Dividend Policy Theories - Essay Example

Dividend Policy Theories A dividend is the distribution of profit from income earned or reserves. It represents the compensation to shareholders for the loss of utility and the risk taken by investing in the company (Latham 2010,p4). Dividend can be paid in cash or non-cash in the form of bonus shares (Tools 2014, p1). The management of a corporation can use retained profits only to finance dividends. Dividend policy is a measure adopted by the company in allocating funds for dividend payment and retention of income. After calculation of annual profit, the company is faced with the option of retaining the profit and reinvesting it (Garrison 2014, p1). Similarly, the company can opt to distribute net income to shareholders in the form of dividends or retain part of the income and distribute the rest to the shareholders in dividend form. The goals and plans influence the decision of the management on how to distribute profits. The management of the company is an agent of the shareholders; it has a responsibility of maximizing shareholders’ wealth. The wealth of shareholders is closely tagged to the market value of the shares. The greater the value of the share, the more the wealth of the shareholders. One of the factors that influence shareholder wealth maximization is the dividend policy adopted by the management. This paper will discuss dividend theories and also assess the dividend policy used by The Coca-Cola Company. According to Modigliani and Miller, shareholders are indifferent as to the timing and value of a dividend paid they have the same worth (Latham 2011, p1). The theory assumes that the markets are perfect and efficient. Additionally it assumes that the economy has no taxes, same lending and borrowing rates as well as availability of accurate information to all investors. Lastly, the theory assumes that investors accord the same weight to capital gains and dividends. It is important for the management to note the registration dates of its shareholders. There exist two types of dates; cum-dividend date and ex-dividend date. Cum dividend share prices have rights to dividends while ex-dividends are not entitled to the dividend payment (Latham 2011, p1).According to this theory, the stock price declines by the present value of the dividend declared. This is because the management pays dividends in the present, dividends are not discounted, and the fact that new buyers of shares are not entitled to dividends. The accurate market price is obtained by subtracting the dividend element from the market price. According to this theory, the management has a responsibility of making investments that have a positive net present value in order to maximize the wealth of the shareholders. Shareholders have access to perfect information and therefore they would know when the management makes a wrong investment choice. The theory assumes that shares are divisible and numerous that is; unsatisfied shareholders can sell part of their shareholding. In conclusion, the theory assumes that dividends are insignificant in determining the wealth of the shareholders. Investment projects determine a company’s cash flow which then affects company’s profitability (Latham, 2010, p3). A wrong investment decision adversely affects the future profitability of the entity. The company’s management must critically assess investment projects and settle on a plan that maximizes the future profitability prospects of the corporation. Payback period is a method used in evaluating an investment project. The management should choose projects having the shortest payback period. Net present value is yet another method, and it compares the present value of cash inflows with the current value of cash outflow. The management selects projects with positive net present value. Investments with positive net present value are wealth creating. The weighted average cost of capital (WACC) is used to evaluate investment decisions. It provides the required rate of return by investors. The WACC is used to calculate the net present value of investment opportunities. The management settles on investments with the highest net present value and ignores those with negative net present value. Failure to invest in projects with a positive net present value inhibits the ability of the company to fulfill the expectations of its shareholders and bond holders. The higher the net present value, the greater the expected returns to shareholders. Therefore, the net present value of investments positively affects shareholders’ wealth. The cost of capital is the least return that must be guaranteed to convince the shareholders or bondholders to buy shares and bonds. The companys capital structure and risk profile influence its cost of capital. The higher the risk, the greater the return demanded by the investors. The weighted average required returns from a business’s investors are used to calculate the required return of the project. The total market value of shares represents the amount foregone by shareholders for opting to hold onto the shares rather than selling the shares (Latham 2011, p15). Anyone willing to buy the shares has to satisfy the opportunity cost to the investors and must, therefore, offer to buy the shares at a price that is above their market value. Therefore, the prevailing market value of an entity’s shares represents the shareholders’ investment in the business. Valuation of a company is crucial as it acts as a guide to investors when making investment decisions such as mergers, sale and purchase of shares. The growth rate of the company’s business influences the market value its shares. Shareholders own capital of the business and rank last during distribution of the enterprise’s assets in the event of winding up. It is, therefore, important that the management maximizes the worth so that shareholders do not lose during liquidation. Price earnings method is used to compute the value of a corporation. This method applies the earnings per share that provides the amount of net income available to each outstanding share (Shaun 2013, p1). The price earnings ratio method assumes that there is a quantifiable relationship between a company’s value and its annual profits (Latham 2012, p10). This method assumes that the previous year’s income predicts future profits of the company. The perpetuity formula computes the value of the entity by dividing the annual dividend by the cost of capital. The Gordon growth model integrates the growth rate of the company’s dividends when calculating the value of the company. This model assumes that shareholders do not want to lose their purchasing power due to the passage of time. This, therefore, implies that the management must keep on increasing the dividend payout in order to maximize the wealth of the shareholders. A progressive, positive dividend growth rate maximizes the wealth of shareholders. Managers have a responsibility of maximizing the long term returns to shareholders. Shareholders are concerned with share prices and dividend payouts. In the event of a merger, the management of the acquiring company must ensure that the merger maximizes the value to the shareholders. Financial analysts measure dividends either in terms of the absolute amount, payout ratio or dividend yield. The absolute value approaches expresses dividend in the form of pence per share. The payout ratio represents dividends in as a proportion of income after tax that is declared as dividends. Dividend yield, on the other hand, is a percentage that is computed by dividing the dividend per share by the market price of the stock (Latham 2008, p10). There are various dividend policies that can be utilized by the management. Constant dividend policy is where the authority gives a fixed amount of dividend every year. This system is attractive to shareholders because the dividend payout is predictable. A constant growth policy is where the amount of dividend increases by a fixed rate. This policy considers the impact of inflation on the value of the dividend; hence it is a more reliable dividend policy. The Gordon growth model assumes a policy of constant dividend growth. A proportionate dividend policy is where a consistent proportion of profits after tax are paid out every year as dividend (Latham 2008, p13). Proportionate dividend policy is unreliable policy especially if the entity’s profits are inconsistent. A zero dividend policy is where the management awards no dividend; this dividend policy is common in new companies. It is common in such companies because young companies need to grow and thus the management opts to reinvest all profits made. Total shareholder return measures the returns to shareholders and considers the increases in share prices (Latham, 2008, 22). Hundred percent dividend policies are where the net profit of the company is distributed to the shareholders in the form of dividends. This policy increases the accountability of the directors to the shareholders. However, the company is faced with a shortage of funds for subsequent investments. A residual dividend policy is where the amount to be paid out as a dividend is the residual income after money has been allocated to the company’s investment project. This system is unreliable because net income and investment capital demands vary from year to year. A cum-dividend share is one that entitles the original shareholder to all future dividend payouts. Ex-dividend shares allow the subsequent owner to future dividends but deny the new owner the forthcoming dividends. This trait makes ex-dividend stocks unattractive to investors. When a share converts into ex-dividend, its price falls by the value of the next dividend. Theories of dividends are classified into the dividend relevance and dividend irrelevance theory. Modigliani and Miller are the pioneers of dividend irrelevance theory. The irrelevance theories suggest that dividend payout have no impact on the value of stocks. Managers can only increase shareholder wealth by considering projects with a positive net present value. The relevance theories, on the other hand, support the idea that dividends have an impact on market value of shares. They attack fundamental assumption used by dividend relevance approaches. Managers can maximize shareholder wealth by giving dividends. The Modigliani and Miller theory suggests that dividends are irrelevant and have no significant influence on the share price (Latham 2008, p30). The theory states that the value of shareholder wealth is not dependent on the amount of a dividend. According to the theory, the management can only maximize shareholders’ wealth by choosing projects with positive net present value. Shareholders are not concerned with the value of a dividend awarded but the growth of the company. Shareholders want the companies that they have invested to grow at the highest rate possible. Companies with a high growth rate are more attractive than those paying dividend but increasing at a lower rate. Shareholders might decide to sell shares of the company if the directors start issuing shares. The shareholders’ move is informed by the fact that the distribution of income as dividends reduces amount of investible funds and thus leads to a slower growth rate. The residual theory of dividends opposes dividend relevance theory. According to the theory, dividends are residual and are paid after the firm has allocated funds to investment projects and retained some profit. The theory holds that dividend payment is useless as a proxy in determining the future market value of the firm (Laiboni 2013, p1). It advises managers never to pay dividends at the expense of future investments with positive net present value. Investors that subscribe to this theory are concerned by the future growth prospects of the firm, not the dividend the corporation declares. However, this theory lacks empirical support and. The theory only states the obvious because the management normally declares dividends after allocating funds to future investments. On the other hand, there exist shareholders who are interested in the dividends. They care about the growth rate of the company. Such investors are attracted to a company that gives regular dividends. If the management decides to reduce annual dividends then, the shareholders might dispose of the shares. In reality, shareholders do not have adequate access to company as the directors. Therefore, dividend announcements serve as a signal about the company’s fate. A reduction in annual dividend gives a negative signal even if the reduction is due to retention of income for investment. The vice versa is true. If the company announces high dividends, then shareholders take it as a positive signal regardless of the fact that the enterprise may be performing poorly. If the management defers payment of dividends in cash the potential of future growth of dividend increases. However, such a move is uncertain. Payment of a cash dividend offers a higher degree of certainty. If the management distributes all profit to shareholders as dividends, they might be forced to issue new stocks in order to raise funds for future investments. In reality, companies take dividend and a change in dividend seriously (Latham 2008, p38). Walter’s model asserts that dividends are relevant to shareholder wealth. The theory assumes internal financing, hundred per cent pay out or retention and constant earnings per share ratio. It also assumes that the cost of capital shall remain fixed. It holds that in the stock prices in the long run reflect the present value of expected dividends (Narwani 2011, p16). Retention of net income affects the share price because it impacts on future dividends. The management can maximize shareholders wealth by declaring dividends. However, most of Walter’s assumptions are unrealistic. The cost of capital in reality is not fixed but keeps on varying. Additionally only few companies can survive without external financing. The internal rate of return keeps on changing. Gordon model asserts that dividend policies influence share price. The share price reflects the future dividends that will accrue to the share (Narwani 2011, p24). The management can increase shareholder’s wealth through the dividend policies. Discounted future expected dividends reflect the market value of the company’s share. The model shares similar assumptions with the Walter’s model. It assumes no external financing, steady retention rate, zero taxes and a constant cost of capital. Critics of this model challenge the assumptions such as zero external funding, constant cost of capital as well as the existence of zero taxes. There is hardly any economy that operates without taxation. The tax preference theory attacks Modigliani and Miller assumption of zero effects of taxation. Modigliani and Miller assert that there is no difference in tax treatment between dividends and capital gains (Laiboni 2013, p23). In reality, treatment of dividend and capital gains are different. Many investors are interested in after-tax income, and this affects their demand for dividends. The theory suggests that a little dividend issue lowers the cost of capital and maximizes the company’s share price. In summary, low dividends maximize the wealth of shareholders. Management can pursue a dividend policy of issuing minimum dividends in order to optimize shareholder wealth. The agency hypothesis supports dividends relevance proposition. The interests of shareholders and management always conflict. The conflict of interest forces shareholders to incur agency costs in order to monitor the management. Payment of dividends is used to reconcile the interests of these two parties. The management can achieve the goal of shareholder wealth maximization by declaring high dividends. Now to the practical aspect of the paper. Coca-Cola Company pays its dividend on an annual basis. The yield of the company’s stock is approximately 2.8 %( Stoyan 2014, p1). The dividend pay-out by Coca-Cola Company has been increasing every year with slight variations in the trend. Fifty-three percent of the entity’s profits are distributed to the shareholders as dividends (Nasdaq 2014, p1). The management of the corporation appears to have adopted a steady growth dividend policy. A dividend paid by the entity seems to be increasing at a constant rate hence a constant growth policy. Dividends by the entity are predictable due to their constant growth rate. The management of the entity is fulfilling their responsibility of maximizing shareholders’ wealth. According to dividend relevance theory, the continued increase in dividends awarded by the company is related to the stock price. The market value of the share reflects the present value of investors’ expectation of dividends. The dividend pay-out in2014 is greater than the dividend paid in 2013.According to signalling hypothesis; the current dividend might be a sign of favourable conditions within the company. The movement in share price of the business has a positive relationship with the management’s dividend policy. Dividends paid by Coca-Cola Company have an influence on the market value of its share. In conclusion, the management of corporations applies the relevant and irrelevant dividend theories in order to optimize the wealth of shareholders. The management can use dividends or invest in projects with positive net present value to maximize wealth. Various dividend policies applied by the management depend on the characteristics of the company. Reference List Garrison, S,.2014. Dividend Policy.[Online] Available at: http://www.studyfinance.com/lessons/dividends/ [Accessed 12 December 2014] Laiboni, M.,2013. Dividend Policy Theories. [Online] Available at: http://laiboni.wordpress.com/2013/08/02/dividend-policy-theories/ [Accessed 12 December 2014] Latham, D,. 2008. Dividend policy. London: Wesley. Latham, D,. 2010. Dividend theory in an efficient market. London: Wesley. Latham, D, .2010. Investment Appraisal.London: Wesley. Latham, D,. 2011. Weighted average cost of capital (WACC). London: Wesley. Narwani, P,. 2011. Dividend Policy.[Online] Available at: http://www.slideshare.net/PoojaNarwani/dividend-policy-9334231 [Accessed 12 December 2014] Nasdaq. 2014. Coca-Cola Company (The) Historical Stock Prices.[Online] Available at: http://www.nasdaq.com/symbol/ko/historical [Accessed 12 December 2014] Shaun, C., 2013. Earnings per share.[online] Available at: http://www.myaccountingcourse.com/financial-ratios/earnings-per-share [Accessed 12 December 2014] Stoyan, B,. 2013. The Coca-Cola Company Dividend Focus.[Online] Available at: http://www.dividend.com/news/2013/dividends-in-focus-the-coca-cola-company-ko/ [Accessed 12 December 2014] Tools, A,. 2014. Types of dividends.[Online] Available at: http://www.accountingtools.com/types-of-dividends [Accessed 12 December 2014] Read More