International business finance - Essay Example

On the other hand, too high or too frequently declared cash dividends may deplete internally generated capital, compelling the company to resort to more costly external financing according to the pecking order theory. Miller and Modiligliani (1961) proposed that the value of a firm was not dependent upon its dividend policy (Azzopardi, 2004). Rather than imply that the prospects of a regular cash income are not an important motivation of shareholders to invest in a firm, it is more likely, rather that there are different preferences and investment horizons for different potential investors.

Generally a type of firm or industry would tend to attract investors of a similar profile with similar investment expectation, although not to the extent that deviation from one, ideal, type of dividend policy would dissuade potential shareholders from investing. Shareholder wealth is enhanced in two ways: by capital gain through the rise in the price of the stock, and through income distribution in the form of cash dividends. The dividend discount model implies that stock valuation should rise with rising cash dividends.

On the other hand, pecking order theory proposes that retention of earnings in the company allows the firm to explore new opportunities for expansion without sourcing additional capital from external, costly sources. Finally, there is the signalling theory that opines that cash dividend declarations conveys the information to investors concerning the company’s long-term sustained earnings potential (Azzopardi, 2004; Kapoor, 2006). Determinants of dividend policy formulation Despite the apparent straightforward relation between dividend policy and stock price that determines shareholder wealth, empirically the relationship between them is not clear cut.

There exist conflicting factors that qualify the manner dividend policy impacts upon the firm’s value and, therefore, shareholder wealth (Malla, 2009). The market therefore tends to associate various factors with dividend payout, which in turn influence the manner policy makers approach the issues surrounding dividend policy formulation. It is commonly assumed that the best dividend policy is one that increases shareholder wealth by the greatest amount, since it is presumed that the objective of policy setting is to increase the wealth of its shareholders (Adefila, 1995).

However, correlation studies of stock prices and dividend policy revealed a relatively loose correlation between shareholder wealth and dividend policy, leading to the conclusion that various internal and external factors affect the formulation of dividend policy, some of which may not impact positively on shareholder wealth in the short term. The studies recommend a holistic approach to the formulation of dividend policy, since shareholder wealth is not the only consideration, nor even the overriding purpose, of setting the dividend pay-out.

The findings of Adefila, made two decades ago and in relation to an emerging market, are consistent even with findings of recent studies conducted in developed markets such as the United States. Gill, Biger & Tibrewala (2010) determined that in the US setting, the particular firm’s industry is also determinative of the typical (if not optimal) dividend payout policy adopted by it. It was found that the dividend payout ratio is dependent upon the