Study About The Theories Of Dividend Policy Finance Essay
Dividend is a form of payment made to shareholders by an organization. It is a part of profits paid out to shareholders. When a company earns a profit the money earned can be put into two uses that is it can be invested again in the business for better growth in the near future, or it can be paid as dividends to its shareholders.
Dividend policy became an issue of interest in financial industry when Joint Stock Companies came into existence. Dividends canalso bedefined as “a distribution of earnings in real assets among the shareholders of the company in proportion to their ownership’’. Dividend policy implies to the payout policy, in which the managers decide the size and the way the cash would be distributed to its shareholders.
In any company, the main goal of the management is the shareholders wealth maximization, that translates into maximizing the value of the company as measured by the price of the company’s stock. This goalcan be achieved by giving the shareholders a “fair” payment on their investments.
THEORIES OF DIVIDEND POLICY:
DIVIDEND IRRELEVANCE THEORY
DIVIDEND RELEVANCE THEORY
DIVIDEND IRRELEVACE THEORY:
The dividend irrelevance theory, whichis based on the firm’s dividend policy,is independent of the value of its share price and the dividend decision is a positive residual. The value of the firm is also determined by its investment and financing decisions withan optimal capital structure, and not by its dividend decision. A common dividend policy should be able to serve all firms because the dividend policy is irrelevant in determining firm value.
Modigliani and Miller (1961) pointed out that“the investors who are rationalmay make the choice but maximise their utility, which are indifferent to receiving capital gains or dividend on their shares’’. From the perspective of maximising the shareholders utility, the company can maximise its market value by having an alternative investment policy, which will be beneficial to the shareholders.
Such polices are used in companies which invest in projects to get a positive net profit which will maximise the whole companies net present value. A company, which has no funds, can raise funds from the capital market by allowing finance on projects.
Hence, according to Modigliani and Miller, the decision on investment is divorced from the dividend decision. A company’s choice of dividend policy, given its investment policy, is really a choice of financing strategy.
ARGUMENTS FOR DIVIDEND IRRELEVANCE:-
A firm cannot earn excess of its cost of the capital invested. Firm distributes its earning to the shareholders in form of dividends.
M&M (1961) argue that “a firm’s value is generally determined by its investment policy and is split in the form of funds and dividends which are to be reinvested and thus this does not affect the value of a firm’’.
This show there is not been a proper perfection in knowing the capital markets.
The client plays a major role in the company who refers to the person who has money to invest; client is the one who come out with lots of preferences with hight and low payout demand.
There is also an argument to change the dividend policy from low to high payouts.
M&M(1961), Black and Scholes argue that “all clients are satisfied, and their demands for low or high payouts will not be affect the share price of a company’’.
There has also been an argument that the prices will not effect the dividends with future earnings rather than to the dividend itself.
There has also been a strong argument between M&M(1961) and those of the dividend irrelevance proponents, and the residual theory.
DIVIDEND RELEVANCE THEORY:
A theory by Miller and Modigliani that, in a perfect world, the value of a firm is unaffected by the distribution of dividends and thus, it is determined solely by the earning power and risk of the assets of a company.
Dividend relevance theory, it states that the current dividend payment reduces investor uncertainty and ultimately which result in a higher value for the firm’s shares.
In the capital market, the absence of transaction costs and tax is irrelevant in the dividend policy because it does affect the shareholder value. The dividend policy can be offset by the management by adjusting the sale of stock or by also adjusting the dividend streams of investors through stock purchase.
This was a theory proposed by Myron J. Gordon(1959) and John Linter(1956). Therefore, Dividend relevance theory suggests that investors are taking a risk generally and would rather have dividendstoday rather than share appreciation and dividends tomorrow.
Dividend relevance theory also states that dividend policy effects the share price of a company. Therefore, an optimal dividend policy should be determined which will ensure the better wealth of the shareholders. Empirical studies do not support this theory. However, some of the market participants tend to suggest that there is some connection between dividend policy and share price in a company.
Thus, when dividends are raised, investors view it as recognition of future earnings increase. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. A dividend reduction may state that management may forecast poor earnings in the future. Therefore companies with high dividends will have clients to invest with low marginal tax rates ad strong desires for current income and also companies with low dividends will attract a client with a need for current income, and who often have high marginal tax rates.
ARGUMENTS FOR DIVIDEND RELEVANCE:-
There are two groups which is based on the argument about dividend policy since many years they are:
Conservative group believes that “higher dividend payouts will result increase the value of a company’’.
On the other hand it also believes that “a high value of dividend will decrease the firm’s value’’.
There are some assumptions in business that the earnings paid out as dividends should be given a much higher multiplier while evaluating the shares than not to distribute earnings.
Shares that have a high payout will have a natural client for shares; the only reason for this is because dividends are spendable income and taxable. Whereas capital gains are an additional income to the capital of a company.
Myron J Gordon(1959) and John Lintner(1956) have suggested that “in the early sixties, investors see current dividends as less risky than future dividends and capital gains’’.
One more reason could be that companies may have plenty of free cash flow but they may have only a few investment opportunities.
Another major scenario is the effect of taxes which is likely to interfere with the dividend irrelevance.
Generally speaking, if dividends are taxed more than capital gains then they are more chances to transfer the dividends into capital gains.
Apart from the difference between income and capital gains, there has also been an effect on differential rates of personal income tax and also there is a possibility that a company may have shareholders of both private and corporate types, who are generally taxed under different tax conditions.
Dividend payment has negative impact on shareholders wealth:
Arguments for and against of a cash dividend payout that would have an impact on the Market value of a company:
Arguments favouring the impact:
Dividends reduce cash flow of a company which leads to decrease the value of the company’s capital which would result in the increase of shareholders wealth.
If a company pays higher cash dividend to the shareholders, it gives more sign of chances about its future to its investors and the increase in dividends may lead directly to an increase in the company’s share price in the market.
Arguments against the impact:
Shareholders have to pay tax on their income that they receive in the form of dividends form the company, which in turn causes tax liability.Also, high cash dividend payout would lead to the decrease in the earnings of a company and would also lead to shortage of cash when a company wants to make investments. This may affect the growth of a company.
In other words shareholders would also invest in the stock market when they receive good amount of dividends from the company.
Arguments for and against, whether a cash dividend is paid or not is irrelevant in the context of shareholder maximization
Arguments favoring the impact:
Shareholders generally prefer a regular income from dividends when their money if invested in a company, in case a company does not declare dividends to its shareholders one of the reasons could be due to an efficient capital market, as the company realize that their income by selling a part of their shareholdings are in the form of homemade dividends.
The Net profit value (NPV) of a company plays a major role when divides are given to its shareholders. Dividends would not necessarily be paid to its shareholders as destroying shareholders wealth in the real world could quickly be replaced by having a new set of shares.
Arguments Against the impact:
Dividends are “sticky” because firms are generally reluctant to change dividends; in particular, firms in order to avoid cutting dividends even when earnings of a company drop.
It is also argued that the share prices of a company tend to reduce when there is a reduction in the dividend payments.
Ainternal cost arises from, an agent acting on behalf of a shareholder. Agency costs are also one of the core problems such as conflicts of interest between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value. But management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.
Arguments for and against weather dividend payments should be avoided, as they would lead to a decrease in shareholder wealth.
Arguments favoring the impact of shareholders wealth:
The main impact on the firm’s dividend policy on its value is an unresolved issue. Miller and Modigliani state that, “thedividend policy should not affect the shareholders wealth’’. Dividend irrelevance is also supported by the empirical work of Black and Scholeswhich leads to an argument in the M&M(1961), However, Black and Scholes shows the ability of firms to adjust dividends and to appeal tax which included investors and argue that this supply effect may account for their finding of no relationship between dividends and stock returns.
Arguments against the impact of shareholders wealth:
Since managers have information that outside investors do not have, dividend policy is a costly-to-replicate vehicle for conveying positive private information to market participants. In line with these arguments, of models by Bhattacharya (1979) and Miller and Rock (1985), among others, find that dividend payments avoided would convey negative information about the company’s growth and future cash flows.
If a company avoids dividend payment to its investors, shareholders would withdraw their investment that they have invested in the company and thus this would also have an negative impact on the shareholders wealth.
FACTORS AFFECTING THE DIVIDEND POLICY OF A COMPANY:
Stability of Earnings: Every company has an important bearing on the dividend policy. Company’s having regular earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes. This is because they can easily predict their savings and earnings.
Liquidity of Funds: Availability of cash flow in a company is also an important factor in dividend decisions. A dividend represents a cash outflow, it mean that greater the funds and the liquidity of the company the better the ability to pay dividend. The liquidity of a firm depends on the investment and financial decisions of the company which in turn explains growth of expansion and the method of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend.
Extent of share Distribution: Nature of ownership also effects the dividend decisions in a company. A company is likely to make decisions against the shareholders for the suspension of dividend. On the other hand, a company having which has a good number of shareholders arewidely distributed and forming low or medium income group, which would in turn face difficulty in securing such assent because they will emphasise to distribute higher dividend.
Taxation Policy: High taxation reduces the earnings of the companies and also the rate of dividend is lowered down. Government levies dividend-tax of distribution of dividend when its beyond a certain limit. This effects the capital formation of a company.
Past dividend Rates: When a company formulates the Dividend Policy, the directors must keep in mind the dividend paid to the shareholders in past years. The current rate should be around the average past rate. If it has been increased the shares will be subjected to speculation. The company should consider the dividend policy of the rival organisation.
Ability to Borrow: Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources. Such Companies may have a better dividend pay-out ratio. Where in smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend payout ratio if they require any funds.
Policy of Control: Policy of control is another factor where dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear that they would not be any control and diversion of policies of the existing management. So they prefer to meet the needs through retained earnings.
Time for Payment of Dividend: Payment of dividend means outflow of cash. Therefore a company distributes its dividend to the shareholders its least needed by the company because there are peak times of periods of expenditure. Management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances.
Regularity and stability in Dividend Payment: Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, in spite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.
Dividend policy is concerned with level of dividends for the shareholders of a company.Since the formulation of the M&M proposition in 1961, financial economists have been arguing about whether dividends have any effect on the long-term market value of the firm. The irrelevant dividend theory based on the works of M and M, states that the value of the firm is not affected by its dividend policy and is therefore irrelevant in the determination of ordinary share price. The relevant dividend theory is based on behavioural dividend models and states that under real life market conditions, the value of the firm is affect.
The relevant dividend theory by Gordan (1959)and Linter (1956)is based on behavioural dividend models and states that under real life market conditions, the value of the firm is affected by its dividend policy and is therefore relevant in the determination of ordinary share price. Under market imperfections such as taxes, transaction cost and imperfect information, firms tend to adopt a stable and consistent dividend policy because firms perceive a dividend policy to be important to shareholders.
Thus we conclude based on the managements’ views of a company on dividend payments and the effect on firm value. Because the dividend policy is a natural consequence of dividend theory being applied, the conclusions to this are categorised under the dividend policies, such as the managed dividend policy, and also there is a consequence of the relevant dividend theory and the residual dividend policy, a consequence of the irrelevant dividend theory.
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