Financial Times
August 18, 1992, Tuesday
HEADLINE: Making good news of a dividend cut
BYLINE: From Professor ADAM BRANDENBURGER and Dr BEN POLAK
Sir, Paul Marsh ('Why dividend cuts are a last resort', August 12) correctly
observes that managers usually have better information than investors, that
dividend cuts signal bad news to the market, and that companies try to smooth
dividends, avoiding 'cuts at (almost) all costs'. But the implication that
this situation is satisfactory is unwarranted.
Consider a manager who knows his company would be best served by cutting
the dividend (instead using the funds for some project) but is worried about
the company's share price. If he were to cut the dividend, the market would
see this as a signal that the firm was in trouble and the share price would
fall.
The market would not be irrational in drawing this conclusion: prevailing
'ground rules' imply only distressed companies cut dividends. The manager
could try to explain the real reason for the dividend cut, say in the annual
report. But this tactic is available to all companies (including ones in
distress) and so has little credibility. Thus managers often continue to
pay high dividends, even when it is not in the best interests of their companies
and shareholders.
This is a vicious circle: as long as only distressed companies lower dividends,
the market will treat dividend cuts as bad news, and the resulting low share
price will discourage healthy companies from even beneficial cuts.
How do we break this circle and promote more flexible dividend policies?
One way would be to encourage managers to be less concerned with today's
share price and more concerned with long-term earnings. This could be achieved
by long-term contracts and stock options restricting early sale.
Adam Brandenburger,
Harvard Business School, Boston, MA 02163, USA.
Ben Polak,
Society of Fellows,
Harvard University, Cambridge, MA 02138, USA.