Discuss whether dividends are irrelevant

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This essay addresses the issue of dividend policy. Dividend policy is one of the most controversial issues of corporate finance. There are three broad and divergent views surrounding the controversial question of: Do dividends increase the value of the firm, Is dividend policy relevant? The prevailing idea before the seminal work by Modigliani and Miller (MM) was that increased dividend payouts increase firm value and dividends are important. However later MM argued that a firm's value is decided by the success of its investments and not by how it pays dividends. A more radical view suggests that in view of the differential taxation of dividends and capital gains, dividends will reduce the firm's value as they are taxed at a higher rate and hence argue that the dividend policy is important. These three divergent views are further discussed in detail in the essay.

Case for the low dividend payout:

Miller Modigliani argues that the dividend policy is irrelevant:

Our theoretical discussion starts with the dividend irrelevance proposition by Nobel Laureates Miller and Modigliani. The proposition states that the dividend policy affects only the allocation between ordinary income and capital gain, and has no effect on the total gain to the shareholders. In a perfect capital market the shareholders can effectively undo the firms dividend strategy. If a shareholder receives greater dividends than desired, he or she can reinvest the excess, Conversely, if a shareholders receive a smaller dividend than desired than he or she can sell off the extra shares of stock. This argument is due to MM and is similar to their homemade-leverage concept.

However MM argument is useful in introducing the concept of dividend, it ignores many factors in practice. It rests on several assumptions. It does not take into account the real world factors like the personal taxes and the costs involved with the issue of news shares. It assumes the condition of free capital markets.

The leftist school of thought have a more critical view of the high dividend payouts. Their arguments are based upon the level of taxes. E.g. in US although both cash dividends and the capital gains are taxed at a maximum rate of 15%, dividends are taxed when distributed whereas capital gains are deferred until the stock is sold. Hence the tax rate on dividends is greater than the effective rate on the capital gains. They also argue that for a firm with extra cash, the dividend payout decision will depend on personal and corporate tax rates. If personal tax rate is higher than a corporate tax rates, a firm will have an incentive to reduce the dividend payouts. However, if personal tax rates are lower than the corporate tax rates, a firm will have an incentive to pay out any extra cash as dividends.

Consequently dividend payments create a tax disadvantage for investors that should reduce the returns to stockholders after personal taxes. Stockholders should respond by reducing the stock prices of the firms making these payments, relative to the firms that do not pay dividends. In this scenario, a firm will be better off either retaining the money they would have paid out as dividend or repurchasing share.

On the other hand the rightist view advocates the high dividend payout ratio as they believe it increases the firm's value. They present four reasons for it.

Desire for current income: Individuals desiring higher current income will tend to invest in the high dividend securities. These investors may not be paying much in taxes and consequently don't care about the tax disadvantage associated with the dividends. Also the Tax Exempt Investors like educational institutions pension fund endowment funds and trust funds etc would prefer high dividend stocks.

Tax and legal benefits from higher dividends: A low or high dividend payout stock could have different impact on the different set of investors depending on the tax rates and the other laws prevalent at that point in time. For Example in some countries corporate investors benefit from 100% dividend exclusion where as are taxed on capital gains. In this case high dividend low capital gain stock will be more appropriate for the corporations to hold. Also trust and endowment funds, pension funds and some categories of investors like widows and orphans may prefer high dividend stocks because of tax exclusion.

Uncertainty resolution: It is also argued by Professor Mayron Gordon that high dividend policy also benefits the stockholders because it resolves uncertainty. Since the investors price the security in lights of the forecasting and discounting of the future dividends, greater uncertainty exists for the dividends to be received in distant future than forecasts of the near term dividends. Therefore the stock price should be low for the companies that pay small dividends now in order to remit higher dividends later.

Dividend, investment policy and management incentives: Shareholders of mature companies which have plenty of free cash flow but few profitable investment opportunities don't always trust their managers to spend their retained earnings wisely and fear the money being put towards the their own bonuses or other form of incentives. In some cases they may build a larger empire rather than a more profitable one. Hence they claim larger or more generous dividends because it signals a more careful and value oriented investment policy.

The empirical evidence suggests that the dividends are important assuming ceteris paribus conditions. Companies are generally reluctant to cut the dividends as a cut is often a signal that a firm is in trouble and may infer to the investors a fall in earnings and cash flow leading to a fall in stock price. Due to the information asymmetries effect, the investors cannot be as informed and knowledgeable of the company as the management which leads to them assuming that the management can better predict the future earnings. Hence under these conditions a dividend increase implies two commitments from the management, first that the higher dividend will be maintained over the long term, and second that the earning will grow to sustain the dividend. Thus in this case investor perceives the dividend increase as positive and this causes the share price to rise. Thus this signalling effect also explains why managers do not like big change in the dividends. Through the Linter's (1956) classic study, researchers have noted how managers set dividends in line with sustainable future earning, and avoid dividend cuts as much as possible. This is shown below: Suppose that a firm always stuck to its target payout ratio, then a dividend payment in the coming year (DIVt) would equal a constant proportion of earnings per share (EPSt).

DIVt = DIVt-1 + K . (T. EPSt - DIVt-1) where K = adjustment rate

T = Target Payout Rate

Hence through this approach managers are able to smooth out the dividends and offer a consistency or steady progression of dividends in relations to the earnings which can fluctuate over the years. The empirical evidence also suggests that investors respond positively to the share repurchase announcements (for example Vermaelen 1981, Dann 1981, Howe et al. 1992, Perfect et al.1995). Due to information asymmetries, investors predict that a share repurchase generally means that shares are overvalued and any share repurchase announcement causes the share price to rise The signal effect of the dividend is also evident from the following two real world examples:

In 1974 a largest investor owned US electric utility company Consolidated Edison announced on a market close that it was omitting its regular quarterly dividends of 45 cents a share. The news was received negatively by the market given the size and the prominence of the firm and its long dividend history. Consequently, as a result heavy selling led to the decline in its share to $12 from $18 and the company lost one third of its market value overnight. This illustrate that the shareholders can react very negatively to unanticipated cuts in dividend.

Also an unexpected increase in the dividend signals good news. For Example in 1989 Bank of Montreal earnings per share dropped from $4.89 the previous year to $0.04 due to increased loan loss provision for LDC debts. However the annual dividend was increased slightly from $2 to $2.12 by the management. This signalled to the market that the earnings would recover in 1990 which actually did happen.

Hence in both these cases the stock price react to the change in dividend. This reaction can be attributed to the amount of the future dividend and not to the change in the dividend payout policy. This signal is also called the information content effect of the dividend. Therefore if dividends provide some reassurance that the new level of earning are likely to be sustained, it will lead to the increase in the share price and similarly the announcement of dividend cuts are usually taken as bad news and stock price may fall.

Alternatively, an increase in the dividend may sometimes lead to the fall in the stock price if the investors believe that the increase means firm having to forgo some of it profitable projects or positive NPV projects.

Stockholders tend to invest in firms whose dividend policies match their preferences. Stockholders in high tax brackets who do not need the cash flow from dividend payments tend to invest in companies that pay low or no dividends. Whereas, stockholders in low tax brackets who may need the cash from dividend payments will usually invest in companies with high dividends. This clustering of stockholders in companies with dividend policies that match their preferences is called the clientele effect and may help to explain why some companies not only pay dividends but increase them over time.

Although MM argument of dividend irrelevance can be said to be too idealistic due to the number of assumption, it makes a good case against the view: that a firm that invests in poor projects making substandard returns cannot hope to increase its value to the investors by just offering them higher dividends. Also a firm with great investments may be able to sustain its value even if it does not pay any dividends. The tax argument against the dividends could also be said to be of a less important issue in present world scenario than it was in 1970s and 80s, since now in most countries the marginal rate for both capital gain and dividend is now at the converging end.

Since the rightist case of dividends being important is mainly based around the signalling effect and the preference for current income, we cannot rule out the fact that the dividend policy signals to the market may differ in different places as in some countries the investors may be less preoccupied with the dividend changes for instance in Japan there is closer relationship between the investors and the corporations, therefore information on dividends may be more easily and effective shared with the investors. Therefore Japanese corporations are more prone to cut their dividends when there is a drop in earnings, also investors there may not mark the stock down as sharply as in the US (see Appendix Fig 1) (K.L et V.A. Warther, June 1998). However it does not propose that signalling is not relevant, but is a less important issue in some countries. The preference for current income although dissolved by the MM irrelevance theory and the homemade dividend theory which provides the remedy for the mismatch in the desired and the actual income level cannot be considered as a sound argument due to the over simplistic assumption of free capital market, no taxes, no transaction costs, perfect market knowledge etc held behind those theories. However we cannot fully determine whether the tax argument of leftist against the dividends, or the preference for current income argument of rightist in favour of the dividends is stronger argument. Unfortunately, no empirical work has determined which of these two factors dominates, perhaps because the clientele effect argue that the dividend policy is quite responsive to the needs of the stockholders. Besides dividend decision is important because it determines the payout received by the shareholders and the funds retained by the firm for investment. Also the previous research establishes that 69.8% of companies and 18.5% of the investors favour a stable dividend policy especially in Japan (see appendix Fig 4) providing the sentiments of the corporate and investor community in general. Hence by weighing up both sides of the argument in relation to the dividends, it suggests that dividends and dividends policy is an important issue, however the companies need to understand the trade off involved between dividends, reinvestment and the firm value.



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