Dividend Policy in Publicly Traded Companies - Assignment Example

For a firm with good future growth and investment opportunities, investors want the firm to put the earnings in other investment opportunities. Whereas for a non-growth company, investors would prefer to present dividend income rather than future capital gains which are uncertain. [2]The dividend policy of a firm will divide the earnings into two parts as Dividends and Retained Earnings. Dividends are paid to the investors as cash for their share of the assets of the company. Whereas Retained Earnings are used to fund the long term growth of the company, which are used to generate future earnings.

The percentage of Dividends distributed and Retained Earnings are determined by the Payout Ratio of the Dividend Policy. Higher the Payout ratio, higher the Dividends and lower the Payout Ratio simply lower the Dividends. Usually, growth-oriented firms have a lower payout ratio and higher Retention Ratio. That means a large number of earnings are retained to increase future earnings. The investors of low dividend paid companies will get their returns through capital gains. The relation between growth and Payout Ratio can be best understood by Dividends, on one hand, increase the cash earnings of the investors and reduce the share on the assets of the firm.

In the case of the high tax on the earnings of the dividends by the government, investors are more interested in the firm to keep the earnings for the future growth of the earnings. Otherwise for low growth-oriented firm investors want cash dividends as they can earn more return elsewhere. According to Miller and Modigliani in a perfect market condition and in a no-tax situation investors are indifferent to a company that pays a dividend and another not pays a dividend. Whatever the investors lose in the form dividends are gained through capital appreciation.

The investors believe that the dividends are put to earn further gains in the future. On the expectation of increased future earnings the prices of the stock increase giving the investors capital investors which they can make by selling the stock at a higher price. But stock market history shows us that dividends really matter for any particular stock. Most of the non-dividend-paying companies are invariably loss-making dogs[4] These companies do not have earnings capacity in their business and are struggling even to pay the dividends shareholders.

Investors think the company has lost its earning capacity. The selling pressure decreases the prices of those non-dividend company shares. This is quite opposite to the dividend theory of the stock market as well as what Miller-Modigliani postulated."One look at the JSE highest dividend yield share reveals the problem: It is Northern Engineering Industries Africa whose 3 000% dividend yield places it way ahead of second-placed SA Reit at 70%."[5]The above example explains that the highest dividend paying Northern Engineering Industries has a higher price than the SA Reit, in spite of both the companies operate in the same industry.

Higher dividends attract more and more investor interest in the stock. Thus the price of the shares increases on future dividends as well as capital gains.