The Residual Dividend Theory - Example

Does it matter whether or not firms pay dividends? Why? Contents Contents Introduction 3 Discussion 3 Dividend Policy and Stock Price 4 View Dividend Policy is Irrelevant 4 View 2: High Dividends Increase Stock Value 5 View 3: Low Dividends increase Stock Value 6 The Residual Dividend Theory 6 Dividend Decision in Practice 7 Conclusion 8 References 9 Introduction In the world of corporate finance, the finance manager faces two operational decisions, one is financing decisions and another is capital budgeting. The financing decision is concerned with the way asset of a company is financed while capital budgeting decision is concerned with what real assets a company needs to acquire. But managers are often faced with a third decision whenever firms start to generate profits. The managers are needed to take decisions on how much profit should be distributed to the shareholders in the form of dividends and how much should be retained back into the organisation. The term dividend policy indicates the practice which management adopts for distributing dividends or in other words the pattern and size of cash distributions to the shareholders. Dividend policy decisions have engaged the managers since the birth of modern Commercial Corporation. This report will take a look at the dividend policy decisions of an organisation and how it affects the organisation. Discussion The dividend Policy consists of two basic components. First indicates the dividend payout ratio indicating the amount of dividends which is to be paid relative to the company’s earnings. The second component indicates the stability of the dividends over a period of time. A financial manager faces many trade-offs in formulating a dividend policy for the company. Considering the fact that management of the company has decided on the how much to invest and chosen the debt-equity mix for financing their investments, the decision for paying large dividend indicates simultaneously deciding to retain little profits which in turn leads to greater reliance on external equity financing. On the other hand, given the firm’s financing and investment decisions, a small dividend payment indicates high profit retention with less need for external equity funds. Dividend Policy and Stock Price The primary task of a financial manager is maximization of shareholder’s profit. They need to understand the relationship between dividend payout and stock value. The value of a stock is defined as the present value of the future expected dividends. There are many views with respect to this theory. View 1: Dividend Policy is Irrelevant Many managers are of the view that stock prices changes occurs due to dividend policy announcements and hence dividends are regarded as important but some are of the view that dividends are irrelevant. The view that dividends are irrelevant is based on two preconditions. The first assumption is that the borrowing and investment decisions have already been made and these decisions are not altered by the amount of any dividend payments. The second assumption is existence of perfect capital markets which indicates that companies can issue stocks without any costs of doing so, investors can buy and sell stocks without incurring any transaction costs, and all relevant information about the firm is available, absence of personal or corporate taxes, no agency and bankruptcy costs (Malkawi, Rafferty and Pillai, 2010, pp. 171-175). Given the above assumptions the effect of dividend decision on the stock price may be stated unequivocally. There is no relationship between dividend policy and stock value. One dividend policy is similar to another one. Hence the investors are actually concerned with the total returns they get out of their investment decisions and they are indifferent of whether the returns they get come from dividend income or capital gains. They understand that given the investment policy, the dividend decision is actually a choice of financing strategy. Thus to finance growth the company has two options. The company may use internally generated funds for its growth and hence paying fewer dividends without issuing any new stock. Another option is to issue new equity shares and thus using internally generated funds i.e. profit to pay the dividends. In the first case the value of shares will increase due to capital gains, in the second case the shareholders will receive dividend income. The only difference in both the case is the nature of return though the total amount of returns will be same (Baker, 2009, p. 96). The dividend payout decision of a firm could affect the share price if the shareholder has no other way of receiving income from their investment. But assuming that the capital markets are efficient, a shareholder can always sell shares in case he needs current income. But if the firm pays dividend, the shareholder can eliminate any dividend received by using the dividend money to purchase stock. Hence the investors can personally create desired dividend stream, no matter what the dividend policy is. View 2: High Dividends Increase Stock Value The view that the dividend policy of a firm is unimportant assumes that an investor must use the same required rate of return whether income comes through dividends it through capital gains. But dividends are far more predictable than capital gains and dividends can be controlled by the management but it cannot dictate the share price. The incremental risk associated with capital gains with respect to dividend income implies that a higher required rate for discounting a dollar of dividends. Hence investors would value a dollar of expected dividends more than a dollar of expected gains. Hence dividends are more certain than capital gains (Keown, Martin, Petty and Scott, 2005, p. 608). But increasing the dividend of a firm does not reduce the basic riskiness of the stock, instead if the dividend payment requires the management to issue new stock it will only transfer ownership and risk to the new owners from the current owners. Thus current owner who receive the dividend trade an uncertain capital gain for cash dividend. View 3: Low Dividends increase Stock Value There is a third view which proposes how dividends can actually hurt the investors. The above argument is based on the difference in capital gains and tax treatment for dividend income. For these taxpayers, the objective is maximization of after-tax return on investment relative to the risk assumed. The objectives are achieved by minimizing the effective tax rate on the income and thus try to deferring the payment of taxes. The above three views presents the way a financial manager has to take into consideration before deciding on the dividend policy. Given the perfect market assumptions, the argument that dividends are irrelevant is difficult to refute. But in the real world such assumptions don’t hold true. The second view of dividing the risk by splitting cash flows between retention and dividends is not appealing. And the third view of tax argument is persuasive. And if payment of low dividend is advantageous, then the companies would not have paid any dividends. The Residual Dividend Theory The Floatation costs which a company incurs can influence the dividend decision. Presence of floatation cost makes the firm issue large number of securities to receive proposed investments. For example, if the firm needs $ 5, 00,000 for proposed investments then the company has to issue new stock worth greater than $ 5,00,000 to offset the floatation costs incurred. Thus raising equity capital by means of sale of common stock turns out to be more expensive than funds raised through retention of profits. Thus floatation costs eliminate the indifference between new common stock and internal capital. Hence dividends only when profits are left after using it for investment purposes. In effect dividend will be paid from residual earnings left. According to this theory, dividend policy is a passive influence and it has no direct effect on the share market value (Lease, 2000, p. 281). Thus the dividend policy of the firm depends on capital structure, investment opportunities available to the company and presence of internally generated capital. Most managers are of the view that dividend is important but they have no mandate. Dividend Decision in Practice Financial managers have to work in the world of reality while setting dividend policy of a firm. There are many factors which influence the decision of a firm about its dividend though it may be unique to the company. Liquidity Position: Presence of large amount of retained earnings does not indicate that the company has huge cash position available to them for payment of dividends. The net liquid asset position of a firm is independent on the retained earnings account. Historically though a firm with sizable retained earnings has huge cash position but they are used for payment of maturing debt. Dividends are usually paid with cash instead with retained earnings, thus firms must have cash balance to pay dividends. Thus the liquidity position of the firm improves the dividend payment ability. Legal Restrictions: Presence of legal restrictions may restrict the amount of dividends a firm pays. The first is statutory restrictions which can prevent a firm from paying dividends. In case the liability of a firm exceeds its assets, or if the dividend is paid from funds investment in the firm or if the accumulated profit is less than the amount of dividend to be paid. The second type is legal restriction which is firm specific. Presence of constraints like dividends can’t be paid without repayment of debt, or legal requirement of maintaining a given amount of working capital etc. Conclusion Dividend policy is an important decision to be made by financial managers. They are faced with many trade-offs when formulating the dividend policy for the company. Financial managers need to take decision regarding dividend policy and stock price. When dividends influence share price, it is due to the desire of investor to minimize and defer their taxes. When the investment opportunities of a firm increase, the dividend payout ratio should decrease. Apart from this there are a number of factors which influence the dividend policy of a firm which the financial managers need to take into account. References Baker, H.K. 2009. Dividends and Dividend Policy. New Jersey: John Wiley & Sons. Keown, A.J., Martin, J.D., Petty, J.W. and Scott, D.F. 2005. Financial Management: Principles And Applications, 10/e. New Delhi: Pearson Education India. Lease, R.C. 2000. Dividend policy: its impact on firm value. Harvard: Harvard Business School Press. Malkawi, H., Rafferty, M. and Pillai, R. 2010. “Dividend Policy: A Review of Theories and Empirical Evidence”, International Bulletin of Business Administration. Vol. 1(9), pp. 171-175. Read More