Dividend Policy and Shareholder Wealth - Literature review Example

Dividend Policy and Shareholder Wealth 2007 Executive Summary Financial management theorists have varying opinion on the effect of a company’s dividend policy on the shareholders’ value. While Modigliani-Miller (1961) postulated that dividend policy is irrelevant for the purpose of the firm’s shareholders’ value, under certain conditions, subsequent researchers have argued that the assumptions in the theory are too stringent. In the real world, dividend announcements are often followed by share price movements. According to some researchers, the dividend policy has a signaling effect by indicating that the firm will continue to pay high dividends as well as continue to grow its earnings, thereby having a positive effect on share value. Besides, non-investor stakeholders prefer higher dividend payouts to free cash flows with the firm. On the other hand, the stakeholders’ theory postulate that investors prefer lower dividend payouts rather than higher implicit transaction costs that the firm would then incur. The effect of a firm’s dividend policy on its shareholders’ value is a controversial topic in financial management. While some theorists postulate that a firm’s dividend outflows decrease (Litzenberger and Ramaswamy, 1979) or increase (Gordon, 1959) the shareholder value, others find dividend policies irrelevant (Miller and Scholes, 1978) for the firm’s value (cited in Holder, et al 1998). The firm’s dividend policies determine whether to re-deploy its profits for its expansion or to pay higher returns to shareholders’ equity. Dividend payout may be of two kinds – cash dividends or share repurchases. The dividend policy is a complex decision for the firm and it determines the financing pattern of a firm’s investment and expansion strategy. A firm can expand its investment by reducing the dividend payout and increasing internal accruals of current profits. On the other hand, a firm might decide to increase dividend payouts when a firm achieves a high growth stage and further expansion may lead to high risks or excess funds. The relationship between a firm’s dividend policy and shareholders’ wealth was first studied by Modigliani and Miller (1961). According to them, dividend payouts simply alter the allocation of funds between the shareholders’ income and capital gains, without affecting the net value. Modigliani and Miller (1961) found dividend policy irrelevant for shareholders’ wealth on the basis of assumptions of perfect capital markets in which there are no transaction costs, rational behavior of economic units, perfect knowledge about firms’ investment policies and cash flows and managers acting on behalf of the firm’s shareholders (Holder et al, 1998). The independence of shareholders’ wealth from the dividend policy will not hold true in the absence of each of these assumptions. For example, Titman (1984) shows that stakeholders other than equity holders have incentives to maximize shareholders’ wealth in order to reduce transaction costs, e.g that of job searches by employees or maintenance costs by customers (Holder et al, 1998). In the real world, shareholders expect higher dividends. In most cases, announcements of dividends are usually followed by favorable sentiments in the share market indicating that shareholders’ are positively affected by higher dividend payouts, irrespective of Modigliani-Miller’s dividend irrelevance theory. This is perhaps because of the simplifying assumptions of the theory that is typically not adhered to. For example, investors do not usually have perfect information about the firm’s intrinsic values. The asymmetry of information exists between the firm’s managers and investors and the release of certain information immediately affects the firm’s share value. Dividend payouts have a signaling effect on the firm’s value in that it indicates that the firm will continue to pay out higher dividends in the future and also will be committed to higher earnings to sustain the dividend payouts. Also, higher dividend also indicates lower free cash flows of the firms, a phenomenon that is favorably accepted by investors in the face of conflict of interest between managers and investors of firms. Free cash flow usually affects the firm’s value negatively since investors perceive it as an indication to financial slack on the part of the managers. In both cases, higher dividend payouts increase the share value and higher shareholder value of the firm (Natti, 2006). According to the stakeholder theory, the firm’s investment decisions like dividend payout ratios affect the operating income (Cornell and Shapiro, 1987). The non-investor stakeholders’ interests affect the firm’s investment decisions through legal relationships like product contracts (product warranties, wage contracts, etc.) that incur explicit costs and other non-contractual relationships that incur implicit costs. Larger the implicit costs, the larger the requirement of firms to sell goods and services. As the firm invests more to meet the implicit costs of non-stakeholders’ claims by reducing dividend payouts, higher is the shareholders’ value through reduction of transaction risks. Such firms that have higher investments to meet non-stakeholders’ claims, however, require higher liquidity since they may need to meet implicit claims any time. Typically, these firms have conservative financing modes with limited debt burdens. Although such firms finance their operations more through equity in order to avoid financial distress brought about through debt, they may limit the dividend payout ratios in order to maintain sufficient liquidity so that cash accruals rather than debt may finance their expansion or regular operations. According to Myers (1984), firms prefer internal accruals related to investment decisions over external financing. Shapiro (1990) maintains that lower dividend payouts signal that the firms are able to meet the implicit stakeholders’ claims. In order to estimate the implicit stakeholders’ claims, Cornell and Shapiro (1987) consider alternate product lines and brands of a firm. There may be exchanges across products and brands of firms in relation to its stakeholders’ claims. For example, if a firm decides to brand all its products under a single category, then the stakeholders’ claims might be higher than it would otherwise be. Stakeholders would then feel that default on any implicit claim would have a higher effect on the firm’s value than it would be on a diversified firm with unrelated lines of business. For example, GE has a number of unrelated businesses ranging from get engines to household appliances. Any effect on the jet engine business will have little impact on the firm’s consumer appliances businesses. Hence, stakeholders would limit the valuation of risks on account of transaction costs of each line of business (Holder et al, 1998). The “clientele influence” theory of dividend policy postulates that tax repercussions affect the firm’s dividend policies. The investors prefer dividends or profit redeployment by the firm depending upon the tax rates and brackets. Typically, investors who are in the higher tax brackets prefer the firm to reinvest the earnings while those in lower tax brackets prefer dividend income (Blackand Scholes, 1974). Higher dividend payouts involve potential tax costs and opportunity costs related to possible investment opportunities. Recent studies have noted that higher dividend payouts may mean that investors ultimately lose out from the potential benefits of reinvesting profits (Droms, 1990) and the necessity of accessing more expensive financing avenues (Shapiro, 1990). There is also a line of argument that corporations attract double taxation through the corporate income tax as well as the personal income tax when dividends are paid to investors. Corporate entities are here considered separate entities from investors. While some researchers have argued that “double taxation” of dividends are voluntary payments of corporations and should not be taxed since the organization has already paid corporate tax, proponents of the tax argue that investors could live on dividends without paying any taxes if there was no dividend tax (investopedia). On the whole investors would rather have the corporation plough back the profits rather than receiving dividends if dividend taxes are higher than corporation tax. Despite the theory of irrelevance of the dividend policy, investors prefer dividend earnings out of their risk-averse nature rather than out of love of risks. Dividends are in the nature of predictable investment flows while capital gains are uncertain. Moreover, in the context of market imperfections like agency costs and taxes, dividends become all the more relevant for investor preferences. The positive impact of the signaling incentive of dividends becomes the economic rationale for firms’ dividend policies. Besides indicating the future earnings pattern, the stability of the firm’s dividend policy also eliminates the uncertainties involved in share price fluctuations. However, the share price movement is really related to the reason behind the dividend policy, that is the earnings growth of the firm, and a downturn of the share price may be reversed only with a rise in the actual earnings of the firm (Shapiro, 1990). Although there is unanimity in the dividend policy theory, the approach may be broadly classified according to the following categories: 1) Pure Residual Dividend Policy – when the firm’s return on equity is greater than that the investor could earn from alternate avenues, then investors prefer managers to reinvest the earnings, 2) Smoothed residual dividend policy – the policy is in general to maintain a smooth rate, with changes being made only with exceptional changes in earnings, 3) constant payout residual dividend policy – the dividend policy to closely follow changes in earnings patterns and 4) small quarterly dividend with annual bonus that benefits both investors and managers (Sharon and Frank, 2005). Thus, the Dividend Irrelevance theory postulated by Modigliani-Miller (1961) is rather restrictive. Since the assumptions on which the theory is based usually do not occur in real life, dividend policy does affect shareholders’ value. While one set of researchers argue that dividend policy affects shareholders’ wealth positively (through signaling effect or reducing free cash flows), others argue for a negative effect (stakeholders’ theory). The clientele theory is more ambiguous since it may have either a positive or negative effect depending on the investor’s tax bracket. Works Cited Holder, Mark E., et al., 1998, Dividend policy determinants: an investigation of the influences of stakeholder theory - Special Issue: Dividends, Financial Management, Autumn, http://www.findarticles.com/p/articles/mi_m4130/is_3_27/ai_53649447 Titman, S., 1984, "The Effect of Capital Structure on a Firm's Liquidation Decision," Journal of Financial Economics (March), 137-151. Gordon, M.J., 1959, "Dividends, Earnings and Stock Prices," Review of Economics and Statistics (May), 99-105. Litzenberger, R.H. and Krishna Ramaswamy, 1979, "The Effect of Personal Taxes and Dividends on Capital Asset Prices: Theory and Empirical Evidence," Journal of Financial Economics (June), 163-195. Miller, M.H. and F. Modigliani, 1961, "Dividend Policy, Growth, and the Valuation of Shares," Journal of Business (October), 411-433. Miller, M.H. and M.S. Scholes, 1978, "Dividends and Taxes," Journal of Financial Economics (December), 333-364. Myers, S.C., 1984, "The Capital Structure Puzzle," Journal of Finance (July), 575-592. Natti, Keisuke, 2006, Does Dividend Policy Enhance Shareholders’ Value, http://www.nli-research.co.jp/eng/resea/econo/eco060309.pdf Shapiro, A.C., 1990, Modern Corporate Finance, New York, NY, Macmillan Publishing Co. Sharon, Kania L and Bacon, Frank W, What factors motivate the corporate dividend decision? http://www.asbbs.org/Files/2005/PDF/Kania.pdf http://www.investopedia.com/terms/d/double_taxation.asp Read More