Lahore School of Economics

Which dividend policy is the best?

Financial Management II
Adil Ahmad Kamal Aziza Emaan Burki Fahad Akhtar Chaudry Fahad Saeed Jamal Atif Munj Khwaja Fahad Liaqat Mahnam Zahid Submitted to: Ms. Samra Chaudery 6/4/2013

Research Paper

Abstract

For many years models are developed for the understanding and to inscribe on research of dividends policies but they havent decided it that which policy is the best policy. Dividends policy is a policy which decides that what portion is to be given to shareholders of a firm and there are three major dividend policies (bird in hand theory, tax preference theory and MM theory). The topic of are research is quite interesting for the point of decision making and to decide which policy of dividends is the best policy and how to prove is quite intricate but trying is our hope. This paper carries views of different researchers and authors about three major dividend policies. and after carrying this research we conclude that every dividend policy has its own significance and we cannot say that one dividend policy is the best, all of them are equally important as companies and investors have their own goals and interests.

Introduction
Questions and issues regarding dividends and dividend policy have always been a topic of interest in finance. There are three main dividend policies: Bird in hand theory, dividend irrelevance and tax preference. Frankfurter et al. (2004) state that dividend theories and hypotheses can be categorized into six classes:

1. The bird-in-the-hand theory, according to which the only reason for the corporation to exist is to pay dividends to its shareholders. 2. Tax effects for both corporations and individuals. 3. Clientele effects 4. Signaling with dividends. 5. Agency theory and free cash flows. 6. Sociological and psychological theories.

The dividend irrelevance theory was put forward by Miller and Modigliani. Khan, Burton and Power (2011) stare that according to MM, the dividend paid by a firm does not influence its market value since it will be matched with an equivalent capital loss; this theory of irrelevance has been supported by a number of authors including Black and Scholes (1974), Miller and Scholes (1982) and Kaleem and Salahuddin (2006). (Managerial views about dividend policy in Pakistan, 2011)1

Conversely, this argument becomes invalid in the presence of tax and transaction costs. Further criticism of the dividend irrelevance theory comes from the assumption that there is no information asymmetry. According to the bird in hand theory, developed by Myron Gordon and John Lintner in opposition of the Modigliani-Miller dividend irrelevance theory, Investors think dividends are less risky than potential future capital gains, hence they prefer dividends. This implies that investors are indifferent to whether their returns from holding a stock arise from dividends or capital gains. Therefore stocks with high dividend payouts are preferred by investors and consequently command a higher market price. The third theory, which is the tax preference theory, suggests that investors prefer lower payout companies for tax reasons. This is because long-term capital gains let the investor to put off tax payment until they decide to sell the stock. Furthermore, due to time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future. According to Khan, Burton and Power (2011), in contrast to the dividend irrelevance argument of MM (1961), dividend policy was considered to be an important decision for firms in Pakistan by all those who were interviewed. The interviewees were 23 Pakistani officials who were considered to be knowledgeable about their organizations payout policy. One of the main reasons for their view regarding the importance of dividend policy was a belief that an active dividend policy is an effective tool for attracting investment (Lintner, 1956; Brav et al., 2005).

Discussion
In our research we came across various theories and hypotheses concerning which dividend policy is the best or most preferable. There are several concepts that we are going to shed light to for a better understanding before we can conclude anything. Dividend policy depends on the market structure in accordance with the policies of the country. The leading concepts of dividend policy are firstly, dividend payments can positively alter the market value of the firm (Gordon, 1963; Linter, 1956). Secondly, a positive variation in the dividend decreases the value of the firm (Litzenberger and Ramaswamy 1979). Thirdly, dividend policy does not affect the market value of the firm (Miller and Modigliani 1961). Frankfurter et al. (2004) surveyed 23 financial and 80 non-financial dividend paying Canadian firms. 22.3% of the 80 non-financial firms disagreed or strongly disagreed with the bird in hand theorys assumption that investors generally prefer cash dividends today to uncertain price increases in the future. However 51.6% agreed or strongly agreed with the theory while 26.3% had no opinion. On the other hand, 12.3 % out of the 23 financial firms disagreed or strongly disagreed with the bird in hand theorys assumption while 52.7% agreed or strongly agreed. 35.0% had no opinion. Talking about tax preference and dividend clientele, 34.0% of the non-financial firms disagreed or strongly disagreed with the theorys assumptions while 13.0% agreed or strongly agreed with it. 53.0% had no opinion. Moreover, 34.6% of the financial firms disagreed or strongly disagreed whereas 09.0% agreed or strongly agreed. 56.4% had no opinion. (H.K. Baker et al. / Global Finance Journal 19 (2008) 171186 Table 4).

According to the research made by (H. Kent Baker and Gary E. Powell) in the article almost 83 percent of respondents agree with the statement that a firm should set a target dividend payout ratio and periodically adjust its current payout toward the target. The bird in hand theory supports this format of dividend payment and keeping of retained earnings for future growth of the company. Although it is generally believed that a firm should strive to maintain an uninterrupted record of dividend payments, the bird in hand theory is not the only most preferred way of doing business by company and its shareholders. On the other hand according (ADESOLA AND OKWONG, 2009) states that in both developed and developing countries, the paying of dividends and or keeping of more of the retained earnings by the company has been a pressing issue for both investors and the shareholders. According to the result of the empirical research conducted in the article, suggests that though both the bird in hand theory and dividend irrelevance theory play very vital role for the shareholders & share price of the company in the market. The bird in hand theory has more significance and so the companies should follow a generous dividend policy so that the long term benefit of the stockholders can be maximized.(Nyong 1990, Adesola 2004). Another article talks about that the MM theory that MM require the firms to pay 100percent of the free cash flows they have in every quarter and this way the company cannot keep any cash to further invest .This way the company can only concentrate on either repurchasing the stock or to give high dividends. These points towards the dividend irrelevance theory which can be explained by either MM or Brennan Rubinstiens neutral investment approach in a perfect capital market. But the main process that is skipped in the MM theory is the agency costs which cannot be ignored in the real world so this study points towards the neutral investment approach being the better one.

The article (Distributions, the UK Companies Act of 2006) looked into the methods used by MiMo(1961) in the analysis of the impacts of the dividend payouts and the payout ratios of companies .The article had a lot of emphasis towards the research methods which were skipped during the interpretations of MiMO(1961).The researches excluded the dividends as a determinant of the value of the shares and they also did not give any attention to the differences between income of the firm and the capital of the firm. So this article points towards the Dividend irrelevance theory but it insists that there has been a lot of critical scrutiny on this theory without any sound proof to prove this theory wrong.

Weigand and Baker stated that the trends of dividends have changed over the years. Many companies pay cash as the dividends but that trend is changing now and companies now prefer share repurchases they are profitable from the tax preference theory this way when the stock is repurchased the company does not give cash dividends so it saves on the taxes and does not lose money .Secondly By repurchasing shares of the firms stock, management may signal that the current stock price is less than the stocks real value. The stock repurchase also saves the company the agency costs in the shares and also the minor floatation costs can be saved. This way the company can control the value of the shares in the market and also their cash flows.

The relationship between investment opportunity and the dividend payout policy should also be measured and it is studied in great detail in a research conducted by Joshua Abor (2009). The authors research is based on data collected from 34 emerging market countries which was collected over a time period of 17 years from the year 1990 till the year 2006. The main purpose of the study was to be able to determine the nature of the relationship between investment

opportunity set and the dividend payout policy. The findings of the study reported that there is a negative relationship between investment opportunity set and dividend payout policy. However, this relationship is not negative in every case. There are certain cases where there is a very insignificant on corporate finance, particularly areas pertaining to external financing, debt leverage and debt maturity on dividend payout policy. While the general norm is that firms that are highly profitable tend to give out higher dividends, in emerging and under developed markets, this is not the case. In such markets, the dividends payout policy requires the dividends paid to be kept low. Moreover, correlation between stock price changes and the dividend yields for the shareholders is one that has been studied in great detail in a number of studies. In a study by Khaled Hussainey (2009), a number of different methods were used to analyze the nature of the relationship between dividend yields and the changes in the stock prices. A sample of firms from the London Stock exchange was taken which were then used to analyze this relationship. There were multiple regression analyses used in order to be able to establish this relationship. The study found out that the relationship between stock prices and the dividend yield is positive. This means that in periods when the price per share was high, the resulting dividends were high as well. However, there were certain limitations to the study. The foremost limitation was that only a few companies were selected for the study and the results could have been different, if more companies were selected for the research or if a different market was being taken into consideration. The dividend policies of banks in Pakistan can be determined by essential factors such as capital ratio, earnings per share, last year dividends and the size of the bank (Imran. et al., 2013). The agency problem is settled when dividends are paid out and the money is protected from being

invested into unprofitable projects when used in the form of free cash flow. However, cash flows are negatively related to dividend payouts as an increased cash flow would mean that there may be several other investment opportunities to be availed instead of it being paid out as dividends. Banks in Pakistan follow a stable dividend payout policy pattern as they do not want to avoid or decrease from the level of last payout as they consider it to be most effective for reducing the agency problem (Imran. et al., 2013). In an imperfect market setting where complete information about the market or company is not available, cash dividends are seen as signals determining expected cash flows (Bhattacharaya 1979). Reason being, dividends are taxed at an ordinary income tax rate, however, capital gains are taxed at a lower rate. The assumption considered here is that the life of the asset that is invested into by an agent surpasses the life of the agent himself and ownership of the asset is transferred to other agents. Bergeron (2012) enlightens the research explaining that relationship between dividend and consumption risk; the dividend payout ratio of a stock is negatively correlated to its long-run dividend beta (risk). According to this a firm with a long-run dividend beta of one is advised to select a target dividend payout ratio identical to the market, whereas a firm that is more risky should select a payout ratio less significant than the average, and vice versa. The concluding remarks of Bergeron (2012) stated that the riskier the firm the more it would reinvest its earnings back i.e. pay less dividends. According to the researchers Wang, Mary and Wandle, the firms in U.S which are paying dividends have a stable payout rate of dividends over time also in other countries. The payout rates of Chinese firms respond suddenly with the earning changes as per the developing

countrys dividend policy. For Chinese firms the actual payout ratio lies between the average emerging markets firm and developed firms payout ratios. As day by day China is becoming an important part of global economy, it has strong corporate policies, tax rules, and the role of the State. As the state ownership decreases it results into the incidence in payouts of the regular cash. The cash dividends payments in corporate organizations are consistent with a lot of stakeholders on the basis of its position to appropriate the wealth also from the individual investors. The support behind these findings is of the agency and the dividend policy theories of tax clientele. Fuller and Goldstein found out in there research that when the dividend matters the most on the basis of the market conditions which was not given light on. They examined and found out that the dividend paying firms perform more than the non dividend paying firms at the time when market declines or when the market of something is increasing. If we want the dividends to be irrelevant than the dividends should be irrelevant in all situations, now the dividend paying and non paying stocks must not vary according to the time and the condition of the market. Now the payment of dividends is very difficult in the economies that are declining due to the rise in the rise in financial distress. Most of the tests almost failed to support the free cashflow hypothesis in the case or signaling the other. The main findings of the paper is that the stokeholders do better in dividend paying stocks than the investors who are investing in the non dividend paying stocks mostly in the market recession. Najjar (2009) used relevant and appropriate tools that highlight the factors which demonstrate the similar factors between dividend policy decisions used in developed countries and in Jordan's emerging firms. Jordan's emerging market is owned, in majority, by large owners (institutional owners) which indicate that the perception to be taken into consideration is high capital gains rather high dividend payout ratios. This is in equilibrium to the Lintner's model referred to in this

case which highlights the fact that Jordanian Firms are faster in adjusting their target payout ratios, compared to developed markets. Considering the data set used in this paper, Lintner's model is considerable focusing on the independent variables, Leverage ratio, Business risk, asset ratio, profitability ratio, etc, having their own importance individually. In developed countries, MM's Irrelevancy theory is widely used due to its assumption of perfect market, where as in developing countries, as Jordan's emerging market, it is a weak or semi-strong efficient market, where information is not readily available. Thus, it does not provide sound indication of the signaling effect. Michaely and Roberts (2010) in reference to Lintner (1965) theory, question reasons as to why firms are reluctant to cut dividends or smooth them out on the basis of the structure of the firm. Firstly, the investors reactions to such announcements are a hazard for managers as dividend omissions may result in the equity price to fall; the reaction may increase or decrease asymmetrically. For private firms the sudden change in value is less obvious and potentially not important in the decision making process due to variations in information content. Brav et al. (2005) reports that privately owned firms tend to give dividends in response to minor changes and have unpredictable dividend policies. Public companies tend to smooth out their dividends more than private firms and are less likely to alter their dividend payments in response to sudden changes and shocks. According to Michaely and Roberts (2011) private wholly owned firms (firms owned by close kin) are the closest to Miller and Modigliani (1961) irrelevance theory as they are accounted to the least severe information and agency problem. One such contribution is to provide explicit evidence that dividend smoothing is directly tied to the scrutiny of the public capital markets. Whereas, dividend policy for private firms seems to be that of residual financing that takes place after investment decisions.

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Conclusion

After searching, analyzing and competing each policy with each other we are on a conclusion that each policy is very significant, as Frankfurter et al. (2004) carried a survey which shows that different firms prefer dissimilar dividend policies. As stated in this paper that shareholders and investors have their own preferences and interests, some prefer to take high dividends amounts annually and some prefer capital gains. On the other hand firms has its own goals and preferences, some prefer paying of dividends and some prefer keeping more of the retained earnings, because of which they support different dividend policies. After studying all the articles finally we suggest that it is bias to specify one dividend policy to be titled the best.

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References

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