Does a Dividend Policy Matter - Essay Example

Does a dividend policy matter? Contents Does a dividend policy matter Contents 2 Introduction 3 Analysis 3 Bird in the Hand Argument 5 Tax Advantage Argument 5 Hypothesis of Dividend Irrelevance 6 Clientele Effects of Dividends Hypothesis 7 Conclusion 8 References 10 Introduction There are two consensuses with regard to dividend policy such as academic consensus and the other is the consensus of practitioners. Dividends don’t play an important role according to the academic consensus. This consensus tells that it is not expected of the market to pay premium prices for firms that have adopted dividend policies that can be considered as generous. It considers the process of paying dividend by firms as something which is irrelevant. It is also of the opinion that dividend policies actually decrease the value of the shares because there is a tax implication on paying dividend by firms and this is in contrast to capital gains. But the practitioners are of the opinion that dividend policies do play an important role in this regard. They provide examples in this regard that there are numerous companies whose share prices have jumped to a new high after their announcement to pay regular dividends. The process of paying dividend by companies is considered very important because it sends a powerful message to outsiders of the company about the future prospects of the organization. If an organization is able to pay out consistent dividends over time to its shareholders, it can be concluded by the general public that the fundamentals of the organization are very strong. Analysis It should be noted in this regard that focusing solely on the dividend policy of an organization is not sufficient. The company must also have the money that is required to pay dividends to its shareholders. Any company’s sources of funds must equal its uses of such funds. If an organization pays dividends to its shareholders and this is considered as use of funds, there must be something that has to change in the uses and sources statement. In this regard it could be said that given the investment policy of the firm, the dividend policy decisions of any firm is dependent on the choice of its financing strategy. An organization has to take a decision in this regard whether it wants to rely heavily on external funds to finance its projects and then paying back those funds to the providers of finance in the form of higher dividends. The other way is to retain a part of its earnings to finance its growth. Ploughing back of profits is an important tool by which an organization can effectively finance its projects without relying too much on outside sources of funds (Miller, 1977, pp. 261-265). It can be said at this point that generous dividend policies may not be considered as the best for an organization. The organization’s investment policy goes a large way in determining the dividend or financing policy that is adopted by an organization. The investment policy of the organization can be considered as the main thing which drives its engine. It is in this regard that academicians say that dividend policy of an organization doesn’t really matter much with regard to determining the value of any organization. There are mainly three theories of dividends which are contradictory to each other. The first approach is of the opinion that paying dividend by organizations actually increases the value of the firm. The second approach is of the opinion that high dividend payouts by an organization have detrimental effect on the value of the firm. The third approach to dividend payment assumes that payment of dividend by organizations is of no relevance and that every effort by the company in this regard is wasted. These approaches have been embodied in three theories related to dividend policy. The act of dividend payment by organizations increases the value of the firm has been named as ‘bird in the hand’ argument (Miller and Modigliani, 1961, pp. 411-415). The act of high dividend payouts by organizations has detrimental effect on the value of the firm has been named as ‘tax advantage’ argument. The third act of assuming payment of dividend by organizations as irrelevant has been named as ‘hypothesis of dividend irrelevance’. Bird in the Hand Argument This argument assumes that any payment of dividend by organizations has favourable impact on the value of the company as it is considered to increase the value of the firm. The world is filled with uncertainties and as such investors prefer cash dividends which is considered as ‘bird in the hand’ in relation to future capital gains which is considered as ‘two in the bush’. If an organization pays higher dividends, it reduces the uncertainty that is associated with future cash flows in the minds of the general public. It also assumes that a payout ratio which is high will reduce the capital cost for the organization and in the process increase the value of shares of the company. Modigliani and Miller (1961) have hugely criticized this argument by saying that the risk factor of any organization is largely determined by its operating cash flows and not by the way how the company distributes its earnings among its shareholders. They also suggested that the level of dividend that is paid by a company is determined by the risk factor of the organization. It implies that the risk factor of the organization’s cash flow influences the dividend decisions of organizations and that any increase in the payment of dividends will not in any way reduce the risk of the company. Tax Advantage Argument Modigliani and Miller have assumed the existence of a perfect capital market to exclude any implications of tax. It has been assumed in this regard that there is no difference in tax treatment with respect to dividend and capital gains. But this is not the case in the real world. Practically there are existence of numerous taxes which affect dividend decisions of organizations and also the value of the firm (DeAngelo, 1991, pp. 357-360). In reality the tax treatment is different for dividends and capital gains and because the general public is interested in only the after tax return, these factors play a significant role which may affect the demand for dividends by individuals. The tax advantage hypothesis suggests that lower the payout ratios for an organization, the lower is the cost of capital for an organization. In other words it can be said that if dividend payout ratios are lower for an organization, it will contribute in a large way in increasing the value of the firm. This argument is based on the fact that the tax implications are different with respect to dividends and capital gains. The tax on dividends is considered to be higher with respect to capital gains tax. Moreover dividend payment by organizations is taxed immediately whereas the tax on capital gains is deferred till the share or stock is actually sold (Rubinstein, 1976, pp. 1229-1230). It is because of these tax advantages of capital gains over dividends that there are many investors who prefer companies with high retained earnings against those companies that tend to pay all of their earnings by way of dividends. It is considered in this regard that a low payout ratio will lead to reduced cost of equity and thereby increase the prices of stock for an organization. Hypothesis of Dividend Irrelevance Dividend decisions of organizations have no impact on the cost of capital and also on its stock price under perfect market conditions. Under such circumstances, the wealth of shareholders remains unaffected and as such they remain indifferent between capital gains and dividends (Brennan, 1971, pp. 1115-1118). According to this hypothesis, dividend decisions are irrelevant because the value of a firm is largely determined by the earning potential of the firm and also by the investment decisions that it makes. It is irrelevant in this regard to look at the way an organization distributes its earnings among its shareholders. This hypothesis further states that given the investment decisions of the firm, the policy with regard to dividend payment that is adopted by an organization will not in any way affect the current prices of stock of an organization. Investors tend to calculate the value of a company with respect to its future earnings and this not affected by factors such as whether the company is paying dividend or not. Modigliani and Miller based their research upon certain assumptions such as the existence of a perfect capital market and that there are only rational investors. The assumptions that are made for the dividend irrelevance theory to hold can be enumerated as follows: I) There are no differences with respect to tax implications on capital gains and dividends, II) There is no existence of floatation and transaction costs while trading on securities, III) The market participants have equal and free access to every information that is available in the market, IV) There is no existence of agency problem which means that there is no conflict in interests of security holders and managers, and V) Each and every participant of the market is price takers. Clientele Effects of Dividends Hypothesis Modigliani and Miller have also argued that the pre-existence of clientele impacts of dividend may play an important role in decisions of dividend policy under certain circumstances. They pointed out that the choice of portfolio by individual investors may be influenced by the existence of certain market imperfections such as different tax rates to facilitate various mixes of dividends and capital gains, and transaction costs. The existence of these factors may lead investors to choose those securities that reduce these costs. The tendency of investors to get attracted to certain types of dividend paying stocks is called the clientele effect of dividend. It may be noted in this regard that the existence of the clientele effect may affect the dividend policy decisions of organizations and that it may be attracted to certain clienteles but the existence of perfect market conditions ensures each clientele is as competent as the other; hence it can be concluded that the valuation of the firm is not affected and as such it renders the dividend policy to be irrelevant. In reality investors are faced with different tax treatments with respect to capital gains and dividend income. They also incur considerable costs while trading securities such as transaction costs. There are many clienteles such as investor clienteles, minimisation of transaction cost clientele, and minimisation of tax clientele (Jensen, 2005, pp. 5-9). These various clienteles will get attracted to different firms that follow dividend policies that suit their situations in particular in a better manner. For instance, the organizations that operate in high growth industries usually pay no dividend and they attract a clientele that has a preference for appreciation in price to dividends. Organizations that pay a huge part of their earnings by way of dividend usually attract a clientele that has a preference for high rates of dividends. It should also be noted in this regard that clienteles like institutional investors have an attraction for stocks that are dividend paying because of their advantage with regard to tax implications as compared to individual investors. Conclusion Given the investment policy of any organization, the dividend decisions of any organization is solely dependent on its financing strategy. An organization has to take a final decision in this regard whether it wants to rely heavily on external sources of finance or that it will fund its growth projects from internally generated funds. Ploughing back of profits is an important tool by which an organization can effectively finance its projects without relying too much on outside sources of funds. It can be said that the option of generous dividend policies may not be considered as the best option for an organization. The organization’s investment policy goes a large way in determining the dividend or financing policy that is adopted by an organization. But it is considered that the process of paying dividend by companies is considered very important because it sends a powerful message to outsiders of the company about the future prospects of the organization. As shareholders do not get opportunities to participate in the matters of management of the company, it is better for an organization to distribute its earnings by way of dividend. If an organization is able to pay out consistent dividends over time to its shareholders, it can be concluded by the general public that the fundamentals of the organization are very strong. References Brennan, M., 1971. A note on dividend irrelevance and the Gordon valuation model. Journal of Finance Vol. 26 (2), pp. 1115–1118. DeAngelo, H., 1991. Payout policy and tax deferral. Journal of Finance, Vol. 46 (2), pp. 357–360. Jensen, M., 2005. Agency costs of overvalued equity. Financial Management, Vol. 34 (1), pp. 5–9. Miller, M. and Modigliani, F., 1961. Dividend policy, growth, and the valuation of shares. Journal of Business, Vol. 34 (1), pp. 411–415. Miller, M., 1977. Debt and taxes. Journal of Finance, Vol. 32 (2), pp. 261–265. Rubinstein, M., 1976. The irrelevancy of dividend policy in an Arrow–Debreu economy. Journal of Finance, Vol. 31 (1), pp. 1229–1230. Read More