Managerial Finance And Dividend Policy - Case Study Example

Managerial Finance And Dividend Policy Introduction Payment of dividends is one of the most critical indicators of the financial performance of the company and the company’s ability to dividends is always viewed favorably by the market. Dividends are basically the returns that a firm pays off to its shareholders as returns for the funds invested by them. Investors therefore often consider dividends as the strongest signal to the market with regards to the ability of the company to provide a consistent stream of income to the investors in the market. It is also critical to note that the stock prices are determined by the discounting of future cash flow streams of the firm and dividends are considered as the major cash flows that investors receive from the firm. Thus in order to continuously attract the attention of the investors intact despite the fact that theoretically dividends and dividend policies do not matter most to the overall reputation and value generating capability of the firm. There are various dividend policies that companies adapt during the course of their business as such policies largely depend upon the ability of the company to consistently pay out the dividends. Major types of dividend policies include providing consistent payouts either in the form of cash or stock splits. These policies often depend upon the ability of the firm to pay off dividends in most consistent manner thus constantly relaying a signal to the market regarding the ability of the firm to pay returns to shareholders. This paper will discuss the critical aspect of why the companies pay dividends and what are some of the implications for paying the dividends not only for the firm but for the managers of the firms as well besides discussing as to how the financial managers use dividends in their overall financial policies and how the payment of dividends can affect the firm value. What are dividends? Before discussing as to why the firms pay dividends, it is really critical that an explanation of the dividends and how they are paid is provided. Dividends are the returns that are paid by the firm to its shareholders as their portion of the profits earned by the firm. It is however, critical to understand that it is not necessary that a firm shall pay dividends only when they earn profits as many firms despite incurring losses provide dividends to their shareholders. Many companies in US provide quarterly dividends however this frequency may vary in different countries according to the practices that may be prevalent in that particular country. However, most of the firms across all over the world offer dividends either on semi- annual or annual basis based on the practices. It is important to note that the extent of dividend payout is always decided by the Board of Directors of the publically traded firms and are often paid out to the shareholders within few after the declaration of the dividends by the board of directors. Types of Dividends It is however, important to note that the dividends necessarily do not need to be in the form of cash only as there are various types of dividends that are paid out to the shareholders. Mostly firms pay dividends in the form of cash or stock dividends and there are no fixed rules as to when to issue cash dividends and when to issue stock dividends. However, the decision as to which type of dividend to announce largely depends upon the circumstances faced by the firm. Dividends and Earnings As discussed above that the firms often pay dividends out of their earnings and as such different empirical studies have suggested that the dividends tend to follow the earnings of the firm. Thus dividends and earnings of the firm are positively correlated with each other and as such the extent of dividends increase as the firm earns more profit. Further, the changes in the earnings are mostly followed by the changes in the earnings also as the firm tend to adjust the payment of dividends relative to their earnings. It has also been observed that the firms do not change the dollar value of their dividends so frequently and as such dividends are considered as sticky in nature. This is also due to the fact that firms often want to maintain a consistent ratio of the dividends paid out whereas the second concern is the perception that the decrease in dividends are often viewed negatively by the firm. Thus firms in order to maintain their dividend patterns often avoid changing the dividends so frequently. It has also been argued that the dividends of the firm often show smoother trends than their earnings. Therefore the overall volatility of the dividends is relatively less as compared to the volatility observed in the earnings of the firm. This may also be attributed to the fact that firms often tend to avoid sending negative signals to the market regarding their capability to pay dividends. It has also been observed that the dividends of the firm often follow the life cycle of the firm i.e. the dividend patterns often show typical stages or patterns of star up, expansion, rapid growth, maturity as well as decline. This cycle is often faced by the firms too and as such the dividends paid out by the firms often reflect the overall stage of the firm’s life cycle also and firms often adapt the dividend policies that accurately reflect the actual stage of the life cycle of the firm. It is also because of this reason that the high growth firms often tend to pay higher dividends whereas relatively old and mature firms tend to pay the dividends according to their own stage of life cycle. The dividend Controversy The famous Miller and Modigliani Theorem is considered as one of the landmark theoretical attempts to define the role of dividends and their impact on the firm value. According to this theory, in a world with no taxes, transaction costs as well as different other market imperfections, dividends are irrelevant. This also means that the dividends do not significantly affect the firm value and its useless to focus on any dividend policy for the purpose of deriving value for the shareholders of the firm. What is also however, significant to note that the market imperfections as well as the impact of taxes may help create the value for the shareholders of the firm and M M may not provide an accurate description in a world where taxes and transaction costs exists. One of the implications of the dividend irrelevant theory is the assumption that the firm that pay more dividends often have to offer less price appreciation and must have to maintain the same level of returns to be provided to the stock holders. The conclusion of this dividend irrelevant theory can also be drawn by stating that the value of the firm’s stocks does not change when a firm changes its dividend policy under the given conditions. Thus whether a firm is paying higher dividends or lower dividends, they may not affect the value of the firm and hence dividends are irrelevant Another important argument that has been put forward is the assumption that the dividends often create strong tax disadvantages for the shareholders. This assumption is basically put forward in the context of double taxation and argues that the shareholders are being taxed heavily on their dividend receipts as compared to the taxes they pay on earning through price appreciation of the stocks. This argument therefore holds that the payment of dividends basically reduce the overall returns to the shareholders when the impact of personal taxes is incorporated into the return calculations. Thus the natural consequence of this would be the fact that the stock holders will be willing to pay the low price on the stocks of such firms as compared to the firms that pay no dividends. Thus it will be in the benefit of the firms for not issuing the dividends as firms will be better off by not issuing them.(Chen & Ken, 2003) The arguments for not paying off the dividends therefore are often focused on the impact of taxation on the dividends as under the taxation laws of many countries; the capital gains are given more favorable treatment as compared to the dividends. It is because of this reason it is argued that the firms shall not pay the dividends as their payment will make both investors as well as firms worse off.(Shepherd, 1976). This debate of not paying off the dividends therefore may be concluded with the assumptions that the higher the income levels of the share holders, higher will be the tax rates and as such the dividends shall be paid out in lower amounts. Similarly, as the overall tax disadvantage of paying the dividends increases, the overall aggregate amount paid as dividend always decreased therefore it may be relatively not in the favor of both the shareholders as well as the firm not to pay the dividends.(Allen,1992) However, despite such disadvantages, firms still pay dividends and they pay them with relative consistency. Following section will discuss as to why the firms should pay the dividends. Why firms Pay Dividends There are different reasons as to why the companies pay dividends and what can be the different implications of paying the dividends. Dividends traditionally are being considered as the primary source through which publically traded firms often provide returns to their shareholders and a firm can achieve this objective by employing different policy approaches. One of the most important implications of dividends for the investors is based on the assumption of bird in hand philosophy. It is argued that the investors and shareholders tend to rely more on dividends over the capital gains as the dividends are considered or perceived as more stable and certain as compared to the capital gains. Given the overall volatility of the market, it is therefore often felt by the shareholders and investors that the dividends are more certain as compared to the price appreciation therefore they force the firms to pay out the dividends. Another important argument in this regard is also directed to the fact the value of the firm is often determined by the future cash flows of the firm. The dividends are considered as more accurate proxy of the future cash flow generating capacity of the firm therefore in order to get the favorable treatment on the market, firms tend to pay out the dividends. Further, if the firms are planning to start out new projects and continue to pay out higher dividends without changing its investment policy, it will have to replace the dividends with the issuance of new stock issues for funding their new projects. Therefore those investors who are being paid higher dividends may loose present value of the price appreciation that may occur as a result of this. Firms also pay dividends when they earn excessive cash and as such they are often compelled to pay off the dividends out of their excess cash. However, it is also critical to understand that this excessive cash shall be a permanent phenomenon and as such its payment as dividends shall not hamper the overall long term growth objectives of the firm. If the excess generation is a temporary aspect of the firm than the firm shall look into its overall long term growth objectives and must retain such cash in order to fund their future growth prospects. The re-investment of the excessive cash is also critical due to the fact that in case the firm has to initiate new projects, the overall cost of issuance of new stock may be relatively more as compared to the cost of spending internally generated funds. Payment of dividends is also critical due to the fact that it provides an strong signal to the market regarding the overall financial stability of the firm. This ability of the firm to pay off dividends with consistency therefore offers a great relief to the shareholders regarding the willingness and ability of the firm to provide consistent returns to their shareholders. Agency theory often postulates that the external shareholders often expect higher cash dividends because it reduces the chances for managers to manipulate the cash of the company. (Baker & Kolb, 2009). Thus shareholders often attempt to reduce the opportunity cost of allowing managers to take decisions which are mostly in their own interests rather than in the interests of shareholders. One of the arguments is also put forward in terms of the free cash flows earned by the firm. It is argued that if the free cash flows are left at the mercy of the managers, they may invest it into the projects that may not yield into the increase of the value of the firm and its shareholders. It is also important to note that the shareholders often prefer to have dividends as compared to not receiving any dividends at least. This is critical due to the fact that it is always assumed that the rational investors shall often reject the dividends as the same may result into the decline in the overall value for them as well as for their firms. However, despite such assumption there is growing evidence which indicate that the investors tend to prefer large and consistent dividends. Another important argument that has been mentioned above is the fact that dividends serve as strong information signal to the market. Investors and other stakeholders of the firm often scrutinize the actions of the firm in more detailed manner and as such the issuance of dividends is one of the signals that are often positively picked up the market and market participants. Further, the issuance of the dividends is often having very strong implications for the future cash flow generation capability of the firm. Few of the empirical studies have provided the credibility to this signaling theory by asserting that the announcements of dividend increase or decrease do have an impact on the prices of the stocks of the firm.(Tse,2005). Further, as discussed above that the firms often issue dividends keeping in view their investment and financing needs therefore firms may also issue dividends in order to change their overall debt ratios. This is because of the fact that when firms pay out dividends they basically attempt to take away the portion of funds from their lenders and pay out to the shareholders. As a result of this policy, the overall prices for the bonds tend to decrease whereas the share prices increase. Conclusion Dividends are critical for keeping the confidence of shareholders intact and as such there are different reasons as to why the firms pay out the dividends. One of the important argument is based on the signaling theory which attempt to provide justification for the issuance of dividends whereas M&M clearly outlines that in a world which is free from taxes and transaction costs, the increase or decrease in the dividends may not result into the increase of decrease in the value of the firm and as such dividends are irrelevant. References 1. Allen, D (1992) Target Payout Ratios and Dividend Policy: British Evidence. Managerial Finance. 18 (1) 9 – 21 2. Baker, Kent, & Kolb, Robert (2009). Dividends and Dividend Policy. New York: John Wiley and Sons. 3. Chen, A & Kane, E (2003) IMPACT OF DIFFERENTIAL AND DOUBLE TAXATION ON CORPORATE FINANCIAL POLICIES IN AN INFLATIONARY WORLD. Research in Finance. 20 (1) 1 – 17 4. Shepherd, A (1979) Dividend Policy and the Value of the Enterprise. Managerial Finance. 2 (3) 319 - 329 5. Tse, C (2005) Use dividends to signal or not: an examination of the UK dividend pay out patterns. Managerial Finance. 31 (4) 12 – 33 Read More