dividend policy consideration

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Dividend PolicyConsideration

ABSTRACT

A comprehensive understanding of dividends and

dividend policy by reviewing the main theories andexplanations of dividend policy including dividendirrelevance hypothesis of Miller and Modigliani, bird-in-the-hand, tax-preference, clientele effects,signalling, and agency costs hypotheses. Dividendscontinue to be the most important distributionmechanism. Of those firms who make some kind ofdistribution, 94% pay dividends, compared to 39% ofthe firms buying back shares When firms globally arefaced with insufficient cash flows to maintain thedividend, their first response is to cut the dividend,followed by cutting deferrable investment andborrowing up to the credit rating limit. Thewillingness of firms to cut thedividend when cashflows are insufficient reduces the relative signallingpower of dividends over share repurchases.

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costs of free cash flow and with a pecking-ordermodel where firms avoid issuing securities due toasymmetric information costs and other flotationcosts.

LITERATURE REVIEW

The literature on dividend policy has produced abody of theoretical and empirical research, attemptsto present the main empirical studies on corporate

dividend policy. However, due to the enduring natureand extensive range of the debate about dividendpolicy which has spawned a vast amount of literaturethat grows by the day, a full review of all debates isnot feasible. The paper reaches at a conclusion thatthe famous statement of Fisher Black about dividendpolicy "the harder we look at the dividends picture,the more it seems like a puzzle, with pieces that just

do not fit together". Firms dividend policies continueto puzzle financial researchers. In this, It is said thatinvestor demand for stocks paying cash dividends ispositively related to the trading friction that investorsface when creating homemade dividends. We furtherhypothesize that the likelihood a firm will pay cashdividends is positively related to investor demand fordividend payments and therefore inversely related tothe market liquidity of the firms stock. Examiningthe empirical evidence, we find strong support forour hypothesis.

DIVIDEND POLICY THEORIES

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The study of dividend policy has captured theattention of finance scholars since the middle of thelast century. They have attempted to solve several

issues pertaining to dividends and formulate theoriesand models to explain corporate dividend behaviour.

Three main contradictory theories of dividends canbe identified. Some argue that increasing dividendpayments increases a firms value. Another viewclaims that high dividend payouts have the oppositeeffect on a firms value; that is, it reduces firm value.

The third theoretical approach asserts that dividends

should be irrelevant and all effort spent on thedividend decision is wasted. These views areembodied in three theories of dividend policy: highdividends increase share value theory (or the so-called bird-in-thehand argument), low dividendsincrease share value theory, and the dividendirrelevance hypothesis.

1. Dividend Irrelevance Hypothesis1.1. Dividend Irrelevance Hypothesis

Given that in a perfect market dividend policy has noeffect on either the price of a firms stock or its costof capital, shareholders wealth is not affected by thedividend decision and therefore they would beindifferent between dividends and capital gains. Thereason for their indifference is that shareholder

wealth is affected by the income generated by theinvestment decisions a firm makes, not by how itdistributes that income.

1.2. M&M Proof of Irrelevancy

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To understand the M&M proposition of dividendirrelevancy, we shall start with the basic valuationmodel of common stock, which is the dividenddiscount model (DDM). Generally, the DDM states

that the value of a stock is a function of futuredividends (as a proxy for earnings) and the requiredrate of return on the stock. For example, the value ofa share at time zero (today) is simply the presentvalue of all future dividends discounted at anappropriate discount rate. the firms investmentpolicy is the key determinant of its value anddividend policy is the residual. Operating cash flows

depend on investments.

1.3. Empirical Evidencedividend irrelevance proposition has provided thefoundation for much subsequent research ondividend policy. the proposition of dividendirrelevancy was based on several bindingassumptions about the nature of perfect capital

markets. Introducing market imperfections mightchange the view that dividend decision is irrelevant.Importantly, if dividend policy is relevant it mayinteract with other decisions made by the firm aboutinvestment and financing.

2. High Dividends Increase Stock Value (Bird-In-The-Hand Hypothesis)

In a world of uncertainty and imperfect information,dividends are valued differently to retained earnings(or capital gains). Investors prefer the bird in thehand of cash dividends rather than the two in thebush of future capital gains. Increasing dividendpayments, ceteris paribus, may then be associated

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with increases in firm value. As a higher currentdividend reduces uncertainty about future cashflows, a high payout ratio will reduce the cost ofcapital, and hence increase share value. That is,

according to the so-called bird-in-the handhypothesis high dividend payout ratios maximize afirms value.

3. Low Dividends Increase Stock Value (Tax-Effect Hypothesis)

3.1. The Basic ArgumentThe tax-effect hypothesis suggests that low dividendpayout ratios lower the cost of capital and increasethe stock price. In other words low dividend payoutratios contribute to maximising the firms value. Thisargument is based on the assumption that dividendsare taxed at higher rates than capital gains. In

addition, dividends are taxed immediately, whiletaxes on capital gains are deferred until the stock isactually sold. These tax advantages of capital gainsover dividends tend to predispose investors, whohave favourable tax treatment on capital gains, toprefer companies that retain most of their earningsrather than pay them out as dividends, and arewilling to pay a premium for low-payout companies.

Therefore, a low dividend payout ratio will lower thecost of equity and increases the stock price.

3.2. Empirical EvidenceThe tax-effect hypothesis (hereafter called TEH) isbased on a simple proposition. Many investors are

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faced with dividends being taxed at a higher ratethan capital gains. In addition, dividends are taxedimmediately, while taxes on capital gains aredeferred until the gains are actually realized.

Therefore, the TEH suggests that taxable investorswill demand superior pre-tax returns from stocks thatpay a large proportion of their income in the form ofhighly taxed dividends. In other words, investors willvalue the dollar of capital gains greater than a dollarof dividends, resulting in lower dividend-stocksselling at a relative premium to their higher-dividendcounterparts. From the empirical studies referenced

above, the evidence with respect to the TEH appearsto be inconclusive. The empirical work on dividendsignalling has examined two main issues. Firstly,whether share prices move in the same directionwith dividend change announcements. Secondly,whether dividend changes enable the market topredict future earnings.

4. Agency Costs and Free Cash Flow

Hypothesis of Dividend PolicyOne of the assumptions of perfect capital market isthat there are no conflicts of interests betweenmanagers and shareholders. In practice, however,this assumption is questionable where the owners ofthe firm are distinct from its management. Anothersource of the agency costs problem that may beinfluenced by dividend policy is the potential conflict

between shareholders and bondholders.Shareholders are considered as the agents ofbondholders funds. In this case, excess dividendpayments to shareholders may be taken asshareholders expropriating wealth from bondholders

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CONCLUSIONThe scarcity and unreliability of financial data oftenresulted in investors making their assessments ofcorporations through their dividend payments ratherthan reported earnings. In short, investors were oftenfaced with inaccurate information about theperformance of a firm, and used dividend policy as away of gauging what managements views about

future performance might be. Consequently, anincrease in divided payments tended to be reflectedin rising stock prices. In perfect capital markets, it isasserted that the value of a firm is independent of itsdividend policy. However, various marketimperfections exist (taxes, transaction costs, agencyproblems, etc) and these market imperfections haveprovided the basis for the development of various

theories of dividend policy including tax-preference,clientele effects, and agency costs.

Limitations

Time limit

Language

Lengthy research paper

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Reference:-Dividend Policy: A Review of Theories andEmpirical EvidenceHusam- Aldin Nizar Al-MalkawiMichael RaffertyRekha Pillai

TABLE OF CONTENT

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Abstract -------------------------------------------1

Introduction---------------------------------------2

LITERATURE

REVIEW----------------------------------3

DIVIDEND POLICY THEORIES---------------------------

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Conclusion--------------------------------------

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Limitations

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dividend policy consideration

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