The Significance of Dividend Policies - Term Paper Example

2007/2008 Assignment "It doesn't really matter how much dividend we pay to our shareholders. The value of their shares is going up so fast on thestock MARKETS that they are making enough money irrespective of the dividend". Discuss this statement Abstract The dilemma of whether to return cash to its stockholders and if so how much in the form of dividends haunts every private and public company owner. Many schools of thought have taken conflicting views on this issue. The " dividend irrelevance" group of thought will reveal that dividends have nothing to do with firm value because there is no tax disadvantage to an investor to receiving dividends, and that firms can raise funds in capital markets for new investments without having to go through high issuance costs. Another school of thought believes that dividends are adverse for the average shareholder as they attract taxes and cause fiscal disadvantages. Last but not the least the third group lauds large dividends as positive signal to shareholders that all is well. So where does the modern shareholder satisfaction stand in relation to dividend policies This is the main issue which I will review in my paper below. CONTENTS Introduction...3 1- introduction 3 2- Definitions and views from academics 4 3-CAse study and a reconciliation of academic views 9 4- Conclusion 14 References: 15 1- introduction "The nearly universal policy of paying substantial dividends is the primary puzzle in the economics of corporate finance."(Black 1976 cited by Frankfurter 2002) This question relates to a consideration of the corporate dividend policy as to whether shareholders should be paid sufficient dividends or whether or not they are making sizeable profits on the stock market. Over the last half century academics have spoken in great depth over this issue and suggested conflicting theoretical frameworks to explain their points of view.(Frankfurter 2002).The problem is that these assertions often lack empirical depth to the criticism and stumble upon self contradictions in an attempt to explain corporate dividend behaviour.(Frankfurter 2002).Today academic opinion is divided as to whether dividends are attractive to shareholders and will have a positive impact in stock prices.(Frankfurter 2002 )Another school of thought contends that prices are negatively correlated with dividend payout levels.(Frankfurter 2002).The third view is that firm dividend policy is irrelevant in stock price valuation. (Frankfurter 2002).My paper will discuss and try to reconcile all these views towards a better theory and understanding of this issue. These views are best summed up as being based upon, the tax effect ( Litzenberger and Ramaswamy (1980),)Clientele effects explanations (Elton and Gruber, 1970), Agency theory explanations(Easterbrook 1984), Signalling models(John and Williams (1985), and psychological/sociological explanations (Frankfurter and Lane 1992). Frankfurter and Wood (2002) have even gone ahead to suggest that none of the dividend theories are unequivocally verified. Academics and theorists like (Adam Smith 1937) have recognised that there will always be agency costs related to taking care of shareholder priorities and controlling unruly management staff.(Corporate Governance issues). 2- Definitions and views from academics Dividend policy has a large bearing on agency costs and many academics have recognised this (Fama and Fama) but their belief that payments of large dividends would potentially compensate for the shareholders are often ignored during decision making in a company according to John and Kalay 1982 "Debt covenants to minimize dividend payments are necessary to prevent bondholder wealth transfers to shareholders .Although potentially substantial in precipitation of agency costs, its dividend policy is not a major source of bondholder wealth expropriation. In firms where dividend payouts are limited by bondholder covenants, dividend payout levels are still below the maximum level allowed by the constraints" (Frankfurter 2002). However there is a negative aspect to large dividend payments which are known to affect the funds base required to fund the consumption and investment opportunities of a company as this will affect the capital reserve of the company. (Frankfurter 2002).It is worth noting here that the issue of dividend payments relates strongly to the principles enunciated by Berle and Means (1932) that the shareholder should be allowed to invest in all profitable opportunities through the company's managers. Jensen 1986 has even suggested that there be a model which after financing all positive net present value projects causes conflicts of interest between managers and shareholders. (Frankfurter 2002) Other academics have suggested that because the modern stakeholder is faced with uncertainty as to the market conditions and how they will manifest themselves as risks, they will make their own unique decisions as to how they will respond to the market failures and irregularities. It is often said that payment of large dividends will do little to prevent this behaviour as this has deeper psychological premises. It has also been suggested that the dividend policy rules are incompatible with the notions of maximization of the shareholder wealth by reinvesting the money (Frankfurter 2002).However majority of the literature suggests that if the shareholders desire dividends they should be paid so as to increase the corporation's stability by making them feel more important to their organisation and thus make them feel more responsible for it. Research has shown the following observations that dividends will inevitably lag behind earnings, and might become sticky (that is firms will be unlikely to vary them) and will avoid cutting them even when things are not so good with the firms. Dividend policies will tend to waver over the life span of the firm based upon growth rates, cash flows, and are positively dependant upon project availability. It is also an assumption and to a large extent true that earnings and dividends are positively connected since dividends are paid out of earnings. (Frankfurter 2002).According to John Linter, writing in the mid-fifties there are a few constant patterns to dividend policies, namely firms will set target dividend payment ratios, by deciding on what they are willing to pay in the long term and whether they change dividends to match the long-term and sustainable shifts in earnings, finally the management will be more concerned about dividend levels rather than change or variations in them. At the same time Fama and Babiak have observed a lag between earnings and dividends, by regressing changes in dividends against changes in earnings in both current and prior periods and have agreed with the views of Lintner .It can also be gleaned from academic theories that firms will be reluctant to raise dividends and these will follow a much stable path than earnings themselves. (Frankfurter 2002).The firms' policy of dividends is also related here as the five stages in the growth life cycle (that is tart up, rapid expansion, high growth, mature growth and decline.) are all reflected through the dividend decisions. The question thus presents a Valid point in the sense as to what Miller Modigliani called Dividend irrelevance policy where some kinds of firms remain unaffected by dividend decisions, that is those types which are small companies with substantial investment needs or large companies with significant insider holdings and significant holdings by pension funds (which are tax exempt) and minimal investment needs. The diagram below by (Bhattacharyya, 2007) shows empirical evidence on how the dividend policy remains a puzzle as represented by what he calls the stylized facts as they emerge from a study of the empirical literature. Bhattacharyya (2007) has made some valid points in relation to the empirical evidence and numerical confusion (as shown by the diagram).He says that there are many conflicting and competing views about investment by managers and dividend payments, " The managers control the firm; therefore, they might invest cash in projects with negative net present values, but which would increase the personal utility of the managers in some way. A dividend reduces this free cash flow and thus reduces the scope for overinvestment; rather, they put forward plausible hypotheses.. dividends are used to take away the free cash from the control of the managers and pay it off to shareholders. (Bhattacharyya, 2007). The other view in this regard is that "In corporations with large cash flows, managers will have a tendency to invest in low return projects. . takeovers and mergers take place when either the acquirer has a large quantum of free cash flow or the acquired has a large free cash flow which has not been paid out to stakeholders." (Bhattacharyya, 2007) Bhattacharyya, (2007) has thus gone further to elaborate that empirical evidence reveals a stable trend in relation to the existing theories of dividend policy and (as mentioned above) the existence of certain stylized facts and when these factors are put together they become conflicted. (Bhattacharyya, 2007).He stresses instead on utilizing the asymmetric information paradigm where instead of the signalling models the dividend policy is a result of a screening contract set up by an uninformed principal. His model reveals that since the signalling models ignore hidden information (the productivity of the agent is not observable) (Bhattacharyya, 2007). Thus the dividend under his theory has an inverse relationship to managerial type; the lower the productivity of the manager the more he will try to attract investors with a higher dividend. (Bhattacharyya, 2007) .I would agree with him to the extent that it is true that higher dividends are connected to the concealment of the moral hazard and hidden information. The idea is appealing. No pain. No gain. The riskier the shares, the more difficult it becomes to attract investment and thus the tool of higher dividends. (Bhattacharyya, 2007). However this view does not go far with academics who immediately dismiss it, as if being true whether firms are spending a great deal of time wondering about something the shareholders do not care about. There is an ounce of truth however to this notion. If there is bad reputation about the firm as an investor, payments of large dividends will simply not help. This reminds us of the Enron saga where once the cat was out of the bag nobody wanted to trade with the Enron because of its shoddy reputation. Another query can possibly be whether dividend policy should actually influence managerial decisions in the wake of making amends for negative investor reactions, whether or not the firm is making any profit As owners do not the investors should rise and fall with the management together Since they are technically owners and given that they are paid large dividends, should they also be made to forgo dividends in a bad business year and take the consequences of regulatory constraints, investment magnitude, debt, and firm size Another worthy consideration here is the "Clientele Effect" which may explain why shareholders are not likely to be influenced by dividend decisions; that is, take the example of companies that do not pay any dividends like Microsoft and there has not been a lag in share sales due to this fact. Why then are these shareholders content This is the clientele effect where reputation matters more than money to the rational investor. However as discussed in the case study below, large companies do pay special attention to their dividend payments. 3-CAse study and a reconciliation of academic views To take an example of the Yamaha group of Companies it is worth noting that they take their dividend policy seriously by emphasising that the shareholders interests represent one of the highest management priorities of Yamaha Motor. Their dividend policy is centred on paying cash dividends to accurately reflect on business performance, using the payout ratio as an indicator .Recently they announced their Basic Policies Regarding Return of Profits to Shareholders (Announced in January, 2005) as including disclosure and implementation of explicit dividend policy, increase of total amount to be returned to shareholders, payment of cash dividends that accurately reflect business results, giving priority to capital gains, and aiming to achieve more than 10% in annual EPS growth .1The company has also announced that it intends to raise the EPS by more than 30% in the next three years and to maintain a payout ratio of at least 10% for the time being, and may aim for 15%, depending on circumstances.2If the equity ratio exceeds 50%, or the interest-bearing debt reaches zero in the future, the company will aim for an even higher payout ratio.3The diagram below shows Yamaha's dividend policy aimed at attracting new investors. All in all there will always be a tension between the shareholder dividend desires and the management need for retained earnings for further investment. (Frankfurter 2002).Many academics have then suggested that this tension can be resolved by making the management take into account all endogenous and exogenous current and expected earnings, dividend payment history, dividend level stability as well as the current position of Cash flows. (Frankfurter 2002). Therefore a coherent dividend policy will take into account all variables like Sustainability Current firm profitability, future cash flow expectations, Industry norms. (Frankfurter 2002). In his view of the literature in this area Chiang (2006) has gathered that based on real market conditions investors are in fact attracted by dividends, and they prefer it if the dividends either remain the same or increase over time. (Frankfurter 2002).They will not respond positively to dividend cuts, whether partial or total. The position as it is currently shows that Dividend policy in not a result of any regulatory constraints or any coherent stable policy which often creates tension and bad faith between the shareholders and management. The management might be avoiding large dividends based on market imperfections but this may be sending a bad signal to the stakeholders that either they are not receiving enough return and that they should therefore leave or that their money is not being properly invested. (Frankfurter 2002).Things are further complicated by the fact that these dividends are taxable resources and the dividend that is paid has to reflect this loss through taxes. However what is also true is that a review of the academic opinion suggests that no economic rationale can actually be given to explain the dividend phenomena unless an attempt is made to review this from the perspective of agency costs and shareholder signalling. (Frankfurter 2002).This would mean that since the management knows the intricacies of the distributional support of the project cash flow, the amount of dividends that they will be paying, will be a kind of signalling equilibrium to show good business and the stage of financial development the firm is on. Therefore it can be said that dividends are necessary to transmit information to the capital market about the current cash current cash flow of the firm based on the optimal dividend served. Many academics have spoken of the role of corporate governance within the arena of dividend policies and it has been stated that investor protection has an external component related to it in the sense that the legal environment around the corporate entity and then the internal component are related to the activity developed by the firm and other characteristics (endogenous protection). Thus for Himmelberg et al. (2002) "investor protection' refers collectively to those features of the legal, institutional and regulatory environment - and characteristics of firms or projects - that facilitate financial contracting between insider owners (managers) and outside investors." The research of La Porta et al (2000) suggests that firms operating in the same field or area of study can surprisingly offer different degrees of investor protection and of these features are dividend policies which are a result of the specific operational characteristics and to particular interests. In fact La Porta et al (2000) go on to state that firms in common law countries where investor protection is stronger will have a tendency to make higher dividend payouts when the firms' investment opportunities are poor than do firms in countries with weak legal protection. All this will also be a result of board composition, managerial compensation, takeover defences, and audit. However other academics have concluded that even in the absence of endogenous and exogenous regulation the agency costs will be toned and routed by the pressures of the takeover market. In essence Dividend policy is better viewed as "a corporate tradition" and indeed it does matter how much money is being paid to investors. This is because even in tight times the managers will want to signal good news but will be careful not to offer too high dividends which they are not able to maintain in the future. So dividend payments become the invisible handshake of ownership and control. Current theories have been criticised to ignore other social influences of investor and managerial response and that is why they have been rendered faulty. It has to be understood that like stock prices, dividend policy is a slave to similar psychological influences. (Frankfurter 2002). So moving towards reasons why high profits at the stock exchange do not match up to the attraction within high dividends it can be said that Dividends are an attractive incentive for investors not to hit high tax brackets or those who need the regular cash flows. Firms that regularly pay dividends have investors with higher expectations and therefore cutting or eliminating these dividends can affect the health and wealth of the entire corporate entity. The variances in dividends will help the firms signal to financial markets how confident they feel about future cash flows. This is likely to lead to higher dividends and higher stock prices. Very often lowered dividends will become a negative signal about future cash flows, and stock prices will decline. Firms should tap into the benefits of using dividends for the purpose of financial mix and moving closer to an optimal debt ratio. Such payments help reduce the conflicts between stockholders and managers, by decreasing the cash flows available to managers. However my review of the literature has also sufficed to show that in determining a Tax dividend policy it is important not to be swayed by the "The Bird-in-the-Hand Fallacy" which states that investors will prefer dividends to capital gains based on their certainty or that high dividend rates are a consequence of firms being tempted to pay or initiate dividends in years in which their operations generate excess cash. 4- Conclusion The basic aim of this paper has been to explore the significance of dividend policies upon shareholder payments as to whether this has a bearing upon shareholder loyalty and positive behaviour. Here i have presented the basic goals of dividend policy and the results of empirical research showing the corporate practice. I have also discussed the concept and the meaning of the dividend, the place of dividend benefits in the profits of the shareholders, and the costs of the dividend payment policy. My conclusion is that not only are these dilemmas not quite understood but the lack of wider results of empirical research on the implemented dividend payment policy makes things more complicated. Black (1976) called the love of dividends by shareholders a puzzle; because of taxes where such a sentiment is economically not rational; however empirical evidence has disproved his view and further models to explain this behaviour have also subsequently failed. Modern economists are predicting a rebirth of the concept of dividends I believe that the situation is well summed up by Chiang 2006 who has concluded that "Academia with its haste to develop universally applicable and mathematically tractable models forgets about the evolution of dividends, and how dividend behaviour across firms changes yet all the while remaining the same. That is why financial economics cannot arrive at a single hypothesis of dividends that can be supported, unequivocally, by empirical evidence. In economics research, financial or otherwise, data are always yesterday's news. Thus, different results for the same hypothesis are going to be found, given the time under consideration. Not unlike the military that always fights the last war, academic research, quite often shows evidence that is already pass when it is finally published" References: Aharony, J. and Swary, I., 1980. 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Journal of Finance 38, pp. 1157-1179. Lakonishok, J. and Vermaelen, T., 1986. Tax-induced trading around ex-dividend days. Journal of Financial Economics 16, pp. 287-319. Lang, L.H.P. and Litzenberger, R.H., 1989. Dividend announcements: cash flow signalling vs. free cash flow hypothesis. Journal of Financial Economics 24, pp. 181-191. Laub, P.M., 1976. On the informational content of dividends. Journal of Business 49, pp. 73-80. Lee, H.-W., & Robert-Grand off, P. A. (1992). The role of growth opportunities in dividend initiations and omissions: dividend signalling hypothesis or free cash flow hypothesis. Unpublished working paper. Lintner, J., 1956. Optimal dividends and corporate growth under uncertainty. Quarterly Journal of Economics 78, pp. 49-95. Shiller, R.J., 1989. Fashions, fads, and bubbles in financial markets. In: Market volatility, MIT Press, Cambridge, MA, pp. 49-68. Smirlock, M. and Marshall, W., 1983. An examination of the empirical relationship between the dividend and investment decisions: a note. Journal of Finance 38, pp. 1659-1667. Smith, A., 1937. The wealth of nations. , Random House, New York Frankfurter, G.M., and Wood, B.G., Dividend policy theories and their empirical tests, International Review of Financial Analysis, Volume 11, Issue 2, 2002, Pages 111-138. Lasfer, M.A., Taxes and dividends: The UK evidence, Journal of Banking & Finance, Volume 20, Issue 3, April 1996, Pages 455-472 Wu, C., Taxes and dividend policy, International Review of Economics & Finance, Volume 5, Issue 3, 1996, Pages 291-305 N. Bhattacharyya, 2007 I. H. Dividend policy: a review ,Asper School of Business, University of Manitoba, Winnipeg Managerial Finance ,Volume 33 Number 1 2007 pp. 4-13 ,Emerald Group Publishing Limited ISSN 0307-4358 Read More