Dictionary of Economics: Dividend Policy and Corporate Finance - Essay Example

Dividend Policy Introduction: Dividends are defined as a form of profit sharing by corporations with its investors. The dividend payout decisions rests primarily on the decision that should the earning be retained for future growth of the firm or to payout dividend to the shareholders. Dividends can be paid either in cash or through stocks themselves. The Preferred stock holders are given a fixed dividend every year irrespective of the firms’ profitability whereas the common stock holders are paid from the company’s profitability and hence the dividends change every year.

Dividend policy are a very important and crucial decision for any firm and needs to be taken in a planned manner so as to have a positive impact on all stake holders. The dividend policy needs to be clearly defined and may change every year depending upon the dynamic nature of the business. The firm can choose to retain all the earnings or pay them out as dividends or even strike a balance in the two. The Traditional Theory: The traditional theory on dividend policy was established by Graham & Dodd.

The traditional relationship stresses the fact that stock value is dependent on the dividends. It presumes that higher dividend paying firms will have a greater value in comparison to the firms that pay lesser dividends. The formula stands as follows: P = [m (D+E/3)] Where P is the market price, M is the multiplier, D is dividend per share, and E is Earnings per share. The traditional approach gives a lot of weightage to dividends being paid in comparison to the retained earnings.

The weightage provided by Dodd and Graham are very subjective and not have an empirical basis. The limitation of the argument is that the P/E ratio and Dividend payout ratios are supposed to be directly linked. However, we know that this is not always the case and despite of nonpayment of dividends the company share price may rise. The Modigliani and Miller Theory: The Modigliani and Miller (MM) theory suggests that the dividends have no impact on the value of the company, thereby deeming the dividends as irrelevant.

The MM theorem is of the view that even if the company retains its profits and does not pay out the dividends, The stockholders will enjoy the capital gain which is equivalent to the earnings retained, and in case, the company does pay out the dividends, the shareholders will then enjoy those dividends which would have the same value as the retained earnings. Hence, The MM theory is also called the Dividend Irrelevance theory pertaining to the issue that dividend policies have no hand to play in the value of a firm.

However, the criticism to the theory comes from its very assumptions. The MM Theory assumes a perfect capital market with all information available which is not the case. It also removes the existence of any floatation or transaction costs. It also assumes no taxes and also relinquishes the desire of investors to obtain liquidity (Villamil, 2006). The formula for the value of a firms stock under the MM Theory is (Villamil, 2006): Po =P1+D1/1+Ke Po = Price of Share Now P1= Price of Share at the end of the period D1= Dividend of Share at the end of the period Ke=Cost Of Equity Bird In Hand View: The Bird in the hand theory goes on to negate the MM Theory by explaining that investors are more likely to prefer dividends as compared to future gains or returns largely due to the underlying uncertainly in the latter.

Under the bird in the hand view, Stocks with higher dividends are more attractive to investors and they are likely to b ought b potential buyers. The Clientele Effect: The clientele effect presumes that the share price of the firm is largely dependent upon the demands and the underlying goals of its investors. Hence, any policy changes in the firm would have an effect on its share price. For example, if some investors are holding a stock due to its high dividend payout and that same company decides to lower its dividend payout policy, the investors are most likely to withdraw their money which will in turn, decline the price of that stock.

The Signaling Effect: Signaling effect takes into account the signal generated through dividend polices changes and announcements. It assumes that if a firm announces high dividends for any particular period that would signal strong future prospects. The theorem stems its findings from game theory, which suggests that a firm with better prospects is more likely to signal positively as compared to firm with not so good prospects. Bibliography Villamil, A. P. (2006). The Modigliani-Miller Theorem.

Illinois: The New Palgrave Dictionary of Economics.