Two basic schools of thoughts on dividend policy have been expressed in the theoretical literature of finance. One school, associated with Myron Gordon and John Lintner, holds that the capital gains expected from earnings retention are more risky than dividend expectations. Accordingly, this school suggested that the earnings of a firm with a low payout ratio will typically be capitalized at higher rates than the earnings of a high payout firm. The other school associated with Merton Miller & Franco Modigliani, holds that investors are basically indifferent to returns in the form of dividends or capital gains. Empirically, when firms raise or lower their dividend, their stock prices tend to rise or fall in like manner; does this not prove that investors prefer dividends?
The term dividend refers to that portion of profit (after tax) which is distributed among the owners/shareholders of the firm and the profit which is not distributed is known as retained earnings. A company may have preference share capital as well as equity share capital and dividends may be paid on both types of capital. However there is no decision involved as far as the dividend payable to preference shareholders is concerned. The reason being is that the preference dividend is more or less, a contractual liability and is payable at a fixed rate. On the other hand a firm has to consider a lot of factors before deciding about the equity dividend. The dividend decision may seem simple enough, but it evokes a surprising amount of controversy, which we will deal with later.
The dividend decision is one of the three basic decisions which a financial manager may be required to take, the other two being the investment and financing decisions.
In dividend decision the financial manager is required to decide one or more of the following:
All these decisions are inter related and have bearing on the future growth plans of the firm. If a firm pays dividend, it affects the cash flow position of the firm but earns goodwill among the investors who therefore, may be willing to provide additional funds for the financing of investment plans of the firm. On the other hand, the profits which are not distributed as dividends become an easily available source of funds at no explicit cost. Every aspect of the decision has to be critically evaluated. The most important of these considerations is to decide as to what portion of profit should be distributed. This is also known as the dividend payout ratio.
While deciding the dividend payout ratio the firm should consider the effect of such policy on the objective of maximization of shareholders wealth. If the dividend is expected to increase the market value of the share the dividend must be paid, otherwise, the profits may be retained and used as an internal source of finance. So, the firm must find out and establish a relationship between the dividend policy and the market value of the share. There are conflicting views on the relationship between the dividend policy and value of the firm.
Dividend policy and Value of the Firm
Dividend policy is basically concerned with deciding whether to pay dividend in cash now, or to pay increased dividends at a later stage or distribute profits in the form of bonus shares. The current dividend provides liquidity to the investors but the bonus share will bring capital gains to the shareholders. The investor's preference between the current cash dividend and the future capital gain has been viewed differently. Some are of the opinion that the future gains are more risky than the current dividends while others argue that the investors are indifferent between the current dividend and the future capital gains.
Various models have been proposed to evaluate the dividend policy decision in relation to value of the firm. While agreement is not found among the models as to what is the precise relationship, it is still worthwhile to examine some of these models to gain insight into the effect which the dividend policy might have on the market price of the shares and hence on the wealth of the shareholders. Two schools of thoughts have emerged on the relationship between the dividend policy and value of the firm.
One school associated with Walter, Gordon, etc holds that the future capital gains are more risky and the investors have preference for current dividends. The investors do have a tilt towards those firms which pay regular dividend. So, the dividend affects the market value of the share and as a result the dividend policy is relevant for the overall value of the firm. On the other hand, the other school of thought associated with Modigliani and Miller holds that the investors are basically indifferent between current cash dividends and capital gains. Both these schools of thought on the relationship between dividend policy and value of the firm have been discussed as follows:
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