Dividend policy of the firm is irrelevant to the rational investor - Essay Example

? Dividend policy of the firm is irrelevant to the rational investor Contents Contents 2 Introduction 3 Dividend Policy 3 Rational for dividend payments 4 Empirical theories: Irrelevance of Dividend Policy 5 Residual theory of Dividend Policy 5 Modigliani and Miller: Dividend irrelevancy theory 5 The Bird in the Hand Theory 6 Irrelevance of Dividend Policy to rational investor 7 Conclusion 8 Reference 10 Introduction Dividend policy is a part of the comprehensive company policy. In order to decide on the distribution of profits to the shareholders from the retained earnings on an annual basis after taking care of the financing needs for investments aimed at future capital gains, the companies adopt dividend policy. There are several theories that explain the aspect of irrelevance of dividend policy to the rational investors. The rational investors are concerned with the maximization of their wealth which forms the basis of the company’s objective. In order to accomplish those objectives, the companies adopt different policies and strategies for implementation (Bruetsch, 2009, p.12). Dividend Policy Dividends are distribution of net profits earned by the company to its shareholders who have invested in their common stocks. The dividend policy of a company is associated with taking the right decision in making payments of cash dividends to the shareholders for distribution of earned profits. The policy involves consideration of the amount of dividends to be paid to the shareholders in proportion to their investments and the time of payments of dividends which may be at the current stage or in future. The dividend policy of a company is very important because the dividend policy of the company over the years provides an insight to the investors of the financial performance and leads to formation of expectations over future dividends (Paul, 2006, p.17). The expectation of dividends in future plays a crucial role in the fixation and fluctuation of share prices of the companies. In efficient markets, the dividend policy of the company causes flow of information to the markets about the relevant events of the past, instantaneous changes of the present market conditions and the expected events of future. Based on this information, the behaviour of majority investors towards their investment in common stock undergoes change. These factors lead to fluctuation in the share prices and valuation of the companies. The relevance of dividend policy to a rational investor has been discussed in the subsequent sections (Gross, 2007, p.14). Rational for dividend payments The objective of investments is aimed at capital appreciation of the assets or securities over the period of holding. So, there is a definite reason for the companies to pay dividends which actually reduces the long term capital appreciation due to liquid payments in the form of dividend. The dividend payments are clear cut statements by the companies to showcase their abilities to manage their assets and performance to achieve financial profits and growth. The payment of dividends by the companies assures majority of the investors of sound financial performance in future and builds confidence for investment in stocks (Xu and Wang, 1997, p.19). The companies decide through their dividend policy on the proportion of dividend payout and the percentage to be kept for retained earnings. The dividend payment allocations are very delicate as the company also has to focus on increasing the financial wealth in future and reduce their dependency on leverage. The interest and tax rates also play an important role in the dividend policy of the companies. A reduction in the tax rates on long term and short term capital gains would urge the companies to cut down their dividend payments and invest more retained earning for long term capital gains (Funke, 2007, p.11). Empirical theories: Irrelevance of Dividend Policy The aspect of irrelevance of dividend policy to a rational investor can be explained by considering the empirical theories of dividend policy. Residual theory of Dividend Policy The residual theory on dividend policy states that a company would only pay dividends from the residual earnings after meeting all the fund requirements for short term and long term investments. The earnings of the company left after financing the feasible investment proposals are referred to as residual earnings. The companies have the topmost priority to invest in projects looking to achieve the target growth and profits for future and then distribute the residual portion of the profits to the shareholders in order to make a confidence statement to the market investors. However, in case no retained earning is left after financing the investments, no dividends would be paid to the shareholders (Bhat, 2009, p.21). The maximization of wealth of the shareholders is possible only by recycling the retained earnings in future investments in order to achieve compounded growth and capital gains. The motives for residual theory are that the companies would not need to acquire debt as they can use its retained earnings to finance the investments. Also the ownership and control structure of the companies would not be compromised. Residual policy would enable the companies to achieve faster capital gains by proper fund management (Carey and Stulz, 2007, p.17). Modigliani and Miller: Dividend irrelevancy theory Modigliani and Miller were the chief proponents of the Dividend irrelevance theory. The Dividend irrelevancy theory suggests that the dividend policy of a firm does not have any effect of the valuations of the company and does not affect the cost of capital. Managers and rational investors should not be much concerned about the dividend policy of the companies as there is no dividend policy which could termed as the optimum dividend policy. The dividend policy is an outcome of the fund requirement of the company for investment in capital projects aimed at achieving capital gains (Harder, 2010, p. 26). Modigliani and Miller undertook some assumptions to explain the irrelevance of the Dividend policy in the valuation of companies and its irrelevance in the area of interest of rational investors. The assumptions were the prevalence of perfect capital market where there would no tax, no transaction cost of securities, presence of rational investors and prevalence of symmetrical market information which means that same information being present with all the investors. Under such conditions the investment policies of the companies would be not vary and is not affected by their dividend policy. The Bird in the Hand Theory The Bird in the Hand Theory was proposed by Litner and Gordon which explains that investors are risk averse in nature. According to this theory, majority of the investors view dividend payments to be more certain than that of the future capital gains. The investments are done by the market investors with an expectation of immediate receipt of profits rather than expected capital gains from future (Nekrassov, 2008, p. 25). The immediate receipt of dividend is considered to be more certain as compared to the certainty of expected capital gains in future which is to be received after a period of time. Dividend payments were considered as having one bird in the hand which is better than the expected capital gains that were compared with two birds in the bush. Also the internal rate of return for discounting the dividend outflows was considered to be low as a result of lower risk. This resulted in increase of the value of ordinary share. The value of the ordinary share is given by: V=D/(r-g), where D is the expected dividend, r is the low internal rate of return and g is the constant growth rate of dividends. This theory was argued by Modigliani and Miller as The Bird in the Hand fallacy. Miller and Modigliani argued that the rate of return which is influenced by the degree of risk is not associated with the payment of dividends. On the other hand the risk is assessed on the nature of investments adopted by the companies for capital gains in future. The nature of investments which determine the future growth rate of the companies depends on the strategies and policies adopted by the companies. Irrelevance of Dividend Policy to rational investor From the empirical literature, it can be observed that the dividend policy of the companies is extremely important from the point of view of information flow to the market. The investors collect the relevant information from the amount of dividend declared by the companies and the time of dividend payout. Thus the dividend policy helps in building the confidence of the investors and this causes an effect on the share prices of the companies. Although majority of the investors appear to be risk averse by nature, the dividend policy is of no relevance to the rational investor. This can be evidenced from the empirical theories on dividend policies as discussed above. The maximization of the shareholders wealth and the wealth of the companies is only possible through compounded growth rates which can be achieved by channelizing the profits earned by the company in one year into financing for investments undertaken for subsequent years considering the short term and long term aspects. The payment of dividends as decided in the dividend policy is only to assure the investors of the sound financial health of the company and its ability to sustain its profitability. A rational investor would thus look into the financial statements of the company and assess the debt-equity mix of financing adopted by the companies, riskiness of investments incurred, the cost of capital incurred by the company for raising capital and other financial ratios on profitability, liquidity, operation and cash flow of the company (Parrino, Moles and Kidwell, 2011, p.28). The dividend policy would be of no relevance to a rational investor who would be aware of the fact that his or her wealth maximization is only possible to reach the maximum limit in the holding period if the company engages its funds in investment portfolios that maximizes return taking consideration of the risk involved. The rational investor would be concerned of the capital gains from the investment of the companies rather than relatively small and short term annual dividends. Due to compounded effect of the time value of money considered in future investments, the capital gains from the future investments of the companies would be much higher. Conclusion The companies give topmost priority to finance their needs of investment looking at the target growth rates to be achieved in the short term as well as long run. Only after meeting the needs of finances, the companies decide to distribute the residual profits to the shareholders in the form of dividend payments. Thus the shareholders would not be concerned of the dividend policy as capital gains for future from the investments done by the company lies at the core of maximization of their wealth. The rational investors are also knowledgeable that there is no dividend policy that could referred to as an optimal dividend policy. The dividend policies are an outcome of the fund requirement of the companies for financing the investment projects. For this reason, the dividends are declared by the companies which lead to restoration of confidence among the shareholders. Thus the shareholders are attracted more towards the investment in the company stocks as a result of which the price of the share rises and the valuation of the companies are increased. Reference Bruetsch, M. 2009. From Capital Market Efficiency to Behavioral Finance. GRIN Verlag; Germany. Paul, J. 2006. Business Environment. Tata McGraw-Hill Education; New Delhi. Gross, K. 2007. Equity ownership and performance: an empirical study of German traded companies. Springer; Germany. Xu, X. and Wang, Y. 1997. Ownership Structure, Corporate Governance, and Corporate Performance: The Case of Chinese Stock Companies, Issue 1794. World Bank Publications; USA. Funke, C. 2007. Ownership Structure As a Determinant of Capital Structure - an Empirical Study of Dax Companies. GRIN Verlag; Germany. Bhat, S. 2009. Security Analysis & Portfolio Management. Excel Books India; New Delhi. Carey, M. and Stulz, R. M. 2007. The Risks of Financial Institutions. University of Chicago Press; USA. Nekrassov, A. 2008. Cost of Equity and Risk in Earnings Components. ProQuest; USA. Harder, S. 2010. The Efficient Market Hypothesis and Its Application to Stock Markets. GRIN Verlag; Germany. Parrino, R., Moles, P. and Kidwell, D. S. 2011. Fundamentals of Corporate Finance - European Edition. John Wiley & Sons; UK. Read More