Does It Matter Whether or Not Firms Pay Dividend - Literature review Example

Does it Matter whether or Not Firms Pay Dividends? By Presented to Location Due Does it Matter whether or Not Firms Pay Dividends? Dividends are part of corporate profits that are given to stakeholders as payments periodically, usually at the end of the business year. They are set by boards of directors and payment is made to registered stakeholders at the record date. Dividends can be paid in the form of cash or stock, or in kind (Feldstein and Green 1983). Many firms pay regular cash dividends on quarterly or annual bases. Sometimes firms pay extra cash dividends and in extreme cases liquidating dividends are paid to investors. Companies may decide to pay dividends in form of stock to ensure that there is no cash that leaves the company (Al-Malkawi, Rafferty & Pillai 2010). When companies need cash, they repurchase their stock and sell it. In other cases, companies may decide to pay dividends in kind, depending on its agreement with shareholders. Many companies have their own established payment rations which are mostly long-term. Big companies use a huge portion of their total earning as dividends while small companies use a small percentage of their earnings for the same purpose (Al-Malkawi, Rafferty & Pillai 2010). Managers of various companies do not care much on the absolute value of dividends but they care about changes in dividends. This makes it hard to increase the percentage of the organization’s total earning that is used as dividends. Dividends are always influenced by sustainable long-term earnings as opposed to temporary short-term earnings as noted by Feldstein and Green (1983). In the event that managers make wrong decisions to the extent of increasing the percentage of earnings used as dividends, they may be forced to rescind withdraw the decisions in a bid to save the company from problems. To this effect managers need to be extra careful when revising dividends payment ratios. Changes in the dividend payouts imply the management’s confidence about the company according to Al-Malkawi, Rafferty and Pillai (2010). The way it is done should be such as to ensure that the stock price is not affected. There exist three view points on whether payment of the dividends matters for companies. One states that dividend payments improve shareholders. The other view holds that dividend payment reduces the firm’s value while the last one holds that payment of dividends has no effect on the company’s value. Existing theories about the relationship between dividends payment and the firms’ values have minimal application since they assume the existence of an efficient market (Brealey & Myers 2003). To this effect, it is assumed that if the market has no taxes, bankruptcy costs, and asymmetric information, the firms’ value is only influenced by its basic operating risks and profitability as Kapoor (2009) notes. In this regard, division of profit into dividends and retained earning has no effects on the value of any firm. The dividends policies are concerned about capital gains and distribution of dividends which do not affect the firm’s market value. If a company wants to borrow more money, keeping its investment constant, and yet increase total payout, it can print extra shares and sell them to new stakeholders (Brealey & Myers 2003). This amounts to value transfer between the old and new stakeholders. The new shareholders give cash returns of the same value as the shares and consequently keep the firm’s value constant (Brealey & Myers 2003). A close analysis of the situation reveals that the company’s value before and after changing the portion of its profit to be paid as dividends is the same. The extra shares which are printed help to raise more cash to fund increased dividends. In some cases, companies may decide to seek for external funding to raise more cash for dividends payment. A recent study involving many firms revealed that an increment in dividends leads to a corresponding decrement in the value of shares held by stakeholders (Gareth and Thomas 2000). This makes the net effect of the actions null, which is implies that payment of dividends does not affect the value of a company. The cash that flows out of the company in the form of dividends is successfully replaced by money that flows into the company’s account from the sale of shares. Investors often do not prioritize capital gains because dividend payment, profit distribution, and retaining earnings are contradictory. The values of stock and company capital increase when an organization chooses to keep a large percentage of its profit for reinvestment (Kapoor 2009). Shareholders can offload some of their shares by selling them in the stock market when in need of cash and, therefore, a company may decide not to issues them with dividends. Also, shareholders may buy more shares for expansion of their investment when issued with dividends. Kapoor (2009) notes that while some investors go about disposing some of their shares to generate some cash, others willingly reinvest their dividends by buying more shares leaving the firm’s value the same as there are no shares that are lost. Also, many shareholders care less about dividends distribution and, therefore, paying dividends do not affect firm’s value in any way. Kapoor (2009) notes the value of any company is influenced by the value of its assets and cash inflows. Even when the total payouts in form of dividends increase, shareholders fill the gap by issuing extra stock. They use extra money for investment in the form of new stock. When the company forms a constant payout scheme, every unit change in dividend paid is reflected in the amount of money gotten by shareholders from share repurchasing (Gareth and Thomas 2000). This means that the amount of money each shareholder can get in terms of shares is decreased when there is increased dividend payment. Those in support of the payment of huge dividends argue that it increases the company’s value as well as the earnings amongst shareholders. Stocks that are associated with high-payouts generally have natural clienteles (Myers & Brealey 2003). High payouts are very popular in finance literature much as the stock market favours liberal dividends payments over niggardly payouts. Investors inclined to this view prefer to buy shares from companies that give higher dividends per share. This means that companies paying high dividends have a potential to attract many investors willing to buy their shares. Shareholders are interested in investments that are more profitable (Gareth and Thomas 2000). In situations where the economy is not strong, shareholders become cautious in making investment decisions. In this regard, they tend to spend a lot of their money on shares of companies that pay high dividends. This is because in addition to the higher value that the money gives, such investments are more profitable and, therefore, safer. The increased demand for higher payments may prompt a company to appeal to external financiers for some cash to meet dividend demands as noted by Brealey and Myers (2003). Although a higher portion of the company’s profit may be paid as dividends, the company’s value remains the same because the high amount of cash spent on dividends is replaced by external financing. Some dividends are highly taxed as noted by Myers and Brealey (2003). In some cases low dividend payouts are even taxed more than capital gains. This calls for companies to pay low cash dividends. Also, companies should convert dividends into capital gains to avoid high dividends taxation. In such cases, investors have no choice but to pay more for stocks which will earn them low dividends (Miller n.d). For companies that focus on maximizing their profits, cash dividends should not be paid as a way of avoiding high taxation on dividends. This is because investors do not see cash dividends as the appropriate way to handle their cash at times of high taxation according to Gareth and Thomas (2000). The company is free to choose another economical means of using dividends to avoid the burden of high taxation. Payment of dividends may affect a company’s value if taxation is very high (Miller n.d). Shareholders’ financial status is improved when the company fails to pay dividends when taxation is higher on dividends than on capital gains. This should, however, not be the case in the event that taxation is not high on dividends (Miller n.d). In other words, when taxation is low on dividends than on capital gains, the company has a good reason to pay dividends. This situation has led analysts of dividends payments to make a conclusion that low dividends payment is made when taxation is high because increased dividends may decrease the company’s value. In the event that there are no taxes or transaction costs, the company’s value is not affected by the payment of dividends (Gareth and Thomas 2000). The change of dividends in relation to their demand is not consistent in this case. To be exact in this case, investors prefer low-payout dividends. This is because they have a wide range of stocks in the stock market to choose from. Many companies pay maximum attention to their clientele (potential investors) just like investors pay attention to companies that pay high dividends to their shareholders. Different companies try as much as possible to meet the preferences of their shareholders as noted by Feldstein and Green (1983). They, however, do not adapt their dividend payment systems to meet the needs of high dividend lovers. Other investors do not choose between high and low dividends and they hold that stock’s value is not influenced by dividend payment. Most companies keep huge proportions of their gained profits as dividends especially if shareholders choose so. Insurance companies or pension funds may have schemes that favourably treat taxes (Feldstein and Green 1983). This makes some investors to demand high dividends so as to invest in such companies to enjoy this favourable tax treatment. This is influenced by the fact that many investors do not want to pay taxes and, therefore, the use all means possible to avoid it. In conclusion, some of the assumptions made by dividend analysts are not applicable in the market. However, dividend payment is a reference point for managers when it comes to making financial decisions. It makes it easy to distribute dividends to stakeholders depending on their equity. When the shareholders need cash, they can convert their shares into cash without the need for dividends. The policies adopted by companies to pay or not to pay high dividends are sometimes influenced by the taxation schemes that apply to their situations. This shows that payment or non-payment of dividends does not affect the company’s value. When taxation is high on dividends, shareholders may look for other ways of generating money to avoid paying theses taxes. The shareholders may also prefer to invest their money in pension funds and insurance companies to avoid paying taxes. Whichever way dividends payment is done it has no effects to the company’s value. References Al-Malkawi, H. N., Rafferty, M. & Pillai, R. 2010, ‘’Dividend Policy: A Review of Theories and Empirical Evidence. International Bulletin of Business Administration, Euro-Journals, no. 9, pp. 171-200. Feldstein, M. & Green, J. 1983, ‘Why do companies pay dividends?’, American Economic Review, vol. 73, no. 1, pp. 17-30, viewed 1 April, 2014 http://nrs.harvard.edu/urn-3:HUL.InstRepos:3204679 Gareth, M. & Thomas, S. 2000, ‘Taxes, Dividend Yields and Returns in the UK Equity Market’, Journal of Banking and Finance, no. 22, pp. 405-423. Kapoor, S. 2009, ‘Impact of dividend policy on shareholders’ value: a study of Indian firms’, Jaypee Institute of Information Technology, India, viewed 1 April, 2014 http://www.jiit.ac.in/uploads/SUJATA%20SYNOPSIS.pdf Miller, M. H. n.d., ‘Do Dividends Really Matter?’ Selected Paper No. 57, Graduate School of Business, The University of Chicago, viewed 1 April, 2014 http://www.chicagobooth.edu/~/media/3AA4879C57AA400C9E6203446A1EF195.pdf Myers, S. & Brealey, R. 2003, ‘Principles of corporate finance’, McGraw-Hill, New York. Read More