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 firm's 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 won't 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 firm's earnings which result from its investment policy and the lucrativeness of its industry. When a firm's 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 doesn't have a current use of the money availed by a particular stock's 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 firm's 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.
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.
The residual theory has been criticized as having no empirical support, but it's 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 firm's cost of equity financing are the dividends the firm is expected to pay to perpetuity, the expected annual growth rate of dividends and the firm's current stock price.
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 firm's stock
g is the expected future annual growth rate of the firm's dividend
The dividend yield and the future growth of the dividends provide the total return to the equity investor. 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, it's 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.
Walter's 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>ke 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 Walter's Model:
P = Market price of the share
D = Dividend per share
r = Rate of return on the firm's 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 Walter's 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 firm's life runs to perpetuity.
Basically, the firm's 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 Walter's Hypotheses
Because the structural underpinnings and implication of the Bird-in-Hand and Walter's 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 firm's 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&M's 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 firm's 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 firm's 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 firm's 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 firm's 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 firm's 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 firm's 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 firm's 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 firm's future earnings and growth. Outside investors may perceive dividend announcements as a reflection of the managers' assessment of a firm's 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.
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.
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 it's likely that indeed in the real world, dividends policy is relevant in determining the value of a firm's stock and by extension its market value.
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