Discuss Dell Inc.s distribution policy of zero dividends, and consider arguments for and against such a policy in the light of your review of literature

        On the other hand, the traditional view infers the importance of dividend patterns to shareholders: the essential reasoning is expressed by the saying “a bird in the hand is worth two in the bush”, i.e. dividends are regarded as a more certain yield than future capital gains, and hence preferable by investors. According to this line of thought, a forthcoming dividend presents a lower degree of risk, whereas future capital gains are characterized by greater uncertainty and, in addition, dependence on market fluctuations. As a result, capital gains will be discounted at a higher rate, decreasing the future share value. The resultant suggestion is to apply the highest possible dividend payout rate after funding the available investment opportunities, in order to maximize shareholder wealth. However, another wing backing the relevance argument asserts that a high dividend is not the best option to enhance shareholder value: indeed, the lower capital gain tax suggests that equity investors would be better off if rewarding methods were other than dividends. To this end, share repurchase has become a common practice among companies. As a matter of fact, through extensive and one-off buybacks of issued shares, a company is able to avoid the higher dividend taxation and, if needed, readjust its capital structure, dilution and level of gearing.

        Despite the academic dispute seems far from agreement and evidence does not ultimately controvert any view, the attitude of managers and investors suggests that distribution policies are relevant. Nonetheless, the traditional view is rejected by managers: it follows that capital gain is not seen as more uncertain than dividends and, thus, investors do not plausibly prefer dividends to it. John Lintner's 1956 survey is one of the best pieces of research illustrating this trend: the results show that managers are more worried about changes in the payout rates rather than about the overall amount of dividends. They follow a long-term target payout ratio depending on earnings, but in the short-term dividends tend to remain stable and are only subject to lagged gradual adjustments. As it seems, managers reject the residual theory and are aware of the expectation created by a dividend rise. Indeed, they are adverse to dramatic increases in the payout rate, since they fear future cuts if earnings are not sustained over the long-run.

        The findings of the above-mentioned study show a common managerial inclination towards smooth dividend patterns. This trend is consistent with other academic research, acknowledging that dividend relevance would essentially be due to outputs of the market imperfection, namely information signalling and clientele effects. The signalling effect is a result of the information asymmetry between manager and shareholder: accordingly, dividends would contain a subliminal message about the future share performance, conveyed through a change in the distribution pattern. This informational content has the advantage of being coded, so as to avoid the disclosure of specific details on future prospects, and constitutes a material evidence of managers' confidence. Given that shareholders read increases or decreases respectively as favourable or unfavourable signals, unexpected changes in the payout rate would lead to remarkable price disruptions. Academic studies, besides demonstrating the existence of signalling, show how share reactions are much sharper for dividend reductions, which means that investors interpret negative signals as more severe. As regards the clientele effect, it can be considered a consequence of taxation and share transaction costs: it is implied that particular company policies attract particular investors, because dividends are not freely adjustable by shareholders to fit individual needs. As a result, unexpected changes in the distribution policy would entail shifts in the composition of the company shareholding and volatility in the share price. The ensuing position would be disadvantageous for both company and investor, since the former could fail to raise the needed funds, while the latter should bear the adjustment costs. Again, evidence shows that investors unwelcome unpredictable changes in the dividend payout and, therefore, a residual policy can not be sustained. Regarding the practical application of these dynamics, managers should set up a neat policy and make every effort to maintain a steady, consistent dividend history. Volatility is likely to result in a higher discount rate, therefore managers have to prepare the investors in case of changes and explain adequately the underlying reasons.

        Besides the academic findings on payout dynamics and management behaviours, it is worthwhile pointing out a number of factors in favour of a high-retention policy: first of all, external finance is more expensive and problematic to raise than retained profits. Secondly, earnings may be outnumbered by expansion investments and be drained on promise of capital appreciation. Typically, mature corporations present more restricted opportunities than growth ones and, thus, they pay higher dividends. Thirdly, using up profits can avoid the issue of new shares and prevent dilution of control for existing shareholders. Furthermore, if managers possess undisclosed data about positive future scenarios, a temporary share undervaluation can occur: issuing new shares rather than using retained earnings would transfer part of the existing shareholder wealth to the buying investors.        

        The previous considerations may suggest why a company like Dell has a dividend averse history. At this point it may be helpful to outline briefly the company profile: Dell was known in the past for its innovative approach to computer customization and for being a massive growth company, capable of major acquisitions. Despite a recent trend featured by a loss of momentum, diversification attempts through further acquisitions are planned for the next future. As regards equity, share repurchases have been the preferred rewarding method: thus, it can be assumed that Dell's clientele prefers capital gain and, allegedly, is relatively risk inclined, in a highly taxed bracket and with no oppressive need for cash. Indeed, over the years a number of proposals in favour of dividend distribution have been rejected by shareholders themselves. Dell's management confirms that the company retains liquidity to purse future growth, through acquisitions pushing business diversification. As regards the repurchase strategy, it is geared to flexibility and control: to clarify, through share repurchases, shareholders can decide whether or not to convert their shares, while the company can choose when to repurchase. Comparatively, a dividend is more similar to a fixed cost. Moreover, whereas the exercise of option rights by managers and employees increases the overall figure of shares outstanding, buybacks help the company by balancing the number and reducing dilution of control for existing shareholders. Share repurchase is also seen as a way to boost the share value and the EPS: in fact, the rise in stock demand increases the share price, while the reduction in the number of total shares enhances the EPS, since the same profit is divided by fewer shares. Conventionally, share buybacks are carried out when the company considers the stock undervalued, in particular if undervaluation is not justified by relative underperformance. To sum up, it can be said that a company buying itself is like a chef paying to eat in his own restaurant, in other words a signal of confidence.

        Notwithstanding the substantial benefits of this strategy, Dell is facing growing pressures to pay dividends. Many analysts cast doubts about Dell's innovation and growth ability: the assertion is that the company struggles to keep pace with a market which has moved towards smartphones and tablets. It seems that recent acquisitions have not fully achieved the sought business diversification, insofar as Dell is stil seen as a pure computing manufacturer. In addition, the share price grazing $15 is too high to be attractive for buying investors, while the balance sheet records $13.9 billion in cash reserves. Thus, the claim for dividend is perhaps legitimate: if Dell is not planning to deploy cash for radical transformations, the shareholders should be rewarded. Technology companies have developed the common praxis of a zero-dividend policy, sustained by the abnormal capital growth due to the “Internet bubble”, insomuch that dividends have sometimes been seen as a signal of zenith performance. However, competitors like Microsoft have started to pay dividends and are still pursuing growth. Despite different cost structures weaken the comparison between the two companies, Dell could perhaps take its cue from Microsoft's strategy, i.e. keep cash to cover one year of operating expenses plus one potential big acquisition, and use the residual to pay dividends.

        It is now to understand whether Dell is a mature company ready to pay dividends: looking at the income statement it can be seen that revenue, gross profit, operating profit have been fluctuating among the same values since 2007. The credit crunch must be taken in account, but supposing management does not possess overturning news, Dell looks hardly like a growth company: assuming it is not, the question is whether a dividend would be feasible. Probably it would not, due to the option-based incentive system: stock options are given out to employees and managers as compensation, and grant the right to buy shares at a fixed price by a set date. The mechanism allows option holders to realize a gain if the shares overperform the option price, but the collateral effects are a rise in the number of shares and a loss of value for existing shreholders, since the same profits are split among more shares. The problem starts when the incentives are not occasional, but regular: in 2010 Dell had 1.96 billion shares outstanding and options for 230 million, or 11.7% of the company value. The share repurchase program is therefore strictly necessary, in order to prevent a fierce dilution. However, with such a large amount of options, extensive buybacks reduce barely the number of shares outstanding: it is estimated that “in the five-year period from 1998-2002, Dell spent $9.8 billion to buy back 940 million shares. But the number of shares outstanding fell by only 29 million”. It seems clear that the gear would get flooded if a dividend were to be introduced.

        The option issue affects also other corporations: in 2003 Microsoft tackled a similar situation transforming the stock options in stock awards. The same action could be undertaken by Dell, but two reasons are allegedly slowing the process: first, options constitute a portion of employees' compensation, but do not have to be reported on financial statements and, thus, companies can depict themselves as more efficient than what they are. Second, it could be said that options are more advantageous than dividends to managers: indeed, buybacks reduce the total number of shares, enhancing the EPS. This action increases automatically the value of stock options which, if exercised and sold back to the company shortly afterwards, turn out to be a profitable yield for option holders. In other words, options would reward managers and employees at the expense of sharholders. This is particularly true when the repurchase timing is wrong, i.e. when shares are bought back during a period of overvaluation. Although the difficulty of setting up a balanced repurchase program must be acknowledged, plenty of analysts argue that Dell's repurchase strategy has often been surprisingly wrong. Micheal Dell's option holding, the plethora of options outstanding and the strenuous resistance to dividends are additional factors that could suggest a possible agency problem. To this end, the company should probably improve reporting transparency, while financial institutions, representing 71% of shareholding, should carry out further investigations.

        To sum up, this work has started pointing out the relevance of dividends and the importance of smooth dividend policies. The modernist approach has been useful to isolate and pinpoint the causes of relevance in the market imperfection. Then the findings on managers' behaviours have proved to be inconsistent with the residual theory, due to information signalling and clientele effects. Furthermore, the traditional view has been rejected, showing that a zero-dividend policy, in conjunction with factors such as intense growth, can maximize shareholder wealth. As far as Dell is concerned, a zero-dividend policy is profitable only if the company persists in pursuing growth, otherwise a payout rate should be reconciled with the share repurchase program. Dell would have the necessary cash reserves and ripeness to pay a dividend, but option-based incentives cause excessive dilution and must be addressed first. However, strong resistance to dividends is expressed by both shareholders and management: the reasons are to be investigated, since the poor transparency may suggest a risk of agency problem.