There are mixed feelings by financial analysts on the relevance or irrelevance of dividend policy. Some of these financial analysts argue against dividend policy and some of them support their arguments.
First they argue that an individual investor will adjust their investment portfolio to reflect their preferences. As such an investor who prefers a regular and steady investment income will choose to invest with the bonds, but not a dividend paying stock. In order to offset the tax on dividend, investors would change their investment portfolio by borrowing in order to earn interests deduction that would be equal to the dividend income. Secondly they argue against the dividend policy and claim that investors will prefer investing with the aim of capital gains since dividends are taxed more highly than capital gains. However there are proponents of a dividend policy who argue that a dividend payout is a sign of the company's future stability.
They also support this with the argument that the funds that should have been paid out as dividends are reinvested, thus increasing the value of the firm and as a result the market value of the firm (Dornbusch, Et al.1987).
This paper is to show the irrelevance of the dividend policy, and that there is no correct
dividend policy.
Dividend policy is the management's stance and acts as a guidance on how much the
company should distribute to shareholders, in form of dividends and how much of the profits should be retained for reinvestment. Theoretically the dividend policy should aim at maximizing the shareholders returns.( John Martin Wachowicz) The policy will be set up depending on the company's financial policy on retention, its future financial growth plans and the investor's attitude, towards retention.
Whatever dividend policy the management decides on, they must limit its financing from
retained earnings as shareholders will expect to be paid some reasonable dividends. (Lawrence Carrel)
The profit that is retained and reinvested would have been distributed as dividends. While deciding on the best dividend policy the directors need to take into consideration the retention ratio which is the difference between the total earnings and the payout ratio. The company directors must maintain a constant dividend policy and a steady dividend growth. (Eugene F. Brigham)
This is the argument by those who support the theory that relate the market value of a company to the dividend policy. This theory has been a source of controversy, supported by some and disputed by others who argue that the value of a company is not affected by the dividend policy.
On the other hand the company should not be overgenerous in paying dividends, and
more so if they are planning to raise external finance from the banks or other credit suppliers.
These financiers may question the rationale of borrowing when and if the company can finance itself through the profits that are distributed to the shareholders (Brigham, 2002).
Again the profit retention is a cheap source of finance since there are no issuing costs but also the control of the company is retained with the existing shareholders, in the power to vote. The effect on tax should also be considered, there are those investors who would prefer a one-off tax charge on capital gains, and those who would prefer receiving current income irrespective of the tax imposed on this income. The decision on the retention is made by the Directors. Another advantage of
retention as a source of finance is that it is a convenient source of finance since it does not have to involve any outsiders.
The dividend policy is based on the two components that make investor's returns, the
capital gain and the dividends. (Michael C. Ehrhardt)
The dividends paid will have an effect to the company share price. A decrease in dividend growth may be interpreted as a weakness in the company's future prospects, and this may lower the market rate of the shares. An increase in the dividend will be interpreted by investors as a sign of growth and positive future prospects and the market share price goes up, thus increasing the value of the company (Crockett & Friend, 2009).
A company that pays low dividends now will be of a higher value in future because the retained profits are reinvested and this results to higher profits in future. A low payout company is appropriate for the investors who prefer capital gains. However capital gains are received in the distant future and they are considered uncertain because a lot of unpredictable events that can happen in future.
Therefore low payout may not necessarily lead to a long time high dividends.( Richard A. Brealey)
An illustration to show the effect of high and low payout ratio;
Assumptions
- Two companies with the same equity capital of 100
- The high payout company pays 80% of its earnings and retains the 20% and the low
payout company pays 20% to its shareholders and retains 80%
- Where growth rate (g) =Return on Equity (ROE) * retention ratio
for the low payout company g=0.2*0.80 =0.16 i.e 16%
for the high payout co. g=0.2*.20 =0.04 i.e. 4%
The low payout company will have a growth rate of 16% while the high payout company has a lower growth rate of 4%.
In the long run the low payout may produce a higher share price because a high
percentage of the earnings are retained and reinvested (assuming the reinvestment is in
productive investments but not into investments benefit only the directors). The investors will receive their returns as future earnings in form of capital gains. The dividend yield and the dividend per share will be low in these low-payout companies.
The decision whether to pay or not to pay dividends is a tradeoff between retained
earnings and raising new equity finance. This theory of low dividends in favor of capital gains in future was supported by relevancy theorists like Professor James E. Walter and also by Myron Gordon who argued that the choice of dividend policy is related to the market value of the firm.( Myron J. Gordon)
This has however been disputed by those who support the irrelevancy theory and who
argue that the dividend policy does not affect the market price of the shares, that whether the profits are reinvested or paid out as dividends does not affect the value of the company.
These are the same theorists who support the bird-in-hand argument where investors will prefer near dividends rather than future dividends. Where two companies with the same earnings power and other assumptions are held constant the company with larger dividends will have a higher share price. Investors will prefer to pay higher for the share that attracts a higher current dividend.
The discounting rate for the low payout ratio is higher, as the discount rate increases a low payout in dividends at the beginning will result into a lower share value.
The irrelevancy theory was first introduced by Miller and Modigliani who implied that in
a perfect market where certainty and rationale prevail, the dividend policy will not affect the price of a firms stock or its cost of capital. The theorem states that in a perfect market process and with assumptions that there are no tax or bankruptcy costs, and availability of asymmetrical information, then the value of a company will not be affected by the sources of finance. (Lecture notes)
Thus the market price of a share is the expected future cash flow of that share where "the quality of information embedded in that expectation is high relative to the information available to the individual participants in the market" (Dornbusch, Fischer & Bossons, 1987).
This is in contrast with the traditional methods of equity valuation where the price of shares was believed to be affected by dividends and the dividend growth. The theory is made with the assumption that investors will prefer the dividends they receive now to expected capital gains. They argue that the dividend yield D1/P0 (gross dividend per share/market price per share) is less risky than when you include the growth rate ka= (D1/P0) +g.
If dividends value increases it may lead to an equivalent percentage increase to shares
market price. This is mainly because investors interpret this increase as a sign of future earnings and as the demand for these shares goes up the price increases. Thus the increase is not related to the investors' preference for dividends. Investors who have low marginal tax rate and those who want short term results shall be attracted to these companies with high dividend rates.
The reverse is also true, where if a company has low dividends, the investors will interpret that the Directors are forecasting low earnings. The share market price will go down. And only investors who want capital gains, which is in the long term will buy these shares. (Eugene F. Brigham)This has a high marginal tax rate.
The payments of dividends
âˆ’ï€ There are sufficient funds and cash to pay the dividends. In this case investors receive cash but the cash balance goes down for the company and its assets are reduced. The investor gains in form of cash but looses in the claims on the reduced assets. To the investor there is no gain or loss just movement of funds.
âˆ’ï€ There is insufficient liquidity to pay dividends and therefore payments of dividends would be financed by issuing new shares.( Jack D. Glen) In this case, the investor gains by the increase of cash. As a result of the dividends paid the company assets go down so the investor loses claim to the company. In reality the investors does not loose or gain but suffers capital loss. The new investors reduce their cash in hand but their wealth is increased through the new shares which they buy at a fair price per share; the fair price being the price of the share before paying dividends less dividend per share.
The existing investors receive the cash provided by the new investors in form of dividends and they lose the capital gain in form of the shares they sell. In the end the value of the company is unaltered.
âˆ’ï€ Dividends are not paid but the investor is need of cash. In this case the investor has the option to sell his/her shares, he loses the investment but gains cash, so she/he doesn't loose or gain. This means that investors will not necessarily depend on dividend for cash but can sell their shares to get the same.
âˆ’ï€ The company decides to pay the dividends but the investor does not need the cash, the investor has the option to reinvest and buy more shares.
Dividend Irrelevance Miller- Modigliani (MM) Hypothesis
They argued that the value of any firm is usually determined by its earnings and the
investment policy but not the dividend policy. The split of the earnings into dividends and retentions is irrelevant when used to determine the firm's value.
Assumptions while using MM Hypothesis
- A perfect capital market situation exists, the investors are fully informed and there are no costs in selling or buying of shares, and there is no one investor who is big enough to
affect the market share of the shares upwards or downwards.
- No taxes both to the individual and company and the taxes rate is the same on dividends and capital gain
- A fixed Investment policy is applied within the company
- No risk of uncertainty, it is possible to predict the future prices and dividends for the
company. The discount rate is the same for all securities and at all times
Illustration
A company has 2million shares at a market price per share of $100 per share and
expected capital expenditure of $30,000 and a positive Net Present Value of $20,000. The company plans to pay Dividend per Share of $15 per share. The company has a nil borrowing policy.
There are limited funds which would pay out dividends and the cash will have to be
raised by issuing new shares.
If there are no dividends paid, then the company's current value = 2m*100= 200m
After the capital expenditure the current value becomes 200m+20=220m
If no dividends are paid the value per share will be $220m/2= $110 per share
If the company pays the dividends of $15 per share then it pays a total of 15*2m=$30m, which it raises by issuing new shares. Shares value after paying dividends becomes $110-15 = $95
The existing shareholder gain $15 per share in cash. But loose the same amount as capital loss to the shareholders.
To issue the $30,000 required capital expenditure at a value of $95 per share then 316 shares will be required ($30,000/95). The number of shares will now be 2m+316000= 2,316,000 at 95 the value of the share will be $22, 0020,000 =$220.2m (2 is as a result of rounding's).
Company value remains the same at $220.
With the assumptions of MM theory the firm's rate of return (r) is the same as the firms cost of capital (k) at all times, and the discount rate is the same for all shares and thus;
r=k=kt
The price of each share must adapt to be equal to the rate of return which is the rate of dividends and capital gains or loss.
Thus; r= Dividends + capital gains (loss) = DIV + (P1-P0)
Share price P0
Where P0 = market price per share at the beginning of period 0
P1 = market price per share at end of period 1
DIV1 = dividend per share at end of period 1
r= rate of return
k= cost of capital
n= number of shares
V= total value of the firm
I1=the total amount of investment at period 1
X1=Total net profit at end of period 1
It then follows that and considering that r=k
P0= DIV1+P1 = DIV1+P1
(1+r) (1+k)
We multiply both sides with n to get the total value of the firm
V= nP0= n(DIV1+P1)
(1+k)
The MM model allows that the company sells (m) number of shares. Then
9
nP0 =n(DIV1+(n+m)P1-mP1
(1+k)
The new shares will be;
mP1=I1-(X1-nDIV1) = (n+m) P1-I1+X1
1+k
Thus the dividend policy, whether to get external or internal finance has not affected the value of
the company.
The MM's argues that when dividends are paid out, this advantage is offset by the
external finance. They further argue that dividend policy only splits cash flows into dividends and retained earnings. The theory supports that internal financing through retained earnings and external financing through issue of new shares does not change the investor's wealth.
Miller (1977) modified the formula in order to accommodate the tax effect to the
individual investor as relating to capital gains. .( Thomas E. Copeland, John Fred Weston)
This theory that there is no relationship between the value of the firm and its dividend policy has been examined and supported by other analysts.
They added that the use of dividend policy as a sign to reveal the company's financial status can be costly, (Bhattacharya, 1979).
There are critics who are against that the dividend policy is relevant and poke holes in the Miller-Modigliani hypothesis and argue that that the theory assumptions are unrealistic in practice. There are no perfect capital markets and there are cases where a single investor may influence the market price of the company shares (Pietesz, 2009). The critics also argue that issuing of new shares will attract issuing costs, underwriter's fees, commissions and preparation costs. An investor, who needs cash when there are no dividends, will have to incur broker's commission.
There are taxes both on dividends and on capital gains and the tax rates differ, and
informed investors will consider the tax effect while deciding on how to invest. Dividend are charged a higher rate than capital gains, the long-term investors will take this into consideration and will prefer the capital gains. Those who prefer current returns will choose the dividends in spite of the higher tax rate. The MM theory assumes that the retained profits are invested profitably while basically this might not be the case. The Directors may be serving their own interests and reinvest in non profitable investments.
This does not increase the value of the company though the dividend policy is a lowpayout in dividends. There is always a risk in uncertainty; it isn't possible for the investor to know the price of shares in the future. There are factors that may affect the price of the shares, like the global economic situation that was recently experienced which affected the stock value of all companies.
A return of money to the investors raises some confidence to the investors.
There is empirical evidence against this view that dividend policy affects the market
value of the company (Bhattacharya, 1988). A study paper on the marginal bondholder on the tax exempt and taxable bonds (Buser & Hess, 1986) has revealed that the tax rate indifference found after comparing the taxable and tax-exempt bonds of a marginal bond holder T (PB) is less than the corporate tax rate T(C). The differential by the two rates and the marginal tax shield that results from debt finance brings in a consideration of other offsetting costs in order to determine the optimal leverage choice. Again studies conducted at the New York Stock Exchange (Bhattacharya, 1988) have shown that a certain percentage increase in the dividend yield will result to investors demanding an equal percentage pre-tax equity returns.
Whatever the dividend policy the directors choose, and other issues held constant, this
should not affect the value of the company. A company's value will not just change or improve just by shifting earnings between dividends and retention. The dividend policy as has been seen in this paper does not affect the market value of the company. The decision of how much to issue out as dividends, or retain as profits, or whether to outsource debt finance will not affect the market value of the company (Bhattacharyn, 1988).
There are other considerations to make including investment policy and most importantly good and quality management of all resources.
