Recently, some multinational companies have suspended paying dividends. If, as some say, dividends are irrelevant, why have share prices plunged in most of these companies? In your answer outline both dividend policy theory and relevant examples. (10 marks)
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Theories of Dividend Policy
1. Residual theory
The essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed.
Using this approach, the firm would treat the dividend decision in three steps, as follows:
Step 1: Determine its optimal level of capital expenditures for the year or period under review.
Step 2: Using the optimal capital structure prepositions, estimate the total amount of equity financing needed to support the expenditures generated in step 1.
Step 3: Because the cost of retained earnings, kr, is less than the cost of new company ordinary shares, ke, use retained earnings to meet the equity requirement determined in step 2. If retained earnings are inadequate to meet this need, sell new ordinary share. If the available retained earnings are in excess of this need, distribute the surplus amount, the residual, as dividends.
With the residual dividend policy, the primary focus of the firm’s management is indeed on investment, not dividends. Dividend policy becomes irrelevant, it is treated as a passive rather than an active, decision variables. The view of management in this case is that the value of the firm and the wealth of its shareholders will be maximised by investing the earnings in the appropriate investment projects, rather than paying out as dividends to shareholders.
Dividends will only be paid when retained earnings exceed the funds required to finance the suitable investments projects. Conversely, when the total investment funds required exceed retained earnings, no dividend will be paid.
2. Irrelevancy theory
The effect of dividends on market price per share has been a controversial one for many years. In 1961, Modigliani and Miller (MM) published an important article dealing with dividends and their effect on shareholders’ wealth. The whole divided irrelevance school originated with this publication.
MM argued that share valuation is a function of the level of corporate earnings, which reflects a company’s investment policy, rather than a function of the proportion of a company’s earnings paid out as dividends.
MM further argued that, given the irrelevance of a company’s capital structure, investment decisions were responsible for a company’s future profitability and hence the only decisions determining its market value.
MM then concluded that share valuation is independent of the level of dividend paid by a company.
MM’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a shareholder and you don’t like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s share. If the cash dividend you received was too small, you can just sell a little bit of your share in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be the same.
3. Dividend Relevance (Traditional view of dividend decisions)
Obviously, the assumptions made by MM are unrealistic. In the real world, investors might prefer one dividend policy over another. If so, a firm’s dividend policy is relevant. According to the dividend relevance theory, then, dividend policy can affect the value of a firm through investors’ preferences.
One of MM’s assumptions that have been hotly debated is that dividend policy does not affect investor’s required rate of return on equity, Ke. For example, Myron Gordon and John Lintner argued that investors prefer to receive dividends ‘today’ because current dividend payments are more certain than the future capital gains that might result from investing retained earnings in growth opportunities, so Ke should decrease as the dividend payout is increased. In effect Gordon and Lintner said that investors value a cedi of expected dividends more highly than a cedi of expected capital gains because the dividend yield component,
d/Po is less risky than the capital gains component, g, in the total expected return equation
Some arguments have been put forward to indicate that payment of dividend is relevant to the investors. These are now considered in turn.
1. Signaling effect (Information Content)
Dividend signaling – an increase in dividends would signal greater confidence in the future by managers and would lead investors to increase their estimate of future earnings and cause a rise in the share price.
The relevance of dividend is based on the premise that the mere payment of dividends imparts certain information to shareholders, known as the information content of dividend theory. This idea implies that dividends have an impact on share prices because they communicate information to investors about the firm’s profitability. An increase in the dividend rate, for example, says favourable things about the future outlook of the company. It has been suggested that implicit in the MM dividend irrelevance argument is this assumption that the market knows a company’s expected return stream exactly and discount this stream to determine the value of the firm. Advocates of information content argue that what is really valued in the marketplace is the perceived return stream. If this is the case, then changes in dividend policy will alter the market’s perception about the firm and therefore affect the valuation process.
This argument implies that dividend policy is relevant. Firms should attempt to adopt a stable (and rising) dividend payout to maintain investors’ confidence.
2. Preference for current income (bird in the hand)
Lintner and Gordon argued that dividends are preferred to capital gains due to their certainty. This is often referred to as the bird in the hand argument and means that an investor will prefer to receive a certain dividend payment now rather than leaving the equivalent amount in an investment whose future value is uncertain. Current dividends, in this analysis, represent a more reliable return than future capital gains.
When MM concludes that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own. If they don’t care, the firm’s dividend policy will not affect the firm’s share price and, consequently, dividend policy will not affect the firm’s required rate of return on equity capital (Ke). Myron Gordon and John Lintner, however, argue that Ke decreases as the dividend pay-out increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a cedi of dividends that they are certain to receive than on a cedi of expected capital gains. They base this argument on the fact that, when measuring total return, the dividend yield component, d/po, has less risk than the growth component g.
If dividends are preferred to capital gains by investors, dividend policy has a vital role in determining the market value of a company. Companies that pay out low dividends may experience a fall in share price as investors exchange their shares for those of a different company with a more generous dividend policy.
3. Clientele effect
It has been suggested that investors are not indifferent as to whether they receive dividends or capital gains. Preferences for one or the other can arise for two main reasons.
Some shareholders require dividends as a source of regular income. This is true of small shareholders such as pensioners and institutional investors such as pension funds and insurance companies. These institutions have regular liabilities to meet.
This need is balanced by stock exchange dealers, who over a small holding period prefer capital gains to dividends payment.
Preferences for dividends or capital gains due to their different tax treatment. A key premise of the irrelevance argument is that investors are indifferent as to whether they receive their return in dividend income or share appreciation. In the absence of personal taxes, this premise is reasonable. However, once differential personal taxes are considered, there may well be a preference for long-term capital gains, since they are taxed at lower rates then cash dividends. Moreover, the tax on capital gains are deferred until an investor actually disposes of the shares. Thus, once personal taxes are considered, it follows that for a given level of risk, investors will require a higher total return on a security the larger the proportion of its return attributable to dividends, since dividends are subject to a higher rate than long-term capital gains.
The existence of preference for either dividends or capital gains means that investors will be attracted to companies whose dividends policies meet their requirements. Each firm will therefore build up a clientele of shareholders who are satisfied by its dividend policy. The implication for a company is that a significant change in its dividend policy could give rise to dissatisfaction among its shareholders, resulting in downward pressure on its share price.
4. Free cash flow Hypothesis
If it is the intent of the financial manager to maximise the value of the firm, then investors should prefer that a firm pay dividends only if acceptable capital budgeting opportunities do not exist. We know that acceptable capital budgeting projects increase the value of the firm. We also know that, because flotation costs are incurred when issuing new shares, it costs a firm more to raise funds using new ordinary shares than it does using retained earnings. So, to maximise value, where possible, a firm should use retained earnings rather than issue new ordinary shares to finance capital budgeting projects. Thus, dividends should be paid only when free cash flows in excess of capital budgeting needs exist. If management does otherwise, the firm’s value will not be maximised.
According to the free cash flow hypothesis, the firm should distribute any earnings that cannot be reinvested at a rate at least as great as the investor’s required rate of return. Everything else equal, firms that retain free cash flows will have lower values than firms that distribute free cash flows, because the firms that retain free cash flows actually decrease investors wealth by investing in projects with IRR< Ke.
The free cash flow hypothesis might help to explain why investors react differently to identical dividend changes made by similar firms. For example, a firm’s share price will not change dramatically if it reduces its dividend for the purpose of investing in capital budgeting projects with positive NPVs. On the other hand, a company that reduces its dividend simply to increase free cash flows will experience a significant decline in the market value of its shares, because the dividend reduction is not in the best interests of the shareholders. Thus, the free cash flow hypothesis suggests the dividend policy can provide information about the firm’s behaviour with respect to wealth maximization
5. Tax aversion
In many countries, dividends have historically been taxed at higher rates than capital gains. In the 1970s, U.S. tax rates on dividend income were as high as 70%, while the taxes on capital gains were 35%. In the late 1990s, the rates were much lower, but the same general relationship was still in place. Dividends were taxed as ordinary income with rates as high as 39.1 %, while long-term capital gains were taxed at 20%. This situation is currently similar in Ghana. Dividends are taxed at 10% whereas capital gains from the sale of share from the stock exchange market are zero.
Under such a situation, according to the tax-aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax-aversion theory implies that investors would want companies to have a zero-dividend pay-out ratio so that they will not be burdened with higher tax rates. In the real world, tax laws often prevent companies from accumulating excess earnings, making dividend payments necessary.
The results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy. Research suggests that higher tax rates do result in lower dividend pay-outs. There is empirical support for the “bird-in-the-hand” theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles are satisfied. (5 points at 2 marks each)