The Hindu Business Line : Dividends: Passe in India?

"THE only thing that gives me pleasure," John D. Rockefeller is quoted to have said, "is to see my dividends coming in." Times were when corporate dividends formed a substantial part an individual's income. Investors demanded it by right and corporates gave it — if they wanted to remain in market favour. Most investors in India still thought that way, though worldover, corporates began cutting down on dividends.

Investors have started respecting companies that were bold enough to state they had no policy of distributing dividends. Dividends now form a small part of an individual's overall income; he expects to earn more through capital gains. More interestingly, the number of companies that are distributing dividends is also declining. Taxation policy is one aspect that makes dividend an unprofitable proposition for corporates and investors. With stringent disclosure requirements, dividend is no longer the peacock's tail — a proud signal of a share's value, desirability and future prospects.

Corporate dividend is becoming irrelevant. While the famous Modigliani-Miller (MM) theory of dividend irrelevance is still much debated in corporate finance, it is coming around to be accepted, notwithstanding its unrealistic test-tube assumptions. In a world as jumbled as this, the "bombshell assertions" of MM (as James Vertin put it in his lead article in the first issue of Journal Portfolio Management) look remarkably sturdy. Dividend irrelevance is not a phenomenon in just the mature markets. The Indian market is already half way to falling in line with the global trend. And Mr Yashwant Sinha's recent changes in taxation policies have only paved the way for such a paradigm shift for the corporate sector.

No dividends please

The most obvious step is to analyse it first from the point of view of taxation, which is one of the most researched aspects in the debate on dividend policy. Simple calculations would indicate that for investors the overall post-tax return is sure to come down dramatically compared to the situation when the dividend tax was imposed on the corporates. At the same time, coporates would find their cost of capital going up significantly. Earlier, since investors went untaxed on dividend income, corporates just had to gross up the market rate of return by the dividend tax burden of 10 per cent to arrive at their cost of capital. Now they would have to gross up the market rate of return by the marginal tax rate of the investors to arrive at the cost of capital. The thumb rule is that the higher the company's effective tax rate and the higher the investors' marginal tax rate, the higher would be the increase in the cost of equity.

If taxation is going to be the deciding criteria, both investors and corporates would not prefer dividends in the new scenario.

The corporates would clearly want to retain their profits and let investors benefit through capital gains. They would welcome a situation where they need not consider dividends as a form of income distribution as that could lower the cost of equity capital.

However, the situation is slightly different in the case of investors. While the investors would be indifferent between dividends and short-term capital gains (as they are taxed at marginal tax rates for individuals), they would definitely prefer long-term capital gains. In any case, there would be no clear preference for dividends. Not paying dividends would turn out to be the equilibrium position and it is likely that both corporates and investors will settle for that. But taxes alone do not explain why dividends would not be preferred. It is not that the Indian investors have noticed this tax disadvantage for the first time.

Investor conditioning

The dividend concept receives considerable support from another community which elaborates its role in providing valuable signals about a company's future prospects to investors. Dividends, as this argument goes, may be a corporate's most cost-effective means of overcoming investor uncertainty resulting from `informational asymmetry'. By either increasing or decreasing dividends, corporates can give valuable insights about a company.

In periodically and predictably raising the dividend, corporates effectively bind themselves to make a series of future payments to investors. This commitment, which is costly in terms of a corporate's future flexibility, provides investors with the assurance that corporates are not sitting on some important piece of negative information. This argument, however, does not explain convincingly how dividends function as the most efficient way of communicating a company's confidence. The fact that most profitable companies pay dividends can be interpreted to mean that dividends have some value over capital gains. But given that there are successful and profitable companies that have never paid dividends and have also declared their intentions of never paying it, leads one to wonder whether investors really value dividends or whether they have been strongly "conditioned" by the corporate's habit to distribute dividends. Successful and profitable companies such as Microsoft, Sun Microsystems and Cisco are cases in point. None of them has ever paid a dividend or plans to do so. But they have not fallen from investors' grace. On the contrary, investors value them highly.

If the attraction for dividends is due to investor "conditioning", this process can be reversed by companies persuasively communicating their intentions to put costly equity capital to more profitable uses. This is what Microsoft and Sun Microsystems did years ago and what many companies are now trying to do. What with more stringent disclosure norms, the signalling theory of dividends would only weaken further in future.

Going out of fashion

If logical arguments suggest a case of no dividends, trends around the world also indicate this. In the 1950s, 9 out of 10 American companies paid dividends. Today only one in five does. Fewer American companies are now profitable, and still fewer distribute dividends. If "growth companies" started this trend, even those with healthy cash flows are joining the list. In the US, only 32 per cent of the most profitable companies now pay dividends, half the proportion that did 20 years ago. J.P. Morgan, an investment bank, estimates that the dividend payout of America's 500 largest companies has fallen from over half of profits in 1990 to about a third now. Similar trends also prevail in the Indian context. Though no Indian company till now has consciously adopted a policy of `no dividends', the recent Budget and the emerging global trends will pave the way for such a shift.

Against this background, the Government's move to reverse the policy looks done with the single intention of balancing the Budget. If global trends are anything to go by, Mr Yashwant Sinha's changes in the policy could become a futile exercise. The Government's hope to increase revenues by replacing safe and steady cash flows with higher, but risky, cash flows could probably become a non-starter.

(The author is Associate Consultant with Satyam Computers.)

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Dividends: Passe in India?