained earnings (the earnings, or profits, that are retained by the corporation) are those funds kept by the corporation to fund operations and growth. These earnings are generated after all preferred shareholders get their dividends. The corporation gets its share in retained earnings, and then the rest is given to common shareholders.
Retained earnings are a very popular method of funding growth and operations because it doesn’t increase debt costs nor does it devalue existing value as would the issuance of more equity, thereby increasing the cost of equity. Retained earnings aren’t always sufficient, however. In those cases, companies fund projects as much as possible with retained earnings and then pursue other forms of capital sourcing for the remainder.
Still, growth simply for the sake of growth isn’t healthy, either, so unless the corporation has a use for retained earnings, it should not incur the extra costs of growth without anticipated increases in revenues, obligating it to declare dividends on earnings.
Regarding dividend policy, it’s important to note a couple of things:
Dividends on common shares aren’t required to be paid, but if the corporation doesn’t intend to incur the extra costs associated with using retained earnings to expand the company, then any unused earnings must be paid as dividends. (Those profits have to go somewhere.)
Even on preferred shares, dividends are guaranteed only on cumulative preferred shares. These are preferred shares that accumulate dividend payments over time if they’re not paid during the time promised, generating something called dividends in arrears. On noncumulative preferred shares, these dividends in arrears are dropped from the dividends-payables if they’re not declared. Most preferred shares are cumulative, however.