Dividend Policy and Its Impact on Firm Value: A

Review of Theories and Empirical Evidence

Abstract: The Empirical and theoretical research on dividend policy has produced an
extensive volume of literature.The research are categorized into two different schools of
thought, the first is that dividend policy of a firm has an impact on its value and the second is
that dividend policy of the firm has no impact on firm value. Even after several years of
research no consensus has emerged, and scholars do not even agree upon with the same
empirical evidence. This study provides with a complete understanding of dividends and
dividend policy by reviewing the theories and their explanations of dividend policy including
both dividend relevance and irrelevance theory of Miller and Modigliani, tax-preference,bird-
in-the-hand, clientele effects, signaling and agency costs hypotheses. This study also attempts
to present the important empirical studies on corporate dividend policy. However, due to the
continuing nature and extensive array of the debate about dividend policy which has hatched a
vast amount of literature that grows by the day, a full-fledged review of all debates is not
feasible.

Key Words: dividend, dividend policy, review, theories

I. INTRODUCTION
The prime objective of financial management in organizations is to maximize its value to the
owners and the shareholders. Though this is challenged by many researchers, the value here
often understood to be reflected in the company’s share price. According to Barman if
dividends are the key indicator of share price and then share price is the key indicator of firm
value,so as to maximize shareholders wealth, the company should adopt a dividend policy that
will increase the share price [1]. When a company makes profits, it can either decide to retain
the profits for investments in new projects or pay out to the shareholders as dividends.

Dividend policy refers to the set of rules or norms that a company follows to decide how much
of its profit it will pay out to shareholders. However, the choice of paying dividends is
ultimately decided by the board of directors of the company, and once dividends have been
declared, it becomes a debt to the firm and cannot be overturned easily [2]. There are various
forms and ways in which dividends can be
paid; a company may decide to pay dividends in the form of cash once or twice in a year or declare
bonus shares. According to Erasmus, from an investor’s perspective, it is not only the level of dividend
payment that may be imperative, but also the stability of dividend payments for a considerable period
[3]. Thus, management should be cognizant of the fact that unanticipated changes in dividend payments
could alienate existing and potential investors [3]. Unstable dividend policy may have an adverse
investors’ perception of the company performance in the financial markets.

This paper intends to provide an understanding of dividend policy by reviewing the existing
theories on dividend policy and their empirical findings. Furthermore, the paper examines the
empirical studies carried out by investigating the relationship between dividend policy and firm
value as measured by its share price and company performance.

II. THEORIES ON DIVIDEND POLICY

A. Introduction
When it comes to dividend theories, there are two foremost schools of thought, the first is that
dividends have an impact on firm value and the second is that dividends do not have an impact on
firm value. This section presents a review of existing theories on dividend policy and their empirical
evidence. The theories on dividend policy are divided into two groups main that include dividends
relevant theories and dividends irrelevant theories. It was seen that the beginning of dividend policy
as important to investors was, to some extent, determined by the evolving state of financial markets.
Investing in shares was initially seen as comparable to bonds, so consistency of dividend payments
was important. It was also seen that in the absence of regular and precise corporate reporting,
dividends were often preferred to retained earnings, and often even observed as a better sign of
corporate performance than published earnings accounts. However, as financial markets developed
and became more efficient, it was thought by some researchers and academicians that dividend
policy would become increasingly irrelevant to investors. Dividend policy remaining evidently
important for researchers has been a theoretically controversial.

Three main opposing theories of dividends can be acknowledged. Some argue that increasing dividend
payments increases a firm’s value. Another view claims that high dividend payouts have the opposite impact
on a firm’s value; means, it reduces the firm value. The third theoretical approach emphasizes that dividends
should be irrelevant and all effort spent on the dividend decision is wasted. These views are incarnated in
three theories of dividend policy: high dividends increase the share price theory (‘bird-in-

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the- hand’ argument), low dividends increase share price theory (argument of the tax-preference), and
the dividend irrelevance hypothesis. Dividend debate is not narrowed to these three approaches. Several
other theories of dividend policies have been existing, which further intensifies the complexity of the
dividend puzzle. Some of the very popular of this dividend policy theory include the information content
of dividends (signaling), the clientele effects, and the agency cost hypotheses.

i. Dividends irrelevant theories

a. The Miller and Modigliani (M-M) model: Erstwhile to the publication of the influential paper by
Miller and Modigliani, it was extensively accepted that the more dividends a firm pays, the greater
the value of a firms [4]. According to Allen and Michaely , this is resulting from the extension of the
discounted dividends approach to firm value [5]. Theory states that the value of the firm (VO) at
date 0, if the first expected dividends are paid after a year, can be calculated as follows:

Where, Dt is the dividends paid by the firm at the end of

period t r1= the required rate of return
Gordon [6] as cited by Allen and Michealy [5], has claimed that the investors’ required rate of
return r1 would increase as a result of increased retained earnings. Gordon felt that higher r1
would dwarf this effect although future dividend stream would probably be higher as a result of the
increase in investment (i.e., Dt would grow faster) [6]. The reason for the increase in r1 would be
higher uncertainty concerning cash flows due to the delaying of the dividend stream.

The M-M model (1959) disagreed with this relevance dividend theory view and pointed out a rigorous
framework for analyzing dividend policy [4]. Miller and Modigliani investigated the impact of dividend
policy on share price of the firm [7]. They exhibited that given a perfect capital market; a firm’s dividend
policy will not impact the firm’s value. The basic idea underlying their argument is that firm value is
determined by firm its present and future cash flows (i.e. a firm’s capital investment decisions). M-M
(1961) showed that shareholder wealth is not affected by the dividend decision alone, and also argued that
the investors would naturally be indifferent to the choice between dividends and capital gains. M-M (1961)
further claimed that if investors needed income, they can essentially create their own homemade dividend
policy by selling their existing equity shares. As cited in Malkawi et al , M-M (1961) upheld that in their
perfect world, dividends are irrelevant. M-M (1961) pointed out that regardless of how the firm

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distributes its earnings; its value is basically determined by its earning power and its investment
decisions [8].

According to M-M (1961), the irrelevance dividend policy argument was based on two basic assumptions
i) Perfect capital market and ii) Rational investors. In the perfect capital market, all traders have
equal and perfect information about the current share price and all other relevant characteristic of
shares. In this perfect capital markets there are no transaction fees, breakage fees, taxes and other
cost. Second, perfectly rational investor’s preferences are indifferent as to whether a given
increment to their wealth is in the form of cash (dividend income) or gain in market price of the
share (capital gains). Thirdly they base their argument on the idea of perfect certainty, which
indicates complete assurance on the part of every investor as to future investment decisions of the
firm and the future profits of every corporation. Because of this assurance, there is no need to
distinguish between equity share and debenture as a source of finance [7].

According to the MM Hypothesis of dividend irrelevance, “the value of a firm is basically

determined by the firm’s investment and financing decisions. Dividend decision has no role in
increasing or decreasing the value of the firm” [1]. The conclusion of this theory is that
management should not burden itself much about dividend policy when it comes to firm value, as
the decision of whether to pay or not pay dividends, has no impact on the value of the firm.

Empirical evidence of the M-M model: The M-M hypothesis is based on a perfect capital market
assumption. In reality, markets are imperfect. Soothing the assumption of a perfect market, Black and
Scholes investigates to see whether dividend policies are relevant and have an impact on increasing or
decreasing firm value [9]. Black and Scholes instituted a portfolio of 25 common stock listed on the New
York Stock Exchange (NYSE) to investigate the relationship between dividend yields and stock returns
[9]. The underlying model used was the Capital Asset Pricing Model. After the 25 portfolios were
constructed, five years of past data was used to estimate the standard deviation beta (β) and
dividend yield was calculated for all the stocks that had at least five years of past data.

In reckoning the dividend yield of a security, Black and Scholes model used dividend paid to the
shareholders in the previous five years, and the market price at the end of every year for the same five
years. The securities were ordered on estimated yield from maximum to minimum, and separated into
five groups. The result of the model did not prove that differences in dividend yield lead to differences in
stock returns. Thus it looked like the dividend policy have no impact on the stock prices [9]. Black and
Scholes results are consistent with the dividend irrelevance theory which states that dividend policy has
no impact on the firm value.Over years of researches, four main theories of dividends relevancy have
been existing: The bird-in-hand hypothesis, signaling theory,tax preference and agency cost theory.

b. Bird in Hand Theory: Myron Goldon and John Lintner developed the bird in the hand
theory [10]. They argue that there is a relationship between dividend payout and the firm’s value. Since
investors value capital gains as risker than dividend, firms have to have a higher dividend payout ratio
tomaximize the share price. In other words, high dividend payout upsurges the stock price [11].
The fact of the matter is the risk of a firm is determined by the risk of its cash flows generated by its
investments, which cannot be changed by dividend policy; therefore, the bird in hand explanation may not
hold factual. In other words, the risk of a firm cannot be reduced by an increase in the dividend payments

[12]. Generally, the bird in hand justification for dividend significance is rejected by most of the
financial economics literatures.

Empirical evidence of the Lintner Model: In contour with Lintner’s study a research was carried out by
[13]. The study investigated the corporate managers of NASDAQ firms that regularly pay cash dividends to
determine their insights on dividend policy and the relationship between dividend policy and firm value to
observe how they view dividend policy. The sample size was 188 firms. The main result of the survey
indicated that NASDAQ managers believed that dividend policy affects firm value as reflected in shares price,
and concluded as dividend policy matters [13]. Further findings point out that more than 90 percent of
managers agreed that a firm should dodge increasing its regular dividend if it expects to reverse the dividend
decision in a year or so. The firms should attempt to maintain stable dividend payment.

Furthermore, the Baker et al, revealed that the majority of managers thought that the market places greater
value on stable dividends than stable pay-out ratios. More than 60 percent agreed that the firm should set a

target dividend pay-out ratio and periodically adjust its current pay-out toward the target. All these findings
are in line with Lintner’s (1956) behavioral description of the dividend setting process [10].

Further findings reveal that 90 percent of managers agreed with the statement that an optimum
dividend policy strikes a balance between present dividends and capital gains that maximizes the share
price. More than 80 percent of managers agreed that a firm should articulate its dividend policy to
produce maximum value for its shareholders and 65 percent agreed that a change in a firm’s cash
dividend will have an impact on its value. Based on this evidence Baker et al concluded that managers
generally perceive that firms today set dividend payments in line with that put forth by Lintner.

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c. Signaling Hypothesis: Signaling Hypothesis argues that there is an existence of

asymmetric information between managers and shareholders. Modigliani Miller Hypothesis assumed
that in a firm, information is available for insiders and outsiders are same; but managers may have
information pertinent to the value of the firm which outside investors do not have (Robinson, 2006) [11].
This information gap illuminates the way managers use dividend declaration as a signal which expresses
valuable information about future performance of the firm to investors. signaling hypothesis argues that
the shareholders may construe an increase in dividend payment as a signal of future profitability; hence
in a positive reaction, the share price will rise and vice versa. [14]. Signaling hypothesis of dividend
policy is supported and cited by many researchers such as Bhattacharya [12] and Miller and Rock [15].

Empirical evidence of the signaling theory: Kaestner and Liu [16]examine the information content of
dividend announcements and found strong support for the cash-flow signaling hypothesis. They
pointed out that on average the stock price response is positively and significantly related to the size
of dividend payment. They further infer that the market perceive dividend payments as a
significant source of information about the performance of the firm.

DeAngelo et al [17] analyzed the signaling theory of dividends. In order to evaluate the empirical significance
of dividend signaling, they investigated the signaling content of dividend decisions made by managers of 145
firms listed on the New York Stock Exchange (NYSE) whose annual earnings decreased after nine or more
consecutive years of growth. In their sample of 145 firms, 68.3% of managers increased dividends in Year 0,
which is the year that the firm’s earning started declining after a consecutive years of growth in profit . They
were not able to establish that the sample manager’s dividend decision in the year of the earnings decline
(year 0) is a useful signal of future earnings prospects.

According to DeAngelo et al, [18] there was no indication that Year 0 dividend increases are associated
with favorable future profit of the firm. They further showed that the evidence shows that there are
three other factors which explain the favorable dividend actions of the firms studied are not informative
signals about future earnings prospects. The three factors they identified are the overoptimistic
approach of the managers; secondly, very modest resource commitments by the firm and thirdly, to
certain extent, manager’s inefficiencies. On the whole their study offers almost no support of the
signaling hypothesis. DeAngelo et al, in their conclusion stated that they found that the dividend
signaling is empirically insignificant and they pose a difficult challenge to the opposite view that
dividend signaling is a fairly important determinant of corporate dividend policy [18].

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Benartzi et al [19] did a further research to examine the implications of dividend signaling. The
study investigated whether the changes in dividends have information content about future
earnings. 1025 organizations listed New York Stock Exchange (NYSE) and American Stock
Exchange (AMEX) is the constituent of their sample. They concluded that there is a strong lagged
and contemporaneous correlation between dividend changes and earnings (Dividend go up when
there is an increase in earnings) from the empirical data but they were unable to find much
evidence of a positive relationship between dividends earnings and future earnings changes.

d. Agency Costs and Free Cash Flow Hypothesis: Modigliani and Miller

approach assumes that there is no conflict between managers and shareholders [7]. However, in
reality, this assumption may not hold true since managers’ interest and the shareholders interest
are not exactly the same. Therefore, the shareholders may incur agency cost, causing potential
conflict between manager and shareholder. The agency costs theory put forward that increasing
dividends is one way of decreasing the agency costs. By paying more dividends the level of reserves
and surplus will reduce and firms have to search for fund from external financing. The agency cost
elucidation for dividends has been reinforced by previous empirical studies [20]. Furthermore,
Easterbrook stated that higher dividends will reduce the available free cash flow for managers;
managers will be entrusted with the job of raising funds from external sources. Shareholders can
prevent managers from acting in self-interest besides monitoring them at low cost [21].

Empirical evidence of the agency theory: La Porta et al [22] in his research investigated agency cost
hypothesis. They studies 4103 companies from 33 countries around the world. These countries are
grouped into two, based on legal protection provided to minority shareholders as countries that provide
good legal protection for minority shareholders and countries where shareholders had poor or no legal
protection. The authors then used cross-sectional analysis for these two groups to study the agency
approach to dividend policy. Two models are used to analyze the influence of investor protection on
dividends payout; one being outcome model and the other is the substitute model. According to the first
model, dividends are an outcome of the strong and effective legal protection available in that country to
the shareholders, which helps minority shareholders to receive dividends from corporate insiders. In the
second model, they pointed out that dividends are a substitute for effective legal protection, which
enables firms in low or unprotected legal environments to establish a reputation of following healthier
dividend policy among the investors. The author’s findings are in line with and also in support of the
agency cost hypothesis. La Porta et al concluded that agency approach is highly significant in
understanding of corporate dividend policy world over [22].
Rozeff study also offers empirical evidence of the agency cost hypothesis. 1000 firms from 64 different
industries were taken as samples for this study [20]. This paper justifies an optimal dividend payout by
engaging to two market imperfections, agency costs and the transaction cost associated with issuing
external finance. He presented the cost minimization model which aims at finding out if dividend payout
ratios are consistently related in the predicted direction to variables which are proxy for agency cost and
transaction costs of external financing. His findings are in line with the hypothesis that outsiders
demand a higher payout if they own a higher fraction of the common equity than if their ownership is
more dispersed. In Addition to this, he argued that increased dividend payout lower agency costs but is
sure to raise the transaction of external financing [20].

e. Tax-Effect Hypothesis [23]: The Modigliani Miller Hypothesis assumes that

dividends and capital gains have no difference with respect to taxes. However, in practice, taxes
may have influence on dividend payments and more importantly, on the value of a firm. The tax
preference hypothesis advocates a low level of dividend payouts is desirable so as to maximize the
value for shareholders. This argument is based on the dividends are taxed at a higher rate and that
too immediately when compared to capital gains, which are postponed until the stock is sold. The
advantages of tax for capital gains motivate investors to prefer firms that retain their earnings
rather than pay dividends. As a result, a low level of dividends will raise the stock price.

Empirical evidence the Tax Factor (Clientele effect): Y-T Lee et al [24]did a comprehensive study to
analyze the tax induced clientele effect. Their study was based on companies listed in Taiwan stock
exchange where capital gains tax is zero and share repurchase was prohibited until 2000. They found
solid evidence of clientele effect. In analyzing investors’ reaction to dividend changes, they pointed out
that institutions as a group display an insignificant response to dividends changes, however individual
investors appear to respond in the direction predicted by the clientele hypothesis. High net worth
individuals (who are in higher tax bracket) reduces their net buying after dividends increase and
increase their net buying after dividends decrease, while less wealthy individuals do the opposite.

Overall the Y-T lee et al study provides proof that Taiwanese shareholders arrange themselves into dividend
clientele, whereby highly taxed individuals tend to hold stocks in firms that pay low or zero dividends and
they trade shares of the firms that increase dividend payout. On the other hand individuals and institutions
who fall under lower tax brackets tend to hold stocks of the firms that pay high dividends [24]. Furthermore,
when Taiwan legalized share repurchase, they found that firms with higher

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concentration of highly taxed high net worth shareholders engaged in share repurchases. The
authors pointed out that tendency to engage in activities like repurchase are significantly related to
the proportion of a firm’s shareholders in higher tax brackets” [24].

Divergent to Y-T Lee et al provided a strong empirical evidence on tax induced clientele effect, Lasfer [25],
Hotchkiss and Lawrence [26] in their research could not find such a strong evidence between dividends and
tax. Lasfer’s investigation shows that companies frame their dividend policies to reduce their tax liability and
to optimize their after tax return of their shareholders. Lasfer [26] concluded that there was no strong
evidence of a tax-induced dividend effect. On the other hand Hotchkiss and Lawrence
[26] state that their results contradict with literatures which concludes that tax based dividend
clienteles are not important, based on the fact that dividend changes do not amount to enormous
changes in total institutional ownership (See also Michaely, Thaler and Womack, 1995 [27]; Binay,
2001 [28]; Grinstein and Michaely, 2002 [29]).

III. CONCLUSION
This study reviewed the existing theories on dividend policy and their empirical findings. From the
reviewed literature, it can be established that dividend policy theories have divergent relevance between
management and the shareholders arising from opposing interests. Management is primarily focused on
the objective growth of the organization while the shareholders are focused on the shareholders wealth
in terms of share price that determine their return on investment. The empirical studies reviewed show a
positive relationship between dividends payout and firm value. Although abundant theories and
empirical evidence have attempted to illuminate why dividends are paid, their results are still
inconclusive. This study conclude with statement “the harder we try to understand the dividend
decisions by firm , the more it seems like a puzzle, with pieces that just do not fit together”

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