Dividend policy of a company is very crucial in order to maintain good relations with the investors (specially the shareholders) of the company. When a company makes a profit, the management decides on what to do with those profits.
They have the option of retaining the profits and reinvesting them so as to earn more profits and increase shareholder wealth in terms of increase in share prices or paying the profits earned as dividend to shareholders so that the shareholders can have some cash in hand.
However, once the company decides to pay dividends, it should establish a permanent dividend policy, which may impact on investors and perceptions of the company in the financial markets. Generally, companies paying dividends are respected by the shareholders given the liquidity preference theory. If the company thinks that it has enough investment opportunities and they would be able to substantially increase the value of the company for the shareholders, it should retain the profits. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.
Factors Favouring Higher Dividend Payout
AGENCY COSTS- Agency costs are differences between the interests of stockholders and the interests of management. More external capital is required to pay higher dividends. This leads to a greater scrutiny in the market therby reducing agency costs.
"BIRD-IN-HAND"- This argument holds that future earnings are less predictable and more uncertain than dividends, at least because they are further in the future. The greater uncertainty of future earnings should be reflected in a higher discount rate on capital gains than on dividends. This in turn would cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future earnings.
"PROSPECT THEORY"- This argument suggests that investors have a different attitude toward capital gains than toward dividends. Capital gains become part of the investment base or permanent capital, which investors hesitate to reduce. Paid dividends, however, are considered as current income and are spendable. Because "homemade" dividends require reduction of capital, they have a different psychological impact than paid dividends and are an imperfect substitute.
Factors Favouring a Lower Dividend Payout
TAXES- Although both capital gains and dividends are taxed, the tax on capital gains is lower and will not be paid until the stock is sold. Since payment of capital gains tax can be delayed, investors will be reluctant to create dividends by selling stock. Investors attempting to undo a dividend payment by buying stock with dividends must pay taxes on the dividends, and cannot totally reverse the dividend. The investor will be better off if the firm retains the earnings and reinvests them to produce capital gains, since tax payment is deferred.
TRANSACTIONS COSTS- In addition to taxes, investors reinvesting dividends will also face various transactions costs such a brokerage fees. Conversely, a firm that pays dividends and then must turn to external sources also faces transactions costs such as the "flotation costs" of issuing new securities. If the firm retains the funds and reinvests directly, both types of cost are avoided.
Other Considerations
DIVIDENDS AS A RESIDUAL- The argument for dividend irrelevancy assumes that all investment takes place at the required rate of return for the firm. In actuality, it is likely that the firm faces a mix of risk and return possibilities. The firm should thus accept all projects with a positive net present value, and pay dividends only if it has more funds than are expected to be required for attractive projects. While attractive to academics, this approach is seldom used in practice because it results in uncertain dividends and a greater perception of risk by investors.
CLIENTELE EFFECT- The clientele effect indicates that investors will tend to hold stocks whose dividend policy fits their needs. That is, investors preferring more certain dividends over uncertain future earnings, or having a preference for current income over capital gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a stock will have a clientele attracted by its dividend policy). Under these conditions, it is not the dividend policy itself that is relevant, but the stability of the policy.
SIGNALING- Most theoretical models assume that information is freely available to all. It has been suggested that in reality access to information varies. Management may have access to inside information, causing an "information asymmetry" between management and stockholders. Signalling refers to the use of dividends and dividend changes to convey information to investors. Similar to the clientele effect, it is not the absolute but rather the relative level of dividends that is important. Under this argument management will avoid increasing dividends unless it is highly likely that the higher level of dividends can be maintained. This implies that a dividend increase is a signal that the firm has reached a new level of profitability, and is a positive signal. A dividend decrease, on the other hand, indicates that profitability has decreased and the former dividend level cannot be supported, a negative signal. Note that under the residual argument, however, a dividend increase (decrease) signals a lack (abundance) of attractive projects and decreased (increased) future firm growth. Because of the potential for false signals, more costly signalling is considered more reliable.
Graham and Dodd Model
Graham and Dodd Model holds that the stock market favours companies, which give more dividends than on, retained earnings. Hence an investor should evaluate a common stock by applying one multiplier to the portion of earnings paid out as dividends and a smaller multiplier to undistributed profits. In other words, more weight should be put on dividends than on retained earnings.
Their viewpoint is expressed as
P=m x (D + E/3)
Where,
P = Market price/share;
m = multiplier;
D = DPS;
E = EPS
Assumptions
The main assumptions of this model are:
Investors are rational.
Under conditions of uncertainty they turn risk averse.
Implications and Criticism
The main implication of this model is that weight attached to dividends is equal to four times the weight attached to retained earnings. This can be shown by re-arranging the above formula:
P=m x (D + (D+R)/3)
The weights provided by Graham and Dodd are based on their subjective judgements. So the conclusion of this model is that a liberal payout policy has a favourable impact on the stock price.
Example
Alpha Ltd. has recorded an EPS of Rs. 6 for 1998-99. The company follows a fixed dividend payout ratio of 75%. If the multiplier for the industry is 12, compute the expected market price for the share based on the Graham-Dodd Model.
Solution
The dividend per share is Rs. 6 * 0.75 = Rs.4.50
Based on the Graham-Dodd Model, the expected market price would be
P = m (D + E/3)
= 12 (4.50 + 6/3)
= Rs. 78 per share.
