A Companys Dividend Policy - Essay Example

? FINANCIAL MANAGEMENT by A company’s dividend policy refers to its decision to pay out cash to its shareholders, in what amount, and in what fashion. The most apparent and vital element of this policy in a company is the firm’s decision whether to pay a cash dividend, how often it must be distributed, and how large the cash dividend should be. In a wider perspective, dividend policy entails decisions that include whether to distribute cash to the company’s investors through share repurchases or particularly designated dividends other that frequent dividends, and whether to depend on stock other than cash distributions (Allen & Michaely 2002). Non-conventional types of dividend payments, particularly share repurchases are in most cases used currently, and therefore, the dividend decision is much more multifaceted and complex than it was in the past. In addition, there are more significant types of shareholders who should be satisfied today-particularly institutional investors-while managers once merely have to satisfy individual stockholders. Therefore, n increase in the dividend payout is taken to be good news. The company is showing that it not only has positive cash flows, however these cash flows are rising sufficiently to validate an elevated payout to shareholders. The company “proves” its cash flow by paying out some of that cash to its shareholders. This means that higher dividends might indicate lasting greater earnings for the company. How this argument has been contradicted that the dividend policy is irrelevant. It is for this reason that this paper will examine on the fact that company's dividend policy is irrelevant to its market value. The following dividend growth model is usually in calculating the effects of dividends: In this model ,all factors kept constant, a greater dividend and greater growth rate will lead to rise in the value of P0, however a greater dividend leads to g to be lesser and vice versa. In addition, a lower needed rate of return, R, would cause P0 to increase, and usually a stock with greater dividend has fewer risks, which means that it has a lower needed rate of return (Allen & Michaely 2002). The Modigliani-Miller (M&M) theorem, (Irrelevancy Theory) (1961) forwarded by Franco Modigliani and Merton Miller, influences the base for modern view on capital structure, although it is usually perceived as merely scholarly because it presumes away numerous significant elements in the capital structure decision. The theorem argues that, in a perfect market, the value of a firm is irrelevant to how that firm is funded. This outcome offers a basis used to study real global reasons why capital structure is appropriate. These other reasons comprise agency costs, bankruptcy costs, information asymmetry, taxes among others. The theorem has been used to show that dividend is irrelevant to firm’s market share. Merton Miller and Franco Modigliani (MM) under their theory argued that in perfect financial markets (no transactions costs certainty, no taxes, or other market imperfections), the value of a company is impacted by the allotment of dividends. They claim that company’s value is mainly driven the prospective income and risk of its investments, therefore, maintaining income or paying them to the shareholders in dividends does not affects its value (Grullon et al 2002). MM through its theory indicated that provided the company is attaining the returns anticipated by the market, it does not matter whether the returns is directed to the stockholder as individuals currently, or reinvested. They would perceive it in terms of dividend or price appreciation. Therefore, in this case the shareholder can develop their individual dividend through selling the stock when they need cash (Lie 2000). They qualified their argument through this calculation: V t = 1/1+rt[Dt+Vt+1-m t+1P t+1] Where rt = Discount rate Dt = Total Dividends Paid V t+1 = Firm Value @ t+1 = ntP t+1 M t+1P t+1 = Amount raised in equity = It-[Xt-Dt] It = Capital Investments Xt = Income @t Vt = 1/1+rt[Dt+Vt+1- It-[Xt-Dt] = 1/1+rt[Vt+1-It+Xt] From the above calculation, dividends are not in the final equation; therefore it implies that dividends are irrelevant to company’s market value. Furthermore, it can be argued that the dividend policy is irrelevant for the reason that the market price of the firm’s common stock is unaffected under diverse dividend policies. For instance, if a company increases to dividends that are paid out to its shareholders, the company has to offset this increasing through issuing new common stock to fund the available investment prospects. If on the other side, the company lowers its dividend payout, then the firm will have more funds accessible internally to funds its investment projects (Lie 2000). In either policy, the current value of the firm, through the resulting cash flows to be accrued to the present investors is independent of the dividend policy. Through changing the dividend policy, one the kind of return is impacted (capital gains versus dividend earnings), and not the total return. Therefore, this means that dividend policy will only be relevant if it impact on the wealth of stakeholders. The thought behind the irrelevance argument is that if the company has a lower payout ratio now, it will reinvest the capital into the firm, grow the firm quicker and pay greater dividends afterward. On the other side, if the company has a greater payout ratio currently, the firm will reinvest less capital back into the company and pay lesser dividends afterward. Provided the needed return is earned on investments, it is irrelevant which kind of choice the firm will undertake (Allen & Michaely 2002). Moreover, dividends in a company are more predictable as compared to capital gains since the management may have control over the dividends, whilst they cannot influence the company’s stock price. Therefore, investors are less certain of getting revenue from the capital gains than from the firm’s dividend revenue. The incremental uncertainty linked to capital gains relative to dividend revenue must therefore make the firm to use greater required rate in discounting a dollar of dividends. Through carrying this, the company will give a greater value to the dividend income than the capital gains for the firm (Baker & Wurgler 2004). It is also apparent that if the firm can increase dividends without varying other elements in the company, then the firm will increase in value. Nevertheless, there is a trade-off between paying greater dividends and implementing other things in the company. The irrelevance argument, therefore, argues that the resulting trade-off is fundamentally a zero-sum game and that selecting one dividend policy over the other will not affect company’s stock price. Recall the dividend growth model: P0 = D1 / (RE – g). In the nonexistence of market imperfections, which include transaction costs, taxes costs, and information asymmetry, it can be shown that an rise in the prospect dividend, D1, will decrease income reinvestment and retention and reinvestment. This will in turn lower the growth rate, g. consequently, both the denominator and the numerator rise and the net result on P0 will be zero (Harding et al 2006). In terms of clientele effect, it argues that dividend policy is irrelevant since investors who opt for higher payouts will invest in the companies that have greater payouts; whereas those investors who opt for low payouts will invest in companies that offer low payouts. Therefore, if a company alters its payout policy, it will not impact the stock value, but will basically end up with a diverse pool of investors. This is right provided the “market” for dividend policy is in symmetry. This implies that, if there is glut demand for firms with higher dividend payouts, then a low payout firm might be capable to raise its stock prices by switching to a higher payout policy. This is only likely to happen until the surplus demand is fulfilled. This means that in this case dividend policy will be irrelevant as the firms can change easily depending on prevailing market situations (Lie 2000). In addition, a company might to purchase back exceptional shares rather than paying a cash dividend (or in its place of raising usual dividend). If the company presumes there are no market imperfections, then shareholder’s wealth is unaltered by the option between cash dividends and share repurchases. This is basically one more illustration of dividend policy irrelevance when the taxes are absent or other imperfections in the market (Allen & Michaely 2002). List of References Allen, F., and R. Michaely, 2002, “Payout Policy,” Working Paper, forthcoming in North- Holland Handbook of Economics (eds. G. Constantinides, M. Harris and R. Stulz), 2002 Baker, M., and J. Wurgler, 2004, "A Catering Theory of Dividends" Journal of Finance 59, 1125-1165. Grullon, G., R. Michaely, and B. Swaminathan, 2002, “Are Dividend Changes a Sign of Company Maturity?”Journal of Business 75, 387-424. Harding J, Liang X & Ross S 2006, ‘The Optimal Capital Structure Of Banks Under Deposit Insurance And Capital Requirements’, available at: http://www.econ.uconn.edu/working/2007-29r.pdf, accessed on the 28th March 2013. Jung, K., Y. C. Kim and R. Stulz, 1996, “Timing, Investment Opportunities, Managerial Discretion, and the Security Issue Decision”, Journal of Financial Economics 42, 159- 185. Lie, E., 2000, “Excess Funds and Agency Problems: An Empirical Study of Incremental Cash Disbursements,” Review of Financial Studies 13, 219-248. Read More