Dividend decision refers to the decision-making process of a company’s management to determine how much of its profits to distribute to shareholders in the form of dividends or retain for reinvestment in the business. This decision is crucial for any business, as it affects the company’s financial health and the interests of its shareholders. The dividend decision is influenced by several factors such as the company’s earnings, profitability, financial position, growth prospects, and capital requirements.
There are three main dividend policies that companies may follow:
- Regular Dividend Policy: Under this policy, a company pays out a fixed amount of dividend on a regular basis. The dividend amount may be the same every year or may vary depending on the company’s earnings.
- Stable Dividend Policy: Under this policy, a company pays a fixed percentage of its earnings as dividends every year. The dividend amount may be adjusted based on the company’s earnings.
- Residual Dividend Policy: Under this policy, a company first invests in all profitable projects and then distributes the remaining profits to shareholders in the form of dividends.
The decision of which dividend policy to follow is influenced by several factors such as the company’s growth prospects, financial position, and cash flow requirements.
Dividend decisions also involve deciding the dividend payout ratio, which is the percentage of earnings that a company pays out as dividends. The dividend payout ratio is influenced by several factors such as the company’s earnings, financial position, and growth prospects.
Dividend decisions also include deciding whether to pay out dividends in cash or in the form of stock dividends or share buybacks.
Advantages of paying dividends include:
- Attracting investors: Companies that pay regular dividends may attract investors who are looking for a steady source of income.
- Enhancing shareholder value: Paying dividends can increase the value of the company’s stock and enhance shareholder value.
- Signaling financial strength: Paying dividends can signal to investors that the company is financially strong and profitable.
- Reducing agency costs: Paying dividends can help reduce agency costs, which are costs incurred when managers act in their own interests rather than the interests of shareholders.
Disadvantages of paying dividends:
- Reduced flexibility: Paying dividends reduces the company’s flexibility to reinvest profits in the business or pursue growth opportunities.
- Unpredictable earnings: Companies that pay dividends may have unpredictable earnings, which can make it difficult to maintain a steady dividend payout.
- Tax implications: Dividends are subject to taxes, which can reduce the amount of money that shareholders receive.
- Inflation risk: Dividends may not keep pace with inflation, which can reduce their real value over time.
Theories for relevance and irrelevance of Dividend Decision
There are two major theories related to the relevance and irrelevance of dividends, namely the dividend relevance theory and the dividend irrelevance theory.
Dividend Relevance Theory:
According to this theory, dividends are important to investors, and they affect the value of the firm. The dividend relevance theory is based on the idea that investors prefer current dividends over future capital gains. The theory suggests that investors are risk-averse and prefer a certain return in the form of dividends over the uncertain return in the form of capital gains. Therefore, the payment of dividends by a company can increase the value of the firm and, consequently, the wealth of the shareholders.
The dividend relevance theory is based on the following assumptions:
- Investors prefer current dividends over future capital gains.
- Dividends are less risky than capital gains.
- The market value of the firm is positively related to its dividend policy.
Dividend Irrelevance Theory:
The dividend irrelevance theory suggests that the payment of dividends has no effect on the value of the firm. The theory is based on the idea that investors are indifferent between current dividends and future capital gains. Therefore, the payment of dividends by a company does not increase the value of the firm or the wealth of the shareholders.
The dividend irrelevance theory is based on the following assumptions:
- Investors are rational and have access to the same information about the firm.
- Investors are indifferent between current dividends and future capital gains.
- The market value of the firm is determined by its future earnings and risk.
In conclusion, the dividend relevance theory suggests that dividends are important to investors and affect the value of the firm, while the dividend irrelevance theory suggests that dividends have no effect on the value of the firm. Both theories have their supporters and critics, and the debate on the relevance and irrelevance of dividends is ongoing in the field of finance. The choice of dividend policy depends on a variety of factors, such as the firm’s financial needs, tax considerations, and the preferences of the shareholders.
Walter’s Model, also known as the dividend relevance model, was proposed by James E. Walter in 1956. This model attempts to establish the relationship between the firm’s dividend policy and the market value of its shares. The basic assumption of the Walter model is that the company is an all-equity firm that has no debt.
According to Walter’s model, the market value of a firm is directly related to its expected return and the rate of retention. The model assumes that there is a constant opportunity cost of capital, which is the minimum required rate of return that investors expect from an investment in the firm’s shares. The opportunity cost of capital is represented by the symbol ‘k.’
Walter’s model suggests that there are two types of investors in the market: those who prefer current income and those who prefer capital gains. The model assumes that these two types of investors are equally important and that the firm’s dividend policy affects both groups.
The Walter model has two key components:
- The dividend payout ratio (DPR)
- The internal rate of return (IRR)
The formula for the dividend payout ratio (DPR) is:
DPR = Dividends per share / Earnings per share
The formula for the internal rate of return (IRR) is:
IRR = (Earnings per share – Dividends per share) / Dividends per share
The Walter model suggests that the market value of the firm is directly related to the IRR and inversely related to the DPR. The model states that as the DPR increases, the IRR decreases, which, in turn, decreases the market value of the firm. Conversely, as the DPR decreases, the IRR increases, which, in turn, increases the market value of the firm.
The key assumption of the Walter model is that the IRR is constant and that it is greater than the opportunity cost of capital (k). If the IRR is less than the opportunity cost of capital, the firm should retain all earnings and not pay any dividends. If the IRR is greater than the opportunity cost of capital, the firm should distribute all earnings as dividends.
The Walter model’s approach to dividend policy is considered relevant in the short run, but it may not be relevant in the long run. In the long run, a firm’s investment opportunities change, and the IRR may not be constant. Additionally, the model does not consider the impact of taxes, inflation, and other factors that may affect the firm’s dividend policy. As a result, the model has been criticized for its simplicity and unrealistic assumptions.
Gordon’s Model is another dividend policy theory that is widely used by companies to determine their dividend payout ratio. It was developed by Myron J. Gordon and Eli Shapiro in 1956. The model is also known as the Gordon Growth Model or the Constant Growth Model.
The Gordon Model assumes that the value of a company is equal to the present value of all future dividends. The model assumes that dividends are paid out of earnings, and the company has a constant growth rate. The formula for the Gordon Model is as follows:
P = D / (k – g)
P = Price per share
D = Dividend per share
k = Required rate of return
g = Expected growth rate of dividends
The formula shows that the price per share is equal to the dividend per share divided by the difference between the required rate of return and the expected growth rate of dividends. The model assumes that the company’s dividend growth rate is constant.
The Gordon Model can be used to calculate the required rate of return for a company’s stock, given its current market price and dividend payout. The model is also used to determine the fair value of a stock, given its expected future dividends.
One of the main advantages of the Gordon Model is its simplicity. It is easy to use and understand, and it provides a quick estimate of a stock’s fair value. However, the model has some limitations. It assumes that the company has a constant growth rate, which may not always be the case. In addition, the model assumes that the company will continue to pay dividends in the future, which may not always be true.
The Modigliani-Miller (MM) approach to dividend policy was developed by economists Franco Modigliani and Merton Miller. Their work on corporate finance, published in a series of papers in the 1950s and 1960s, challenged traditional assumptions about the relationship between a company’s dividend policy and its value.
According to the MM approach, a company’s dividend policy is irrelevant to its overall value and investors are indifferent between receiving dividends and reinvesting earnings. The basic idea is that investors can create their own cash flows by selling shares if they need income, so whether a company pays dividends or retains earnings makes no difference to their overall wealth.
The MM approach is based on a number of assumptions, including:
- Perfect capital markets: The MM approach assumes that capital markets are perfect, meaning that there are no transaction costs, taxes, or other frictions that could impact the value of a company’s shares.
- Investors are rational: The MM approach assumes that investors are rational and have access to the same information, so they will make the same decisions about buying and selling shares based on a company’s earnings and growth prospects.
- Constant cost of capital: The MM approach assumes that a company’s cost of capital is constant, regardless of its dividend policy. This means that the cost of equity is the same whether the company pays dividends or retains earnings.
- No agency costs: The MM approach assumes that there are no agency costs, meaning that managers always act in the best interests of shareholders.
- Under these assumptions, the MM approach shows that a company’s value is determined solely by its earning power and the risk of its investments, and not by its dividend policy. This means that a company can increase its value by investing in projects with positive net present values, regardless of whether it pays dividends or retains earnings.
Critics of the MM approach argue that it is unrealistic to assume perfect capital markets and rational investors. In the real world, transaction costs, taxes, and other frictions can impact the value of a company’s shares, and investors may not always act rationally.
Despite these criticisms, the MM approach remains an important contribution to the theory of corporate finance and continues to influence research on dividend policy and capital structure.