Dividend policy

1.0 Introduction
Dividend policy is a vital part of a corporate’s financing decision. This dividend-payout
policy will determine the amount of earnings that can be retained in the firm as a source of
financing (Horne & Wachowicz, 2008). Over the past 40 years, financial theorists have
debated the extent to which dividend policy should and does matter to a firm’s market value
and thus its shareholders. One group of theorists believe that dividend policy is irrelevant to
shareholders, through the company’s market value. This group is for the view that only
decisions of the corporates that are directly related to investment in non-current and working
capital affect the market value. On the other hand, another group contends that dividend
policy is of relevance for many reasons and that it does impact on the market value and
therefore, on shareholders’ wealth.

2.0 Irrelevance of Dividend Policy

Miller and Modigliani (“MM”) provide the most comprehensive argument for the irrelevance
of dividends. MM assert that, under perfect capital market conditions (no taxes, no
transaction costs, symmetric information among all investors) and assumption that future
profits are known with certainty, the dividend policy of a company should have no impact on
its cost of capital, market value of firm and thus, on the wealth of shareholders. They argue
that the firm’s value is determined exclusively by the earnings power of the corporate’s assets
or its investment policy, and that the way in which the earnings stream is divided between
retained earnings and dividends, does not affect this value (Miller and Modigliani, 1961).

However, in the real world, the MM hypothesis lacks practical relevance due to its unrealistic
nature. To begin with, both individuals and firms incur transaction costs. A company issuing
new shares incurs flotation costs (underwriting fees, registration expenses, legal costs),
estimated to stand at 4-10 per cent of the capital raised. Shareholders selling shares to create
“homemade” dividend would incur transaction costs and in some jurisdictions, capital gains
taxes. Moreover, selling shares on a periodic basic to create an income stream of dividends
can be problematic over time if share prices are volatile; a decline in share price may lead to
shareholders selling more shares to create the same dividend stream (CFA Institute 2011).

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BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
3.0 Relevance of Dividend Policy
A number of arguments have been put forward to support the contrary position, that is,
dividends are relevant under conditions of uncertainty. In other words, the market value of
the firm is affected by the dividend policies and investors are not indifferent as to whether
they receive returns in the form of dividend income or share price appreciation.

3.1 Walter’s Theory on Dividend Policy

Professor James Walter formed a model for share valuation that states that the dividend
policy of a company has an effect on its valuation. He distinguished between 2 factors that
influence the price of the firm vis-à-vis the dividend pay-out ratio and the relationship
between the Internal Rate of Return (r) and the Cost of Capital (k) (Borad 2014).

Walter’s model is based on the following assumptions (Borad 2014):

i) Investment is financed entirely by retained earnings; therefore, there is no debt or

new equity issued;
ii) Constant r and k. The business risk remains constant for all investment decisions;
iii) Constant Earnings per Share (EPS) and Dividend per Share (DPS);
iv) Earnings are distributed as dividend or reinvested immediately, that is, a 100%
retention or pay-out ratio; and
v) Long or indefinite life of the company.

The following table shows a summary of how firm’s value is affected through his model.

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BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
 Impact of an Impact of a
Relationship
increase in decrease in Optimal
between internal Type of
dividend pay-out dividend pay-out Dividend
rate of return and Firm
on value of the on value of the Pay-out ratio
cost of capital
company company
r>k Decreases Increases Growth Firm Zero
Declining
r<k Increases Decreases 100 per cent
Firm
Normal/
r=k No change No change Constant Any ratio
Firm
Adapted from: eFinanceManagement.com (2015)

Just like MM, Walter’s model has been criticised on the grounds of unrealistic assumption:
no external financing and a constant r and k. This is so because in the real world, it is
difficult to follow these principles as corporates do require external financing and business
risks do change as investment increases (Pujari 2015).

Though Walter’s model had some pitfalls, it follows that the value of the firm is affected by
the dividend policy and therefore, the directors of corporates might want to consider in which
type of firms it stands before taking any such decisions.

3.2 Bird in the Hand Argument

Benjamin Graham (1934), John Lintner (1962) and Myron Gordon (1963) are some financial
theorists who argued that given perfect capital market conditions, investors have a preference
for a dollar of dividend to a dollar in potential capital gains from reinvestment of earnings as
they perceive dividends as less risky. The viewpoint is “… the typical dollar of reinvestment
has less economic value to the shareholder than a dollar paid in dividends” (Clayman et al.,
2012).

This argument is known as the ‘bird in the hand’ argument, a reference to the proverb “a bird
in the hand is worth two in the bush”. By assuming amount of capital gains is more risky
than the same amount in dividend, Graham B., Lintner J. and Gordon M. hold that firms
paying dividend will have a low cost of equity capital, resulting to a higher share price
(Clayman et al., 2012).

SAURTY Shekyn Das (1310709)

BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
MM disparages this argument on the grounds that an increase in dividend payments today
will not have any effect on the risk of future cash flows. Such actions will, therefore, only
lower the ex-dividend price of the share.

3.3 Tax Argument

In many jurisdictions, dividend income is taxed at higher rates than capital gains. One proof
of this could be the case of the United States: in the 1970s, taxes on dividend income were as
high as 70% as compared to a relatively low capital gains rate of 35%. Even in 2002, long-
term capital gains tax rate was 20% and that of dividends stood at 39% in the U.S. (CFA
Institute 2011).

Hence, one can argue that in such countries, taxable investors should prefer companies with
low dividends but high reinvestment of earnings, promoting growth opportunities.
Presumably, any growth in earnings in excess of the opportunity cost of funds would translate
into higher share prices. If, for any reason, a firm lacked this growth opportunity sufficient to
consume its retained earnings, it could distribute such funds through share repurchases (CFA
Institute 2011).

However, real world market situations may complicate this picture; in some countries,
corporate regulations may prevent companies from never distributing excess earnings as
dividends or deem share repurchases to be dividends if the repurchases appear to be on-going
in lieu of dividend payments.

3.4 Clientele Effect

Another factor that may affect a company’s dividend policy is a clientele effect. In the
context of dividend policy, this effect refers to the existence of a group of investors drawn to
invest in firms with specific dividend policies. For instance, retired investors may prefer
higher current income and therefore, hold stocks with high dividend payouts and yields,
whereas younger workers (with long-time horizons) might favour owning shares in firms that
reinvest a high percentage of their earnings for long-term share price appreciation and thus,
have less preference for stocks that pays dividends (Horne & Wachowicz, 2008).

Empirical evidence shows that many investors show a preference towards dividend payments.
Some institutional investors, such as mutual funds (Collective Investment Schemes in
Mauritius), exchange-traded funds, trusts and foundations, or even banks, will only invest in
companies that pay a dividend. They normally require a minimum dividend yield or require
SAURTY Shekyn Das (1310709)
BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
that the dividend yield be in the top quartile of the relevant stock universe. All of these
considerations suggest that there exists a clientele effect and that market participants can be
classified into those who prefer to receive return in terms of dividends and those preferring
capital gains returns (Clayman et al., 2012).

In spite of the existence of such clientele effect, it does not follow that dividend policy affects
equity values but only that some investors care more about dividends than others. In
particular, in an equilibrium dividend market (where demands of all clienteles for different
policies are satisfied by enough numbers of companies), a firm cannot affect its own share
value by altering its dividend policy. A dividend policy change would merely bring a shift in
clientele; thus, promoting dividend policy stability.

3.5 Signalling Effect

As mentioned above, one of the assumptions of MM hypothesis is symmetric information. In
reality though, corporate managers have access to more detailed and in-depth information
about the company than outside investors. This situation of asymmetry raises the possibility
that increases or decreases in dividend may impact on the share price because they convey
new information about the company. A company’s Board of Directors may use this dividend
‘tool’ to signal to investors how the company is really doing. Actually raising, maintaining
or cutting dividends may convey more reliable information to investors than plain positive
words from management because in this case, money is involved. Empirical studies support
the thesis that dividend initiations are seen as positive information and future earnings growth
by investors, whereas the contrary (dividend cuts) are associated with future earnings
problems. As a result, declarations can help to reconcile the gap between the share price and
their intrinsic value (CFA Institute 2011).

For this signal to be effective, it must be difficult or costly to mimic by another entity without
the same attributes. In the short term, the firm can make use of borrowings to fund the
dividends but, increases in dividend can be expensive in the long-run. This is so because a
firm (not expecting of cash flow in the future) will not be able to maintain the high levels of
dividends in the long run (Ross 1977; Myers and Majluf, 1984).

Many companies take pride in their record of consistently increasing dividends over a long
period of time. These firms are very often called “dividend aristocrats” by Standard & Poor
Rating Services (2011). However, dividend cuts can send a positive signal as well. For

SAURTY Shekyn Das (1310709)

BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
example, in 1993, IBM (the giant of mainframe computers which holds an impressive record
for dividend payments) announced a more than 50% cut in its dividend payment and
explained that the reason behind this was a restructuring of its business to non-mainframe
technology. Although there were varying opinions about this, this cash flow was successfully
used for reorganisation. In 1996, IBM resumed its dividend payments which have increased
every year since then (Clayman et al., 2012).

Besides, few can argue that Microsoft’s dividend declarations were not corporate events of
some importance. In spite of its phenomenal past in development, growth and dominance in
the technology industry, Microsoft never paid a dividend since its inception because this cash
was claimed to be used in Research & Development to further discoveries and unforeseen
advances. It was only in 2003 that the latter declared a first dividend of 6 dollar cents per
share. This was then followed by an annual dividend of $0.32 and a special year-end
dividend of $3 in 2004 (Clayman et al., 2012).

Clearly, the signalling effect was more relevant than the actual cash impact on the company
or investors for Microsoft. On one side, some investors viewed these declarations positively,
as a signal to broadening its investor focus while discouraging unprofitable expansion. On
the other hand, others viewed this as an acknowledgement that the company is now a mature
one and that it would not reap high returns from reinvestment of earnings (CFA Institute
2011).

Dividend declarations may provide information to current and prospective investors

regarding the future of the company. Increasing or initiating a dividend may signal an
encouraging signal, whereas omitting or cutting dividends might send an undesirable pointer
(CFA Institute 2011).

3.6 Agency Costs

In many large, publicly traded corporations such as Microsoft or Ford Motor Company, there
is a separation between managers (controlling the operations of the firm- Finance Director)
and outside investors (owning the company). The 2 parties being different means managers
may have the incentive to maximise their own wealth at the company’s expense because they
do not own a percentage of the company and are not affected by costs of such actions. This
problem is commonly known as the Agency Problem.

SAURTY Shekyn Das (1310709)

BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
At times, managers may opt for negative NPV projects; although the firm will grow in terms
of sales and assets (therefore enlarging managers’ span of control), it will spawn negative
economic returns. This potential overinvestment agency problem may be alleviated by the
payment of dividends. By paying out all free cash flow to equity for dividends, managers
would be reserved in their ability to overinvest by undertaking negative NPV projects. This
concern of management creating an overinvestment agency cost is the Jensen’s free cash flow
hypothesis of 1986 (CFA Institute 2011).

However, this issue needs to be evaluated case by case. For example, Microsoft (as
mentioned above) had accumulated large cash flows over the years but it does not mean that
the corporate was squandering its cash on unprofitable projects. Furthermore, this
accumulation can be seen as a provision for financial flexibility to counter the effects of
changing environments or contingencies, as it was the case for Ford Motor Company.
Considering the life-cycle conditions of companies, it can be concluded that it makes sense
for growing companies (characterised by rapid changes in cash flows) to hold large cash
flows and pay little or no dividend, but this does not follow for mature firms.

When a company is financed by a mixture of debt and equity, the payment of dividends can
aggravate the agency conflict between bondholders and shareholders. This is so because
upon payment of dividends, the ‘cash cushion’ available for the disbursement of fixed
payments to debt holders reduce. Also, large dividend payments, with the aim to transfer
wealth from debt holders to shareholders, could lead to underinvestment in positive NPV
projects and thus intensify the risk for the corporate to default on its debts. In practice, in
order to mitigate this risk, bondholders require a covenant to be included in their indenture
(contract) that defines the maximum amount of dividend distributions during the lifetime of
the bond. These pledges do not, however, restrict the payment of dividend from new
earnings or new issue of equity; they simply attempt to avoid dividends being financed
through the realisation of assets or issuance of new debt.

Thus, the payment of dividend may strengthen the relationship between managers and
shareholders, but may also increase the gap between bondholders and shareholders
(worsening their conflicting interests). This is likely to be a factor which needs to be
considered before reaching a final decision for dividend policy. However, this argument does

SAURTY Shekyn Das (1310709)

BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
not provide for any clue about a positive or negative relationship between market value of the
firm and dividend policy.

4.0 Conclusion
In theory, with the presence of market perfections, the Miller and Modigliani (1961)
hypothesis holds: dividend policy is irrelevant to the wealth of the shareholders and the value
of the firm. But in reality, the absence of market perfections means dividend policies
somehow matter. Professor Walter explained the value of the firm through mathematical
terms and concluded that dividend policy has an impact; the ‘bird in the hand’ theory argues
that investors value a dollar of dividends today more than uncertain capital gains in the
future; and a third theory argues that in countries where dividends are taxed more than capital
gains, taxable investors would prefer companies which reinvest the earnings for growth
opportunities. Other arguments put forward for dividend policy are the clientele effect,
signalling information and the agency problem. Unfortunately, trying to find a relationship
between firm value and dividend policy is inconclusive and difficult because of the existence
of various variables.

SAURTY Shekyn Das (1310709)

BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015
References
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STANDARD AND POOR’S RATING SERVICES, 2011. S&P 500 Dividends in 2011.
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SAURTY Shekyn Das (1310709)
BSc (Hons) Finance (Minor: Law)
DFA2002Y(3) Corporate Finance
20 April 2015