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Dividend Policy and Firm Valuation

Dividend Policy and Firm Valuation

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An essay for the 2012 Undergraduate Awards Competition by Rui Li. Originally submitted for Accounting at None, with lecturer Dr J. Peter Green in the category of Business & Economics
An essay for the 2012 Undergraduate Awards Competition by Rui Li. Originally submitted for Accounting at None, with lecturer Dr J. Peter Green in the category of Business & Economics

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Published by: Undergraduate Awards on Aug 30, 2012
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10/27/2013

 
  Dividend Policy and Firm ValuationPage 1 of 12
 
Abstract:
This paper aims at critically evaluating whether dividend policy in the current economicclimate is important to the valuation of listed companies. In traditional corporate finance,investment and financing policies are viewed as the most important policies to a company.However, with more companies going public, the dividend policies adopted by somecompanies have featured heavily in the news. If dividend policy is relevant to firm value andthe correlation is significant, it is important for the finance manager to formulate the dividendpolicy carefully so as to maximise the wealth of shareholders and the value of the firm.After several decades of study by many scholars, there is still no general consensus on theimportance of dividend policy. This paper therefore attempts to present a fair view towardsthis long lasting debate about dividend policy by reviewing: (1) the dividend policyirrelevance school, advocated by Miller and Modigliani (1961), and (2) the dividend policyrelevance school, including four arguments - bird in the hand theory, information contenteffect theory, tax induced clientele effect theory, and transaction costs induced clientele effecttheory. This paper also provides empirical evidence to support each argument.Having recognised numerous and significant imperfections in the current economic climate,this paper comes to the conclusion that dividend policy is relevant to firm value. However,the importance of dividend policy varies from one industry to another, and even differsbetween companies within the same industry. This paper suggests that the relationshipbetween dividend policy and firm value should be analysed on an individual company basis.In addition, although dividend policy is relevant, the financing and investment policies shouldstill be the key determinant in valuing a firm as suggested by Miller and Modigliani (1961).
Keywords:
Corporate Finance, Firm Value, Dividends, Dividend Policy Irrelevance,Dividend Policy Relevance.
 
DIVIDEND POLICYANDFIRM VALUATION
 
  Dividend Policy and Firm ValuationPage 2 of 12
 
DIVIDEND POLICY AND FIRM VALUATION
1.
 
Introduction
On 24 January 2012, when Apple’s chief executive Tim Cook announced the first quarter’s
results and the estimated $90bn (£58bn) cash reserve, its dividend policy started to featureheavily in the news. Whether Apple should pay out dividends, something Steve Jobs wasvehemently opposed to, has become a favourite Wall Street parlour game, according toGarside (2012). How important is dividend policy for a company? To what extent willdividend policy have an impact on the firm value?Whether dividend policy affects the valuation of a firm, or a listed company to be specific,has been a controversial issue for a long time. In order to resolve this puzzle, it is important toclearly define dividend policy and firm value at the first place. According to Firer, Ross,
Westerfield and Jordan (2004, pg. 563), dividend policy is “the time pattern of dividend payout”. Therefore dividend policy question is “whether the firm should pay out a large percentage of its profits now or a small percentage” (Firer 
et al. 2004, pg. 563). Pike andNeale (2009, pg. 457) define that the value of the company is
synonymous with the value of the equity
, assuming that there is no company borrowing. Therefore, they suggest that thevalue of a firm depends on its dividend-paying capacity. Pike et al (2009, pg.70) further pointout that, for distressed companies with no dividends, the market is valuing
more distantdividends on hopes of a turnaround in earnings
, or
break-up value if recovery is unlikely
.This paper discusses the impact of dividend policy on the firm value. The reminder of thispaper is organised as follows:
 
Dividend policy irrelevance school & empirical evidence;
 
Dividend policy relevance school & empirical evidence;
 
Dividend policy and firm value under current economic climate;
 
A brief summary of the main results.
2.
 
Dividend policy irrelevance school
Miller and Modigliani (1961) published a seminal academic paper illustrating that, under aperfect capital market with rational investors, the specific dividend policy adopted by thecompany is irrelevant to the firm value. To qualify for the perfect capital market condition,Brennan (1971) suggests that the following criteria should be satisfied: (1) all investors aretrying to maximise their wealth; (2) all investors have similar expectations; (3) all investorsare rational people; (4) all investors expect each other to be rational people as well.
 
  Dividend Policy and Firm ValuationPage 3 of 12
 Furthermore, Pike and Neale (2009) highlight some additional underlying assumptions tosupport the dividend policy irrelevance hypothesis: (1) there are no flotation or transactioncosts; (2) information is costless and equally available to everyone; (3) there is no distortingtax; (4) all investors have the same access to borrowings; (5) all participants are price takers;(6) dividend decisions are not used to convey information.
2.1. Supporters:
Miller and Modigliani (1961, pg.414) argue that
“given a firm’s investment policy, the
dividend payout policy it chooses to follow will affect neither the current price of its sharesnor the total returns to s
hareholders”
. They suggest that, in a perfect capital market whererational people try to maximise their benefits, investors are indifferent to whether receivingdividends right now or receiving capital gains in the future. What investors really care iswhether the company can adopt an optimal investment policy, which will allow the companyto invest in projects generating positive net present value and thus increasing the firm value.In other words, dividend policy is merely a choice of financing strategy according to Watsonand Head (2010).From investors
point of view, Miller and Modigliani (1961) argue that dividend policy isirrelevant because investors are always able to create homemade dividends. The idea of homemade dividends implies that
investors can undo company dividend policy byreinvesting dividends or selling shares
(Firer et al. 2004, pg. 564). The investors have theability to transfer the disappointed dividend policy into a desirable dividend policy by buyingor selling on their own rights. Therefore, there is no particular necessity to find out whichdividend policy benefits the company the most. From this perspective it can be concludedthat dividend policy will not influence the firm value at all.From the firm
s point of view, Pike and Neale (2009) suggest that the dividend policy is alsoirrelevant. They highlight in their paper that, when a firm can get access to sufficient externalfinancing, the dividend policy will not impact on the firm value. Their rationality is based onthe consideration that companies can recoup the required finance by selling shares. No matterwhich kind of divided policy the company adopts and no matter how much dividends thecompany pays out, the company can always sell shares to fund beneficial investments. Inother words, the choice of choosing dividend policies will not preclude profitable investment.Therefore, dividend policy is irrelevant to the firm value.Firer et al. (2004) also advocate the dividend policy irrelevance thought under perfect capitalmarket. They suggest that dividend policy cannot raise the dividend at one day withoutdecreasing the dividends on the other days. Dividend policy is in fact providing a kind of trade-off between paying out dividends on different days. When taking the time value intoconsideration, the net present values of dividends under different dividend policies should bethe same. In other words, dividend policy does not matter. The choice of choosing differentdividend policies cannot affect the current value of the firm.

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