Gujarat dividend policy tackles principal-agent problem

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The Gujarat government has announced a policy regarding dividends that has taken the market by storm. Listed Gujarat state PSUs are on a roll in market on Wednesday. GSPL shares rose close to 7.4%, GNFC increased 8%, Gujarat Alkalies inched up closed to 11% while GMDC share shot up 18.75%.

The Government of Gujarat has announced that minimum amount of dividend will depend on one of the two criteria. First is 5% of net worth and second criteria is 30% of profit after tax. Dividend will be decided on whichever is higher between the two.

At the same time government is not in favour of company keeping lot of cash with themselves. If state PSU’s have net worth of Rs 2,000 crore or more, their cash and bank balance is Rs 1,000 crore or more then these companies should buyback their shares.

At the same time if reserves and surplus are at lest 10 times higher than paid-up equity share capital, then these companies should issue bonus shares.

Shareholder aspect of announcement

This dividend policy goes back to principal agent problem in the market. Share holders invest their money in the company but its managers run them. Hence there is no guarantee that managers will take action in favor of shareholders. They might earn the profit but instead of returning it back to share holders they might use it for empire building or buying private jets and such thing.

This policy indicated with this decision state PSU’s are required to give large amount of decision so they won’t use money for unnecessary activities. This will lead to more discipline and prudent actions by managers. Hence principle-agent problem is solved to some extent.

Government lack of trust in state PSUs

There is another aspect of the decision. Firms retain money in order to reinvest them in profitable projects. Since firms are required to pay back large money to investors they won’t be able to grow.

This indicates government doesn’t believe that firms have good investment opportunities so they should not keep money. It is good from capital flow point of view as investors can get back cash and they can invest them in more profitable companies.

At the same time dividends and buybacks are considered partial liquidation of company. So in a way government is trying to partially liquidate its state PSU’s. Now it needs to be seen whether such actions will also be followed by other state government and central government.