Professional Documents
Culture Documents
Ahsan Aslam
Ahsan Aslam
Reg # l1f19bsaf0096
Dividend Theory
Dividends and share price growth are the two ways in which wealth can be provided to shareholders.
There is an interaction between dividends and share price growth: if all earnings are paid out as
dividends, none can be reinvested to create growth, so all profitable companies have to decide on what
fraction of earnings they should pay out to investors as dividends and what fraction of earnings should
be retained.
The term dividend refers to that part of profits of a company which is distributed by the company
among its shareholders. It decides the proportion of equity earnings to be paid to equity share holders
& the remaining proportion of net earning are retained in the firm . Payment of dividend is has two
opposing effects.
Relevance Theory
According to relevance theory dividend decisions affects value of firm, thus it is called relevance theory.
Walter’s Model ,Gordon’s Model.
Irrelevance Theory
According to relevance theory dividend decisions do not affect value of firm, thus it is called irrelevance
theory. Residual Theory, Miller & Modigliani Hypothesis ( MM Approach)
Dividend Decisions
3.Argues that the dividend policy affects the value of the firm
Internal financing
Constant return & Cost of capital
100% payout/retention Constant EPS and DIV
Infinite time
GROWTH FIRMS
Expand rapidly
Yields returns higher than opportunity cost (r>k)
Value per share is maximized if all earnings are retained
Optimum payout ratio is 0%
NORMAL FIRMS
DECLINING FIRMS
The firm do not have any profitable investment opportunities to invest the earnings –
They earn on their investments rates of return less than the minimum rate required (r<k)
Optimum payout ratio is 100
Dividend policy do not affect the firm’s value – it is affected by the investment policy
The shareholders do not necessarily depend on dividends for obtaining cash
P0=DIV1+P1 (1+k)
The firm has sufficient cash to pay dividends: Shareholder’s get cash ; but firm’s assets drop
(cash)
The firm issues new shares to finance the payment of dividends: Shareholder’s get cash ; but
they forego their claims on assets in favor of new shareholders
The firm does not pay dividend but shareholders need cash: Shareholders can create ‘home-
made dividend’ (selling off part of their shares) ; the effect will be same as that of the second
case
However, this equilibrium is reached only if the amounts retained are reinvested at the cost of equity.
So, no change in the share value, and so the dividends are irrelevant.
In this case, the share price rises because the extra earnings retained have been invested in a
particularly valuable way.
In summary:
If the company retains earnings and uses those to ‘do more of the same’ then the share price
should not be affected.
If the company retains earnings and uses those to produce higher returns than demanded by
investors (and that could be through expanding current operations to become more efficient
and cost effective) then dividends should be cut as that will increase shareholder value.
If the company retains earnings and uses those to produce lower returns than demanded by
investors (and that could be through keeping excess cash in the bank, earning very little) then
dividends should be increased to avoid the share price falling. If the company can think of no
good use for its earnings, it should distribute them to shareholders who can then decide for
themselves what to do with them.
Practical considerations
As so often occurs, theoretical outcomes do not always match practical considerations. So too with
dividend irrelevancy. Perhaps this is because investors do not understand or believe the theory or
perhaps it is because, to derive the theory, simplifying assumptions have to be made, such as the
existence of perfect markets with no transaction costs and perfect information.
Lack of trust in directors’ forecasts or justifications for dividend cuts. Really, this point follows on
from above. Directors might have been very open about a dividend policy but if investors do not
share directors’ optimism about the future success of the company, the share price will be
affected.
Investors’ preference for current consumption rather than future promises (the ‘bird in the
hand’ argument). Here, it is argued that a current dividend means that investors have safely
received cash. Whereas, if the dividend were deferred they are at the mercy of future events
and risks. This argument is very persuasive, but it is incorrect. Market forces should mean that a
share price has been correctly set for the level of risk and returns made. If more cash is paid out
as dividend the investor has to decide how to invest that cash. It could be spent on another
investment which has higher returns and higher risk or on one where both returns and risks are
lower. In either case, diversified investors should be happy with the deal because the capital
asset pricing model states that extra risk is correctly compensated for by extra returns.
The clientele effect. This idea suggests that investors buy shares that ‘suit’ their needs. So, a
pension fund will base much of its investment portfolio on its need to produce income to pay to
pensioners. It will therefore invest heavily in shares that pay regular, relatively predictable
dividends. Similarly, tax can affect investment decisions if gains are taxed less severely than
income. If a company abruptly changes its dividend policy it will disturb investors’ carefully
constructed portfolios and investors will have to adjust their mix of shares incurring transaction
costs. It is sometimes argued that if a cut in dividend reduces an investor’s income, the investor
can sell some shares to manufacture ‘income’. Of course, this will again incur transaction costs
and different tax treatment.
Company liquidity. Irrespective of all the potential share price movements that a change in
dividend policy might cause, companies have to ensure that their liquidity is sound and might
have dividend reductions forced on them if they are to stay solvent.
Borrowing covenants. Sometimes lenders put clauses in loan agreements which limit dividend
payments, for example to a certain fraction of earnings. This is the lender trying to ensure that
the loan is more secure. If less cash is paid as dividends, liquidity might be better (though, of
course, cash can still be consumed on the purchase of non-current assets).
Here is perhaps a good place to mention scrip dividends. These allow shareholders to choose to receive
shares as full or partial replacement of a cash dividend. The number of shares received is linked to the
dividend and the market price of the shares so that roughly equivalent value is received. This choice
allows investors to acquire new shares (if they don’t need the cash dividend) without transactions costs
and the company can conserve its cash and liquidity. There can also be beneficial tax effects in some
countries.
Constant dividends: in this approach dividends are predictable but shareholders might be
dissatisfied if they see earnings rising but they are stuck will low dividends. If a larger and larger
fraction of earnings is retained, shareholders might begin to question whether the company can
find enough investment opportunities of the right quality.
Constant growth: again, predictable and very attractive to shareholders. However, the dividend
growth rate might not match earnings growth rate.
Constant pay-out ratio: for example, (1 – b) = 25%. A clear and presumably logical link between
dividends and earnings. However, in some circumstances this policy might produce signals that
are mis-interpreted. Directors know that shareholders prefer predictable dividends and
shareholders know that directors know their preference. Therefore, shareholders might
interpret the cut as signalling that earnings are poor and will not improve any time soon. If,
however, earnings fall yet the directors maintain the dividend, this is often interpreted as
signalling that the fall in earnings is temporary and the directors feel sufficiently confident in the
company’s future to maintain the dividend in absolute terms.
Dividends as residuals: relating back to what was covered in the first section of the article,
before paying dividends, directors should first spend earnings on investments in the company
that yield:
o Investments that yield more than the cost of equity (this will increase shareholder value)
Only after these investment opportunities run out should the company pay dividends from the residual
earnings, thus allowing shareholders to make the best use they can of their receipts.
No dividend: Microsoft and Apple both went many years without paying a dividend. It is difficult
to use the dividend valuation model in these circumstance without making very contentious
assumptions about what future dividends might be. Nevertheless, share values rose dramatically
as both companies were immensely successful and, on a P/E approach to valuation, they were
plainly very valuable indeed.
Conclusion
Dividends and dividend policy will be a continuing cause of debate and comment. The theoretical
position is clear: provided retained earnings are reinvested at the cost of equity, or higher, shareholder
wealth is increased by cutting dividends. However, in the real world, where not necessarily all investors
are logical and where transaction costs and other market imperfections intervene, determining a
successful and popular dividend policy is rather more difficult.