Print Email Download

Study On The Theories Of Dividend Policy Finance Essay

Dividends are a form of payments made by an organization to its shareholders. 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: it can either be re-invested in the business for further growth, or it can be paid as dividends to its shareholders.

Dividend policy has been an issue of interest in financial industry when Joint Stock Companies had come into existence. Dividends are also defined as “a distribution of earnings in real assets among the shareholders of the company in proportion to their ownership’’. Dividend policy imply to the payout policy, in which the managers decide the size and the way the cash would be distributed to its shareholders.

In a company, the main goal of the management is the shareholders wealth maximization, which translates into maximizing the value of the company as measured by the price of the company’s stock. This goal can only 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 is based on the firm’s dividend policy and is independent of the value of its share price and that the dividend decision is a positive residual. The value of the firm is also determined by its investment and financing decisions with an 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 rational, may 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 shareholder utility it states that a company maximises its market value by adopting an optimal investment policy. Such a policy is represented by a company which invests projects that yield a positive net present value and maximises the net present value of the company as a whole. A company with insufficient internal funds can raise funds on the capital market, allowing it to 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 in excess of its cost of the capital invested. The firm should distribute its earning to its 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’’.

Thus, from this we get to know that there has not been perfection in understanding the capital markets.

The clientele of a company refers to a person who has money to invest, who come in all varieties of preferences, and some with low pay out and some with high pay out demands.

There has also been an argument in changes of the dividend policy from low to high payouts.

M&M(1961), Black and Scholes argue that “all clienteles are satisfied, and their demands for low or high payouts will not be affected on the share price of a company’’.

There has been a argument to this that the prices would be 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, states that the current dividend payments reduce investor uncertainty and ultimately result in a higher value for the firm’s shares.

In capital markets, the absence of taxes and transaction costs, dividend policy is irrelevant because it cannot affect the shareholder value. The effect of any dividend policy can be offset by management adjusting the sale of new stock or by investors adjusting their dividend stream through stock purchases or sales.

This was a theory proposed by Myron J. Gordon and John Lintner. Therefore, Dividend relevance theory suggests that investors are generally risk averse and would rather have dividends today than possible share appreciation and dividends tomorrow.

Dividend relevance theory states that dividend policy affects the share price of a company. Therefore, optimal dividend policy should be determined which will ensure the maximization of the wealth of the shareholders. Empirical studies do not support this theory. However, actions of market participants tend to suggest that there is some connection between dividend policy and share price in a company.

Thus, when dividends are raised, this is viewed by investors 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. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. And also, companies with low dividends will attract a clientele with a need for current income, and who often have high marginal tax rates.

ARGUMENTS FOR DIVIDEND RELEVANCE:-

There has been an argument on dividend policy since many years, which has resulted in two groups.

A Conservative group believes that “higher dividend payouts will result in an increase in 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 has also been an assumption 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.

There also seems to be a natural clientele for shares that have high pay outs because dividends are a spendable and taxable income. 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 distinction 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.

Clientele Effect:

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.

A internal 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, “the dividend policy should not affect the shareholders wealth’’. Dividend irrelevance is also supported by the empirical work of Black and Scholes which 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 affects 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 are widely 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.

CONCLUSION:

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.

BIBLOGRAPHY:

Travlos, Nickolaos (2001) “Shareholder Wealth Effects of Dividend Policy Changes in an Emerging Stock Market: , Vol 5, No 2.

Watson Denzil ( 2004), “Dividend policy’’, Corporate Finance – principles and practice.

Miller, M. and Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. Journal of Business, 34, 411−433.

Kapoor, Sujatha ( 2009), “Impact on dividend policy on shareholder’s value.

Baker, H.K. (1999), “Dividend Policy issues in regulated and unregulated firms: a managerial perspective”, Managerial Finance, Vol.25 No.6, pp.1-19.

Frankfurter, M, George and Wood Bob ,G ( 2003), “Dividend Policy Theory and Practice”, Academic Press.

Lease, C,.Ronald &John Kose (August 2001),”Dividend Policy: Its Impact on Firm Value”, Financial management Association Survey and synthesis series, Harvard Business School Press.

Miller, M.H. and Modigliani, F. (1961), ‘‘Dividend policy, growth, and the valuation of shares’’,Journal of Business, Vol. 34, pp. 411-33

Anand Manoj(2001), “Factors influencing dividend policy decisions of Corporate India”, ICFAI Journal Of Applied Finance,2004 ,Vol.X ,No.2

Print Email Download

Share This Essay

Did you find this essay useful? Share this essay with your friends and you could win £20 worth of Amazon vouchers. One winner chosen at random each month.

Request Removal

If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please click on the link below to request removal:

Request the removal of this essay.


More from UK Essays

Paid Writing Services

Free Content

About UK Essays

Order Now

Instant Price