January 10th, 2018
Dividend Payout Policy|Reasons for Payment or non-Payment of Dividends
The Reasons to pay or not pay dividends and the level of dividends could also be arguable on other propositions. Baker, Powell and Veit (2002) for instance provide tax-preference, signalling, and agency costs explanations among other reasons for paying or not paying dividends. The tax preference hypothesis argues that where investors receive a “favourable tax treatment on capital gains – lower capital gains tax rate and deferral of capital gains tax – [they] may prefer stocks with low dividend payouts” (Baker, Powell & Veit 2002, p. 243). Bhattacharyya (2007) notes that though recent trend has been to reduce taxes levied on dividends; dividends taxation has historically been higher in comparison to that levied on income from capital gains. The tax preference hypothesis is also supported by the “capital asset pricing theory”, where investors “offer a lower price for the shares because of future tax liability of the dividend payment” (Frankfurter & Wood 2002 p. 112). This then implies that in the presence of taxes investors could form clienteles that favour stocks with a particular level of dividend yield (M&M 1961; Frankfurter & Wood 2002). Proponents for dividend irrelevancy theory however proposed that the clientele effect would only account for nominal changes in the composition of the portfolio but not for major alterations predicted by earlier research (Modigliani 1982). Azzopardi (2004) however in evaluating tax effect on an entity’s dividend policy, demonstrates how investors under different taxation schemes would receive different amounts of cash when equal distribution amounts are assumed. This then could validate the perspectives of the tax preference hypothesis.
Secondly, Baker, Powell and Veit (2002), identify a signalling explanation to the structure of dividend policy that a company adopts from a review of literature. Studies have proposed that, by being insiders who have more knowledge of the state of affairs of the company, managers could structure dividend payment amounts to convey such information to private investors (Bhattacharya 1979; Miller & Rock 1985). Dong, Robinson and Veld (2005) investigations support such signalling reasons by inquiring from individual investors their reasons for requiring dividend payment. Managers thus could increase their dividend payments when they perceive that the market prices of the entity’s stock are lower than its intrinsic value (Baker, Powell & Veit 2002). Baker, Powell and Veit (2002) however observe that to be successful at such signalling, other firms should not be in possession of inside information that would allow them to copy the change in dividend without a possible future reversal. Further Tse (2005) argues out that signalling is not universally applicable to all firms.
A third explanation for dividend payment explored by Baker, Powell and Veit (2002) is the agency cost hypothesis. Such observes that through dividend payment, “managers must raise funds more frequently in the capital markets where they are subjected to the scrutiny and the disciplining effects of investment professionals” (Baker, Powell & Veit 2002, p. 244). Shareholders are thus perceived to accept the higher costs of dividend payment in exchange for the higher regulation that such professional community offers (Easterbrook 1984; Baker, Powell, & Veit 2002). It is proposed that through dividend payment, free cash flows that would act as an incentive for imprudent management investing decisions are reduced; thus making managers to go back to the capital markets to search funds needed for needed investment funds (Jensen 1986). Norohna, Shome & Morgan (1996) however contend that agency cost explanations are context specific and that such do not influence dividend decisions when there exists ways to control for agency problems. D’Souza (1999) also finds a negative relationship between agency costs and dividend policy in an analysis of international firms.
These counter findings in the attempts to analyze the role of an entity’s dividend policy on the value of the firm make it difficult to pinpoint the optimal dividend policy. Such inquests are further made difficult due to the observations that dividends in the actual business environment could be losing their value. Fama and French (2001) provided one such study that observed that an increasingly higher percentage of firms were stopping their dividend payments as characteristics of public listed firms changed. H. DeAngelo, L. DeAngelo, and Skinner (2004), nevertheless noted that despite a decrease in number of dividend payers; those that still paid increased their amounts offsetting the effect of increasing non-payers who they contended were mainly comprised of firms that initially paid small amounts. To add to such studies Skinner (2008) noted that “firms that only pay dividends are largely extinct” with more firms opting for share repurchases as a better way to provide a return to their investors (p. 582). Such contrasting findings of theoretical models and empirical surveys lead to an inquiry as to whether there exists an optimal dividend policy. go to part 5 here.