Given the company’s investment policy, dividend policies affects only the level of outside financing required (in addition to retained earnings) to fund new investment and pay the dividend. This means that each dollar of dividends represents a dollar of capital gains lost.
According to M&M, the only important determinant of a company’s market value is its investment policy because it is responsible for the company’s future profitability. As a result, it does not matter whether the firm pays out its earnings or not. The basic contention (and recommendation) underlying the M&M proposition is that manager should subordinate the dividend decision to investment decisions .
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Optimal Dividend Policy (Gorden & Lintner, 1962) : Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm's stock price. Addresses the investor preference for receiving dividends without selling stock, arguing that a capital gain "in the bush" is perceived as riskier than a dividend "in the hand." Miller & Modigliani refer to this theory as the "bird in the hand fallacy," suggesting that most investors will reinvest their dividends in the same or similar firms anyway and that in the long run risk is determined by asset cash flows not dividend policy.
This theory from Myron Gordon is rather an argument about investment policy than about dividends. What the “Bird in the Hand”-Theory is really saying is that companies paying low dividends tend to have riskier investments. For this reason – and not for the low dividend perse – investors discount the earnings of low dividend (and therefore risky) company more heavily. The market discounts future earnings according to the risk of the company, regardless of whether those earnings will be retained or distributed. However, what is important to recognize is that higher risk causes lower dividend, and not the reverse.
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Dividend Relevance Theory (Graham & Dodd, 1988) : The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value. Since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase.
This theory suggests that a low dividend payout ratio will maximize firm value. Results of empirical tests of these theories are mixed and have not led to definitive conclusions. In the less than theoretical "real world", companies budget future dividend payments the same way that they budget any other cash outflow such as debt service requirements, capital expenditures, or any foreseeable demand for cash. As a result, when a board of directors sets a general dividend policy, it is often in terms of and always in consideration of projected cash flows - not earnings. Thus, the internal policy might well be described as a certain percentage of cash flow, even for companies that express their policy publicly in terms of payout ratios or a percent of earnings
In the real world, markets cannot be absolutely efficient or wholly inefficient. Markets are essentially a mixture of both, and daily decisions and events cannot always be reflected immediately into a market; moreover, if all participants were to believe that the market is efficient, no one would seek extraordinary profits, the force that keeps the wheels of the market turning.
Semi-strong market efficiency, as indicated by Jack Treynor, holds that the market will not be always either quick or accurate in processing new information. On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance .
Report to Board of Directors
---- Begin of Report ----
As a part of basic financial policy choices, dividend policy will have significant impact on our net earnings and cash flow statement. In this report we are going to observe the relationship between dividend policy and the company’s value related issues. The following report will focus on these topics:
- Why dividend policy comes into focus?
- What’s the impact of dividend policy on our market value?
- What’s the impact of dividend policy on our financial performance?
- What factors may affect dividend policy?
- How shall we pay dividend?
During the previous, our firm presents a stable tendency of profit growth. The financial statement reports a certain amount of retained earnings by the end of each year. Whether to pay out retained earnings as dividend or re-invest for expansion is now becoming a core component of our financial decision portfolio.
If there are not enough investments that generate positive NPV, it is time to return cash to stockholders. Potentially, good reasons for paying dividends are :
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The Clientele Argument: There are stockholders who like dividends, either because they value the regular cash payments or do not face a tax disadvantage. If these are the stockholders in our firm, paying more in dividends will increase value
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Dividends as Signals: Since dividends require hard cash from the company, we can understand why investors would favor firms with established dividend records, instead of accepting profit generated solely by accounting people. Investors would refuse to believe a firm’s reported earnings announcements unless they were backed up by an appropriate dividend policy
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Wealth Transfer: By returning more cash to stockholders, there might be a transfer of wealth from the bondholders to the stockholders.
These points imply that, our dividend policy can be used as a signal to enhance investors’ confidence on the company’s future performance.
Dividend Policy & Market Value
As we know, the company’s market value equals to the present value of all future dividends. Despite what we mentioned above, higher payout increases market confidence, it also leaves less retained earnings to fund future growth of the company. Thus, we must find a balance between this trade-off, current income for stockholders (dividends) & future growth of the company (retained earnings). The stock price supposedly will be maximized when the market thinks management has found just the right balance .
A dividend initiation or increase may be welcomed only as a sign of higher future earnings. It is worthy of noticing that, investors do not get excited about the level of a company’s dividend, they worry about the change, which been viewed as key indicator of the sustainability of earnings . For instance, if we have sufficient profitable investment opportunities but limited available cash, the share value may increase by reducing current dividends to increase investment. If we are lack of such investment, shareholder may be better off if the excess cash is paid out to them in the form of higher dividends. In these situations, the signal sent to the market about internal investment opportunities and prospective company performance would be both satisfied .
Dividend Policy & Cash Flow
Cash flow, the only ‘real’ thing to measure a company’s financial healthy. Paying out cash dividend has inevitable impact on cash flow, which can be called “cash flow shock”.
Since a high-dividend-payout policy will be costly if we don’t have enough cash flow to support it, dividend increases signal our good fortune & management’s confidence in future cash flow.
We hypothesize that the method used to distribute cash flows reflects the nature of the underlying cash-flow process and shapes investors' expectations about the permanence of cash-flow shocks. The hypothesis has two parts. First, share repurchases to distribute cash-flow shocks that are primarily transient, while cash dividends contains a larger permanent component. Second, the market recognizes this association and uses the announcement of a particular distribution method to update its belief about the permanence of past and contemporary cash-flow shocks .
Dividend Policy & Its affecting factors
Generally, there are some legal considerations about a firm’s dividend policy, which are applicable to all of the listed companies :
- Dividends can only be paid out of profit and are not to be paid out of capital.
- A dividend cannot be paid if it would make the company insolvent.
- Dividend restrictions may exist in covenants in trust deeds and loan agreements.
- Under imputation, if a company has the capacity to pay a franked dividend then, as a general rule, it must do so.
In the previous parts of this report, we have already mentioned about some factors to be considered when setting up our dividend policy, such as:
- Clientele effects
- Availability of retained earnings
- Profits variability
- Long term objectives
- Investment opportunities
- Cash flow requirement
Here to be noted that, according to the agency model, the basic motivation of dividends is that unless firm’s profits are paid out as dividends, corporate managers may divert the cash flow for personal use or pursue unprofitable investment projects. Dividend payouts can be seen as means to reduce the free cash flow that managers can use at their own discretion .
How Shall We Pay Dividend
Dividend level varies with the total volatility of future cash flows and not just the systematic or market-related component of risk . Having a review of listed companies during the last 40 years as showed:
We suggest that, managers must be aware of the large negative impact that dividend reductions have on stock prices. As a result, when managers anticipate uncertain future cash flows, they reduce the payout ratio to avoid the possibility of having to reduce dividends in the future. .
When change occurs in dividend policy, it could be followed by significant news event by the markets; when we attempt to reduce dividends, it might also become significant bad news to the market. The suggestion is, general trend is to smooth cash dividends over time, and normally, we only announce dividend payments when it is sustainable. The reason behind smoothing the curve is using the decisions for change to bring good news to the market .
Stability of dividends can be accomplished by distributing the same ordinary dividend year after year. In exceptionally good years, some extraordinary dividends may be paid out. The dividends are designated as extraordinary to inform shareholders that these added dividends are not to be expected every year in the future. However, the ordinary dividends should grow in step with earnings. Thus, the board of directors sets the dividend at some target proportion of long run average earnings .
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Conclusion
Dividend policy is at the very core of corporate finance, especially when it comes to the payout, great emphasis on the company’s cash flow.
Deciding what percentage of earnings to pay out as dividends is a basic policy choice confronting managers because it determines what funds flow to investors and what funds are retained by the firm for reinvestment .
We observe that dividends and share prices are positively correlated, it does not mean the former causes the latter. In the long-run higher dividends must be supported by higher earnings and hence higher firm value and shareholder wealth, but it does not follow that increasing dividends will bring these things about!
We have already seen that if firm investments and hence earnings prospects are held fixed, higher dividends actually serve to decrease share prices. If higher dividends take a larger share of future earnings, the share price (which is the PV of those future earnings that are retained) will have to fall .
Notes and Reference
Resource:
R.A.Brealey, S.C.Myers, 1988, Principles of Corporate Finance, 3rd edition, McGraw, USA, pp357
M.H.Miller, F.Modigliani, “Dividend Policy, Growth and the Valuation of Shares”, Journal of Business, 34: 411~ 433 (October 1961)
Klaus Spremann, Pascal Gantenbein, 2001, Theories and Determinants of Dividend Policy, Stefan Beiner, pp3
M.J.Gordon, “Dividends, Earnings and Stock Prices”, Review of Economics and Statistics, 41: 99~105 (May 1959)
B.Graham, D.L.Dodd, 1934, Security Analysis: The Classic 1934 Edition, McGraw Hill, USA
Jack Treynor, "What Does It Take to Win the Trading Game?" Financial Analysts Journal, January/February 1981
Resource: Aswath Damodaran, Returning Cash to the Owners: Dividend Policy, , Slide 28
R.A.Brealey, S.C.Myers, A.J.Marcus, 2001, Fundamentals of Corporate Finance, 4th edition, McGraw, USA, pp437
R.A.Brealey, S.C.Myers, 1988, Principles of Corporate Finance, 3rd edition, McGraw, USA, pp357
R.A.Brealey, S.C.Myers, A.J.Marcus, 2001, Fundamentals of Corporate Finance, 4th edition, McGraw, USA, pp438
J.M.Stern, D.H.Chew, 1998, The Revolution in Corporate Finance, 3rd edition, Blackwell, USA, pp144
Wayne Guay, Jarrad Harford, 1999, The cash-flow permanence and information content of dividend increases versus repurchases, Resource:
Resource: , slide 6
Jensen, Michael C., 1986, Agency Cost of Free Cash Flow, Corporate Finance, and Takeovers, American Economic Review 76(2), pp.323-329.
Resource: , Dividend Policy and Cash Flow Uncertainty
, G.M.Frankfurter, B.G.Wood,
Resource:
Resource:
Klaus Spremann, Pascal Gantenbein, 2001, Theories and Determinants of Dividend Policy, Stefan Beiner, pp1
Resource: , slide 7
