The importance of clarity

This North Yorkshire plant was once the UK's biggest coal-fired power station, owned by Drax. Now moving to convert three of the six generating units to burn wood pellets instead of coal, you could be forgiven for thinking "what on earth has happened here?"

The company has explained that they are struggling with dramatic shifts in the UK electricity market, for example installations of wind and solar farms plus increased government rules on carbon emission to combat climate change. This has led to a drop in annual profits and when this was announced, shares fell more than 10% this month. Whilst the 17% fall in earnings was expected, analysts still predict a less generous dividend policy in the future.

As well as announcing financial results, Drax announced they would carry out a review of its dividend pay-out policy in line with reinventing the business. They did say that they would discuss this dividend policy with shareholders as they are moving from coal electricity generation to new businesses.

In a bold move, the chief financial officer has confirmed they will not be cutting the dividend and that the review was just a result of the way the company's earnings had changed as a result of dealing with government efforts to wean the UK off coal power.

In an attempt to diversify operations by launching a new strategy, Drax have invested £340 million in the acquisition of a business-to-business energy supplier as well as looking into building four gas power plants to fill gaps in the UK market. Interestingly, analysts have argued that with the business transformation being confirmed last year, expectations were raised regarding dividend information. It is surprising that Drax haven't communicated any more specific information, considering investors and shareholders have been waiting a long time for clarity.

An important question to consider when looking at a corporate dividend policy is: if Drax have made such great investments like the £340 million acquisition, should dividends be lowered? It is interesting that Drax have said that they won't cut the dividend pay-out and yet haven't provided shareholders or investors with any more clarity.

The bird-in-the-hand theory argued by Linter and Gordon states that dividends are preferable to capital gains because of uncertainty. Future gains are uncertain and investors would rather have the money now than leave it tied up in uncertain investments. Drax should consider this and aim to improve their communication with their investors and shareholders to avoid risking the relationship.

Developing on the theory, if a company pays low dividends, investors may sell those shares and buy shares in a company paying higher dividends which means the share price would decrease in the company paying lower dividends. Contrastingly, higher dividends could indicate a lack of attractive investments and lower future investment returns whilst low dividends could indicate many attractive investments and therefore, better future prospects.

Ending on an important point to think about...

If Drax and its management are planning to cut the dividend pay-out, they need to ensure they communicate to investors and shareholders the reason for doing this clearly as share price and shareholder wealth could suffer.