Dividend policy
Encyclopedia
Dividend policy is concerned with taking a decision regarding paying cash dividend in the present or paying an increased dividend at a later stage. The firm could also pay in the form of stock dividends which unlike cash dividends do not provide liquidity to the investors, however, it ensures capital gains to the stockholders. The expectations of dividends by shareholder
s helps them determine the share value, therefore, dividend policy is a significant decision taken by the financial managers of any company.
s have different views on present cash dividends and future capital gain
s. Another confusion that pops up is regarding the extent of effect of dividends on the share price
. Due to this controversial nature of a dividend policy it is often called the Dividend puzzle.
Various models have been developed to help firms analyse and evaluate the perfect dividend policy. There is no agreement between these schools of thought over the relationship between dividends and the value of the share or the wealth of the shareholders in other words.
One school comprises of people like James E. Walter and Myron J. Gordon
(see Gordon model
), who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.
Two important models supporting dividend relevance are given by Walter and Gordon.
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.
Walter's model says that if re 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 k are extremely important to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :
where,
The market price of the share comprises of the sum total of :
Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter.
has also supported dividend relevance and believes in regular dividends affecting the share price of the firm.
Gordon has given a model similar to Walter's where he has given a mathematical formula to determine price of the share.
where,
Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.
The Modigliani
and Miller
school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach :
Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach.
When a firm has to issue securities to finance an investment, the existence of floatation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as floatation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments.
This residual decision is distributed in three steps:
The dividend policy of such a kind is a passive one, and doesn't influence market price. the dividends also fluctuate every year because of different investment opportunities every year. However, it doesn't really affect the shareholders as they get compensated in the form of future capital gains.
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s helps them determine the share value, therefore, dividend policy is a significant decision taken by the financial managers of any company.
Concept
Coming up with a dividend policy is challenging for the directors and financial managers of a company, because different investorInvestor
An investor is a party that makes an investment into one or more categories of assets --- equity, debt securities, real estate, currency, commodity, derivatives such as put and call options, etc...
s have different views on present cash dividends and future capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
s. Another confusion that pops up is regarding the extent of effect of dividends on the share price
Share price
A share price is the price of a single share of a number of saleable stocks of a company. Once the stock is purchased, the owner becomes a shareholder of the company that issued the share.-Behavior of share prices:...
. Due to this controversial nature of a dividend policy it is often called the Dividend puzzle.
Various models have been developed to help firms analyse and evaluate the perfect dividend policy. There is no agreement between these schools of thought over the relationship between dividends and the value of the share or the wealth of the shareholders in other words.
One school comprises of people like James E. Walter and Myron J. Gordon
Myron J. Gordon
Myron J. Gordon was an American economist. He was Professor Emeritus of Finance at Rotman School of Management of the University of Toronto. In 1959, Gordon published a method for valuing a stock or business, now known as Gordon growth model.Gordon held a B.A. from the University of...
(see Gordon model
Gordon model
The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....
), who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.
Relevance of dividend policy
Dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. The people who support relevance of dividends clearly state that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is iscounted at a lower rate, ke thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.Two important models supporting dividend relevance are given by Walter and Gordon.
Walter's model
James E. Walter's model shows the relevance of dividend policy and its bearing on the value of the share..Assumptions of the Walter model
- Retained earnings are the only source of financing investments in the firm, there is no external finance involved.
- The cost of capital, k e 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.
- The firm's life is endless i.e. there is no closing down.
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.
Model
Dividends paid to the shareholders are re-invested by the shareholder further, to get higher returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the firm. Another situation where the firms do not pay out dividends, is when they invest the profits or retained earnings in profitable opportunities to earn returns on such investments. 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, its 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
In a nutshell :
- If r>ke, the firm should have zero payout and make investments.
- If r
- If r=ke, the firm is indifferent between dividends and investments.
Mathematical representation
Walter has given a mathematical model for the above made statements :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 comprises of the sum total of :
- the present value if 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.
Criticisms
Although the model provides a simple framework to explain the relationship between the market value of the share and the dividend policy, it has some unrealistic assumptions.- The assumption of no external financing apart from retained earnings, for the firm make further investments is not really followed in the real world.
- The constant r and ke are seldom found in real life, because as and when a firm invests more the business risks change.
Gordon's Model
Myron J. GordonMyron J. Gordon
Myron J. Gordon was an American economist. He was Professor Emeritus of Finance at Rotman School of Management of the University of Toronto. In 1959, Gordon published a method for valuing a stock or business, now known as Gordon growth model.Gordon held a B.A. from the University of...
has also supported dividend relevance and believes in regular dividends affecting the share price of the firm.
Assumptions
Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions proposed by him :- The product of retention ratio, b, and the rate of return ,r, gives us the growth rate of the firm g.
- The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
Model
Investor's are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating a higher value of the share. In short, when retention rate increases, they require a higher discounting rate.Gordon has given a model similar to Walter's where he has given a mathematical formula to determine price of the share.
Mathematical Representation
The market price of the share is calculated as follows:where,
- P = Market price of the share
- E = earnings per share
- b = Retention Ratio ( 1- Payout ratio)
- r = rate of return on the firm's investments
- ke = cost of equity
- br = growth rate of the firm (g)
Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.
Conclusions
Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of them have shown the supremacy of regular dividends through their models and clearly stated the strong relationship between dividend policies and market value of the firm.Irrelevance of Dividend Policy
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...
and Miller
Merton Miller
Merton Howard Miller was the co-author of the Modigliani-Miller theorem which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William Sharpe...
school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach :
- decisions regarding financing and investments are made and do not change with respect to the amounts of dividends received.
- when an investor buys and sells shares without facing any transaction costs and firms issue shares without facing any floatation cost, it is termed as a perfect capital market.
Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach.
Residuals theory of Dividends
There is a small assumption in this theory which says that the external financing to re-invest is either not available, or is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings there and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will give out dividends.When a firm has to issue securities to finance an investment, the existence of floatation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as floatation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments.
This residual decision is distributed in three steps:
- evaluating the available investment opportunities to determine capital expenditures.
- evaluating the amount of equity finance that would be needed for the investment, basically having an optimum finance mix.
- cost of retained earnings
Extension of the theory
The dividend policy strongly depends on two things:- investment opportunities available to the company
- amount of internally retained and generated funds which lead to dividend distribution if all possible investments have been financed.
The dividend policy of such a kind is a passive one, and doesn't influence market price. the dividends also fluctuate every year because of different investment opportunities every year. However, it doesn't really affect the shareholders as they get compensated in the form of future capital gains.
Conclusion
The firm paying out dividends is obviously generating incomes for an investor, however even if the firm takes some investment opportunity then the incomes of the investors rise at a later stage due to this profitable investment.Modigliani and Miller Approach
The Modigliani–Miller theorem states that the division of retained earnings between new investment and dividends do not influence the value of the firm. It is the investment pattern and consequently the earnings of the firm which affect the share price or the value of the firm.Assumptions
The MM approach has taken into consideration the following assumptions:- there is a rational behavior by the investors and there exists perfect capital markets.
- Investors have free information available for them.
- No time lag and transaction costs exist.
- securities can be split into any parts i.e. they are divisible
- No taxes and floatation costs.
- The investment decisions are taken firmly and the profits are therefore known with certainty. The dividend policy does not affect these decisions.
Model
The dividend irrelevancy in this model exists because shareholders are indifferent between paying out dividends and investing retained earnings in new opportunities. The firm finances opportunities either through retained earnings or by issuing new shares to raise capital. The amount used up in paying out dividends is replaced by the new capital raised through issuing shares. This will affect the value of the firm in an opposite ways. The increase in the value because of the dividends will be offset by the decrease in the value for new capital raising.External links
- Dividend Policy by Alex Tajirian
- Corporate Dividend Policy by Henry Servaes (London Business School) and Peter Tufano (Harvard Business School)