Role of Dividends and Their Effect on Shareholder Wealth - Example

Running Head: Role of Dividends And Their Effect On Shareholder Wealth University Name: Introduction Dividends play a major role in the financial operations of any given Company particularly on the shareholders wealth. Dividends can either increase the shareholders wealth or decrease it depending with it effects. The dividend policy of a company relates to the form of dividends and the retention of profits for the future use in the business. The two objectives of dividend policy distribution of the dividends and retention of earnings for growth are in conflict. Dividend policy of a company affects: - Long term financial decisions Shareholder’s wealth. (Michaely, 1999) Discussion The dividend policy can be formed in view of the following considerations. 1. Where are shareholders preferences? Do they want dividend income or capital gains? 2. What are the financial needs of the company? 3. How much should be paid out of dividends 4. Should a company follow a stable dividend policy 5. What should be the form of dividend? The dividend policy of a company is decided on the basis of the above considerations. The efforts should be made to bring a balance between the desires of the shareholders and the needs of the company. Shareholders may be interested either in dividend income or capital gains. For example a wealthy shareholder in a high income tax bracket may be interested in capital gain instead of dividend income. On the other hand the retired shareholders may be more interested in cash dividends. Similarly, the majority shareholders like unit trust, insurance companies among others also prefer cash dividends because they have to pay a return to their deposition. The small shareholders mostly do not have specific objective to buy shares. They may buy shares to receive dividend income or get capital gain. The directors should therefore adopt a dividend policy, which fulfils the requirements of different classes of people. (Starks, 2000) A high dividend pay out might be harmful to the long term because in this case, profits cannot be used for the further expansion of the company. However, this policy will be beneficial to raise the share prices in the short run. If the dividend policy is decided in view of the long-term financing requirements then the company will pay high dividends only when the firm does not have profitable investment opportunities. A policy of low dividends and higher retained earnings can utilize long-term earnings and dividends. A company’s dividend policy may be also restricted by the availability of liquid fluids. If only a limited amount of cash can be made available, a high dividend policy is not possible. Sometimes the shareholders give a higher value to the near dividends than the future dividends. Higher dividends increase the value of shares, while lower dividends reduce the value of shares. (Rozeff, 2002) In case of stock split where ordinally shares are sub-divided, the nominal value of these shares is reduced and a shareholder will receive more shares for each share held previously, For example the nominal value per share is $20 at present and it may be decided to split it into four ordinally shares of $5 each. In this case four ordinally shares will be issued for every share held previously. The stock dividend and the stock split are similar except for the difference in the accounting treatment. In case of stock dividend, the number of shares increases without any change in the nominal value of each share and total balance of reserve decreases. With a stock split the balance of share capital account does not change, but the nominal value per share will change. The opposite of share split is reverse split, with reverse split it means the decrease in the number of shares by increasing the nominal value per share. In such a scenario total share capital will remain the same. (Rozeff, 2002) Stock split makes shares more attractive this is because the reaction in the market price caused by the stock split encourages more investors to purchase shares. It encourages the marketability of a company’s shares, for example, the share of a company with a nominal value of $100 will be purchased by rich persons only, but those shares with nominal value of $10 can be purchased by poor persons as well. Stock split increases the total dividend of a shareholder, for example a company maybe paying a cash dividend of $3 per share before the stock split. But after split of three for one, the company may pay a cash dividend of $1 per share. A shareholder holding 100 shares before the split will receive a total cash dividend of $300. The number of shares owned by the shareholder will increase to 300 after the split and his total cash dividend will be $400. The increased dividends may favourably affect the after-split market price of the shares. Stock split will lead to an increase in shareholders wealth. A low nominal value per share increases the market value more proportionately and this result in an increase in shareholders wealth, for example the market value per share at normal value of $20 is $25 and at normal value of $5 the market value of 4 shares will be $28 that is higher than $25. (Johnson, 1998) The company management while informing the market that the company is expected to earn higher profits in the future also uses stock splits. The market price of high growth firm’s shares increases very fast. The stock split thus has an information value that the share has been splited to avoid future high price per share. An unexpected issuance of new equity will definitely reduce the corporate financial leverage ratio a thing that will make the debt less risky As a result, the debt’s market value increases at the expense of the shareholder. According to Mackinlay (1998), unexpected decrease/increase in regular cash dividends will lead to a significantly negative/positive stock market reactions. In addition, he says that this is expected to persist even after controlling for contemporaneous earning’s announcements .His study finds a positive connection between announcement-related abnormal return and the stock dividend factor. Stock dividends will always issue a free share of common stock to its existing shareholders for every stock owned by the shareholders. Stock dividends carries finer slicing of a given company’s value and does not have any direct wealth effects to the shareholders in case they (stock dividends) lacks cash flow implications to establish the free cash flow effects of cash dividends increases. two empirical methods are used, first, higher level of net income plus depreciation (free cash flow) the greater the risk of misusing funds and the stronger the expected stock market response to cash dividend increases. The underlying principle is that higher cash flow levels are in greater risks of being wasted. However, such a posing danger can be curtailed through a dividend pay out. This should be done in consideration that the take over bid are less beneficial to shareholders specifically for those companies with higher levels of free cash flow. Secondly, the slower the pace of the company’s growth opportunities the higher the market reaction to dividend increases. To ensure dividend yields positive effects on to the shareholders wealth any given firm must focus on the stability of dividends. The optimum dividend policy is the one that raises the market price of shares as well as increasing the company’s profitability over a specified period of time. A firm should always follow a stable dividend policy since the stability of dividends is always considered a desirable policy by the management of most business organisations. Stability of dividends means maintaining regularity in the amount paid as dividends. Stability of dividends is very important due to the following reasons. The policy enables a company to raise more funds, It helps in raising the market prices of the shares in a company It encourages those people who wants dividend income regularly to buy the shares of the company Angelo and Skinner (2001) points out that, stability of dividends occurs in various forms some of which are discussed below. (i) Constant dividend per share Under this policy the dividend amount per share is a fixed amount, which remains the same irrespective of earnings. It is easier to follow this policy especially in cases where the earnings are stable. The policy favours those people who mainly depend on dividend income. (ii) Constant dividend per share plus extra dividend Under this policy a firm pays a small fixed amount of dividends annually but also pays an extra dividend if the company makes higher profits during any given year. This policy enables a company to pay a small fixed amount without default or without any commitments to pay higher amounts. This policy is more flexible. (iii) Constant pay out ratio The pay out ratio is the ratio between the dividends and earnings. Under this policy the pay out ratio remains constant but actual dividend fluctuates due to change in earnings for example if pay out ratio is 30% then at earning per share $5, the dividend will be $1.50 and at earnings $10 it will be $3 per share this policy is particularly more suitable for those companies whose earnings fluctuates every year. These companies are not required to pay and dividend if the company incurs loss during a particular year.(Angelo and Skinner, 2001) Conclusion Optimum dividend policy will increase the company’s profitability over a given period of time as well as raise the market price of shares. A stable dividend will make it possible for those people who want dividend income regularly to buy shares in a company, enable a company to raise more funds and helps in raising the market price of shares in a company. A high dividend pay out in any given company will turn out to be harmful in the long term since profits can not be used for the firm’s further expansion. If divided in the view of the long term financing requirement the dividend policy dictates that the company will pay high dividends only when it fails to have profitable investment opportunities. Higher dividends will always increase the value of shares whereas lower dividend will make the value of shares to decline. Reference Angel, J. (1998): Tick Size, Share Prices, And Stock Split, journal of finance. Angelo, L.and Skinner, D. (2001): Dividend And Losses, Boston, Harvard Business school press Johnson, J. (1998): The Dynamics Of Dividend Reduction, London, Oxford University press. Mackinlay, A. (1998): Economics & Finance Studies, London, Phillip Wallage. Marsh, P. (1992): Equity Rights Issues And The Efficiency Of UK Stock Market, journal of finance (September) 839 – 8621 Michaely, R. (1999): Do Change In Dividend Signal The Future Or The Past? Journal of Finance 52:1007-1030. Modigiliani, M.(1989): Dividend Policy And Valuation Of Shares, Cambridge Irwin. Rozeff, M. (2002): The Wealth Effect Of Company Initiated Management Changes, London, Oxford University press. Schutz, P (200): Stock splits, tick size and sponsorship, journal finance 55:429 – 450. Starks, L. (2000):Investment opportunities and dividend announcements, New York, McGraw-Hill. Read More