Should Managements’ primary goal is shareholders’ wealth maximization?
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business, or it can be paid to the shareholders as a dividend.
Dividend policy has been an issue of interest in financial literature since Joint Stock Companies came into existence. Dividends are commonly defined as the distribution of earnings (past or present) in real assets among the shareholders of the firm in proportion to their ownership.  Dividend policy connotes to the payout policy, which managers pursue in deciding the size and pattern of cash distribution to shareholders over time.
Managements’ primary goal is shareholders’ wealth maximization, which translates into maximizing the value of the company as measured by the price of the company’s common stock. This goal can be achieved by giving the shareholders a “fair” payment on their investments. However, the impact of firm’s dividend policy on shareholders wealth is still unresolved.
THEORIES OF DIVIDEND POLICY:
DIVIDEND IRRELEVANCE THEORY
DIVIDEND RELEVANCE THEORY
DIVIDEND IRRELEVACE THEORY:
The dividend irrelevance theory is based on the premise that a firm’s dividend policy is independent of the value of its share price and that the dividend decision is a passive residual. The value of the firm is determined by its investment and financing decisions within an optimal capital structure, and not by its dividend decision. A common dividend policy should be able to serve all firms because the dividend policy is irrelevant in determining firm value.
Modigliani and miller pointed out that investors who are rational, in the sense that they always make the choice but maximise their utility, are indifferent to receiving capital gains or dividend on their shares. From the perspective of maximising the shareholder utility is that a company maximises its market value by adopting an optimal investment policy. Such a policy is represented by a company which invests in all projects that yield a positive net present value and hence maximises the net present value of the company as a whole. A company with insufficient internal funds can raise funds on the capital market, allowing it to finance all projects.
Hence, according to Modigliani and Miller, the investment decision is divorced from the dividend decision. A company’s choice of dividend policy, given its investment policy, is really a choice of financing strategy.
ARGUMENTS FOR DIVIDEND IRRELEVANCE:
The residual theory outlined above suggests that if the firm cannot invest further to earn in excess of its cost of capital, it should distribute the earnings to its shareholders. M&M argue that the firm’s value is determined by the investment policy and that the split between dividends and funds to be reinvested does not affect this value, under the assumptions explained. This argument is also supported by Miller, Black and Scholes. This party raised the following question: If companies could increase their share price by distributing more or less cash dividends, why have they not already done so?
‘This brings us to the real world scenario with wrinkles of imperfection in its capital markets, a far cry from the understanding of a perfect capital market. The clientele of firms, in this context referring to persons with money to invest, come in all varieties of preferences, some with low-payout and others with high-payout demands. M&M argue therefore that changes in dividend policies from low-to-high payouts, for example, should not have a bearing on the market value of the shares, but rather on the clientele that the firm will attract. Looking at this from the other end, Miller, Black and Scholes argue that if all clienteles are satisfied, their demands for high or low payouts will have no effect on prices of shares.12 In the real markets, studies have however shown that large changes in dividends do affect share prices.13 However M&M’s counter-argument to this is that the effects on the prices are attributable to the informational content of dividends with respect to future earnings rather than to the dividend itself. The shift in the clienteles questing to satisfy their preferences is what may cause prices to change. This characteristic allows firms to avoid having to identify the indifference curves of individual shareholders when establishing their investment policies.
There is a strong consistency between the M&M views and those of the ‘dividend irrelevance’ proponents, and the ‘residual theory’ discussed above.
DIVIDEND RELEVANCE THEORY:
A theory put forth by Miller and Modigliani that, in a perfect world, the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets.
Dividend relevance theory, that current dividend payments reduce investor uncertainty and ultimately result in a higher value for the firm’s shares.
In perfect capital markets, in the absence of taxes and transaction costs, dividend policy is irrelevant in the sense that it cannot affect shareholder value. The effect of any dividend policy can be offset by management adjusting the sale of new stock or by investors adjusting their dividend stream through stock purchases or sales.
This theory was proposed by Myron J. Gordon and John Lintner. Dividend relevance theory suggests that investors are generally risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share appreciation and dividends tomorrow.
Dividend relevance theory proposes that dividend policy affect the share price. Therefore, according to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders. Empirical studies do not support this theory. However, actions of market participants tend to suggest that there is some connection between dividend policy and share price.
The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world.
Thus, when dividends are raised, this is viewed by investors as recognition by man-agreement of future earnings increases. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low dividends will attract a clientele with little need for current income, and who often have high marginal tax rates.
ARGUMENTS FOR DIVIDEND RELEVANCE:
The dividend controversy over so many years of debate, has resulted in two extreme groups apart from the above discussed ‘middle-of-the-roaders’. A conservative group, the Rightists, believe that higher dividend payouts will result in an increase in the value of the firm. The Leftists on the other hand believe that a high dividend will decrease the firm’s value. A common belief in the business and investment communities is that earnings paid out as dividends should be allotted a much higher multiplier in evaluating shares than that to undistributed earnings.14 The Rightist group argue that there seems to be a natural clientele for high-payout shares because dividends are regarded as ‘spendable’ income whereas capital gains are additions to capital. Myron J Gordon and John Lintner suggested in the early sixties15 that investors see current dividends as less risky than future dividends or capital gains. Their proposition came to be known as the ‘bird in the hand’ argument, and suggested that the lower uncertainty attached to dividends received will result in a lower
Discount factor applied to the firm’s earnings resulting in a higher stock value.
That said, shareholders may realise capital gains by selling stocks, whenever they
Feel they have not received enough returns by way of dividends. However there Still remains much sympathy with the argument that investors prefer higher Dividends. One reason may be because mature companies may have plenty of free cash flow but few profitable investment opportunities.
Another major departure from the perfect market scenario is the effect of taxes which, together with other imperfections is likely to interfere seriously with the hypothesis of dividend irrelevancy. If dividends are taxed more heavily than capital gains16, then it is more advantageous to transmute dividends into capital gains. It is a growing practice that when companies make large one-off distributions to shareholders, they do so by repurchasing stocks. However this cannot be done frequently because the tax authorities may identify the scheme, deem the distribution as a dividend and tax it accordingly with the higher rates. Another argument put forward by the ‘Leftist’ group is that taxes on dividends have to be paid immediately whereas capital gains tax can be deferred until shares are actually sold. Apart from the distinction between income and capital gains, there is also the effect of differential rates of personal income tax and also the possibility that a company may have shareholders, both private and corporate, who are taxed under different tax regimes.
Dividend payment has negative impact on shareholders wealth:
[arguments for and against]
The main impact on the firm’s dividend policy on its value is an unresolved issue. Miller and Modigliani demonstrate that, the absent imperfections, dividend policy should not affect the shareholders wealth. Dividend irrelevance is also supported by the empirical work of Black and Scholes leading to an argument in the M&M paper, Black and Scholes shows the ability of firms to adjust dividends to appeal to tax included investors and argue that this supply effect may account for their finding of no relationship between dividends and stock returns.
FACTORS AFFECTING THE DIVIDEND POLICY OF A COMPANY:
Stability of Earnings: The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods.
Age of corporation: Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend.
Liquidity of Funds: Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend.
Extent of share Distribution: Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasise to distribute higher dividend.
Trade Cycles: Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up.
Government Policies: The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.
Taxation Policy: High taxation reduces the earnings of the companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.
Legal Requirements: In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend.
Past dividend Rates: While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation.
Ability to Borrow: Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds.
Policy of Control: Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy.
Repayments of Loan: A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout.
Time for Payment of Dividend: When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances.
Regularity and stability in Dividend Payment: Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, in spite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.
It seems that there is no conclusion set in stone on the dividend irrelevancy controversy. Since the formulation of the M&M proposition in 1961, financial economists have been arguing about whether dividends have any effect on the long-term market value of the firm. The irrelevant dividend theory based on the works of M and M, states that the value of the firm is not affected by its dividend policy and is therefore irrelevant in the determination of ordinary share price.The relevant dividend theory is based on behavioural dividend models and states that under real life market conditions, the value of the firm is affect.
The relevant dividend theory is based on behavioural dividend models and states that under real life market conditions, the value of the firm is affected by its dividend policy and is therefore relevant in the determination of ordinary share price. Under market imperfections such as taxes, transaction cost and imperfect information, firms tend to adopt a stable and consistent dividend policy because firms perceive a dividend policy to be important to shareholders .
This chapter dealt with analysing responses based on managements’ views on dividend payments and the effect on firm value. Because the dividend policy is a natural consequence of dividend theory being applied, the conclusions to the study are categorised under the dividend policies, namely,the managed dividend policy, a consequence of the relevant dividend theory and the residual dividend policy, a consequence of the irrelevant dividend theory.
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