Why Companies Pay Dividends - Literature review Example

Why companies pay dividend? I. Introduction Dividends are defined as the income paid by investments and that both bonds and stocks can pay for it. (Tyson 2006, p. 215) When a firm declares and issues a dividend to its shareholders, this payment is not tax deductible and, instead, the receipt of it generally is considered to be taxable income to the shareholders.(Frenczy 2008, 8-21) These also underscore that since the firm that issued the dividends did not receive offsetting deduction, tax is paid both at corporate and individual levels as a consequence. Dividends are often compared with capital gains, the mutual funds that have made gains to be distributed to the investors. The different tax treatment between dividends and capital gains however generally work against the former. A number of companies pay dividends and in some, it is a given in the way their organizations are run. This paper will explore why anyone cares about it at all. Specifically, this paper will address the questions why companies pay dividends; why investors pay attention to it; do dividends affect an organization’s value and how do managers use dividends in the organizational financial management; among others. The idea is to identify whether dividends have any bearing or effect on an organization particularly in terms of equity and firm value. Summary of Literature Review The review on the current dividend literature provided in the following section is particularly focused on the areas related to the positive and negative characteristics of dividends to business organizations. Such outline of studies was aimed at determining how other scholars answered the question posed by this paper. The review summarizes the current studies and research on dividends policy, particularly. An important dimension to the review, however, which would have a pivotal effect on this paper as a whole was the passage of the Jobs and Growth Tax Relief Reconciliation Act. II. Literature Review The corpus of literature available in regard to corporate payout policy and dividends is extensive. However, this review would focus on two major areas: why do dividends matter for corporations and does it matter how business organizations distribute cash to its shareholders. Miller and Modigliani are considered to be the authorities in regard to framing dividend questions in their finance research. They, particularly focused on how dividend policy is considered a choice between financing with internal equity or financing with external equity. In their study, Miller and Modigliani offered proof that dividends do not matter in a world that is characterized by perfect markets. The fundamental rationale of their argument is that firm values are determined by choosing optimal investments. There has been numerous studies undertaken designed to empirically test Miller and Modigliani’s theory. These, however, such as those studies undertaken by Kalay and Michaely (2000), remained inconclusive. Of course, it is important for any attempt at credible examination of the significance of dividends for organizations if there is no credible approach to dividend calculation. Burton Beam and John McFadden offered a process in their book called Employee Benefits (2001). Here, they focused on using the “experience rating model” because the method supposedly achieves the ultimate degree of premium equity among shareholders. (p. 401) Since Miller and Modigliani’s irrelevant dividend argument is based on perfect markets, what happens in the more real cases of imperfect markets? Albarran, Chan-Olmstead and Wirth (2006) discussed this with their four market imperfections and their impacts to dividend: 1. Taxes the tax differential between dividends and capital gains argues for an inverse relationship between dividends and shareholder value or stock price. 2. Transaction costs: the existence of transaction costs argue for the retention of profits and the use of this internally generated equity rather than external equity for the company. (A specific example that demonstrates this variable is what Benjamin Graham and David Dodd called as the “plowback earnings” (p. 382) in American dividend policies. Here, by withholding dividends or by paying small parts or the withheld dividends’ earnings, corporations acquire more money. This has been made possible because dividend policies in America are permitted to be arbitrary and selfishly determined. 3. Imperfect Information: Since investors do not have access to company information, it argues for a positive relationship between dividends and stock price. 4. Market restrictions: Many institutional investors cannot buy stocks unless they pay a dividend. Also, there are individual investors who will not buy stocks unless they pay dividends. As a result, dividend paying stocks broadens the market demand for dividend paying securities and creates a positive relationship between dividend and stock price. (p. 147) S.R. Vishwanath offered a discussion on how dividends may be bad for an organization. One of the arguments he presented in this regard is that dividends are taxed at a higher rate than capital gains in many countries. He said that the tax on capital gains will be paid only when the investors sell shares and so a company that pays no dividends should be more attractive to investors than a similar company that pays dividends. (p. 598) Because of the tax disadvantage of dividends, it made sense for companies to analyze how they view and use dividends. It is interesting to note that despite the tax disadvantage (as illustrated by Vishwanath, for instance) there are corporations who continually do so. There are two main reasons for this as offered by financial economists. Cordes, Ebel and Gravelle (2005) wrote about them: The first – known as the traditional view – argues that dividends offer nontax benefits to shareholders that offset their apparent tax disadvantage… The second explanation or “tax capitalization” view assumes that dividends offer no nontax benefits to shareholders relative to retained earnings. (p. 213) Cordes, Ebel and Gravelle also added that corporations have no alternative to dividends like share repurchases for distributing funds to shareholders. Their discussion of these arguments included several actual examples and case studies that underscored the points they made. One of the most updated work in regard to the trend on dividends and dividend policy is those by Grullon and Michaely (2002). These authors cited, for instance, that there is a large decrease in the number of firms paying dividends and that the number of corporations buying back their shares has increased dramatically in the past 40 years. This work appeared to reflect the significance of dividends for firms today. Unfortunately, Grullon and Michaely’s study – as was the majority of literature on the subject - was undertaken before the enactment of the Jobs and Growth Tax Relief Reconciliation Act in 2003, wherein the tax rate differential between dividend and capital gains was removed. This law changed the rules on the taxation of dividends. Dividends were taxed at a rate as high as 38.6 percent and long-term capital gains were subject to a maximum tax of 20 percent in the previous law. The 2003 legislation radically reduced those figures. For those in the 15 percent bracket or less and those with taxable income of $65,100 or less, the tax rates on dividends has been slashed to zero and that regardless of ones income, the maximum rate on dividends has been capped at 15 percent. (Schnepper 2008, p. 425) And so, obviously this changes the dynamics on how dividends are perceived in terms of its value to business organizations. For instance, one school of thought posited that because the 2003 tax reforms introduced tax cuts for direct retail investors and institutions investing funds for retail investors such as mutual funds, a likely expectation would be for firms with relatively large holdings of retail investors to initiate or increase dividends. Fundamentally, dividends and capital gains should also be perfect substitutes for each other today as taxes are now eliminated as differing factor. All in all, there is still a lack of literature, particularly those offering empirical evidence, on this aspect and that this paper will attempt to cover the gap. Also, the widespread emphasis on the tax model for the analysis on dividends – why it is preferable or not in comparison with other payout schemes – deserves to be reexamined. This emphasizes the fact that the body of literature tends to focus on general theories to explain the importance or “unimportance” of dividends. More corporation-specific models must be analyzed to determine the value of dividends for organizations. References Albarran, A Chan-Olmstead, S and Wirth, M 2006, Handbook of media management and economics, New York: Routledge. Beam, B and McFadden, J 2001, Employee Benefits. Dearborn Trade Publishing. Cordes, J Ebel, R and Gravelle, J 2005, Encyclopedia of taxation and tax policy. The Urban Institute. Ferenczy, I 2008, Employee Benefits in Mergers and Acquisitions. Aspen Publishers Online. Graham, B and Dodd, D 2008, Security Analysis: Principles and Technique. McGraw Hill Professional. Grullon, G and Michaely, R 2002, Dividends, share repurchases, and the substitution hypothesis. Journal of Finance, 57, 1649-1684. Kalay, A and Michaely, R 2000, Dividends and taxes: A Reexamination. Financial Management, 29:2, 55-75. Miller, M and Modigliani, F 1961, "Dividend Policy, growth and the valuation of shares," Journal of Business 34:411-433. Schnepper, J 2008, How to Pay Zero Taxes 2009. McGraw Hill Professional. Tyson, E 2006, Personal Finance for Dummies. For Dummies. Vishwanath, S.R. 2007, Corporate Finance: Theory and Practice. SAGE. Read More