Irrelevant a Company's Dividend Policy to its Market Value - Essay Example

?Discuss the Proposition that a Company's Dividend Policy is Irrelevant to its Market Value Dividend irrelevance theory basically signifies that an issuance of dividends must have little or no impact on stock price. This theory is “A postulation that the dividend policy of a company should have minimal effect on the investment decisions made by an investor due to the fact that the payment or non-payment of a dividend will not necessarily impact the net return to the investor. The assumption is that dividends not paid are reinvested by the company to generate more profit, thus higher stock values” (Dividend Irrelevance Theory n.d.). Different scholars have different opinions regarding dividend irrelevance and dividend relevance. Some argue that dividend policy will not affect the wealth of the shareholders, whereas some have the opinion that the decisions about dividend policy will affect the shareholder’s wealth and the firm’s valuation. “Dividend policy refers to the decision regarding the magnitude of the dividend payout, the percentage of earnings paid to the stockholders in the form of dividends. The central, and as yet unresolved, issue concerning dividend policy is whether changes affect firm value” (Dividend Policy 2012). Following are the factors which influence the dividend policy: • Market deficiency for example taxes, agency costs, asymmetric information, flotation costs and transaction costs. • Behavioral considerations for instance illogical shareholder behavior, behavioral desires of shareholders and usual behaviors of firms. • Industry characteristics for example profitability, size, investment opportunities, availability of cash on probable cash flows and future earnings. • Managerial likings for example smoothing of dividends and the disinclination to decrease future dividends. Arguments for the Dividend Irrelevance: Dividend Irrelevance is a theory that an organization’s strategy of dividend has no actual influence on the value of the company. “The main cause for paying or not paying dividends is the cost of tax. Though dividend irrelevance is not absolutely accurate, it is a superior adequate estimate to the certainty that basic assessment should usually do not take into account strategy of dividend” (Expert 2012). The enduring assumption of dividends involves with the aim that if the organization cannot spend its income to make a revisit that is more than expenditure, it must deliver the income by paying dividends to shareholders. “The theory of dividend irrelevance is founded on the basis that an organizations dividend strategy is sovereign of the value of its share value, in addition to the dividend choice is an inactive residual. The price of the organization is resolved by its financing and investment decisions in a best capital formation, and not by its decision of dividend. A general policy of dividend should provide every industry its value of shares, as the policy of dividend is irrelevant in resolving the value of the firm” (Barman n.d., p. 17). This method suggests that dividends symbolize earnings residual more willingly than a dynamic decision variable that influences the organization’s worth. Such a vision is reliable with the theory of dividend irrelevance put forward by the authors Merton H. Miller and Franco Modigliani. “The authors argue that the industries value is ascertained only by the earning risk and authority of its resources, and that the way in which it divides its earnings stream among dividends and internally maintained funds, does not influence this cost. The big variations in dividends increased the value of share. When there is an increase in the dividend, the share prices also get increase and when the dividend decreases, the share price gets reduced” (Gitman 2008, p. 513). An organization fascinates investors whose liking for the stability as well as payment of dividends match with an organization’s solidity of dividends and actual payment pattern. The shareholders wish for constant dividends on the basis of revenue from the organization which disburse on the same amount of dividend each period. The value of the shareholder’s firm’s stock is unaltered by dividend policy for the following three reasons: The value of the company is determined solely by the risk of assets and its earning power. If dividends do influence cost, they do so solely for the reason of their informational content, which indicates organizations earnings expectations. A customer’s effect exists that reasons a firm’s investors to receive the dividends they expect. “In summarizing the dividend irrelevance theory, Botha (1985:53) states that the logic of the irrelevance theory is not disputed given the assumptions on which the theory is based. There may be a tendency to criticize the theory, based on the lack of realism of the assumptions underlying the model. However, it is now generally accepted that the value of a model lies in its predictive or explanatory power and that the model cannot be judged by reference to the realism of its underlying assumptions” (Barman n.d.). Arguments against the Dividend Irrelevance: “A somewhat different argument for dividend irrelevance was presented by F. Modigliani and M. H. Miller. They argued that the investor need not passively accept the dividend policy of the firm. Instead, the stockholder can adjust the policy to the desired stream of payments. The stockholder can shift dividends to closer time periods by selling stock, producing a "homemade" immediate dividend increase at the expense of later payments. Conversely the stockholder can shift dividends to a later period by using dividends to purchase stock, increasing future payments” (Dividend Policy 2012). Some researchers are of the opinion that dividend irrelevance is set up on unrealistic assumptions. The following are the arguments: The investors, who are reluctant to take risks, prefer stable and current returns. For them as well as the shareholders, dividends indicate the development of the company to investors and shareholders. Managers allocate this information with the shareholders in the form of financial reports. Rising dividends communicate constructive indication about the future forecast of the company, which results in a higher share price. In the same way, lower dividends provide negative impact, which causes a lower price of shares. The shareholders prefer dividend irrelevance in the existence of taxes. Dividends provide indication about companies’ victory, and also influence the prices of stock. This policy gives information about the past performance of the company, and does not provide information about the future of the company. It is calculated on the basis of perfect market situations. Ideas and Evidence in Support of Dividend Relevance: According to this concept, dividend policy affects the wealth of the shareholders. Decision about dividend policy becomes relevant due to the idea that it provides information to the managers and shareholders about the profitability of the firm. This concept is supported by the theories of two eminent scholars. Walter’s Approach: Prof.  James E. Walter judge that dividend pay­outs are applicable and have an influence on the prices of share of the firm.  He further asserted, asset policies of a firm cannot be divided from its dividend policy and both are inter­related. The selection of a suitable dividend policy influences the firm’s value.  For example, if the return is higher than the cost of capital, the firm will show growth, and the dividend pay-out will be zero. If the return is lower, dividend pay-out is 100% and the firm needs to pay all the earnings as dividend to the shareholders. This approach shows that the firm has a long life in the market. Gordon’s Approach: According to him, if return is higher than the cost of capital, the price of shares increases and the dividend pay-out decreases. The firm distributes smaller dividends and retains its earnings. Similarly if return is lower, the share price increases with dividend pay-out and the shareholders and the firm get better benefits. “Gordon’s model assumes investors are rational and risk averse.  They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns.  The shareholders therefore prefer current dividends to avoid risk.  In other words, they discount future dividends.  Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected. Gordon explains his theory with preference for current income” (Dividend Decision n.d.). Role of Dividend Payments in Managing Agency Problem: Dividends are regarded as a method to reduce agency problem by giving shareholders their share. An agency problem arises when an agent acts like the principal. This happens when the agent’s priorities and interests are different from those of the principal. “Accordingly, potential agency problems are higher when a firm's capital is largely earned, since the more a firm is self-financed through retained earnings, the less it is subject to the ongoing discipline of capital markets. A regular stream of dividends reduces the threat of agency problems that become increasingly serious as earned equity looms ever larger in the firm's capital structure” (Picker 2007). From the view point of the investor, the dividend policy is irrelevant to market value because any preferred flow of payments can be simulated by suitable purchases and sales of equity. Therefore, shareholder will not pay a premium for every particular dividend policy. The agency problem starts from the separation of finance and management. The agency form on dividends can be divided into two types: 1) It reflects on dividend payments as a solution for the agency conflict between managers and shareholders: The managers are concerned with low dividend payment. This has maximized the assets size under the control of management, which results in flexibility in choosing investments, and decreases the need to rotate to capital markets to finance the investments. Shareholders put down little optional cash in management’s hands and force managers to invest in the capital market. These markets present adequate services to the managers. As a result, shareholders can exercise dividend policy to support managers to safeguard the best interests of owners and higher dividend payments. 2) The second type of agency models points out that dividend payment policies are replacements for solving the governance problems in a firm: When the firm improves its dividend payment, it is obligatory to go to the capital markets to increase the finance. This in turn will direct to an analysis of management by the investors so as to reduce agency problems. Conclusion: A firm that has spent on bad projects cannot look forward to save its figure with shareholders by offering them a higher rate of dividends. “Managers have incentives in retaining funds because they can fully control shareholders’ wealth. Therefore, one may certainly claim that retention bears a strong relation to dividend irrelevance issues if agency problems are assumed” (Magni n.d., p. 18). Many shareholders consider dividends as an important factor that increases their wealth. With the uncertainty of the market and fluctuations in the prices, it is considered that the managers will adopt a smoother dividend policy, rather than paying a constant rate of earnings to the shareholders. Reference List Azzoparadi, F 2004. Dividend Irrelevance and the Clientele Effect. University of Leicester. [Online] Available at < http://www.francoazzopardi.com/research/dividend-irrelevance-and-the-clientele-effect.pdf> [Accessed on 20 March 2012] Barman, GP n.d. An Evaluation of How Dividend Policies Impact on the Share Value of Selected Companies. [Online] Available at [Accessed on 20 March 2012] Basse, T 2009. Dividend Policy and Inflation in Australia: Results from Co integration Tests. International Journal of Business and Management. [Online] Available at [Accessed on 20 March 2012] Dividend Decision. n.d. Sikkim Manipal University. Available at [Accessed on 20 March 2012] Dividend Policy. 2012. Reference for Business. [Online] Available at [Accessed on 20 March 2012] Dividend Irrelevance Theory. n.d. InvestorWords.com. [Online] Available at [Accessed on 20 March 2012] Expert, N 2012. What is a Dividend Irrelevance Theory? NiftyLiveCharts. [Online] Available at [Accessed on 20 March 2012] Gitman, LJ 2008. Principles of Managerial Finance. 11th Edn. Pearson Education. [Online] Available at [Accessed on 20 March 2012] Magni, CA n.d. Relevance or Irrelevance of Retention for Dividend Policy Irrelevance. Department of Economics. [Online] Available at [Accessed on 20 March 2012] Picker, L 2007. Why Do Firms Pay Dividends? The National Bureau of Economic Research. [Online] Available at [Accessed on 20 March 2012] Read More