Analysis of Dividend Policy - Literature review Example

Dividend Policy Introduction Dividend policy can be defined as "A company's stance on whether it will pay out profits as dividends or keep them as retained earnings. If the company decides to issue dividends, the policy will outline whether or not the dividends will be issued on an ongoing basis, or if the dividend payout will be infrequent" (http://www.investorwords.com/ ). The dividend policy of the firm is determined by the fact that the manager's depression to influence the capital structure of the firm by leveraging would allow him to independently act by increasing debt thus reducing equity. Therefore the basis of the dividend policy itself is determined by the manager's ability to manipulate the capital structure of the firm. If the debt-to-equity ratio is in favor of the former the manager would have greater dispersion in determining the dividend policy. More debt means less tax liability and less dividend payout. When debt holders power increases vis--vis equity holders dividend policy becomes an instrument in hands of the manager to play each groups against the other (Pike, & Neale, 2003). 2. Analysis The dividend policy and the capital market structure of the firm can be examined with reference to a number of theories. The Modigliani-Miller Theorem is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm (Ross, Westerfield, & Jaffe, 2002). In recent times these theoretical constructs have been developed in line with an ever increasing tendency to consider the leverage issue of the company. Leveraging by managers to achieve exclusive personal goals is nothing new. In fact it's the conflict of interests between the principals or owners (or shareholders) and the agents (or managers) that has thrust the issue of leverage to the fore. In other words the complex issues revolving around capital structure of the firm are basically influenced by this conflict in which managers tend to have more information about the probable outcomes of future investments than shareholders. Thus this information asymmetry leads to a series of other problems. Disagreement between managers' behavior on the one hand and the shareholders' behavior on the other gives rise to a series of other related problems, e.g. information asymmetry, agency costs, taxation and bankruptcy costs. Information asymmetry refers to the manager's ability to control the flow of information in his favor so that the principal or the owner would have less access to information (Jonathan, & DeMarzo, 2007). Agency costs are related to the principal-agent relationship. For example when a principal hires an agent he does so with the intention that the latter would act in conformance with certain rules to bring about what the former wishes. However the motivating factor behind such performance is the monetary compensation such a good salary to the manager. Therefore such behavior on the part of the manager would not be in his best interest. His tendency to deviate from what is expected of him is common among all managers. In order to reduce such negative behavior the manager must be adequately compensated. However the principal does not know what the agent would do to ensure that his own interest prevails. Costs that are associated with this behavior are known as principal-agent costs or the principal-agent problem. (a). Asset substitution effect Assuming that projects are riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and share holders to condone such risky investment decisions on the part of managers. However in the long run with new projects rising, the value of the firm is bound to decrease while a net transfer of wealth from debt-holders to share holders is more likely. (b). Underinvestment problem Managers would not hesitate to reject projects with positive Net Present Value (NPV) because they would not be bothered to increase the value of the firm any more than to allow the accrual of benefits associated with riskier debt to debt-holders themselves rather than to share holders. (c). Free cash flow problem Finally there is the problem of free cash flow. In the absence of free cash flow benefits accruing to investors, the manager has a tendency to reduce the value of the firm through prodigal behavior, such as granting bonuses and higher salaries. Therefore higher levels of leverage would act as a preventive factor of such behavior and ensure discipline. While these agency costs reduce the level of market perfection, there is no certainty that their ultimate impact would not be reduced in the light of intervening influences such as demand for and supply of debt /equity being regulated through efficient wealth redistribution methods (Glen, 2005). Next there is the problem of taxes. When corporate taxes are considered the firm is entitled to interest expense deduction which enables it to increase value of its assets. In other words investment related tax benefits would increase the value of the firm. According to Modigliani and Miller (1963) the tax exemption allows the firm to reduce the leverage-based premium in the cost associated with raising the equity capital. Subsequently Miller added personal taxes to the equation. According to Miller when the equilibrium occurs, the individual tax liability will be so greater as to offset any benefits related to the corporate gain. This renders capital structure irrelevant. Next bankruptcy costs are associated with the probable event of the business going bankrupt. Bankruptcy costs are divided into direct and indirect costs. Direct costs include those associated with legal process and deadweight losses. Thus there can be identified some important theories which are incorporated with dividend polices of the firm. 1. Modigliani-Miller Theorem Modigliani-Miller Theorem (M&M) occupies a very important place in the determination of relevance or irrelevance of capital structure for the value of the firm. Therefore it's equally important in examining the efficiency of capital markets. According to M&M the value of a firm depends on its capacity to earn and distribute profits among its shareholders along with the associated risk of assets. In other words the value of the firm has nothing to do with the way in which it makes its investments and distributes dividends. The firm might adopt one or more of the following methods to finance its assets. After all M&M says that it is irrelevant how the firm finances its assets whether by issuing equity or raising debt. Even the dividend policy does not matter. If there were no dividend policy at all still it would be irrelevant. In short M&M is also known as "capital structure irrelevance theorem" (Bond, & Mougoue, 1991). Therefore it's essential to consider the very basis of M&M in the backdrop of an evolving theoretical framework on the subject and delineate the connected arguments on the relative efficiency of the capital market. The firm might borrow and invest, it can issue shares or/and it can reinvest money from its reserves. Whatever it does, its freedom to choose between choices is limited by the very structure of capital. Despite this limitation according to M&M there is no need for the firm to have a dividend policy. Above all M&M seeks to prove its validity through an example of two firms, one adopting a leverage policy in which the firm borrows money partially (debt) and finances its assets and another adopting an unlevered approach in which it finances its assets only through equity. M&M comes to the conclusion that the value of both the firms would remain the same. 2. Trade-off theory Trade-off theory is not against the existence of bankruptcy costs. The theory supports debt-financing of assets rather than equity-financing because of the associated tax benefits. The theory goes onto add the disadvantages also (Chew, 2000). Its original of the existence of bankruptcy costs entails more of a burden in times of failure because bankruptcy would further encumber the firm with debt. Further there are non-bankruptcy costs also such as trained staff leaving the company and demanding favorable settlement packages. Above all such costs would compel the firm to increase its debt. As for a particularly advantageous position of the firm vis--vis its competitors, there is very little to be mentioned by way of well-geared capital ratios. The theory does not necessarily mention about the relevance or irrelevance of capital structure except to support a very high content of debt or leverage. As for the dividend policy of the firm, the theory seems to identify the existence of a dividend policy depending on the degree of leverage (Baker, & Wurgler, 2004). The higher the leverage the higher the after-tax profits for distribution or/and plouhging back into the business. As for the optimum capital structure of the firm the theoretical underpinnings do not elaborate the degree of divergence or convergence between variables. 3. Agency costs Most of the current literature on corporate finance regards agency costs as a very important deciding factor in capital structure. A number of authors have substantially contributed to the exploration of Agency cost problem. Asymmetrical distribution of information within and without the business organization causes a series of problems. Yet the manager (agent) acts in the best interest of shareholders, i.e. the principal. This information failure ultimately causes such agency problems as moral hazard and adverse selection. There are three fundamental problems associated with agency costs. (i). Underinvestment problem (ii). Risk shifting behaviour problem (iii). Free cash flow hypothesis (i) Underinvestment problem The management of a firm might not consider investing in low risk assets such as bonds because such bonds' yield is low. The temptation to maximize yield for shareholders will be so irresistible and as a result they may ignore debt-holders' preference for low risk investments. From the viewpoint of debt-holders low risk investment opportunities would guarantee a steady return (Brealey, Myers, & Allen, 2006). However from the viewpoint of shareholders it will not generate a high level of return. Despite a rise in the value of the firm shareholders would not like to invest in low risk projects, thus leading to a higher level of risk prone investments. (ii) Risk shifting behaviour problem Risk shifting or bond-holder expropriation hypothesis is based on the premise that shareholders have a tendency to maximize their gains at the expense of bondholders. Managers who prefer projects with negative Net Present Value (NPV) invariably support shareholders to gain. Such a decrease in value will decrease the value of debt by a smaller margin but add to the value of equity by a smaller percentage. This problem of overinvestment gives rise to a subsequent series of connected issues. (iii). Free cash flow hypothesis Jensen & Meckling (1976) in his free cash flow hypothesis argues that managers would act in their own self interest, thus accumulating benefits for themselves at the expense shareholders. These benefits can be both tangible and intangible and pecuniary and non-pecuniary. Jensen hypothesized that with the consequent growth of the firm managers would be more vulnerable to making injudicious investment decisions because they are motivated by intangible non-pecuniary benefits such as prestige and power. Such risk-prone behaviour on the part of managers would lead to making sub-optimal investments in their blind attempt to "grow" the firm by not distributing profits to shareholders. They might go to the extent of initiating riskier takeover bids. 4. Pecking order theory Pecking order theory was developed in response to the relatively weaker arguments of Trade-off theory by Myers and Majluf (1984) and simply states that managers choose their financing sources according to the inherent rule of least effort in which equity-financing is carried out only as a last resort, i.e. after exhausting every possibility of raising debt. Thus according to Myers and Majluf the firm goes by priorities - first, it uses internal reserves, then debt and finally equity capital. In contrast to Trade-off theory, Pecking order theory has a clear advantage in that it adequately captures the negative relationship that exists between the firm's profitability and debt determines the degree of relevance or irrelevance according to trade-off theory. . According to Pecking order theory this proposition has a number of other advantages. In the first instance, firms attempt to match their ratios of target dividend payment with their investment plans. Secondly such sticky dividend pay-out policies would ensure a constant positive cash flow despite unpredictable profit margins and erratic changes in investment opportunities. However there is no guarantee that the net cash flow would be always greater than the sum total of capital expenditures. Conclusion Variety of theories has come with a variety of explanations to the relevance/irrelevance of capital structure in determining the value of the firm. However there is very little theoretical analysis of the relevance or the irrelevance of a dividend policy for the firm. Despite these shortcomings both in theory and empirical literature there is a valid hypothesis on the subject of efficient functioning of capital markets as the harbinger of an end to capital structure and its related theories in determining the value of the firm and acting as a deciding factor. Market imperfections include information asymmetry, agency costs, taxation problems and bankruptcy costs. Information asymmetry is primarily attributed to the conflict of interests between the principals and agents. In other words it's based on the principal-agent problem. In order to ensure an efficiently functioning capital market this imperfection has to be removed thus rendering the significance of capital structure in determining the value of the firm irrelevant. Secondly agency costs constitute another market imperfection. Agency costs are divided into three sub-categories. They are asset substitution effect, underinvestment problem and free cash flow problem. Asset substitution effect occurs when managers behave in such a manner to substitute debt in place of equity through new and riskier investments. Under investment problem occurs when managers act in a manner such as to reject projects with positive NPV because they are less likely to tolerate an increase in the value of the firm, thus indirectly conniving to transfer the benefits to debt-holders. Free cash flow problem occurs when managers tend to be overgenerous with distribution of benefits to investors. Agency costs might not be totally wiped out unless the principal-agent problem is solved. Finally there is the problem of bankruptcy costs. They occur in situations like the company going bankrupt, e.g. legal costs and payments to those affected. Taxation also entails similar problems which cause the functioning of capital markets to be inefficient. Thus in conclusion this writer holds the view that despite imperfections in competitive markets for finance, there are still possibilities to develop efficient capital markets through substantial promotion of free market forces. Thus capital structure of the firm and therefore a particular dividend policy are both irrelevant. References 1. Baker, M & Wurgler, J 2004, 'A catering theory of dividends',Journal of Finance, vol. 59, pp.1125-65. 2. Bond, MT & Mougoue, M 1991, 'Corporate dividend policy and the partial adjustment model',Journal of Economics and Business, vol. 43 pp.165-77. 3. Brealey, RA, Myers, SC & Allen, F 2006, Corporate Finance, McGraw Hill, New York. 4. Chew, DH 2000, The New Corporate Finance: Where theory meets practice, McGraw-Hill, New York. 5. Glen, A 2005, Corporate Financial Management, Pitman Publishing, London. 6. Jensen, MC & Meckling, WH 1976, 'Theory of the firm: Managerial behavior, agency costs, and ownership structure', Journal of Financial, Economics, vol.3, no.4, pp.305-360. 7. Jonathan, B & DeMarzo, P 2007, Corporate Finance, Addison Wesley, Massachusetts. 8. Modigliani, F & Miller, MH 1963, 'Corporate income taxes and the cost of capital: a correction', American Economic Review, vol. 53, pp. 433-443. 9. Pike R & Neale, B 2003, Corporate Finance and Investment: Decisions and Strategies, Prentice Hall, New Jersey. 10. Ross, SA, Westerfield, RW & Jaffe, J 2002, Corporate Finance, McGraw Hill, New York. Read More