For and Against the Irrelevance of Dividend Policy - Essay Example

? For and Against the Irrelevance of Dividend Policy Dividend Policy Dividend Policy is regarded as the clear or embedded decision of a corporation’s Board of Directors with respect to the extent of available income which is supposed to be allocated among the shareholders of the corporation (Kimmel et al, 2010). This decision of the corporation is regarded as a financing decision. Dividends can be handed over in terms of cash as well as stock or property. In a scenario of cash dividend declaration, the funds depart from the company in an irretrievable and permanent manner. When earnings are dispensed as dividends, the company is deprived of funds which are needed for augmentation and development, and this might result in the company looking for supplementary capital from external sources. Firms are not legally required to pay dividends to stockholders. Similarly, the stockholders cannot officially compel the Board of Directors to declare dividends. In addition to that, even courts cannot meddle in this affair (Kapil, 2011). Arguments For Dividend Irrelevance In the year 1961, two senior professors, Franco Modigliani and Merton Miller (M&M) stated that a firm’s value has no correlation with its dividend policy. According to them, the market value of a company is decided only by the actions pertaining to investment and operations that result in cash flows. The structure of capital and policies related to dividends are simply financing actions or in other words, purely the ways in which cash flows from operations are allocated among the investors. Modigliani and Miller were awarded Nobel Prizes for this exclusive effort concerning Accounting and Financing. The M&M proposal gave birth to scholarly analysis in the field of finance and accounting. Since their attempt, numerous researchers in economics, finance and accounting have come up with various models and theories to explain the irrelevance and relevance of dividends to the market value of the company. Besides the M&M Theory proponents known as Middle of the Roaders; there exist Rightist and Radical Left groups with their own viewpoints (Brealey, 2007). Residual Theory states that if a company is not capable of investing further to earn in surplus of its capital expenditure, then it should apportion the earnings among the stockholders. Over the years, the evolution of M&M Theory has propagated the notion that a company’s dividend policy is irrelevant to its market value. The major argument stated by the M&M theorists is that the investment strategy is the most important determinant of a company’s market value, while the division between the dividends and the reinvestments does not have an effect on this value. However, this explicit suggestion has been made under certain assumptions (Baker et al, 2005). These assumptions largely entail capital markets which are perfect with no taxes and a steady interest rate in the market with limitless borrowing. The clients or potential investors who come with money are varied in terms of preferences for low disbursement and high disbursement demand for dividends. The proponents of dividend irrelevance emphasize on this point, elucidating that policy changes with regard to high or low disbursements of dividends, affects the clientele or the investors that the company will influence, not its value. Though research illustrates that major alterations in dividends somehow affect stockholder prices. However, the response of the proponents of dividend irrelevance is that the influence on the prices is associated with the informational substance of dividends in relation to potential earnings instead of the dividend itself. It is the inclination in the preferences of the investors that results in modifications of prices. Another argument in the support of dividend irrelevance is the fact that most investors are little affected whether or not dividends are paid as they know that if dividends are not paid, then the earnings are reinvested which ultimately maximizes their wealth. Furthermore, investors often use the dividends to buy more shares, exhibiting the insignificance of dividends with reference to market value of the company (Gibson, 2009). Since dividends are irrelevant, advocates of the Dividend Irrelevance Theory argue that value of a company is obtained chiefly from the built-in efficacy of the company’s assets and the capability of the management group. If the company’s assets are substantial in number alongside being attractive to probable investors, then the value of the firm enhances in the eyes of the investors which in a way persuades them to buy shares of the company, In addition to that, another noteworthy aspect which plays a major role in establishing value of a firm is the ability of the management team. Since it is the management team which ensures that stockholders wealth is maximized, therefore management team is the most significant entity of a company as far as the investors are concerned. If the management team of a company is highly effective as well as efficient, which accomplishes the goals of the company in a very productive and composed manner; then it is obvious that the market value of such a firm will rise in the market due to the credibility of the management team associated with it (Morden, 2004). As a result, investors will pour in their money in such a company due to the integrity and capability of the management team in achieving the desired targets. In this approach, the role of dividends in determining the value of the firm can be regarded as more or less negligible. Dividends are also irrelevant because the value of a company is significantly influenced from the profits related to operations made by the firm, not only presently but also those which are expected to be made in future periods. While the firm recognizes the positive-NPV investments and can enter the capital market in a costless manner; it can issue any preferred level of dividends in any time frame. However, the irrelevance of the dividends is highlighted when the company pays dividends out of its total earnings. In such a case, it will have to issue new stock to its stockholders in order to continue the cycle of cash which is required to fund the investment projects. Hence, if a company retains all its earnings, then it can finance the investments internally with no necessity of obtaining funds from outside sources. This will not affect the value of the firm as in a world which is free of taxes; stockholders do not distinguish much between dividends and gains from capital. As long as the expectations of the stockholders are being fulfilled, the stock prices will remain uninfluenced by the changes in dividend policy. Though the propositions of the M&M Theory seem to be viable under the assumptions made, however, in reality, there exist several imperfections such as the existence of taxes which restrict the irrelevance of dividends to a certain extent (Ogilvie, 2008). Arguments for Dividend Relevance On considering the other side of the debate, there exist several arguments in support for dividend relevance. A traditionalist faction, also known as the Rightists, has been of the stance that bigger disbursements of dividends result in an increased value of the company. While another group called Leftists firmly believe that higher pay-outs of dividends dwindle the company’s value. The argument established by the Rightists is that for high-pay-out stocks, there exists almost a natural clientele of potential investors as dividends are considered to be spendable income whereas gains in capital are believed to be only supplements for capital. In the 1960’s, Myron J Gordon and John Lintner came up with the idea that present dividends are less precarious in contrast to future dividends or gains from capital. This proposal was named as ‘bird in the hand’ argument (Gitman, 2006). It primarily implies that the low risk factor associated with the dividends received will yield a low factor of discount in relation to the company’s income, thereby increasing the value of the company’s stock. However, it has to be mentioned that stockholders can earn capital gains through selling of their stocks, if, they believe that returns from dividends have not been sufficient. Yet, it is usual for the investors to favour high dividends. On putting aside the assumptions of the M&M Theory and viewing the world in a more realistic manner, it is found out that the consequences of taxes, in addition to other market imperfections critically challenge the propositions of dividend irrelevancy (Megginson et al. 2009). In a scenario when taxation related to dividends is higher than capital gains, then it is wise and more profitable to convert the dividends into capital gains at the earliest. When companies decide to make one- time hefty allocations to stockholders, it is customary way to carry out this phenomenon through re-buying of stocks. Conversely, if this practice is done more often, then things might become clearer to understand for the tax agencies, which can then declare the distribution to be a dividend and consequently, tax it with increased rates. This can certainly hurt a firm’s value quite badly in the eyes of the investors. Leftists also suggest that taxes associated with dividends are required to be paid straight away while those linked with the capital gains can be held up in expectancy of the selling of stock (Lumby, 1988). A very common problem faced by quite a few corporations is related to the Agency Theory which basically involves conflict between the owners (stockholders) and the management. The Agency Theory states that stockholders push for higher dividends with the intention that managers do not get relaxed and start misusing cash. Though the stockholders would prefer to keep an eye on the activities of the managers but this tends to generate high costs. Dividends seem to solve this problem very effectively as when stockholders get dividends, the management then has to approach external sources in the market for financing. Though these external sources lend the money in most cases, but at the same time, they scrutinize the performance and integrity of the managers, thereby indirectly addressing the concern of the stockholders. Hence, dividends play a viable role in solving the Agency problem (Frankfurter et al. 2003) The thing to ponder upon is that if dividends are irrelevant, as stated by the M&M Theorists, then there must be some reason that companies continue to disburse dividends, when they can hold them back to reinvest in NPV investments. This suggests the fact that the practical world is not as perfect as illustrated by the irrelevance proponents, instead the combination of the imperfections of the capital market in conjunction with the fact that investors are not completely rational leads to increased significance of the dividends. This in turn influences the value of the company in more than one way. Proponents of the Relevance theory believe that Dividend Policy can be regarded as a realistic mechanism in which dividends play the role of a lively decision variable whereas retained earnings are considered to be the left over part (Baker, 2009). In this manner, it can be stated that dividends are not just a mode of dividing the income among the stockholders but they are significant in their own way. This is because any discrepancy which increases or decreases the dividend pay-out ratio can have a serious effect on the stockholders wealth (Arnold, 2008). For instance, if a company out of the blue decreases the dividend pay-out ratio without notifying the clientele or investors in advance, then this can adversely affect the mind-set of the investors with respect to the company. Their trust in the company might dissolve, they might sell the stock of the company and buy the stock of any other company or they might even defame the company through negative publicizing. This illustrates the weight and relevance of dividends and their pivotal task in determining the market value of the company. On the other hand, if a company increases the dividend pay-out ratio, then it would benefit the stockholders in general, who would then spread good word about the company, thereby enhancing its reputation and consequently its market value. Thus, a company’s aim should to be to develop the most effective and efficient policy, with dividend as a key element; that would result in the maximization of the stockholder’s wealth and thereby, enhancement of the company’s market value (Besley et al. 2008). Though there exist several disparities in the arguments of the proponents of Dividend Irrelevance Theory and those of the proponents of Dividend Relevance Theory, yet both are acceptable in different scenarios. While the Irrelevance Theory is based on assumptions regarding the capital market and rationality of investors; the Relevance Theory is based on the imperfections of the real world. However, the two sides also agree upon a few issues such as the recognition of the projects with positive NPVs at exclusive market discount rates (Puxty et al. 1988). Bibliography ARNOLD, G. (2008). Corporate financial management. Harlow, Financial Times Prentice Hall. BAKER, H. K. (2009). Dividends and dividend policy. Hoboken, N.J., John Wiley. BAKER, H. K., & POWELL, G. N. (2005). Understanding financial management: a practical guide. Malden, Mass. [u.a.], Blackwell. BESLEY, S., & BRIGHAM, E. F. (2008). Essentials of Managerial Finance. Mason, Thomson/South-Western. BREALEY, R. A. (2007). Principles of corporate finance. New Delhi, Tata McGraw-Hill. FRANKFURTER, G. M., WOOD, B. G., & WANSLEY, J. W. (2003). Dividend policy theory and practice. Amsterdam, Boston. GIBSON, C. H. (2009). Financial reporting & analysis: using financial accounting information. Mason, Ohio, South-Western/Cengage Learning. GITMAN, L. J. (2006). Principles of managerial finance. Boston, Pearson/Addison Wesley. KAPIL, S (2011). Financial Management. New Delhi: Pearson Education India. KIMMEL, P. D., WEYGANDT, J. J., & KIESO, D. E. (2010). Accounting: tools for business decision makers. Hoboken, N.J., Wiley. LUMBY, S., & LUMBY, S. (1988). Investment appraisal and financing decisions: a first course in financial management. London, ELBS/Van Nostrand Reinhold (International). MEGGINSON, W. L., & SMART, S. B. (2009). Introduction to corporate finance. Mason, Ohio, South-Western Cengage Learning. MORDEN, T. (2004). Principles of management. Aldershot, Hants, England, Ashgate. OGILVIE, J. (2008). CIMA Official Learning System Management Accounting Financial Strategy. Burlington, Elsevier Science & Technology.  PUXTY, A. G., DODDS, C., & WILSON, R. M. S. (1988).Financial management: method and meaning. London, Chapman & Hall. Read More