Does the firm's dividend policy affect firm value?

The objective of the firm is to maximize shareholder value. A central question regarding the firm's dividend policy is therefore whether the dividend policy changes firm value?

As the dividend policy is the trade-off between retained earnings and paying out cash, there exist three opposing views on its effect on firm value:

1. Dividend policy is irrelevant in a competitive market

2. High dividends increase value

3. Low dividends increase value

The first view is represented by the Miller and Modigliani dividend-irrelevance proposition.

Miller and Modigliani Dividend-Irrelevance Proposition

In a perfect capital market the dividend policy is irrelevant. Assumptions

- No market imperfections

• No taxes

• No transaction costs

The essence of the Miller and Modigliani (MM) argument is that investor do not need dividends to covert their shares into cash. Thus, as the effect of the dividend payment can be replicated by selling shares, investors will not pay higher prices for firms with higher dividend payouts.

To understand the intuition behind the MM-argument, suppose that the firm has settled its investment programme. Thus, any surplus from the financing decision will be paid out as dividend. As case in point, consider what happens to firm value if we decide to increase the dividends without changing the debt level. In this case the extra dividends must be financed by equity issue. New shareholders contribute with cash in exchange for the issued shares and the generated cash is subsequently paid out as dividends. However, as this is equivalent to letting the new shareholders buy existing shares (where cash is exchanged as payment for the shares), there is not effect on the firm value.

The left part of Figure 11 illustrates the case where the firm finances the dividend with the new equity issue and where new shareholders buy the new shares for cash, whereas the right part illustrates the case where new shareholders buy shares from existing shareholders. As the net effect for both new and existing shareholders are identical in the two cases, firm value must be equal. Thus, in a world with a perfect capital market dividend policy is irrelevant.

Why dividend policy may increase firm value

The second view on the effect of the dividend policy on firm value argues that high dividends will increase firm value. The main argument is that there exists natural clienteles for dividend paying stocks, since many investors invest in stocks to maintain a steady source of cash. If paying out dividends is cheaper than letting investors realize the cash by selling stocks, then the natural clientele would be willing to pay a premium for the stock. Transaction costs might be one reason why its comparatively cheaper to payout dividends. However, it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.

Why dividend policy may decrease firm value

The third view on dividend policy states that low dividends will increase value. The main argument is that dividend income is often taxed, which is something MM-theory ignores. Companies can convert dividends into capital gains by shifting their dividend policies. Moreover, if dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move. As a result firm value will increase, since total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid. Thus, if capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

Major Factors which Influence Dividend Policy of a Company

1. Stability of Earnings

Stability of earnings is one of the important factors influencing the dividend policy. If earnings are relatively stable, a firm is in a better position to predict what its future earnings will be and such companies are more likely to pay out a higher percentage of its earnings in dividends than a concern which has a fluctuating earnings.

Generally, the concerns which deal in necessities suffer less from fluctuating incomes than those concern which deal with fancy or luxurious goods.

2. Financing Policy of the Company:

Dividend policy may be affected and influenced by financing policy of the company. If the company decides to meet its expenses from its earnings, then it will have to pay less dividend to shareholders. On the other hand, if the company feels, that outside borrowing is cheaper than internal financing, then it may decide to pay higher rate of dividend to its shareholder. Thus, the internal financing policy of the company influences the dividend policy of the business firm.

3. Liquidity of Funds:

The liquidity of funds is an important consideration in dividend decisions. According to Guthmann and Dougall, although it is customary to speak of paying dividends ‘out of profits’, a cash dividend only be paid from money in the bank. The presence of profit is an accounting phenomenon and a common legal requirement, with the -cash and working capital position is also necessary in order to judge the ability of the corporation to pay a cash dividend.

Payment of dividend means, a cash outflow, and hence, the greater the cash position and liquidity of the firm is determined by the firm’s investment and financing decisions. While the investment decisions determine the rate of asset expansion and the firm’s needs for funds, the financing decisions determine the manner of financing.

4. Dividend, Policy of Competitive Concerns:

Another factor which influences, is the dividend policy of other competitive concerns in the market. If the other competing concerns, are paying higher rate of dividend than this concern, the shareholders may prefer to invest their money in those concerns rather than in this concern. Hence, every company will have to decide its dividend policy, by keeping in view the dividend policy of other competitive concerns in the market.

5. Past Dividend Rates:

If the firm is already existing, the dividend rate may be decided on the basis of dividends declared in the previous years. It is better for the concern to maintain stability in the rate of dividend and hence, generally the directors will have to keep in mind the rate of dividend declared in the past.

6. Debt Obligations

A firm which has incurred heavy indebtedness, is not in a position to pay higher dividends to shareholders. Earning retention is very important for such concerns which are following a programme of substantial debt reduction. On the other hand, if the company has no debt obligations, it can afford to pay higher rate of dividend.

7. Ability to Borrow:

Every company requires finance both for expansion programmes as well as for meeting unanticipated expenses. Hence, the companies have to borrow from the market, well established and large firms have better access to the capital market than new and small, firms and hence, they can pay higher rate of dividend. The new companies generally find it difficult to borrow from the market and hence they cannot afford to pay higher rate of dividend.

8. Growth Needs of the Company:

Another factor which influences the rate of dividend is the growth needs of the company. In case the company has already expanded considerably, it does not require funds for further expansions. On the other hand, if the company has expansion programmes, it would need more money for growth and development. Thus when money for expansion is not, needed, then it is easy for the company to declare higher rate of dividend.

9. Profit Rate:

Another important consideration for deciding the dividend is the profit rate of the firm. The internal profitability rate of the firm provides a basis for comparing the productivity of retained earnings to the alternative return which could be earned elsewhere. Thus, alternative investment opportunities also play an important role in dividend decisions.

10. Legal Requirements:

While declaring dividend, the board of directors will have to consider the legal restriction. The Indian Companies Act, 1956, prescribes certain guidelines in respect of declaration and payment of dividends and they are to be strictly observed by the company for declaring dividends.

11. Policy of Control:

Policy of control is another important factor which influences dividend policy. If the company feels that no new shareholders should be added, then it will have to pay less dividends. Generally, it is felt, that new shareholders, can dilute the existing control of the management over the concern. Hence, if maintenance of existing control is an important consideration, the rate of dividend may be lower so that the company can meet its financial requirements from its retained earnings without issuing additional shares to the public.

12. Corporate Taxation Policy:

Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce the residual profits available for distribution to shareholders. Hence, the rate of dividend is affected. Further, in some circumstances, government puts dividend tax on distribution of dividends beyond a certain limit. This may also affect rate of dividend of the concern.

13. Tax Position of Shareholders:

The tax position of shareholders is another influencing factor on dividend decisions. In a company if a large number of shareholders have already high income from other sources and are bracketed in high income structure, they will not be interested in high dividends because the large part of the dividend income will go away by way of income tax. Hence, they prefer capital gains to cash gains, i.e., dividend capital gains here we mean capital benefit derived by the capitalisation of the reserves or issue of bonus shares.

Instead of receiving the dividend in the form of cash (whatever may be the per cent), the shareholders would like to get shares and increase their holding in the form of shares. This has certain benefits to shareholders. They get money by selling these extra shares received in proportion to their original shareholding.

This will be a capital gain for them. Of course, they have to pay tax on capital gains. But the capital gains tax will be less compared to the income-tax that they should have paid when cash dividend was declared and added to the personal income of the shareholders.

Figure 11 illustrates the argument:

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