Once they decide to pay dividends they may possibly establish a permanent dividend policy, which is the set of guidelines a company uses in order to decide how much of its profits it will pay out to shareholders in dividends and that decision depends on the preferences of existing and new investors and the situation of the company now and in the future (Garrison, 1999).
There are various limitations that may affect firm’s decision and must consider when paying dividends to shareholders such as Legal Limitations where added net realised profits is the only way to pay dividends, Liquidity where managers has to consider the effect that future dividend payments may have on liquidity, Interest Payment obligations where if the gearing (level of debt) is high then the available funds for dividends should be reduced and Investment Opportunities where a company could invest in attractive projects rather than to pay more dividends (Watson and Head, 2007).
There are two theories related to dividend, the Irrelevance Theory suggested that dividend policy it is not relevant to security valuation and the Relevance Theory, suggested that it is relevant and affect the value (Bar-Yosef and Kolodny, 1976). Below will see those theories. IRRELEVANCE THEORY Modigliani & Miller (1961) through the Irrelevance Theory stated that share value depends on corporate earnings, which reflect the investment policy of the company, depends only on investment decisions and it is independent of the level of dividend paid.
First of all that theory assume that capital markets are perfect, there are no transactions costs associated with converting shares into cash by selling them and firms can issue shares without incurring flotation or transactions costs to raise equity, whenever needed (Damodaran [Internet source]). Another assumption that Modigliani & Miller made is that there are no taxes at either a corporate or personal level associated with dividend and informations are freely available to all investors. Continuing with the assumptions Modigliani & Miller stated that
In a perfect capital market there are no conflicts of interests between managers and security holders, which is known as the Agency Problem. Shareholders, actually, own a company but managers are the ones who make the business run and decide. The agency problem arise because manager’s interests are different from shareholder’s interests and that is for the reason that managers may prefer to invest in unprofitable projects for their own benefit and that may incur some costs in order to manage the manager’s behaviour (Ming and Ming, 2013).
Modigliani and Miller argues that rational investors, in other words those who prefer their wealth maximization, do not care whether they receive dividends on their shares or investing retained earnings in new opportunities, they have identical borrowing and lending rates and were apathetic to the timing of dividends. Furthermore shareholders can simply sell some of their shares for cash, if dividend are too small. According to Modigliani and Miller a company’s choice of dividend policy is a choice of financing strategy and the investment decision is separate from the dividend decision (Watson And Heat, 2007).
They also argued that investors calculate the value of companies based on their future earnings capitalized value and is not affected by the dividends that a company pay and neither how dividend policies are set from company. RELEVANCE THEORY On the other hand we have the Relevance Theory of Lintner (1956) and Gordon (1959), who argued that dividends are preferred to capital gains due to their certainty, which means that an investor prefer to receive a certain dividend payment now rather than leaving the equivalent amount in an uncertain investment.
If a company pays low dividends may face a fall in share price and that is because investors exchange their shares with shares of a different company with higher dividend policy. Under that theory we have Asymmetry of Information, which means that dividend decisions may contain new information for shareholders and that is because managers have more informations about the health of the company than investors.
Asymmetry of information arises when capital markets are not perfect and depend on the direction of the dividend change and the difference between the actual dividend and the expected dividend by the market. Lintner & Gordon argues that shareholders are not homogeneous, they have different needs and preferences and the majority of them need a fixed income preferring dividends to capital gains which depends on their personal tax circumstances.
A company’s share price is affected downward form the disappointment of its shareholders if there is a significant change in its dividend policy. Lintner and Gordon use a mathematical model, knows as the Dividend Growth Model, to predict the value of ordinary shares through an increasing stream of cash flows. Dividend growth model is the equation:Po=(Do(1+g))/(r-g)=D1/(r-g), where: Po is the current market price of the share, D1 is the dividend at time t1, g the expected future growth rate of dividend, r the required rate of shareholders and Do the current dividend.
The model shows the relationship between the payout ratio, the rate of return, market price of the share and the cost of capital (Answers, 2013). Both theories are established and argued by famous economists and we cannot challenge them, but under a real market conditions we cannot use the Irrelevance theory and that is because some of the assumptions made by Miller and Modigliani are not realistic. Transaction costs are not zero hence there is a price for investors who try to sell their shares and neither informations are freely available to all investors.
Taxes does exists in the real world and issuing securities does incur costs. Moreover the assumption that investors have free informations available for them is unrealistic such as they have to spend time and money in order to have those informations (Watson and Head, 2007). For the reason that Irrelevance Theory’s assumptions are realistic under a perfect market only, the Relevance Theory is more useful in real world since a firm’s valuation is affected from the distribution of cash to investors (Ming J & Ming X, 2013). POLICIES
Using the more realistic theory there are some policies that should be used based on two factors: the company’s operation industry and second the nature of the company and its characteristics. As will see below those policies have advantages and disadvantages. Those Policies are: The Fixed percentage payout ratio policy, The Zero dividend policy and The Constant or steadily increasing dividend Fixed Percentage Pay-out Ratio is the policy where the ‘company pays out a fixed percentage of annual profits as dividends’ (Watson and Heat, 2007).
In that case, firms can create reserves for the years that earnings are fewer than usual or when they have losses. Is better for companies with stable earnings over years (SlideShare, 2012). The main advantage is that a company who choose that policy can easily control and send clear signals to its shareholders, related to the level of company’s performance. The disadvantage is from the company’s point again and is that it limits the available funds for reinvestment (Watson and Heat, 2007).
In Zero Dividend Policy ‘a company could decide to pay no dividend at all’ (Watson and Heat, 2007). That policy is more acceptable for new companies or for firms which need those profits for research new possibilities in the company. However is unacceptable to the most shareholders and that is because the majority of investors are rely on dividend payments as an income and that is the disadvantage of that policy.
On the other hand the advantages are that is by not paying dividends, the administration costs will be eliminated making the operation easier and most important all the profits of the company could be reinvested making the company more attractive for new investors (Watson and Heat, 2007). In Constant or Steadily Increasing Dividend Policy, a company may choose to pay dividend in a constant or steadily increasing ratio. In that case investors prefer a yearly steady growth of dividends and avoid to invest in companies with fluctuating dividend (Lee, 2009).
That policy counter to the zero dividend policy is more acceptable from the majority of investors and the reason is that they expect that payments will continued for ever. That except of the advantage may cause one disadvantage, the problem that shareholders expect dividends that company may be unable to afford. Another disadvantage is the fact that companies who adopt that policy do not have the ability to invest in projects that may be profitable (Watson and Heat, 2007) CONCLUSION
Concluding this report we can say in sure that companies is likely to prefer the theory of Lintner and Gordon, the Relevance Theory, which argues that dividend policy does matter in real world and in the structure of the real market. Then, according to the policies stated above, should be able to choose which dividend policy is better for them. We hope that the contents of this report are useful and will help you to find the best for the company. We are waiting for your chief’s accountant comments and we are ready to help out you on any further matters which may arise on these or any other finance issues.