Dividend Policy

The Dividend Decision, in corporate finance, is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company's stockholders. The firm could also pay in the form of stock dividends which unlike cash dividends do not provide liquidity to the investors, however, it ensures capital gains to the stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.

There are three main factors that may influence a firm's dividend decision:

Free-cash flow - The firm simply pays out, as dividends, any cash that is surplus after itinvests in all available positive net present value projects. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision.

Dividend clienteles - A particular pattern of dividend payments may suit one type of stockholder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

Information signaling - suggests that dividend announcements convey information to investors regarding the firm's future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced.

In fact, many managers resist paying large dividends. Shareholders entrust managers with the task of profitability investing their capital, and for management to return the money suggests an inability to perform a basic managerial function.

Various models have been developed to help firms analyze and evaluate the perfect dividend policy.

One school comprises of people like James E. Walter and Myron J. Gordon, who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.

Relevance of dividend policy means that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm are discounted at a lower rate, ke (cost of capital) thereby increasing the market value. Two important models supporting dividend relevance are given by Walter and Gordon.

The Walter model: the firm's decision to give or not give out dividends depends on whether it has enough opportunities to invest the retained earnings i.e. a strong relationship between investment and dividend decisions is considered.

The Gordon model: regular dividends affect the share price of the firm, the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share. Both models have shown the supremacy of regular dividends through their models and clearly stated the strong relationship between dividend policies and market value of the firm.

Capital structure substitution theory

The capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share (EPS) are maximized. When redistributing cash to shareholders, company managements can typically choose between dividends and sharerepurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.

The Modigliani–Miller theorem states that the division of retained earnings between new investment and dividends doesn’t influence the value of the firm. It is the investment pattern and consequently the earnings of the firm which affect the share price or the value of the firm.