Does it matter whether or not firms pay dividends - Essay Example

Paying dividends Does it matter whether or not firms pay dividends? Why? Introduction One of the essential parts of a company investment return is dividend. Being paid on an annual or quarterly basis, majority of companies pay dividends to the shareholders while others retains their entire profit and reinvest. Even though reinvesting back the profit is vital for the future expansion of the company, it significantly matter whether firms pay dividends. Based on the importance of shareholders in the capital growth of any company, it is fundamental for the management to rewards the shareholders by giving them a portion of the company profits so that they can use it for their own investment or education of their children among other personal use. This paper aims at discussing why it matters whether or not firms pay dividends. A company that regularly pays dividends to its shareholders indicates fundamentals. In 1930s before firms were under legal obligation to pay dividend, their financial health was indicated by their ability to pay dividend. Not withstanding the laws and legislations such as the securities and exchange act of 1934 that brought about a significant level of transparency in the financial management of firms, dividends are still a notable yardstick of the company performance (Horp, 2010). Mature companies pay dividends and still retain more profits for reinvesting. A good example of a company that has benefited from giving its shareholders dividends is Microsoft. During the early years of the company operations, the company did not pay dividends but it reinvested significant portion of its profit for future growth. Eventually, the company growth rate became slower making the management to replace the capital appreciation with dividends in order to maintain the shareholders trust. Having started paying dividends in 2004, Microsoft first dividend stood at $75 billion. The company dividend average is 1.8%. Dividend yield Apart from high profits and audited reports that the investors are interested in, they also like to see the level of dividend yield. Dividend yield is attained by dividing annual dividend per share by current share price (Robert and Clifford, 2003). By looking at the level of the dividend yield of a company, an investor is in a position to make an appropriate investment decision. For example, if the dividend yield is low as compared to other firms in the same industry it can imply two things. First, its share price has increased since the market notes that the company has good prospects and that payment of dividend will not create any problem in the market. Secondly, it can mean that the company is in financial problem and that it is not in a position to give reasonable dividends. Dividend coverage ratio Before investing in a company and evaluating its dividend-paying culture, it is fundamental that one ask himself or herself if it is possible for the company to pay dividend. This is done by computing the dividend coverage. Dividend coverage is calculated by getting the ration between a firm’s earnings and net dividend paid to the shareholders. One of the importances of dividend coverage is that it allows the investors and the management to determine whether the company earnings are adequate to meet the dividend obligation. Dividend coverage of 3 or 2 is proper for the investors. However, if it drops to less that 2 for example it comes to 1.5, this is an indication of a poor prospects and it becomes risky. It is good to note that if the coverage is less that 1, it means that the firm is using the funds it retained in the previous financial to pay dividend. Dividend paying stocks offers various advantages. First, dividends forms part of the total returns. This implies that companies that are in a position to pay dividend indicates that they are historically stable and that they are able to meet other financial obligations. Secondly, it results to less volatility. This implies that by giving the shareholders part of the company profits in form of dividends, it assists in lessening the possible fall of the firm’s stock price. As a result, the level of volatility is reduced (Norris, 2007). Another advantage of giving dividends is that it results to increase in the level of yield. For the shareholders dividends is one of the major source of income thus this makes them to have interest in the performance of the company. Thus, shareholders and investors who gain from the dividends have high interest of providing financial and other forms of assistance to ensure the company remains operational. For the companies that give dividends to their shareholders, they benefit from favorable tax treatment. This implies that as compared to the interest income that is treated by most tax systems as an employment income, dividend income is given a favorable tax treatment. It is worth to note that organizations that adequately manage their cash flow are in a better position to grow their dividend over time. Dividend cut If a firm that has a culture of gradually increasing its dividends, and then at one time it cuts the dividend, this is an indication that a trouble is near and investors should realize this. Even though most companies aims at increasing their annual dividend or maintaining a steady dividend rate shareholders should be wary of the firms that borrow in order to give high dividend (Hoboken, 2002). Most notably, the investors should take note of companies that have a debt to equity ratio of more than 60%. This is based on the fact that high debts may be due to the forces from the Wall Street or other agencies resulting to the inability of a company to pay debts. Great disciplinarian During an investment making decision process by managers and the shareholders, dividends brings a significant level of discipline. While profits retention and reinvestment is a key aspect of ensuring the company maintains adequate liquidity, holding of too much profit may lead to high executive compensation as well as poor use of assets. As indicated by Michael (2009), maintaining of large amount of cash makes a firm to over pay in case of acquisition thus resulting to a damage of the shareholders value. Similarly, it has been noted that firms that have adopted the policy of paying dividend to the shareholders are more efficient in the use of capital as compared to similar companies that do not share their profit among the shareholders (Manfred and Kets, 2003). With the increased cases of frauds and tax evasion among local and international companies, payment of divided is one of the major aspect that reduces the chance of management decision to make fraudulent transaction and divert the company funds. In order to maintain strong relationship between companies and the public, most companies have adopted various corporate social responsibilities such as reduction of carbon, sponsoring of cultural and social activities and assisting the poor families. Paying divided is also a way that companies can use to ensure that the management meets the promises it made to the public (Gomez-Mejia, L et al. 2008). If the public notices that a certain company makes a significant amount of profits but fails to pay dividends to the investors, then the management suffers embarrassment an aspect that can result into damage of the share prices and lack of investors trust. Method of calculating value A major merit of paying divided is that managers and investors have a simpler way of knowing the value of their company. By the use of divided discount model as well as the capital asset pricing model, it is possible to know the value of an organization. This is attained by discounting back all the prospective dividend payment to the present value (Sullivan and Steven, 2003). Based on the fact that dividends are key cash flow to the shareholders and investors, they are in a better position to give a reflection of the company’s value. In the economy, stock that allows for payment of divided are not likely reach unsustainable values. Conclusion Based on the above discussion, it is clear that dividend matters. As the demand for investment portfolio increases, investors have become aware of techniques and company policies that either guarantees positive returns or risky investment. Some of the notable aspect that the paper has discussed and which investors are keenly looking for before investing includes dividend yield, dividend coverage ratio and dividend cut. By analyzing these concepts, investors are in a better position to know the financial position of the company. To the managers .dividend is a great way of acknowledging the public. The public wants to see t6hat companies local firms that makes sustainable profits pays dividend to the local and international investors. Similarly, managers are helped by the dividend policy in knowing the value of their firm. References Gomez-Mejia, L et al. 2008. Management: People, Performance, Change. New York: McGraw-Hill. Hoboken, N. 2002. Investment-Oriented Life Insurance. Handbook of Financial Instruments. London: Wiley. Horp, E. 2010. Kelly Capital Growth Investment Criterion. World Scientific Journal. Manfred, R and Kets, V. 2003. The Dark Side of Leadership. Business Strategy Review 14(3), Michael, S. 2009. The Effect of Enhanced Disclosure on Open Market Stock Repurchases. London: Sage. Norris, S. 2007. Cooperatives pay big dividends. The Guardian. Retrieved 2014-03-23. Robert, D and Clifford S. 2003. Surprise! Higher Dividends equal Higher Earnings Growth. Financial Analysts Journal. Sullivan, A and Steven M. 2003. Economics: Principles in action. New Jersey: Pearson Prentice Hall. Read More