Dividend Policy and Firm Value - Financial Management

There are two major schools of thought among finance scholars regarding the effect dividend policy has on a firm’s value.

Dividend Policy and Value of the Firm

Although Miller and Modigliani argue that dividend policy does not have a significant effect on a firm’s value, Myron Gordon, David Durand, and John Lintner have argued that it does. Each viewpoint is discussed in this section.

Arguments for the Irrelevance of Dividends

The group led by Miller and Modigliani (MM) contends that a firm’s value is determined solely by its investment decisions and that the dividend payout ratio is a mere detail. They maintain that the effect of any particular dividend policy can be exactly offset by other forms of financing, such as the sale of new common equity shares. This argument depends on a number of key assumptions, however, including the following:

  • No taxes. Under this assumption, investors are indifferent about whether they receive either dividend income or capital gains income.
  • No transaction costs. This assumption implies that investors in the securities of firms paying small or no dividends can sell at no cost any number of shares they wish in order to convert capital gains into current income.
  • No issuance costs. If firms did not have to pay issuance costs on the issue of new securities, they could acquire needed equity capital at the same cost, regardless of whether they retained their past earnings or paid them out as dividends. The payment of dividends sometimes results in the need for periodic sales of new stock.
  • Existence of a fixed investment policy. According to MM, the firm’s investment policy is not affected by its dividend policy. Furthermore, MM claim that it is investment policy, not dividend policy, that really determines a firm’s value.

Informational Content MM realize that there is considerable empirical evidence indicating that changes in dividend policy influence stock prices. As discussed later in this chapter, many firms favor a policy of reasonably stable dividends. An increase in dividends conveys a certain type of information to the shareholders, such as an expectation of higher future earnings. Similarly, a cut in dividends may be viewed as conveying unfavorable information about the firm’s earnings prospects. MM argue that this informational content of dividend policy influences share prices, not the pattern of dividend payments per sec.

Signaling Effects In effect, changes in dividend payments represent a signal to investors concerning management’s assessment of the future earnings and cash flows of the company. Management, as an insider, is perceived as having access to more complete information about future profitability than is available to investors outside the company. Dividend changes are thought to provide unambiguous signals about the company’s future prospects —information that cannot be conveyed fully through other methods, such as annual reports and management presentations before security analysts. The signaling effect of changes in dividends is similar to the signaling effect of changes in capital structure discussed in Chapter.

Clientele Effect MM also claim that the existence of clienteles of investors favoring a particular firm’s dividend policy should have no effect on share value. They recognize that a firm that changes its dividend policy could lose some stockholders to other firms with a more appealing dividend policy. This, in turn, may cause a temporary reduction in the price of the firm’s stock. Other investors, however, who prefer the newly adopted dividend policy will view the firm as being undervalued and will purchase more shares. In the MM world, these transactions occur instantaneously and at no cost to the investor, the net result being that a stock’s value remains unchanged.

Arguments for the Relevance of Dividends

Scholars belonging to the second school of thought argue that share values are indeed influenced by the division of earnings between dividends and retention. Basically, they contend that the MM propositions are reasonable —given MM’s restrictive assumptions —but that dividend policy becomes important once these assumptions are removed.

Risk Aversion Specifically, Gordon asserts that shareholders who are risk averse may prefer some dividends over the promise of future capital gains because dividends are regular, certain returns, whereas future capital gains are less certain. This is sometimes referred to as the “bird -in -the -hand” theory. According to Gordon, dividends reduce investors’ uncertainty, causing them to discount a firm’s future earnings at a lower rate, thereby increasing the firm’s value. In contrast, failure to pay dividends increases investors’ uncertainty, which raises the discount rate and lowers share prices. Although there is some empirical evidence to support this argument, it is difficult to decide which is more valid —the MM informational content (or signaling effect) of dividends approach or the Gordon uncertainty resolution approach.

Transaction Costs If the assumption of no transaction costs for investors is removed, then investors care whether they are paid cash dividends or receive capital gains. In the MM world, investors who own stock paying low or no dividends could periodically sell a portion of their holdings to satisfy current income requirements. In actuality, however, brokerage charges and odd -lot differentials make such liquidations expensive and imperfect substitutes for regular dividend payments.

Taxes Removal of the no -tax assumption also makes a difference to shareholders. As discussed earlier, shareholders in high income tax brackets may prefer low (or no) dividends and reinvestment of earnings within the firm because of the ability to defer taxes into the future (when the stock is sold) on such income. In his study of dividend policy from 1920 to 1960, John A. Brittain found evidence in support of this proposition.In general, he found that rising tax rates tend to reduce dividend payout rates.

Issuance (Flotation) Costs The existence of issuance costs on new equity sales also tends to make earnings retention more desirable. Given a firm’s investment policy, the payout of earnings the firm needs for investments requires it to raise external equity. External equity is more expensive, however, because of issuance costs. Therefore, the use of external equity will raise the firm’s cost of capital and reduce the value of the firm. In addition, the cost of selling small issues of equity to meet investment needs is likely to be prohibitively high for most firms. Therefore, firms that have sufficient investment opportunities to profitably use their retained funds tend to favor retention.

Agency Costs It has also been argued that the payment of dividends can reduce agency costs between shareholders and management.The payment of dividends reduces the amount of retained earnings available for reinvestment and requires the use of more external equity funds to finance growth. Raising external equity funds in the capital markets subjects the company to the scrutiny of regulators (such as the SEC) and potential investors, thereby serving as a monitoring function of managerial performance.

Conclusions Regarding Dividend Relevance The empirical evidence as to whether dividend policy affects firm valuation is mixed. Some studies have found that, because of tax effects, investors require higher pretax returns on high -dividend payout stocks than on low-dividend payout stocks.Other studies have found that share prices are unaffected by dividend payout policy. Many practitioners believe that dividends are important, both for their informational content and because external equity capital is more expensive than retained equity.Thus, when establishing an optimal dividend policy, a firm should consider shareholder preferences along with investment opportunities and the relative cost of retained equity versus externally raised equity.


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