The Hindu Business Line : Relevance of special dividends

Companies typically pay dividends from the profits earned during a year. A popular corporate finance theory has it that dividends are irrelevant to investors. Why? If Hero Honda does not declare dividends, you can generate the same cash flow by selling some quantity of shares that you hold.

But dividends are considered important because investors view them as a signal about a company's future profitability. As insiders, managers know more about the company than we do. So, if the managers increase the dividend payout, it is perceived as a signal that the company is expected to do well in the future. Why?

Suppose the company does not do well the following year, the managers may be forced to cut dividends. The investors will then bring down the company's stock price because they do not like dividend cuts. The corporate managers know this. They do not, therefore, increase dividends unless they expect the company to do well in the future.

Now consider a situation where a company's profit has increased. The managers want to reward the shareholders with higher dividend. But they do not want the investors to think that such an increase means that the company is likely to do just as well in the near future. What would the managers do?

If the managers call the increased dividend payout as special dividend, the signalling effect would be different. One, investors would know that it is a one-time payment. Two, they would understand that by increasing the dividend payout, the managers are not signalling that the company will do just as well in the future.

Special dividends are, therefore, another way of rewarding the shareholders without sending wrong signals about the company's future profitability.

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