January 10th, 2018
Dividend Payout Policy| Relevance or Irrelevance of Dividends
A basic assumption of corporate finance would be that management decisions are always informed on wealth creation for the shareholders. One of such decisions would be as regards the payment of dividends as a return to the shareholders for their investment in the company. Research thus has widely argued on the value that an entity derives from payment of dividends. As the basis of such research was a paper by Miller and Modigliani [M&M] (1961) that posed that a firm’s market value as represented by its stock price bore no association with the dividend policy adopted by the company – that a higher dividend payout would subsequently require more stock sales to support an entity’s investment projects. In the presence of taxation, M&M (1961) proposed that only the clienteles of investors formed with a penchant for specific dividend yield levels will change. The paper made assumptions of an ideal environment characterized by “perfect capital markets, rational [investor] behavior, and perfect certainty” in its attempt to assess how differences in dividend policy, impacts on the stock market prices (M&M 1961, p. 411). These findings were supported by some of the early studies carried out later (Black & Scholes 1974; Miller & Scholes 1982; Miller 1986). In such conceptualizations of dividend policy; management attention to structure the appropriate dividend policy for the entity would be an exercise in futility since different policies would not have any beneficial effect on the stockholders’ wealth.
On the basis of the real market environment M&M findings have however, as is the case with idealized systems, attracted much criticism. One such is that M&M argument “does not explain why companies, the public, [and] investing analysts are so interested in dividend announcements” (Bhattacharyya 2007). Baker, Powell and Veit (2002) had earlier noted that market imperfections such as: “differential tax rates, information asymmetries between insiders and outsiders, conflicts of interest between managers and shareholders, transaction costs, flotation costs, and irrational investor behavior” would make the dividend policy decision pertinent to the value creation at the market (P. 242). Attempts to incorporate real world scenarios have given rise to two different conceptualizations of effect of dividend policy on value creation. One of these proposes an increase in the value of the entity with the increase with amounts of dividend payouts while the other proposes an inverse relationship between dividends paid and value created (Frankfurter & Wood 2002; Azzopardi 2004).
Based on the first proposition – where higher dividends are associated with higher market prices – a number of arguments are advanced. One of these is that since dividends are likely to be a more ‘spendable’ income as compared to capital gains; investors would view current dividends to have a lower risk as compared to either future dividends or capital gains (Gordon 1960; Azzopardi 2004). This uncertainty in future dividends amount ‘the bird in hand principle’ would lead to preference of currently high dividend paying stocks. Thus, it can be posed that at any one given moment there would be a section of investors – “a natural clientele” – that would be willing to buy high dividend paying stocks (Azzopardi 2004). These exemplify investors who are risk averse and would like a quick return on their investment such as those in low tax brackets. On the other hand; investors with high incomes and in high tax brackets and who have no immediate need for cash incomes could prefer low dividends in exchange for increased investment in the company (Azzopardi 2004). A third group would be those in need of a regular income. Such could prefer stocks that offer some degree of certainty in returns thus leading to their purchase of stocks with a stable payout rate. Alteration of the payout level for any of these groups might lead to a shift in investor base in line with their interests which may result into changes in stock prices. Such changes would lead to adjustment costs for shareholders who, and/or costs of lost investment opportunities and those of raising finance to offset cash flows shortages for the company (Azzopardi 2004). Go to part 4 here.