Dividend Policy: A Review of Theories and Empirical Evidence, Essay Example

Introduction

Dividend payout policies ultimately determine what return shareholders should receive, what form the payout should take, and how investors will react to the distribution of funds or rewards. Overall, the goal of the company is to determine a dividend payout policy that will maximize shareholder interest in the company. If the goal of the organization is to encourage shareholders to buy more stakes in the company, then it will be beneficial to provide a dividend payout that maximally appeals to the target group. It is also essential to make potential shareholders aware of the dividend announcement date and ex-dividend date so they are aware of the time by which they need to make their stock acquisition in order to gain the financial or physical incentive. When creating a divided policy, organizations must ultimately decide whether they should keep their profits in the company for future investment, distribute surplus to shareholders in the form of dividends, or used to buy back shares.  In addition, companies must determine how much of the surplus to distribute to shareholders and whether to distribute the dividends in monetary form. The discussion posed concerning theory related to dividend issuance and the dividend decision for companies is based on the information provided in slides 15 and 16 of “Seminar A1 Dividend Policy”.

Slide 15

To decide the most relevant policy to use, companies must first determine whether providing a dividend would be relevant or irrelevant. Thus, the irrelevance hypothesis was developed by Miller and Modigliani (1961). This theory states that “given that in a perfect market dividend policy has no effect on either the price of a firm’s stock or  its  cost  of  capital,  shareholders  wealth  is  not affected  by  the  dividend  decision  and  therefore  they would  be  indifferent  between  dividends  and  capital gains” (Al-Malkawi et al., 2010). Therefore, increasing or decreasing the dividend will not increase of decrease the value of the firm (Slide 15). However, it is necessary to consider that this model assumed that there are no differences between taxes and dividends and capital gains, that no transaction or flotation costs are implemented when stock is traded, all stockholders and traders have access to the same information, and there are no major conflicts of interest within the organization. Thus, the irrelevance hypothesis could considered to be true in an ideal situation, but this situation does not typically reflect normal market practices.

If a dividend is deemed to be relevant, the bird-in-the-hand theory may be applicable. This theory argues that lower payouts result in higher costs of capital. This is ultimately because a higher capital gains/dividend ratio reflects a larger return due to increased risk (Brigham, 1992). This theory, however, is countered by the belief that stockholders will not distinguish between earning funds as a dividend or as capital gain from increased stock value. Furthermore, it is important to consider that the tax-effect hypothesis negates the dividend irrelevance hypothesis. Because the dividend irrelevance hypothesis assumes that there are no differences between taxes and dividends and capital gains. The tax-effect hypothesis is a more realistic representation of reality (Elton et al., 2002).

The clientele effect hypothesis explains that a company’s stock will respond to market supply and demand, how investors will react to a tax, and react to policy changes or dividend changes (Fama et al., 2001). This theory provides the best understanding of the whole of economic situations that will impact the value of the dividend and/or stock. Meanwhile, the dividend signalling theory indicates that when companies announce an increase in dividend payouts, it will act as an indicator of strong prospects. While it is debated as to whether this marks strong company prospects, companies can use this tactic, this happens when the amount of dividends offered are being changed.

Slide 16

Overall, an understanding of dividend theories reflect a balance between company policy and intent of the shareholder (Slide 16). The forces that promote a high payout include some clienteles, owner control, uncertainty, and signalling. The forces that promote a low payout include a tax system, some clienteles, high growth potential for the firm, low liquidity in the firm’s assets, and instability of underlying earnings (Rustagi, 2011). The force promoting a fluctuating dividend is influenced by providing a dividend as a residual and having the dividend only available after positive NPV project have been financed. Last, the forces promoting a stable dividend include some clientele preferences, owner control, management desire to avoid a dividend cut, signalling, and stability raising credit standing for debt. A stable dividend is provided when clientele preferences exist, agency theory is applied, the company wishes to avoid dividend cuts, dividend signalling is used, and stability raises credit standing. Ultimately, because each company is in a unique situation, different dividend theories will apply to them. Furthermore, it is reasonable for the relevant theories to change for these organizations due to the presence of an unstable market climate. It is important for companies to have a comprehensive understanding of these theories to make the appropriate decisions for their fims.

References

Al-Malkawi HN, Rafferty M, Pillai R. (2010). Dividend Policy: A Review of Theories and Empirical Evidence. International Bulletin of Business Administration, 9: 171-200.

Brigham EF. (1992). Fundamentals of financial management. The Dryden Press.

Elton EJ, Gruber MJ, Blake CR. (2002). Marginal Stockholder Tax Effects and Ex-Dividend Day Behavior Thirty-Two  Years Later. Retrieved from http://people.stern.nyu.edu/eelton/working_papers/marginal_effects.pdf

Fama EF, French KR. (2001). Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay. Journal of Financial Economics, 60: 3–43.

Miller MH, Modigliani F. (1961). Dividend Policy, Growth,  and  the  Valuation of Shares. Journal of Business, 34: 411-43.

Rustagi RP. (2001). Management Accounting. Taxmann.