Does It Matter Whether or Not Firms Pay Dividends - Example

Does it matter whether or not firms pay dividends? Why? Contents Does it matter whether or not firms pay dividends? Why Contents 2 Introduction 3 Discussion 3 Tax advantage argument 4 Bird in the hand argument 5 Hypothesis of dividend irrelevance 6 Lintner’s model 6 Conclusion 7 Reference 8 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. Discussion 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. But it should be noted in this regard that the sole focus on dividend policies of an organization is not considered to be sufficient. An organization should have the potential to pay dividends to its shareholders. 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 be very specific in this regard whether it wants to rely on external sources of funds to finance its projects and then paying back to 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. It should be noted at this point that generous dividend policies is not considered as the best alternative for an organization. The most important factor is the investment policy of an organization which is considered to go a long way in determining the dividend or financing policy that is adopted by an organization. It is considered as the main thing that drives the engine of an organization. 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 that are said to have contradictory views with respect to each other. The first approach is of the opinion that paying dividends by organizations actually have a positive impact on their value. The second approach is considered to be of the opinion that higher dividends by organizations can have detrimental impact on the value of an organization. The third approach with regard 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 which is considered to increase the value of the firm has been named as ‘bird in the hand’ argument. The act of high dividend payouts by organizations which is considered to have 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’. 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 the scenario is considered to be different in the real world. Practically there are existence of numerous taxes which affect dividend decisions of organizations and also the value of the firm. In reality, tax treatment is considered to be different for dividends as compared to capital gains. The general public is interested in only the after tax return and as such 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 for dividends as compared to 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. 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. 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 of today is filled with uncertainties and as such investors prefer cash dividends which is considered as ‘bird in the hand’ as compared 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. 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. According to this hypothesis, dividend decisions are irrelevant because the value of a firm is largely dependent on the earning potential of the firm and also on its investment decisions1. 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 is not affected by factors such as whether the company is paying dividend or not. Lintner’s model The model is considered to have two parameters such as: I) Target payout ratio, and II) The rate of change in current dividend in accordance to its target. The model is said to have been developed based on two important considerations as follows: I) The target of dividends-to-earnings ratio is set by organizations with regard to the amount of positive NPV of projects that they are considered to currently have, and II) The increase in earnings of organizations is considered not to be sustainable in future years and as such managers of organizations are considered reluctant to make any changes in dividend policies until they feel that the new level of earnings are sustainable in future years also. 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. Reference Baker, H., 2009. Dividends and Dividend Policy. Hoboken: John Wiley & Sons. Read More