Dividend policy firm value pdf

Dividend policy refers to the set of rules or norms that a company follows to decide how much of its profit it will pay out to shareholders. However, the choice of paying dividends is ultimately decided by the board of directors of the company, and once dividends have been declared, it becomes a debt to the firm and cannot be overturned easily [2].

Thus, management should be cognizant of the fact that unanticipated changes in dividend payments could alienate existing and potential investors [3]. This paper intends to provide an understanding of dividend policy by reviewing the existing theories on dividend policy and their empirical findings. Furthermore, the paper examines the empirical studies carried out by investigating the relationship between dividend policy and firm value as measured by its share price and company performance.

Introduction When it comes to dividend theories, there are two foremost schools of thought, the first is that dividends have an impact on firm value and the second is that dividends do not have an impact on firm value. This section presents a review of existing theories on dividend policy and their empirical evidence.

The theories on dividend policy are divided into two groups main that include dividends relevant theories and dividends irrelevant theories. It was seen that the beginning of dividend policy as important to investors was, to some extent, determined by the evolving state of financial markets. Investing in shares was initially seen as comparable to bonds, so consistency of dividend payments was important.

It was also seen that in the absence of regular and precise corporate reporting, dividends were often preferred to retained earnings, and often even observed as a better sign of corporate performance than published earnings accounts.

However, as financial markets developed and became more efficient, it was thought by some researchers and academicians that dividend policy would become increasingly irrelevant to investors. Dividend policy remaining evidently important for researchers has been a theoretically controversial. Three main opposing theories of dividends can be acknowledged. The third theoretical approach emphasizes that dividends should be irrelevant and all effort spent on the dividend decision is wasted.

Dividend debate is not narrowed to these three approaches. Several other theories of dividend policies have been existing, which further intensifies the complexity of the dividend puzzle. Some of the very popular of this dividend policy theory include the information content of dividends signaling , the clientele effects, and the agency cost hypotheses.

Dividends irrelevant theories a. The Miller and Modigliani M-M model: Erstwhile to the publication of the influential paper by Miller and Modigliani, it was extensively accepted that the more dividends a firm pays, the greater the value of a firms [4].

According to Allen and Michaely , this is resulting from the extension of the discounted dividends approach to firm value [5]. Gordon felt that higher r1 would dwarf this effect although future dividend stream would probably be higher as a result of the increase in investment i. The reason for the increase in r1 would be higher uncertainty concerning cash flows due to the delaying of the dividend stream.

The M-M model disagreed with this relevance dividend theory view and pointed out a rigorous framework for analyzing dividend policy [4]. Miller and Modigliani investigated the impact of dividend policy on share price of the firm [7]. The basic idea underlying their argument is that firm value is determined by firm its present and future cash flows i. M-M showed that shareholder wealth is not affected by the dividend decision alone, and also argued that the investors would naturally be indifferent to the choice between dividends and capital gains.

M-M further claimed that if investors needed income, they can essentially create their own homemade dividend policy by selling their existing equity shares.

As cited in Malkawi et al , M-M upheld that in their perfect world, dividends are irrelevant. According to M-M , the irrelevance dividend policy argument was based on two basic assumptions i Perfect capital market and ii Rational investors. In the perfect capital market, all traders have equal and perfect information about the current share price and all other relevant characteristic of shares.

In this perfect capital markets there are no transaction fees, breakage fees, taxes and other cost. Thirdly they base their argument on the idea of perfect certainty, which indicates complete assurance on the part of every investor as to future investment decisions of the firm and the future profits of every corporation.

Because of this assurance, there is no need to distinguish between equity share and debenture as a source of finance [7]. The conclusion of this theory is that management should not burden itself much about dividend policy when it comes to firm value, as the decision of whether to pay or not pay dividends, has no impact on the value of the firm.

Empirical evidence of the M-M model: The M-M hypothesis is based on a perfect capital market assumption. In reality, markets are imperfect. Soothing the assumption of a perfect market, Black and Scholes investigates to see whether dividend policies are relevant and have an impact on increasing or decreasing firm value [9]. Black and Scholes instituted a portfolio of 25 common stock listed on the New York Stock Exchange NYSE to investigate the relationship between dividend yields and stock returns [9].

The underlying model used was the Capital Asset Pricing Model. In reckoning the dividend yield of a security, Black and Scholes model used dividend paid to the shareholders in the previous five years, and the market price at the end of every year for the same five years.

The securities were ordered on estimated yield from maximum to minimum, and separated into five groups. The result of the model did not prove that differences in dividend yield lead to differences in stock returns.

Thus it looked like the dividend policy have no impact on the stock prices [9]. Over years of researches, four main theories of dividends relevancy have been existing: The bird-in-hand hypothesis, signaling theory,tax preference and agency cost theory.

Since investors value capital gains as risker than dividend, firms have to have a higher dividend payout ratio tomaximize the share price. In other words, high dividend payout upsurges the stock price [11]. The fact of the matter is the risk of a firm is determined by the risk of its cash flows generated by its investments, which cannot be changed by dividend policy; therefore, the bird in hand explanation may not hold factual.

In other words, the risk of a firm cannot be reduced by an increase in the dividend payments [12]. Generally, the bird in hand justification for dividend significance is rejected by most of the financial economics literatures.

The study investigated the corporate managers of NASDAQ firms that regularly pay cash dividends to determine their insights on dividend policy and the relationship between dividend policy and firm value to observe how they view dividend policy.

The sample size was firms. The main result of the survey indicated that NASDAQ managers believed that dividend policy affects firm value as reflected in shares price, and concluded as dividend policy matters [13]. Further findings point out that more than 90 percent of managers agreed that a firm should dodge increasing its regular dividend if it expects to reverse the dividend decision in a year or so.

The firms should attempt to maintain stable dividend payment. Furthermore, the Baker et al, revealed that the majority of managers thought that the market places greater value on stable dividends than stable pay-out ratios. More than 60 percent agreed that the firm should set a target dividend pay-out ratio and periodically adjust its current pay-out toward the target.

Further findings reveal that 90 percent of managers agreed with the statement that an optimum dividend policy strikes a balance between present dividends and capital gains that maximizes the share price. Based on this evidence Baker et al concluded that managers generally perceive that firms today set dividend payments in line with that put forth by Lintner.

Signaling Hypothesis: Signaling Hypothesis argues that there is an existence of asymmetric information between managers and shareholders. Modigliani Miller Hypothesis assumed that in a firm, information is available for insiders and outsiders are same; but managers may have information pertinent to the value of the firm which outside investors do not have Robinson, [11]. This information gap illuminates the way managers use dividend declaration as a signal which expresses valuable information about future performance of the firm to investors.

Signaling hypothesis of dividend policy is supported and cited by many researchers such as Bhattacharya [12] and Miller and Rock [15]. Empirical evidence of the signaling theory: Kaestner and Liu [16]examine the information content of dividend announcements and found strong support for the cash-flow signaling hypothesis.

They pointed out that on average the stock price response is positively and significantly related to the size of dividend payment.

They further infer that the market perceive dividend payments as a significant source of information about the performance of the firm. DeAngelo et al [17] analyzed the signaling theory of dividends.

In order to evaluate the empirical significance of dividend signaling, they investigated the signaling content of dividend decisions made by managers of firms listed on the New York Stock Exchange NYSE whose annual earnings decreased after nine or more consecutive years of growth. In their sample of firms, According to DeAngelo et al, [18] there was no indication that Year 0 dividend increases are associated with favorable future profit of the firm.

They further showed that the evidence shows that there are three other factors which explain the favorable dividend actions of the firms studied are not informative signals about future earnings prospects. On the whole their study offers almost no support of the signaling hypothesis. DeAngelo et al, in their conclusion stated that they found that the dividend signaling is empirically insignificant and they pose a difficult challenge to the opposite view that dividend signaling is a fairly important determinant of corporate dividend policy [18].

The study investigated whether the changes in dividends have information content about future earnings. They concluded that there is a strong lagged and contemporaneous correlation between dividend changes and earnings Dividend go up when there is an increase in earnings from the empirical data but they were unable to find much evidence of a positive relationship between dividends earnings and future earnings changes.

Agency Costs and Free Cash Flow Hypothesis: Modigliani and Miller approach assumes that there is no conflict between managers and shareholders [7]. Therefore, the shareholders may incur agency cost, causing potential conflict between manager and shareholder. The agency costs theory put forward that increasing dividends is one way of decreasing the agency costs. By paying more dividends the level of reserves and surplus will reduce and firms have to search for fund from external financing.

The agency cost elucidation for dividends has been reinforced by previous empirical studies [20]. Furthermore, Easterbrook stated that higher dividends will reduce the available free cash flow for managers; managers will be entrusted with the job of raising funds from external sources. Shareholders can prevent managers from acting in self-interest besides monitoring them at low cost [21].

Empirical evidence of the agency theory: La Porta et al [22] in his research investigated agency cost hypothesis. The usual policy of a company is to retain a position of net earnings and distribute the remaining amount to the shareholders. Many factors have to be evaluated before forming a long-term dividend policy. Following given below are the different types of dividends: A.

Cash dividend Companies mostly pay dividends in cash. A Company should have enough cash in its bank account when cash dividends are declared. If it does not have enough bank balance, arrangement should be made to borrow funds. When the Company follows a stable dividend policy, it should prepare a cash budget for the coming period to indicate the necessary funds, which would be needed to meet the regular dividend payments of the company.

It is relatively difficult to make cash planning in anticipation of dividend needs when an unstable policy is followed. Thus, both the total assets and net worth of the company are reduced when the cash dividend is distributed.

The market price of the share drops in most cases by the amount of the cash dividend distributed. Bonus Shares : or Stock -dividend in USA An issue of bonus share is the distribution of shares free of cost to the existing shareholders, In India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend.

Hence, Companies in India may supplement cash dividend by bonus issues. Issuing bonus shares increases the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership. The declaration of the bonus shares will increase the paid-up Share Capital and reduce the reserves and surplus retained earnings of the company.

The total net-worth paid up capital plus reserves and surplus is not affected by the bonus issue. Infect, a bonus issue represents a recapitalization of reserves and surplus. It is merely an accounting transfer from reserves and surplus to paid up capital.

The following are advantages of the bonus shares to shareholders: i. Tax benefit: One of the advantages to shareholders in the receipt of bonus shares is the beneficial treatment of such dividends with regard to income taxes.

Indication of higher future profits: The issue of bonus shares is normally interpreted by shareholders as an indication of higher profitability. Future dividends may increase: if a Company has been following a policy of paying a fixed amount of dividend per share and continues it after the declaration of the bonus issue, the total cash dividend of the shareholders will increase in the future. Psychological Value: The declaration of the bonus issue may have a favorable psychological effect on shareholders.

The receipt of bonus shares gives them a chance sell the shares to make capital gains without impairing their principal investment. They also associate it with the prosperity of the company. Special dividend In special circumstances Company declares Special dividends.

Generally company declares special dividend in case of abnormal profits. Extra- dividend An extra dividend is an additional non-recurring dividend paid over and above the regular dividends by the company. Companies with fluctuating earnings payout additional dividends when their earnings warrant it, rather than fighting to keep a higher quantity of regular dividends.

Annual dividend When annually company declares and pay dividend is defined as annual dividend. Interim dividend During the year any time company declares a dividend, it is defined as Interim dividend.

Regular cash dividends Regular cash dividends are those the company exacts to maintain every year. They may be paid quarterly, monthly, semiannually or annually. Scrip dividends These are promises to make the payment of dividend at a future date, Instead of paying the dividend now, the firm elects to pay it at some later date.

Liquidating dividends These dividends are those which reduce paid-in capital: It is a pro-rata distribution of cash or property to stockholders as part of the dissolution of a business. Property dividends These dividends are payable in assets of the corporation other than cash.

For example, a firm may distribute samples of its own product or shares in another company it owns to its stockholders. The company's Board of Directors makes dividend decisions. They are faced with the decision to pay out dividends or to reinvest the cash into new projects.

Dividend policies must always consider two basic objectives: i. Maximizing owners' wealth ii. Providing sufficient financing While determining a firm's dividend policy, management must find a balance between current income for stockholders dividends and future growth of the company retained earnings. In applying a rational framework for dividend policy, a firm must consider the following two issues: 10 i.

How much cash is available for paying dividends to equity investors, after meeting all needs-debt payments, capital expenditures and working capital i. To what extent are good projects available to the firm i.

If dividend is to be paid the declaration date, record date etc. Date of Record: This is the day on which all persons whose names are recoded as stockholders will receive the dividend.

Payment date: The dividend checks are mailed to shareholders of record. Cum Dividend date: This is the last day on which the buyer who buys the stock is entitled to get the dividend. This is the first date on which the buyer who buys the stock is not entitled to dividend.

With a residual dividend policy, the primary focus of the firm is on investments and hence dividend policy is a passive decision variable. The value of a firm is a direct function of its investment decisions thus making dividend policy irrelevant. Dividend Irrelevance Arguments Dividend policy does not affect share price because the value of the firm is a function of its earning power and the risk of its assets.

If dividends do affect value, it is only due to: a. Information effect: The informational content of dividends relative to management's earnings expectations. Clientele effect: A clientele effect exists which allows firms to attract shareholders whose dividend preferences match the firm's historical dividend payout patterns.

A study conducted by Aswath Damodaran12 found that: a Older investors were more likely to hold high dividend stocks and b Poorer investors tended to hold high dividend stocks hence, firms with older investors pay higher dividends and firms with wealthier investors pay lower dividends.

Signaling Effect: Rise in dividend payment is viewed as a positive signal whereas a reduction in dividend payment is viewed as a negative signal about the future earnings prospects of the company, thus leading to an increase or decreases in share prices of the firm. Managers use dividends as signals to transmit information to the capital market. Theoretical models by Bhattacharya 13, Miller and Rock 14 and John and Williams 15 and Williams 16 tell us that dividend increases convey good news and dividend decreases convey bad news.

However, this theory is based on the following assumptions: i. There is an existence of perfect capital markets i. No personal or corporate taxes and no transaction costs. The firm's investment policy is independent of its dividend policy. Investors behave rationally and information is freely available to them iv. Risk or uncertainty does not exist. The above-mentioned assumptions exclude personal and corporate taxes as well as any linkage to capital investment policy as well as other factors that limit its application to real world situations.

Dividend payments reduce investor uncertainty and thereby increase stock value. This theory is based on the logic that ' what is available at present is preferable to what may be available in the future'. Hence dividend policy is relevant and does affect the share price of a firm.

Graham and D. Dodd This theory simply concludes that since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase. This theory suggests that a low dividend payout ratio will maximize firm value. However to increase their job security and status in the eyes of the shareholders companies can adopt percent payout. However this policy is not followed in practice. Firms can thus avail of new investment opportunities that would be beneficial to shareholders too.

It has been argued that firms payout dividends in order to reduce agency costs. Dividend payout keeps firms in the capital market, where monitoring of managers is available at lower cost. If a firm has free cash flows Jensen , it is better off sharing them with stockholders as dividend payout in order to reduce the possibility of these funds being wasted on unprofitable negative net present value projects.

This modern view of dividend policy emphasizes the valuable role of dividend policy in helping to resolve agency problem and thus in enhancing shareholder value. There are therefore, conflicting viewpoints regarding the impact of dividend decision on value of a firm. According to him investment policy and dividend policy are inter related and the choice of a appropriate dividend policy affects the value of an enterprise.

On this view, the value of the share is calculated as the present value of an infinite stream of dividends. Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of establishing share value. Gordon's model uses the dividend capitalization approach for stock valuation. In a classic study, Lintner surveyed a number of managers in the 's and asked how they set their dividend policy.

Most of the respondents said that there were a target proportion of earnings that determined their policy. On the basis of interviews with corporate executives, Lintner concluded that firms select target payout ratios to which they gradually adjust actual dividend payments over time.