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Dividend Policy Theories Dividend Policy Theories Dividend policy theories are propositions put in place to explain the rationale and major arguments relating to payment of dividends by firms. Firms are often torn in between paying dividends or reinvesting their profits on the business.
Even those firms which pay dividends do not appear to have a stationary formula of determining the dividend payout ratio. In this paper, we explore various theories which have been postulated to explain dividend payment behavior of firms. Major Schools of thought: At the heart of the dividend policy theories discussion are two opposing schools of thought: One side holds that whether firms pay dividends or not is irrelevant in determining the stock price and hence the market value of the firm and ultimately its weighted cost of capital.
In retrospect, the opposing side holds that firms which pay periodic dividends eventually tend to have higher stock prices, market values and cheaper WACCs. The existence of these two opposing sides has spawned vast amounts of empirical and theoretical research.
Scholars on both sides of the divide appear relentless on showcasing the case for their arguments. Several decades since interest in the area was sparked off by Modigliani and Millerno general consensus has emerged and scholars can often disagree even on the same empirical evidence!
Their key premise is that to investors, payment of dividends is irrelevant as investors can always sell a portion of their equity if they need cash. Therefore, two firms of the same industry and scale should have the same value even when one of the firms pays dividends and the other one does not.
School of Dividend Relevance Supporters of this theory argue that proposers of the dividend irrelevance theory made unrealistic assumptions in crafting their respective theories. Their main argument is that in a real world, payment of periodic dividends will have a positive impact on the stock price of a firm, its market value and its weighted average cost of capital.
The ideals of this school of thought were solidified mainly by GordonLintner and Walter There are other subsidiary hypotheses which support the notion of dividend relevance. The Modigliani and Miller Theorem Modigliani and Miller in rattled the world of corporate finance with the publication of their paper: They proposed an entirely new view to the essence of dividends in determining the future value of the firm.
As such, they argued that subject to several assumptions, investors should be indifferent on whether firms pay dividends or not. The paper was a sequel to the paper in which they argued that the capital structure of a firm is irrelevant as a determinant factor its future prospects. The theory further explains that investors can indeed create their own cash inflows from their stocks according to their cash needs regardless of whether the stocks they own pay dividends or not.
Likewise, if an investor in a non-dividend paying stock needs more money than availed by the dividend, he will simply sell part of his stock to meet his present cash need. Assumptions of the Modigliani and Miller model Modigliani and Miller pinpointed certain conditions which must hold for their hypothesis to be valid: Critique The validity of the Modigliani and Miller theory is highly dependent on two critical assumptions, which unfortunately are not tenable in the real world.
The theory assumes a world in which transaction costs and taxes are absent. In real sense, it is not possible to have an economy in which these two aspects are absent.
The residual theory The residual theory holds that dividends paid by firms are residual, after the firm has retained cash for all available and desirable positive NPV projects. The gist of this theory is that dividend payment is useless as a proxy in determining the future market value of the firm.
As such, the firm should never forego desirable investment projects to pay dividends. Investors who subscribe to this theory therefore do not care whether firms pay dividends or not, what they are concerned with is the prospect of higher future cashflows which might lead to capital appreciation of their stocks and higher dividends payouts.
Firms tend to meet the financing needs of their growth strategies before paying anything out to shareholders and hence a theory stating so would simply be stating the obvious.
This model insists that dividend yield is a more important measure of the total return to the equity investor than the future growth rate of the dividends which is the rate at which the net earnings and the capital gains of the firm will grow at in the future.
Future growth, and hence capital gains cannot be estimated with accuracy and are not guaranteed at all as firms might lose even their entire market value in the stock exchange and go bankrupt.
Assumptions of the Bird-in-the-Hand theory This theory is based on a number of assumptions, as enumerated below: The firm is an all equity firm, i.
No external financing is available and consequently retained earnings are used to finance any expansion of the firm. There are constant returns which ignores diminishing marginal efficiency of investment. The firm incurs a constant cost of capital.
Walter postulated a model which holds that dividend policy is relevant in determining the value of a firm. The model holds that when dividends are paid to the shareholders, they are reinvested by the shareholder further, to get higher returns.
This cost of these dividends is referred to as the opportunity cost of the firm the cost of capitalke for the firm, since the firm could use these dividends as capital if they were not paid out to shareholders.
Another possible situation is where the firm does not pay out dividends, and they invest the funds which could be paid out as dividends in profitable ventures to earn returns.The Federal Reserve System is the central bank of the United States.
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