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Dividend policy theories

Aug

Dividend policy theories (By Munene Laiboni)


1. Introduction:
Dividend policy theories are propositions put in place to explain the rationale and major
arguments relating to payment of dividends by firms. Firms are often torn in between paying
dividends or reinvesting their profits on the business. Even those firms which pay dividends
do not appear to have a stationary formula of determining the dividend payout ratio.
Dividends are periodic payments to holders of equity which together with capital gains are
the returns for investing in a firms stock. The prospect of earning periodic dividends and
sustained capital appreciation are therefore the main drivers of investors decisions to invest
in equity. In this paper, we explore various theories which have been postulated to explain
dividend payment behavior of firms.
Major Schools of thought:
At the heart of the dividend policy theories discussion are two opposing schools of thought:
One side holds that whether firms pay dividends or not is irrelevant in determining the stock
price and hence the market value of the firm and ultimately its weighted cost of capital. In
retrospect, the opposing side holds that firms which pay periodic dividends eventually tend
to have higher stock prices, market values and cheaper WACCs. The existence of these two
opposing sides has spawned vast amounts of empirical and theoretical research.
Scholars on both sides of the divide appear relentless on showcasing the case for their
arguments. Several decades since interest in the area was sparked off by Modigliani and
Miller (1961), no general consensus has emerged and scholars can often disagree even on
the same empirical evidence! The arguments about dividend policy theory are so discordant
in modern day research, that at least there is consensus with Black (1976)s famous words
who defined dividend policy as a puzzle: the harder we look at the dividends picture, the
more it seems like a puzzle, with pieces that just do not fit together
School of Dividend Irrelevance
The main proponents of this view are Franco Modigliani and Merton Miller (1958, 1961). Their
key premise is that to investors, payment of dividends is irrelevant as investors can always
sell a portion of their equity if they need cash. Therefore, two firms of the same industry and
scale should have the same value even when one of the firms pays dividends and the other

one does not. The Modigliani and Miller Approach & the residual theory of dividends are the
main theories supporting the dividend irrelevance notion.
School of Dividend Relevance
Supporters of this theory argue that proposers of the dividend irrelevance theory made
unrealistic assumptions in crafting their respective theories. As such, they argue that if those
assumptions, key of which are the absence of taxes and transaction costs, are relaxed, the
dividend irrelevance theories wont be able to hold water. Their main argument is that in a
real world, payment of periodic dividends will have a positive impact on the stock price of a
firm, its market value and its weighted average cost of capital.
The ideals of this school of thought were solidified mainly by Gordon (1963), Lintner (1962)
and Walter (1963). There are other subsidiary hypotheses which support the notion of
dividend relevance. These include the tax preference theory, the Agency theory, the
Signaling Hypothesis, and The Clientele Effect Hypothesis,
Dividend Irrelevance Theories:
1. The Modigliani and Miller Theorem
Modigliani and Miller in 1961 rattled the world of corporate finance with the publication of
their paper: Dividend Policy, Growth, and the Valuation of Shares in the Journal of Business.
They proposed an entirely new view to the essence of dividends in determining the future
value of the firm. As such, they argued that subject to several assumptions, investors should
be indifferent on whether firms pay dividends or not. The 1961 paper was a sequel to the
1958 paper in which they argued that the capital structure of a firm is irrelevant as a
determinant factor its future prospects.
The M&M theorem holds that capital gains and dividends are equivalent as returns in the
eyes of the investor. The value of the firm is therefore dependent on the firms earnings
which result from its investment policy and the lucrativeness of its industry. When a firms
investment policy is known (its industry is public information), investors will need only this
information to make an investment decision.
The theory further explains that investors can indeed create their own cash inflows from
their stocks according to their cash needs regardless of whether the stocks they own pay
dividends or not. If an investor in a dividend paying stock doesnt have a current use of the
money availed by a particular stocks dividend, he will simply reinvest it in the stock.
Likewise, if an investor in a non-dividend paying stock needs more money than availed by
the dividend, he will simply sell part of his stock to meet his present cash need.
Assumptions of the Modigliani and Miller model
Modigliani and Miller pinpointed certain conditions which must hold for their
hypothesis to be valid:

The capital markets are perfect, i.e. investors behave rationally, information is freely
available to all investors, transaction and floatation costs do not exist, and no investor is
large enough to influence the price of a share.

Taxes either do not exist or there is no difference in the tax rates applicable to both
dividends and capital gains.

The firm has a fixed investment policy.

There is no uncertainty about the firms future prospects, and therefore all investors
are able to forecast future prices and dividends with certainty and one discount rate is
appropriate for all securities over all time periods.
Critique
The validity of the Modigliani and Miller theory is highly dependent on two critical
assumptions, which unfortunately are not tenable in the real world. The theory assumes a
world in which transaction costs and taxes are absent. In real sense, it is not possible to
have an economy in which these two aspects are absent.
2. The residual theory
The residual theory holds that dividends paid by firms are residual, after the firm has
retained cash for all available and desirable positive NPV projects. The gist of this theory is
that dividend payment is useless as a proxy in determining the future market value of the
firm. As such, the firm should never forego desirable investment projects to pay dividends.
Investors who subscribe to this theory therefore do not care whether firms pay dividends or
not, what they are concerned with is the prospect of higher future cashflows which might
lead to capital appreciation of their stocks and higher dividends payouts.
Critique
The residual theory has been criticized as having no empirical support, but its just an
illustration of logic which is all too obvious for corporate decision makers. Firms tend to meet
the financing needs of their growth strategies before paying anything out to shareholders
and hence a theory stating so would simply be stating the obvious.
Dividend Relevance Theories:
1. The Gordon / Lintner (Bird-in-the-Hand) Theory
The bird-in-the-hand theory, hypothesized independently by Gordon (1963) and by Lintner
(1962) states that dividends are relevant to determining of the value of the firm. In a popular
common stock valuation model developed by Gordon, The determinants of the value of a
firms cost of equity financing are the dividends the firm is expected to pay to perpetuity,
the expected annual growth rate of dividends and the firms current stock price.
Where:
k is the return on equity to equity investors
d1 is the forward looking yearend dividend payout
p is the current stock price of the firms stock

g is the expected future annual growth rate of the firms dividend


The dividend yield and the future growth of the dividends provide the total return to the
equity investor(KE=d1/pv + g). This model insists that dividend yield is a more important
measure of the total return to the equity investor than the future growth rate of the
dividends (which is the rate at which the net earnings and the capital gains of the firm will
grow at in the future). Future growth, and hence capital gains cannot be estimated with
accuracy and are not guaranteed at all as firms might lose even their entire market value in
the stock exchange and go bankrupt.
If a firm does not pay dividends therefore, its forward looking market value is severely
affected by the uncertainty surrounding the possibility of the investors ever booking the
capital gains.
Assumptions of the Bird-in-the-Hand theory
This theory is based on a number of assumptions, as enumerated below:
1.

The firm is an all equity firm, i.e. it has no debt in its capital structure.

2.

No external financing is available and consequently retained earnings are used to


finance any expansion of the firm.

3.

There are constant returns which ignores diminishing marginal efficiency of


investment.

4.

The firm incurs a constant cost of capital.

The Walter Model:


Walter (1963) postulated a model which holds that dividend policy is relevant in determining
the value of a firm. The model holds that when dividends are paid to the shareholders, they
are reinvested by the shareholder further, to get higher returns. This cost of these dividends
is referred to as the opportunity cost of the firm (the cost of capital), ke for the firm, since the
firm could use these dividends as capital if they were not paid out to shareholders.
Another possible situation is where the firm does not pay out dividends, and they invest the
funds which could be paid out as dividends in profitable ventures to earn returns. This rate of
return, r, for the firm must at least be equal to ke. If this happens then the returns of the firm
is equal to the earnings of the shareholders if the dividends were paid. Thus, its clear that if
r, is more than the cost of capital ke, then the returns from investments is more than returns
shareholders receive from further investments.
Walters model says that if r<ke then the firm should distribute the profits in the form of
dividends to give the shareholders higher returns. However, if r>k e then the investment
opportunities reap better returns for the firm and thus, the firm should invest the retained
earnings. The relationship between r and ke are extremely important to determine the
dividend policy. It decides whether the firm should have zero payout or 100% payout.

In a nutshell, if D = the dividend payout ratio,

If r>ke, the firm should have zero payout and make investments. (D = 0)

If r<ke, the firm should have 100% payouts and no investment of retained earnings.
(D=E)

If r=ke, the firm is indifferent between dividends and investments.


Mathematical representation of Walters Model:
Where,
P = Market price of the share
D = Dividend per share
r = Rate of return on the firms investments
ke = Cost of equity
E = Earnings per share
The market price of the share consists of the sum total of:

The present value of an infinite stream of dividends

The present value of an infinite stream of returns on investments made from retained
earnings.
Therefore, the market value of a share is the result of expected dividends and capital gains
according to Walter.
Assumptions of Walters model
1.

Retained earnings are the only source of financing investments in the firm, there is no
external finance involved.

2.

The cost of capital, ke and the rate of return on investment, r are constant i.e. even if
new investments decisions are taken, the risks of the business remains same.

3.

The firms life runs to perpetuity.

Basically, the firms decision to give or not give out dividends depends on whether it has
enough opportunities to invest the retain earnings i.e. a strong relationship between
investment and dividend decisions is considered.
Critique of the Bird-in-Hand and Walters Hypotheses
Because the structural underpinnings and implication of the Bird-in-Hand and Walters
theories are similar, they can be jointly critiqued. Although these models provide a simple
framework to explain the relationship between the market value of the share and the
dividend policy, they have some unrealistic assumptions.

1.

The assumption of no external financing apart from retained earnings, for the firm
make further investments is not really followed in the real world.

2.

The constant r and ke are seldom found in real life, because as and when a firm
invests more the business risks change.

Subsidiary Hypotheses of Dividend Relevance


3. The Tax-Preference Theory
The M&M assumption of a perfect capital market excludes any possible tax effect. It has
been assumed by Modigliani and Miller that there is no difference in tax treatment between
dividends and capital gains. However, in the real world taxes exist and may have significant
influence on dividend policy and the value of the firm. In general, there is often a differential
in tax treatment between dividends and capital gains, and, because most investors are
interested in after-tax return, the influence of taxes might affect their demand for dividends.
The tax-preference hypothesis suggests that low dividend payout ratios lower the cost of
capital and increase the stock price. By extension, low dividend payout ratios contribute to
maximizing the firms value. This argument is based on the assumption that dividends are
taxed at higher rates than capital gains. In addition, dividends are taxed immediately, while
taxes on capital gains are deferred until the stock is actually sold. These tax advantages of
capital gains over dividends tend to predispose investors, who have favorable tax treatment
on capital gains, to prefer companies that retain most of their earnings rather than pay them
out as dividends, and are willing to pay a premium for low-payout companies.
Another important tax consideration is that in an estate situation; where an heir is entitled to
shares after the death of a benefactor, no capital gains taxes will be due from the heir in
such a situation.

The Agency Hypothesis


The assumption of a perfect capital market under the dividend irrelevance theory implies
that there are no conflicts of interests between managers and shareholders. In practice,
however, this assumption is questionable where the owners of the firm are distinct from its
management. In these cases managers are always imperfect agents of shareholders and
managers interests are not necessarily the same as shareholders interests, and therefore
they do not always act in the best interest of the shareholders.
Shareholders therefore incur (agency) costs associated with monitoring managers behavior,
and these agency costs are an implicit cost resulting from the potential conflict of interest
among shareholders and corporate managers. The payment of dividends might serve to
align the interests and mitigate the agency problems between managers and shareholders,
by reducing the discretionary funds available to managers (Rozeff, 1982).

The Signaling Hypothesis:Another hypothesis for why M&Ms dividend Irrelevance theory is inadequate as an
explanation of financial market practice is the existence of asymmetric information between
insiders (managers and directors) and outsiders (shareholders). M&M assumed that
managers and outside investors have free, equal and instantaneous access to the same
information regarding a firms prospects and performance. But managers who look after the
firm usually possess information about its current and future prospects that is not available
to outsiders.
This informational gap between insiders and outsiders may cause the true intrinsic value of
the firm to be unavailable to the market. If so, share price may not always be an accurate
measure of the firms value. In an attempt to close this gap, managers may need to share
their knowledge with outsiders so they can more accurately understand the real value of the
firm. Historically, due to a lack of complete and accurate information available to
shareholders, the cash flow provided by a security to an investor often formed the basis for
its market valuation (Baskin and Miranti, 1997).
In this way dividends came to provide a useful tool for managers in which to convey their
private information to the market because investors used visible (or actual) cash flows to
equity as a way of valuing a firm. Many scholars also suggest that dividends might have
implicit information about a firms prospects. Even M&M (1961) suggest that when markets
are imperfect share prices may respond to changes in dividends. In other words, dividend
announcements may be seen to convey implicit information about the firms future earnings
potential. This proposition has since become known as the information content of
dividends or signaling hypothesis. According to the signaling hypothesis, investors can infer
information about a firms future earnings through the signal coming from dividend
announcements, both in terms of the stability of, and changes in, dividends. However, for
this hypothesis to hold, managers should firstly possess private information about a firms
prospects, and have incentives to convey this information to the market. Secondly, a signal
should be true; that is, a firm with poor future prospects should not be able to mimic and
send false signals to the market by increasing dividend payments.
Thus the market must be able to rely on the signal to differentiate among firms. If these
conditions are fulfilled, the market should react favorably to the announcements of dividend
increase and unfavorably otherwise (Ang, 1987, and Koch and Shenoy, 1999).
As managers are likely to have more information about the firms future prospects than
outside investors, they may be able to use changes in dividends as a vehicle to
communicate information to the financial market about a firms future earnings and growth.

Outside investors may perceive dividend announcements as a reflection of the managers


assessment of a firms performance and prospects. An increase in dividend payout may be
interpreted as the firm having good future profitability (good news), and therefore its share
price will react positively. Similarly, dividend cuts may be considered as a signal that the firm
has poor future prospects (bad news), and the share price may then react unfavorably.
Accordingly, it would not be surprising to find that managers are reluctant to announce a
reduction in dividends. (It means that they try to keep dividend stable)
Lintner (1956) argued that firms tend to increase dividends when managers believe that
earnings have permanently increased. This suggests that dividend increases imply long-run
sustainable earnings. Lipson, Maquieira and Megginson (1998) also observed that,
managers do not initiate dividends until they believe those dividends can be sustained by
future earnings.
Dividends are considered a credible signaling device because of the dissipative costs
involved.
The Clientele Effect Hypothesis
Since most of the investors are interested in after-tax returns, the different tax treatment of
dividends and capital gains might influence their preference for dividends versus capital
gains. This is the essence of the Clientele effect. For example, investors in low tax brackets
who rely on regular and steady income will tend to be attracted to firms that pay high and
stable dividends. Some institutional investors with major periodic cash outflows also tend to
be attracted to high-dividend stocks. On the other hand, investors in relatively high tax
brackets might find it advantageous to invest in companies that retain most of their income
to obtain potential capital gains, all else being equal. Some clienteles, however, are
indifferent between dividends and capital gains.
My Stand:
Due to its logic and more favorable empirical support, I favor the dividend relevance theory.
This hypothesis has more realistic assumptions that the M&M hypothesis and therefore is
more probable to be tenable in a realistic world. The assumption that shareholders tend to
be indifferent to current dividends or prospective future capital gains cannot go
unchallenged. Inasmuch as we assume businesses are going concerns, a probability of
bankruptcy, loss of market value or financial distress cannot be ruled out for any particular
firm in the future.
This means that which do not pay dividends might actually end up paying nothing to their
shareholders. This uncertainty should not be compared with the return on investment
actualized by a periodic dividend. The subsidiary theories supporting the dividend relevance

hypothesis are all based on observed phenomena across different domains. Hence its likely
that indeed in the real world, dividends policy is relevant in determining the value of a firms
stock and by extension its market value.

REFERENCES
M,H.Miller & Modigliani,F. (1958). The Cost of Capital, Corporation Finance and the Theory of
Investment. The American Economic Review, Vol. 48, No. 3 (Jun., 1958), pp. 261-297
Black (1976) Black,F. (1976). The Dividend Puzzle. Journal of Portfolio Management 2, 5-8.
Miller, M. H., and Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of
Shares, Journal of Business 34, 411-433.
Gordon, M, J. (1963). Optimal Investment and Financing Policy, Journal of Finance 18, 264272.
Lintner,J. (1962). Dividends, Earnings, Leverage, Stock Prices and Supply of Capital to
Corporations, The Review of Economics and Statistics 64, 243-269.
Walter, J,E., (1963). Dividend Policy: Its Influence on the Value of the Enterprise, Journal of
Finance 18, 280-291.
Rozeff, M, S. (1982). Growth, Beta and Agency Costs as Determinants of Dividend payout
Ratios, The Journal of Financial Research 5, 249-259.
Baskin, J, B. (1988) The Development of Corporate Financial Markets in Britain and the
United States, 1600-1914: Overcoming Asymmetric Information, The Business History
Review 62, 199-237.
Koch, P,D. & Shenoy,C. (1999), The Information Content of Dividend and Capital Structure
Policies,Financial Management 28, 16-35.
Lintner, J. (1956). Distribution of Incomes of Corporations Among Dividends, Retained
Earnings, and Taxes, American Economic Review 46, 97-113.
Lipson, M.L, Maquieira, CP., & Megginson,W. (1998) Dividend Initiations and Earnings
Surprises, Financial Management 27, 36-45.

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