Question 9.E.2: What are the arguments for and against issuing a scrip divid...
What are the arguments for and against issuing a scrip dividend rather than a cash dividend?
Required:
Which of the two do you think is more appropriate, assuming that the managers are concerned with:
(i) flexibility regarding the level of distribution
(ii) ensuring equity between different shareholders
(iii) signalling information clearly to the markets?
Explain each of your answers.
(i) A share buyback is likely to offer greater flexibility. Dividends are normally distributed at regular intervals and shareholders will develop expectations concerning both the timing and amount of the dividends to be received. Failure to meet these expectations could well provoke an adverse reaction among shareholders. Thus, managers usually feel committed to maintaining a sustainable level of dividend payments. This means they will avoid increasing dividends, which then have to be decreased in subsequent periods. Share buybacks, however, tend to be regarded by shareholders as ‘one off’ events and so there is less expectation concerning their amount or the timing. Where a buyback has been announced, but is then postponed, or even abandoned, it does not incur the kind of adverse reaction from shareholders that would normally accompany a cut in dividends.
(ii) A dividend may offer greater equity between shareholders. Where a buyback is carried out when the share price is below its intrinsic value, it will lead to a transfer of wealth from those shareholders that sell to those that hold. A dividend, however, is paid to all shareholders and so does not discriminate between different groups of shareholders
(iii) Dividends are likely to have a stronger signalling effect. A share buyback announcement can send an ambiguous signal to the market as buybacks may benefit managers rather than shareholders.