Dividend policy

Introduction

Extant literature has been dedicated to the evaluation of dividend irrelevance theory (Al-Malwaki et al.,2010).Most of the studies were as a reaction or result of the dividend irrelevance theory that was initially published by Miller and Modigliani (1961).Until now, no agreement has been reached at after several years of research. Intellectuals too, have often disagreed over the existing empirical proof of the proposition. In this paper, we assess the view that the dividend policy of the firm is irrelevant to the rational investor. Our assessment indicates that an introduction of market imperfections completely changes the view that dividend decisions are absolutely irrelevant. Therefore, an assessment of the view that the dividend policy of the firm is irrelevant to the rational investor is absolutely correct so long as the capital market is idealistic and perfect.

What is dividend policy?

According to Lease et al., (2000,p.29) dividend policy is the practice that is followed by the management in making a company’s dividend payout decisions or, the size as well as pattern of a company’s cash distributions over a period of time to shareholders. This concept is one that for long has engaged managerial staff from time immemorial in the history of commercial corporations. It is therefore quite surprising to realize that the concept of dividend policy has remained a contentious issue within the realms corporate finance. Al-Malwaki et al., (2010) mentioned that this very concept has always been a subject of interest to financial scholars from the middle of the previous century (p.172). Most of these scholars have been obsessed with solving various issues regarding dividends as well as formulating models and theories to explicate the behavior of corporate dividend.

This dividend ‘enigma’ has therefore remained unsolved (Al-Malwaki et al., 2010).The dividend puzzle has therefore over the years remained a puzzle that is yet to be solved. The work of Allen, Bernardo and Welch (2000) expressed the contemporary consensual view on this matter by saying that even though a large number of theorems have been expressed in literature to effectively explain its existence; corporate dividend has always remained one of the most contentious puzzles within the confines of corporate finance.

Other scholars who attempted to prove dividend irrelevance theory are Black and Scholes. They did this by use of long-term definition of concept of dividend yield (which refers to the yester year’s dividends when divided by the share price at the end of the year). Their work however, indicated that neither the high-yield nor the low-yield payout decisions of companies seemed to affect stock prices. This study therefore was an empirical evidence of the truthfulness of M&M’s proposition. Another recent work that seemed to support M&M’s work of dividend irrelevance proposition is the work of Bernstein (1996).

Miller and Modigliani’s dividend irrelevance proposition

In order to assess the view that the dividend policy of the firm is irrelevant to the rational investor, we must begin by exploring the theoretical or conceptual framework that acted as the backbone of dividend irrelevance theory. This theory, which has over the years been referred to as the dividend irrelevance theory was initially postulated by Miller and Modigiliani (1961).

This theory is one of the most significant financial management theories and is based on the basic tenets of residual speculation. The authors argued that dividend policy totally has no influence on a company’s share price. In other words, they found no correlation whatsoever between the value of affirm and dividend rate. In this regard, the asserted that dividend decision is completely irrelevant of a firm’s value (Paramasivan & Subramanian,2009,p.101). In order to in order to assess the view that the dividend policy of the firm is irrelevant to the rational investor, we must employ Miller and Modigliani’s dividend irrelevance proposition as our tool of argument.

The dividend irrelevance scenario

In this scenario, there is totally no investor who has a preference between capital gains and shares. Arbitrage dictates that the dividend policy is absolutely irrelevant. The basis of Miller and Modigiliani (MM) theory is that value is always created by a company at a rate that is greater than how it is divided within the firm’s retention and dividend mechanisms. Firms should therefore, not take consideration of the concept of dividend but instead should treat it as the fluctuate derivative of the company’s financing and investment actions.This view is in complete contrast of findings of Baker and Wurger’s (2004) study on dividend behavior that indicated that at face value, shareholder dividends are quite relevant to the company’s share price.

Miller and Modigliani’s work on this residual trend therefore implies that a firm must be totally indifferent between deciding to pay dividends and obtaining external funds or retaining earnings. In other words, companies can be paying dividend while having insufficient retained earnings necessary for it to finance its investment. In this case, the company can source funds externally. MM’s work proved that the resulting loss of value in the firm’s current shares can exactly be equal to the total amount of dividends that are paid due to the firm’s decision to obtain external funding as opposed to using retained earnings.

They also suggested therefore, that dividend policy is quite irrelevant in a market that is deemed perfect. This therefore means that supporting this irrelevancy concept or argument is quite valid regardless of whether the necessary additional funding is raised via debt capital or equity capital. According to Miller and Modigliani (1961), the main determinant of a firm’s market value is therefore its investment policy due to the fact that it is what is responsible for the firm’s future profitability. Consequently, it is irrelevant if a company pays out its earnings or if it fails to do so.

In this regard, the basic disputation and recommendation guiding Miller and Modigliani’s proposition is that the manager should by all means disfavor the dividend decision and instead favor investment decisions. This makes us believe that if their proposition is indeed true then there can never be an optimal dividend policy as a result of the simple reality that the value of a firm will never be affected by such a policy.

As dictated by the Residual Theory of Dividends, dividends and cash flow behaviors should only be concentrated on after a company has ensured that all the investment decisions are made. What means is that the view that the dividend policy of the firm is irrelevant to the rational investor holds true in such a scenario.

Outcome of the assessment

The other reason as to why the view that the dividend policy of the firm is irrelevant to the rational investor holds true is because since in a perfect market scenario, dividend policy has totally no effect on a company’s cost capital or stock price and the shareholder’s wealth is therefore not affected in any way by the dividend policy. What is clear is that shareholder’s wealth is very much affected by the amount of income that is generated by the appropriate investment decisions made by the firm managers and never how that income is distributed.

Therefore ,in the words of M&M, dividends are absolutely irrelevant since regardless of how a company distributes its accrued income, its real value is determined by the level of its investment decisions and earning power. They expressed this by saying that “…given a firm’s investment policy, the dividend payout policy it chooses to follow will affect neither the current price of its shares nor the total returns to shareholders” (Miller and Modigliani ,1961,p.414). The value of companies should in a percept market situation be based on the capitalized value of its future earnings and never in any instance by its dividend decisions or outcomes.

To all investors, the various dividend policies are in reality the same due to the fact that they can all generate “homemade” dividends through a skillful adjustment of their portfolios in a manner that effectively and accurately augers with their preferences. It is important to note that M&M propositions were based majorly on impractical assumptions of an absolutely perfect capital market and very rational investors. These two conditions are never easy to come by in real life. The perfect market in this case refers to a situation whereby; (1) there is no difference existing between taxes paid on dividends and the one paid on capital gains; (2) there are no and flotation or transaction costs incurred whenever securities are successfully traded; (3) absolutely all the market participants have a free and unbiased access to the same data or information (the information is symmetrical and costless); (4) there is no conflicts of interests between the managers and the security holders and (5) all of the market participants are price takers.

As noted earlier on, there are also other scholars who have attempted to prove the dividend irrelevance theory. An example being Black and Scholes .They attempted this by use of long-term definition of concept of dividend yield (which refers to the yester year’s dividends when divided by the share price at the end of the year). Their work however, indicated that neither the high-yield nor the low-yield payout decisions of companies seemed to affect stock prices. This study therefore was an empirical evidence of the truthfulness of M&M’s proposition. Another recent work that seemed to support M&M’s work of dividend irrelevance proposition is the work of Bernstein (1996).

Conclusion

It is important to note that despite all of the efforts that have been placed in proving or disapproving the impact of a firm’s dividend policy on its value, one thing remains clear- this impact has never been solved. As noted earlier, there are several assumptions about the rationality of investors and the nature of the capital markets (must be perfect) that must be held for this proposition to hold true. Assumptions such as (1) no difference existing between taxes paid on dividends and the one paid on capital gains; (2) no and flotation or transaction costs incurred whenever securities are successfully traded; (3) absolutely all the market participants have a free and unbiased access to the same data or information (the information is symmetrical and costless); (4) no conflicts of interests between the managers and the security holders and (5) all of the market participants are price takers makes this M&M models a perfect model of how capital markets work under perfect conditions. An introduction of market imperfections therefore changes the view that dividend decisions are absolutely irrelevant. Therefore, an assessment of the view that the dividend policy of the firm is irrelevant to the rational investor is absolutely correct so long as the capital market is idealistic and perfect.

References