Dividend policy theories

Aug2Dividend policy theories (By Munene Laiboni)

1. Introduction:

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.

Critique

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.

Critique

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.

Where:

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(KE=d1/pv + g). 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:

Where,

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. (It means that they try to keep dividend stable)

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.

My Stand:

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.

 

REFERENCES

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Miller, M. H., and Modigliani, F. (1961). Dividend Policy, Growth, and the Valuation of

Shares, Journal of Business 34, 411-433.

Gordon, M, J. (1963). Optimal Investment and Financing Policy, Journal of Finance 18, 264-

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