Does It Matter Whether or Not Firms Pay Dividends - Essay Example

Does it matter whether or not firms pay dividends? Why? Table of Contents Table of Contents 2 Introduction 3 Irrelevance of dividend policy 4 Rightists’ viewpoint 6 Leftists’ viewpoint 6 Middle of the roaders’ viewpoint 7 Conclusion 7 References 9 Introduction Dividend is an important mode of payment through which companies share a portion of their profits to the shareholders. Therefore, dividend payment indicates the profitability of firms. Dividend payment policies are generally set by the top management and board of directors. The dividend is paid to those shareholders who used to hold the stock at the payment date. There are two types of dividend payment modes. These are cash dividend and stock dividend. In case of cash dividend the shareholders receive dividend cheque from the companies of which they hold the shares. Major of the companies pay cash dividend but still there are few companies in all countries who prefer to pay stock dividend. The companies who pay stock dividend also can repurchase its stocks when they have excess cash balance and sell hose at the time of requirement of cash for business operations. A researcher, John Linter (1956) recommended after his enormous researches on dividend that every company that pays continuous dividend has long term dividend payout ratios. Generally, large multinational companies or more specifically, financially developed companies always pay dividend and the payout ratios of these companies are high. Therefore, they share substantial percentage of their yearly earnings to the shareholders as dividend. But the small or medium size growing companies pay very small amount of their earnings to their shareholders. Secondly, managers of companies focus more in changes of percentage of earnings that need to be paid as dividend rather than the absolute values. The managers always try to increase the dividend per share in each year to make the stock more lucrative and attractive to the existing shareholders as well as new potential investors. for example, if dividend per share of a company was $5 last year then the top management and the board try to make that ratio $6 in the current year so that the shareholders hold their shares or longer period of time with an expectance to get higher return in future along with the growth of the company. Furthermore, dividend payouts of companies depend on the long term sustainable earnings rather than term profitability. Therefore, managers should make dividend payouts very consciously regarding the increase of dividend payouts. If they make any wrong decision regarding revised dividend payout, then they have to cancel the increase in dividend in a special announcement to the shareholders. This is substantial impact of change in dividend payout in stock price of companies as well as perceived value and goodwill of a firm. This is one of the most important and debated topic of behavioural finance. Dividend payout also signals the confidence of the companies, which directly affect the stock price. But the main fact that needs to be analysed is that whether dividend payment matters to the companies or not. This topic receives ample of arguments from investors, financial analysts etc. There are three different types of views have been found over the argument on this topic. People, who are on the right site of this argument, claim that higher dividend payout generally makes the shareholders and investors better off. At the same time the people who are on the left side on this argument, believe that higher dividend payout may reduce the firm value in future. The people in the middle of the road of this argument say that change in dividend policy does not affect the firm’s value (Brealey, Myers and Allen, 2011, p.35). Irrelevance of dividend policy This topic of whether dividend payment matters the firms had sparked much debate by the financial analysts and the investors. Some individual investors argued that there is no positive or negative relationship between dividend payment and firm’s value. One of the most important theories related to this financial argument was Miller and Modigliani theory which is referred as MM theory of dividend signalling. These two researchers had published their research on the study about irrelevance of dividend policy without transaction costs, taxes and other types of market imperfections. MM indicated that dividend policy would affect the firms’ value in an efficient market where there will not be any taxes, bankruptcy and asymmetric information in the market. The value of a firm depends upon the profitability, operating risks rather the ratio of retained earnings and the dividend. Therefore, changes in dividend policy refer to only the declared dividend payout per share by the firms and these changes can not affect the fair value of the firms. If businesses like to increase the total dividend payouts and keep the borrowings and investment policy unchanged then the firms can issue some new shares to new potential investors and this process is called value transfer from old shareholders to new shareholders. In this case, the old shareholders have to give up few of their shares to the new shareholders and similarly the new shareholders have to pay current market price of the shares to the old shareholders. Therefore, in this case, firms’ value remains constant (Baker and Powell, 2009, p.407). From the above analysis it can be said that shareholders have no preferences on capital gain or increase in dividend rather than retained earnings, profit distributions and dividend payment remain contradictory. Opposite to increase dividend payouts, if a company increase the retained earnings and reinvest the money for business expansion then the value of the firm increases due to increase in assets as well as possibility of higher earnings from the new assets. This can surely increase the share price as well as overall firms’ intrinsic value. At the same time, for liquidity of the shareholders, they can simply sell the shares in the market in higher price. On the other side, if a company pays higher dividends, shareholders can buy the shares if they wish to expand their investment. Therefore, shareholders do not concern that much about the dividend. So, changes in dividend payout may not affect the fair value of a firm. Rightists’ viewpoint According to the MM hypothesis, market value of a company determines the market value of assets that the company has and cash flow of the company. Therefore, if total payout increases then shareholders have to fill up gap and generally it can be made up by issuing new shares. However, if the company wants to unchanged the dividend payout then dividend payout will decrease as no of issued share increases. Therefore, the shareholders can repurchase shares to get the same money back as dividend. In this way, it can be said that increasing dividend payment may reduce shareholders’ gain. Before the publication of MM theories, people who are in the right side of this argument believed that higher dividend leads to increase in firm value as well as shareholders’ payoffs. These people prefer to invest only those companies that pay higher dividend because they think there are some natural calamities in the stocks of higher dividend payouts. Shareholders are more cautious in their investments and they generally prefer profitable as well as safe investment in terms of the large multinational companies (Moles, Parrino and Kidwell, 2011, p.671). Leftists’ viewpoint The leftists support for low dividend payouts. They believe that through low dividend payout companies can reinvest more for business expansion and in this way the value of the company as well as share price increases. The shareholders can gain much profit by selling their holdings in higher price than small dividend that companies pay against per share to the shareholders. Another important approach is that, if the dividend is heavily taxed than capital gain then the companies need to pay lower cash dividend. In this case the investors have to pay more for stocks in less dividend payouts and value of a firm decreases as it has to decrease the dividend payouts. Overall, the leftists supports for lower dividend as they believes that highly taxed dividend may decrease the firms value (Fabozzi and Person, 2003, p.559). Middle of the roaders’ viewpoint Black, Miller and Scholes (1974) support the argument of middle of the roaders. These people believe that value of the firms may not affected by the change in dividend payouts. This situation is only happen in efficient market where there is no transaction cost. The people in middle of the road emphasize that dividend changes are not consistent while others two parties believe that, change of dividend payout is demand oriented. Some investors prefer for lower dividend and they have opportunity to choose these stocks from the market while the rights may select stocks of higher dividend payout from the market. Therefore, the firms need not to change in their individual policy for the reason of increase or decrease of firm value due to dividend. Because there are other groups of people who do not care about dividend payouts rather they focus for long capital gain of the firms as well their investments. Conclusion From the above discussion of irrelevance of dividend payout and three different argumentative groups of people views, it has been identified that dividend policy is very much important for the firms to make financial decisions. It measures how the profits are distributed to the shareholders rather than focusing on one aspect i.e. higher or lower dividend payout. But, in real market scenario some theories may not properly applied. Sometimes investors may ask for higher dividend when share price is not increasing for long time. But, sometimes they can ask for lower dividend if taxation is heavy. Though, each party have different overviews according to their own choice and preferences, still it can be concluded that middle of the road position is better for long term wealth creation as dividend is very less compared to continuing growth of the firm. References Baker, H. K. Powell, G. 2009. Understanding Financial Management: A Practical Guide. UK: John Wiley & Sons. Brealey, R. A., Myers, S. C. and Allen, F. 2011. Principles of Corporate Finance, 10th ed. US: McGraw-Hill International. Fabozzi, F. J. and Person, P. P. 2003. Financial Management and Analysis. UK: John Wiley & Sons. Moles, P., Parrino, R. and Kidwell, D. S. 2011. Corporate Finance. UK: John Wiley & Sons. Read More