Impact of Dividend Policy on Share Price - Research Paper Example

Impact of Dividend Policy on Share Price Introduction In present corporate scenario the impact of dividend provides a great influence on the share price of companies. In the dividend decision, the management of the company decides how much portion of the profit will be distributed among the shareholder as dividend. There is average positive correlation between dividend changes and short term abnormal return in different sectors. Dividend refers to the share of profit that is distributed by the company among the shareholders who have invested in the company. Dividend is the one part of earning, which directly goes to the company shareholders. Somehow it benefits the company as well as the shareholders of the company since both of the parties are involved in just making profits on their investments. Therefore, the dividend policy and the share price are related with the “Wealth Maximization” of the share holder. Here the researcher will discuss the different aspects of the dividend policy and its influence on the share price. Moreover, model on the basis of different theoretical models will be discussed for the purpose of the study. Dividend Policy and Share Price To understand the overall idea about the dividend policy, it is essential to categorize the policy. There are mainly two types of dividend policy that is being followed by the corporate sector i.e. residual and managed. The residual dividend policy distributes cash among the shareholders. It is left after the business firm spend desirable amount for the purpose of investment, according to the NPV. The risk related with this dividend policy is very high due to highly variable in nature or it may be zero. On the other side, the managed dividend policy is mainly stressed to increase the return of the shareholders. The managers of the business firm who believe that dividend policy has a strong impact on the share price of firms. It generally uses this mechanism of dividend policy. The primary objective of this optimal dividend policy is to enhance the stock price trend of the business firm that results maximization of shareholders’ wealth. Now-a-days, the business firm relates the dividend policy with the product life cycle (PLC). For an example, a firm with large cash flow, high growth rate and lower trends in project appraisal tries to pay more dividends to the shareholder, as the earnings of the firm are comparatively high. The firms with high growth rate follow different interesting patterns in order to change the pattern of such decisions and enhance the complexity (Lease, 56). Dividends is totally depends on earnings of the business firm. If the earnings of business firms are increased, then the dividend should increase too. On the other side, the dividend cut denotes the decreasing trend of earnings. Assumptions of Dividend Policy It is very essential to understand the situation, how the dividend payout policy affects the share price. Moreover, it will help to recognize the influence of dividend payout policy on share prices. The literature review starts with generalize the overall scenario which called perfect capital market assumptions are as follows. No tax burden is there. Transaction cost would be ignored. There would be some rationality between investors and capital markets. The levels of investment for all the companies are fixed. The corporate executive provides more or less same types of information to the investors (Jacobus, 362). The interest of investors and the managers are interrelated with each other. Influence of Tax Effect on the Dividend Policy of the Business Firm – Modigliani and Miller’s Approach (MM) Miller and Modigliani (MM) first introduced the contradiction of dividend announcement whether it effects on the share price or not. The augmentation of payout from the dividend needs to be combined with the increase of business growth according to the dividend discount model. An alternative Miller Modigliani model suggests that the dividend decisions do not have any impact on the value of the company and similarly it does not have the impact on share prices. It is obvious that the company valuation is assessed from the market capitalization. The effects of taxes are the most important challenge to the ‘dividend irrelevance’ introduced by MM. MM mainly focused on the drawbacks of tax on dividend relative capital gain. Moreover, tax on dividend is more than the tax on capital gain, which affects the fiscal policy. This case also influences the partialities of the tax-paying investors. The average tax paying investors can hold a well-diversified portfolio (Balanced portfolio) of high yield and low yield shares that offers the same facilities on the rate of return after tax. In these circumstances the investors give preferences less dividend payout or no payout. In order to measure the effects of different rate of tax on different companies’ dividend, several number of empirical had arranged in the past. Most of the arguments are divided mainly in segments. Firstly, the different tax rate has no influence on the dividend decision of the concerned company. Therefore, there is no effect of dividend announcement on the share price of the company. Secondly, the different tax rate has high influence on the dividend decision of the concerned company. Therefore, there is no effect of dividend announcement on the share price of the company (Brittain, 256). Dividend Policy and Agency Problem First and foremost the payments of the dividend depend on the preference of the shareholders which is implemented through the management of the business firm. There are different claim holder of the dividend payment i.e. managers, debt holder, suppliers etc. The relationship between agencies exists between the conflict between the debt holders, share holders and the conflict between the management and the shareholder. The share holder of the business firm tries to get more dividends for the purpose of wealth maximization. On the other side, the creditors also look for the higher dividend for the purpose of enhancing the resources that are useful to repay the claim in future. The empirical study highlights that corporate pool influence to transfer the dividend in assets, which affects the claim of the debt holder negatively. On the other side the compensation of the managers depends on the growth, profitability and the size of the business firm. The lower rate of dividend payout helps to enhance the asset size of the firm. This is favorable for the managers but it results negative impact on the investors which create agency problems to managers and shareholders. Dividend Model Prediction It is an important aspect to find out the relationship between the value of the firm and the dividend policy in order to understand the impact. The dividend policy of the firm depends on the form value and vice- versa. The firm’s assessment is considered by the investments and net profits under perfect economic suppositions. Therefore, the firm’s value is inappropriate to its policy of dividend. The dividend prediction model is specialized enough to find out the relationship. Market Efficiency Theory – Based on the Behavioral Approach of Share Price The market efficiency is unpredictable by its definition. So, the changes of share prices of the business firms must be unpredictable and random. Consequently, prices completely replicate all recognized data, and it increases the purchasing power of investors according to the tabulated rates. To predict the return prospects of the firm, it is essential to arrange Proper statistical examinations. The firms capability of dividend yields is determined through dividend price ratio. The prediction of horizon highlights that, the inconsistency of return is responsible for 45 % stock holding in the market place. The primary dividend yield of the marketplace index has forecasted the overall picture of the market place (Frankfurte, 268). There are three types of market efficiency: Weak Form Efficiency: Price reflects all information found in the record of past prices and volume. Semi Strong form efficiency: Prices reflects not only in information found but also it reflects record of past prices, volume and publicly available information. Strong-form efficiency: Price reflects all available information, public as well as private. Here dividend announcement covers all the three types of market efficiency in the form of semi-strong and strong. Empirical Evidence on weak-form Market Hypothesis In is applicable for that situation, where there is no relationship between past and future share price. To established the point it is essential to use correlation test, which shows the dividend announcement really related with share price or not. Empirical Evidence on Semi Strong form efficiency In order to implement this type of efficiency it is important to use event studies. There are two segments to predict the effects of dividend announcements. The first group consists of the firm whose earnings are increased in relation to the average corporate earnings and second group whose earnings are decreased in relation to the average corporate earnings. The study of Ball and Brown finds that before announcement of dividend, stock in the first group earned positive abnormal return. On the other side the second group earned negative abnormal return. However stock of both group have earned normal return. Works Cited Brittain, John. Corporate Dividend Policy. California: Brookings Institution, 2004. Print. Frankfurte, George. Dividend Policy: Theory and Practice. San Diago: Academic Press, 2009. Print. Jacobus, Lee. A World of Ideas. US: Macmillan Higher Education, 2009. Print. Lease, Ronaldc. Dividend Policy - Its impact on Firm’s Value. Boston: Harvard Business School Press, 2010. Print. Read More