Institutional Holdings and Payout Policy - Coursework Example

Examine the View that Dividends are Irrelevant to Rational Investors when Considering the Value of Shares from a Theoretical and Empirical Perspective By: Name: Course: Tutor: Institution: Date Examine the View that Dividends are Irrelevant to Rational Investors when Considering the Value of Shares from a Theoretical and Empirical Perspective Introduction The primary goal of managing and operating businesses effectively is to earn a profit. Business owners are usually interested in the rate of return on their investment. As such, the primary goal of the managers is to ensure they maximize the value to the owners as well as shareholders. According to Lasfer (1995), the firm’s share price normally reflects this value. However, the dividend is the key indicator of the share price. On the other hand, the share price indicates the company’s value. Lee (2005) explains that the shareholders must be given the greatest combination of dividend through an increase in the share price to maximize shareholders’ wealth or value. Primarily, when firms make enormous profits, the managers can either decide to use it for expansion by investing in new projects or pay it to the shareholders in the form of dividends. The dividend policy usually guides this process. Dividend policy is the set of guidelines or principles that companies adopt to decide the amount of the profits that shareholders are to receive (Miller and Modigliani, 1961). Even though, the business uses these sets of principles to determine the value of the dividend the decision on whether to pay the dividends or not lies in the board’s decision. In fact, when the board of directors declares the dividends to be paid it becomes a debt to the corporation and cannot be recanted or rescinded quickly. Dividends can either be paid on temporary or permanent basis or sometimes it can be paid once or twice a year. Deangelo (1995) argues that, investors are usually interested not only in the stability of this payment but also the level of dividend payment. From this perspective, therefore, the managers should be aware of the impacts of unexpected changes in the dividend payment to the potential investors. Both the existing investors and potential investors are affected by the changes since such uncertainties could alienate them from investing with the organization. According to Bhattacharya (1979), unstable dividend payment aspect may negatively influence the perception of the investor based on the long term company’s performance in the financial markets. Even though, most economists believe that it is the value and stability of payment of dividends that the investors should rely on while making decisions; research ascertains that this is irrelevant and should warrants sidelining. Many from other schools of thought including Miller and Modigliani believe that what the company pays in the form of a dividend is totally irrelevant and that the stockholders are entirely indifferent to receiving dividends. To this end, it is evident that, there are idealists in support of the use of dividend payment in making decisions while other theorists are against the idea. As such, there are dividend-relevant theories and dividend- irrelevant arguments. Dividend Irrelevant Theories The Miller and Modigliani (M-M) Irrelevant Theory Before the publication of Miller and Modigliani (1961), it was economically accepted perception by most experts. They believed that the more the shareholders received in the form of a dividend, the higher the value of the company or corporation. The idea emerged from the extension of an already discounted profit approach in getting the firms value. Approximately, the company calculated the value of the company (V) using the following formulae; Source: Miller and Modigliani (1961) This function worked out as the investors return (r1) improved through increased earnings to the firm, and the future dividend could presumably be higher, resulting from increased investment. Miller and Modigliani (1961) critically analyzed the dividend policy in relationship to the share price. They realized that the company’s dividend policy do not have any correlation to the firm’s value in perfect capital markets. They argued that the firm’s current and future cash flows in the market (the choice of the company to invest in optimal projects) was the sole determinant of the firm’s value. Analytically, the shareholders’ wealth is not affected by the dividend decision as had been proposed before. In fact, the investors are naturally indifferent to the choices that they make in between capital and profits gains. Arguably, suppose the investors needed immediate cash they could just create their policy to sell their current shares in the capital markets (Miller & Modigliani, 1961). Their arguments, however, are based on various assumptions. They assumed of a perfect capital market and rational investors. Apparently, when firms pay more dividends, then they must offer less share appreciation price and provide the same amount of returns to the stockholders. In this view, the investors make the investments decisions from the cash flows. For this to work, capital and dividend gains taxed at the same rate must not exist. It means that there no tax advantage or disadvantage associated with the capital and dividend gain. Apart from this assumption, the following must be taken into consideration: 1. There have to be no transaction charges linked with the conversion of price appreciation into cash by selling the share. 2. Investment decisions are unaffected by the dividend policy, and the organizations operating cash flow are same regardless of dividend policy adopted. 3. Company’s that pay more dividend may issue stock, dividend gain with no floatation to invest in a real project. 4. The managers that pay too little dividend do not waste the cash in pursuing their interests. Empirical Evidence of the M-M Model As noted earlier, M-M model is ideally based on the assumption of perfectly operating capital markets. However, in reality the world markets are imperfect. To evaluate the empirical evidence on this irrelevance theory, Black and Scholes (1974) relaxed the assumption of the perfect capital market. As such, they used the Capital Asset Pricing model to test the link between stock returns and dividend gains. In Capital Asset Pricing Model, it is argued that, the projected returns on any security or stock is strictly a function of its β as indicated below. Source: Kaestner & Liu (1998). It is what Black and Scholes (1974) exponentially expanded to derive the empirical evidence on M-M model. Source: Miller and Modigliani (1961) In regressing the equation, the value of ƴ was identified to remain towards zero as possible since its indifferent could mean that dividend policy matters. However, when the value is insignificantly different from zero, then it means that the dividend policy does not equally matter. In practically evaluating this, data for five years was used, and they concluded that dividend policy did not have any effect or impact on the value of the firm (Dahlquist 2009). However, it is imperative to realize that the irrelevance theory has a number of implications. Sincerely, if dividends truly do not have any impact on the value of the firm, then companies take a lot of time in pondering about whom amongst their stockholders are indifferent. Besides, the value of equity in the company does not vary with the change in dividend policy. It means that there is no any correlation between the stock returns and the dividend policy. Dividend Relevant theory Lintner model Before authors could dispute the effectiveness of dividend policy on making of decisions by the investors, Lintner developed a classical model in 1959 to explain the dominance of dividend policy. He realized that, dividend policy was a very active variable in determining decisions made by investors. Ideally, the managers had a believe that, stable dividend payment positively reduces the negative perception of investors about the firm. Lintner (1959) believed that, dividend payments and retained earnings possibly were by-products of the dividend policy. Arguably, investors prefer stable dividends and opt for firms that put more premiums on stable dividend policy. He introduced his system of progressive partial to explain the impact of dividend policy on the value of the firm (Deangelo 1995). Lintner (1959) argued that, the system of continuous partial critically stabilizes dividend distribution within the capital markets thereby providing consistency in the dividend action pattern. Ideally, the effect tends to reduce the adverse investors reaction. In addition, the relationship between the existing dividend rate and current earnings is what determines the amount of any change in dividends. Based on the publicity and frequent reports about company’ returns, the managers have to take further steps in distributing the increase in dividend earnings to the investors. He, therefore, used a simple theoretical model to illustrate decision making in relation to the dividend policy of a firm as follows; Source: Deeptee & Roshan (2009) Tax Factor (Clientele Effect) However, the decision made by investors is critically influenced by various aspects. According to Baker (2002), clientele effect critically affects the decision made by investors about dividends. Lasfer (1995) explains that it is the idea that particular kind of security or shares attract a set of investors, and this will affect the price of the security when the dividend policy changes. In some cases, there are set of investors who like firms that do not pay dividend but use the retained earnings in the expansion of new projects. However, there are other investors who like companies that pay a high dividend. Lee (2005) argues that, when companies change its dividend policies considerably, some investors may sell their securities in the effect of the change while other may continue investing in the company. It is the clientele effect (the decision made influenced by the change in dividend policy). The changes in the firm’s dividend or coupon rates, change in debt levels, changes in tax rates and changes in line of business amongst many aspects of the company cause the clientele effect. Erasmus (2012) concludes that, the clientele effect describes the investors perception or intention to invest in firms that suits their factor endowment such as rate of returns on their capital. On the other hand tax rates influences the decisions made investors about firm’s value in relations to shares. Ajanthan (2013) points out that, shareholders or business partners realize equity appreciation to their dividends when the capital gains or profits get taxed at lower rates than the dividends. Ideally, lower tax rates enable the investors to have high equity appreciation to their dividends. The tax factor induces the clientele effect argument. According to Grinstein and Michaerly (2003), different tax statutes make shareholders have different perspective in respect of return on the capital investment. Apparently, there is an inverse relationship between tax levels and stock returns. Wolmarans (2003) argues that, the tax factor on dividends and capital gains makes investors arrange themselves in sets (Clientele) that suits their effective tax bracket. Individual investors in high tax brackets typically prefer to invest in companies that offer lower dividends to pay less tax while investors in the lower tax bracket prefer firms with large dividend payment (Lumby & Jones 2003). Nonetheless, the investors decisions are influenced by their perception of the entire dividend situation. Perfect perception or imperfect perception can affect it. In the reality, there is no perfect perception. As such, the investors perceptions are usually imperfect. According to Myron (1963), imperfect perception is the possibility of the investors to perceive that firms often retain capital gains to reinvest on its current cash flows. Hence, it replaces the initial dividend flow to the stockholders with an unpredictable and more distant flow in the future List of References Lumby & Jones (2003) Corporate Finance: Theory and Practice (7th ed.) Ch.22 The Dividend Decision. Black, F (1996) The dividend puzzle Journal of Portfolio Management Special Issue pp8-12 Miller, M.H., & Modigliani, F. (1961) Dividend policy, growth and the valuation of shares, Journal of Business, vol.34, no.4, pp.411-433. Grinstein, M. and Michaerly, R. (2003) Institutional holdings and payout policy, Journal of Finance 60, 1389-1426.22.  Wolmarans, H. (2003) Does Lintner’s dividend model explain South African dividend  payments? Meditari Accountancy Research 11, pp. 243-253.23. Ajanthan, A. (2013) The Relationship between Dividend Payout and Firm Profitability: A Study of Listed Hotels and Restaurant Companies in Shri Lanka. International Journal of Scientific and Research Publications, 3(6), pp. 1-6.24.  Erasmus, P. (2012) The Influence of Dividend Yield and Dividend Stability on Share Return: Implications for Dividend Policy Formulation. Journal of Economic and Financial Sciences, 6(1), pp.13-32.25.  Lasfer, M. (1995) Taxes and Dividends: The UK evidence. Journal of Banking and Finance 20, pp.455-472.26.  Lee, Y-T. (2005) Taxes and Dividend clientele: Evidence from trading and ownership structure.  Journal of Banking and Finance 30, pp. 229-24627.  Dahlquist, M. (2009) Direct Evidence of Dividend Tax Clienteles. Available from:http://ssrn.com/abstract=945675 [Accessed 20/08/2014] Baker, K. et al. (2002) Revisiting Managerial Perspectives on Dividend Policy.  Journal of Economics and Finance, 26(3), pp.267-283. 15.  Deeptee, P. and Roshan, B. (2009) Signaling Power of Dividends on firms future Profits A Literature Review. Evergreen Energy- Interdisciplinary Journal, pp.1-9. 16.  Bhattacharya, S. (1979) Imperfect information, dividend policy, and “the bird in hand” fallacy. The Bell Journal of Economics, 10,(1), pp. 259-270.17.  Deangelo, H. et al. (1995) Reversal of fortune Dividend signaling and the disappearing of sustained earnings growth. Journal of Financial Economics, 40, pp. 341-371. 18.  Kaestner, R and Liu, F. (1998) New Evidence on the Information Content of Announcements. The Quarterly Review of Economics and Finance, 38. (2), pp. 251-274. Read More