Dividend Payments Impact On Shareholders Wealth Finance Essay

Dividend is a form of payment made to shareholders by an organization; It’s a profit which is paid out to the company shareholders. When a profit is earned by the company, the profits are used again to invest for a better growth of the company for its future, or it can also be paid to the company shareholders in the form of dividends. Dividends are also paid to the shareholders in the form of cash or shares. The company must have sufficient funds in order to pay dividends to its shareholders. Dividends are generally paid out by a company only when the company make good profit and it’s been paid form its earnings.

Dividend policy is of great interest n today’s financial industries when the joint stock companies came into existences. Dividends can also be defined as “a distribution of company’s earnings which is decided by the board of directors to a class of its shareholders, dividend is also quoted as a percentage of the current market price. It is also known as dividend per share (DPS). Dividend can also be in a form of cash, stock or property.

The level of dividends also depends on the company’s dividend policy. Many large companies have a progressive dividend policy. They are usually paid after half year and full year financial results, even though some companies pay quarterly.

There are various types of dividends which are as follows:

Cash Dividend

• Regular Cash Dividend, Special Cash Dividend, Stock Dividend & Stock Repurchase

Cash dividend: When a company pays dividend in the form of cash is known as cash dividend, cash dividends are generally paid four times a years to its shareholders. Such as Regular cash dividends and special cash dividends.

THEORIES OF DIVIDEND POLICY:

DIVIDEND RELEVANCE THEORY

DIVIDEND IRRELEVANCE THEORY

DIVIDEND RELEVANCE THEORY:

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 dividends today rather than share appreciation and dividends tomorrow. Myron J Gordon(1959) and John Lintner (1956) have also suggested that “in the early sixties, investors see current dividends as less risky than future dividends and capital gains”

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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. However some market participants state that there is some connection between share price and the dividend policy of a company.

DIVIDEND IRRELEVACE THEORY:

According to Modigliani and Miller (1961) the dividend policy is irrelevant to the share price of the company. The value of the firm is determined by the earning capacity of a company and not by its dividend decision.

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”.

The assumption of this theory states that:

There are no transaction cost on the buying and selling of the shares

Investors are having sufficient knowledge about the company

Taxes are ignored

Same interest rate would be available to investors

According to the above assumption, the company which has good prospective with a positive NPV will have a good share price in the market.

Dividend payment has 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 in favour of the impact:

Signalling effect:

If a company pays dividend to its shareholders regularly, it conveys a message to its investors showing the current growth of the company and its future prospectus. Since company pays dividends regularly to its investors, they do not have any agency problem.

Clientele Effect: There are two types of shareholders in the industry. One group who are accepting regular income as dividends for eg: Pensioners. The other group are the ones who are not expecting dividends, because they are interested in the future growth of the company by increasing the capital gain.

Arguments against the impact:

Tax effect:

When shareholders receive income from dividends they have to pay tax which will affect their earnings. If the company pay high dividends to the investors, it would affect the earnings of the company. This would also reduce the cash flow of the company if it wants to make investments.

Earnings:

The market capitalization of the company depends upon the earning per share of the company and not on the dividend policy of the management.

Investment:

If the company pays all its earnings to the shareholders as dividend, they would not have sufficient reserves for future projects. Therefore the growth of the company is an important decision than the decision of the dividend.

Liquidity:

A company would not have any liquid cash left if it pays all earnings and profits to its investors. So liquidity is the main factor in a company as it would affect the business.

Arguments for and against, whether a cash dividend is paid or not is irrelevant in the context of shareholder wealth maximization

Arguments favoring the impact:

The Net profit value (NPV) of a company plays a major role when dividends are given to its shareholders. Dividends would not necessarily be paid to its shareholders as destroying shareholders wealth in the real world is replaced with new set of shares.

Retained earnings:

If the company pays all the income to its shareholders as dividend, then the company would not have sufficient retain earnings to make investment in the profitable projects. If the company needs any funds for the future, it would borrow from sources like equity or debt markets which will increase the cost of the capital because the cost of external funds are comparatively higher than the cost of internal funds.

Arguments Against the impact:

Information content: If the company does not pay dividend regularly to its investors, shows a sign of negative signal to the capital market and hence the share price would also decrease in the market and would also affect the growth of the company.

One of the major problems is the agency cost between the shareholder and the management. The shareholders generally expect a good growth of the company which would in turn give good dividend to the investors. But, the aim of the management is to grow the company in order to maximize the wealth and the power which may not be of interest to the 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:

If the company does not pay dividends to its shareholders, the funds can be utilized for the future growth of the company. There would also be a dual benefit both to the company and the shareholder, where the shareholders may not need to pay an tax on dividend and for the company, they do not need to pay any transaction cost. There is also an argument to change the dividend policy from low to high payouts.

Policy Formulation: In a company there is an administrative cost that is involved with the dividend policy which would in turn reduce the earnings of the company.

Cost of capital: When a dividend payment is reduced, the external financing plays an important role in reducing the cost of capital of the firm. Due to this reduction of cost of capital, the value of the firm has increased because there is an relationship between cost of capital and the value of the firm.

Arguments against the impact of shareholders wealth:

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.

Signalling effect: When a dividend payment is avoided there is an signalling effect which effects the growth of the company and will also have an impact on the share price and effect the shareholders wealth.

FACTORS AFFECTING THE DIVIDEND POLICY OF A COMPANY:

Stability of earnings: Companies which have regular income formulate regular dividend policy than those companies having an uneven flow of income. This can be easily know by the earnings of the company.

Liquidity of Cash: The main factor in the dividend decision of a company depends on the cash flow. The higher the funds the company earns is better for the company in order to pay high dividends to the investors. In order to pay dividends the company needs funds and therefore the availability of cash will be the main factor of the dividend policy.

Extent of shareholders: A company makes decision against the shareholders for the suspension of the dividend to its investors. On the other hand, a company having lots of shareholders are distributed forming high and low income group. This would also have difficulties in securing the assets, because of higher dividend.

Taxation Policy: If a company pays high tax, not the earnings of the company would be affected but also the dividend would be decreased. Tax on dividends is waived by the government only up to a certain limit. This would in turn effect the capital growth of the company. Reduction in tax dividends reduces the value of all the tax payers. The capital gain tax is also likely to be below the shareholders tax rate. Shareholders may also prefer gapital gains to dividends. Directors resolve the conflict between the conflict of interest between the shareholders of a company.

Past dividend rates: When the company pays dividend to its shareholders, it has to review the rate of dividend paid to the shareholders in the previous years, The dividend rate should be should be equal or more to the past dividend rate.

Ability to Borrow: Only large firms and well established firms can borrow funds from the capital market and other external sources. These companies should have a good payout ratio. And smaller firms who are not well established rely on internal sources, and they would also have to build good reserves by reducing the payout ratio.

Legal constraints: There were some constraints in the payment of dividends make by the UK government in the year 1960. There was some control in the payment of dividend. As a government measure, to overcome the anti inflation, but later in 1979, they removed these restrictions so the company must know the legal rules and the government policies before forming the dividend policy.

Policy of Control: This is another main factor for the dividends. The control of the company is determined by the ordinary shares of the company. If the company wants to make investment they need funds. These funds should be obtained from equity capital, If they raise the equity capital, the new shareholders will invest in the company so the directors of the company have full control where they would not want to add any new shareholders to the company, and would announce a low dividend rate to its existing shareholders. The directors do not want to add new shareholders because they would not have any control and diversion on the policies of the management.

Time for Payment of Dividend: Payment of dividends are planned in such a manner that there is no cash flow at the time of issuing dividends, as during the peak time of the company would require funds for urgent finances.

Regularity and stability in Dividend Payment:  Companies maintain dividend equalization fund in order to pay regular dividends to its investors and also have a constant rate of dividends to most of its investors.

Investment opportunity: While the board of directors make dividend policy decisions, they should consider if there is any profitable project or not. If there is a project in which they have to invest, then they have to announce a lower dividend to its shareholders.

Opportunity to collect funds:

The management should think about if there is any source to collect the required funds if needed at a cheaper cost, if not they should not announce more dividends to the shareholders.

Growth: A growth of a company is one of the major factor and plays an important role when dividends are issued to its shareholders. Growth can be measured in sales, market share and the profit of a company.

Conclusion:

Dividend policy is concerned with level of dividends for the shareholders of a company. Thus from the above mentioned two theories, we can conclude the following:

As per the opinion of Director A, dividend should be provided to the shareholders for the following reasons:

Signalling effect: This conveys a message to its investors showing the current growth of the company and its future prospectus.

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.

As per the opinion of Director B, Dividend payment is irrelevant to shareholder maximization wealth for the following reasons.

If the company pays all the income to its shareholders as dividend, then the company would not have sufficient retain earnings. If the company needs any funds for the future, it would borrow from sources like equity or debt markets which will increase the cost of the capital

As per the opinion of the Director C, dividend payments should be avoided due to the following reasons.

If the company does not pay dividends to its shareholders, the funds can be utilized for the future growth of the company. There would also be a dual benefit both to the company and the shareholder, where the shareholders may not need to pay an tax on dividend and for the company, they do not need to pay any transaction cost.

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.