Why choose us?

We understand the dilemma that you are currently in of whether or not to place your trust on us. Allow us to show you how we can offer you the best and cheap essay writing service and essay review service.

Dividend policy

Dividend policy
Discuss the view that the best dividend policy is to use dividend payments to force
managers to conform to the wishes of company shareholders.

Dividend policy is the detailed procedure a firm follows when paying dividends and the amount
payable to the shareholders. The shareholders value emanates from the sum of all the strategic
decisions that literally affects the company’s ability to efficiently and effectively increase the
value of free cash flow periodically. The dividend payout ratio is the actual percentage of
earnings that are payable to the shareholders in terms of dividends. (Mullins 1982) The formular
of the payout ratio is equal to Annual Dividend per Share/Earnings per share or Dividends/Net
Dividend policy refers to the company’s distribution of value and its guiding principles when
implementing the decisions of its shareholders. The value of a firm is significantly determined by
its ability to generate enough income and increase its earning power and also subject to the risk
of its future prospects and the underlying assets, and that its immediate value is entirely
independent of its choice of selection in investment and the distribution of dividends. (Emery &
Finnerty 2004) (Samuels, Wilkes & Brayshaw 1998)
Dividend policy is actually one of the most complex and major aspects in business finance.
Black (1976) in his sturdy three decades observed that the harder one looks at the general
dividend picture it seemed more like a puzzle with pieces that don’t add up or fit together. The
reason why shareholders prefer dividends and also reward managers who make regular dividend
payments is still to be answered satisfactorily.
Dividend policy is twofold, managed and residual. The residual dividend policy amounts to that
dividend that’s simply remains after the company has made its investments by applying the NPV
rule. The amount of dividend is normally zero in this instance as it’s highly variable. A manager
who is interested in creating wealth for his investors or shareholders and believes that dividends
influence share prices will go for the managed dividend policy. The best dividend policy is the
one that maximises the shareholders wealth. The issue whether dividends decisions contribute
positively or negatively to a firm’s value is still debatable.
The free cash flows can be utilized as pay outs for shares repurchases and dividends payments or
they can be used to increase cash reserves or to invest in new projects. A company’s free cash
flow flows eventually determines the amount of payouts that it can ultimately make to its current
investors. The difference between the FCFF and the investments can be used for the payment of
Principal Dividend theory

2 Dividend Policies and Payments

Dividend policy that leads to optimal maximization of the wealth of the shareholder by
maximizing on the firm’s stock price is in most cases ideal for the shareholder. Dividend policy
decisions may or may not affect the value of the firm or its stock prices. (Baker and Powell,
2000) Firms whose growth performances are relatively high with large cash flows and less
projects pay more dividends. Payment of dividend announcement generates positive returns in
the security returns but when no dividends are declared then negative returns are generated.
These may lead to a drop in the share prices of the firm. Dividends normally signal either
positive or negative effects to the potential share holders. (Frankfurter, George and Wood, 2003)
Dividend Irrelevance concept as argued by Miller and Modigliani (1961) showed that under
certain factors the dividend policy of a firm has no effect on its value. The value of a company is
usually determined by choosing investments with optimal returns. The net payout of a company
is the difference between its earnings and investments which is residual. A firm can adjust its
rate of dividends by offsetting changes in the shares outstanding as the payout consists of
dividends and also share repurchases (home-made dividends). Any kind of payments can be
achieved by relevant purchases and also sales of equity which makes the dividend policy to be
irrelevant. Miller and Modigliani conclude that a company’s method or decision of dividend
policy has no effect on the wealth of the shareholders. However, Miller and Modigliani
assumptions are the cost of information is free and equal to all, taxes are non-existent, no agency
costs and transport and flotation costs are also non-existent. The value of a firm is usually
determined by the way a company generates its earnings and not how it dividend and distribute
its dividends. (Modigliani and Miller 1958)
Dividend’s relevance
Bird in the hand theory, led to Gordon and Lintner assertion that capital gains are less certain
than dividends and investors go for cash dividends than capital gains. This makes the stocks that
pay better dividends to be highly valued.
Tax Differential Theory by Litzenberger and Ramaswamy asserts that dividends are taxed more
than capital gains in most countries in the world. This leads to stock holder’s instinctive
behaviour to prefer fewer dividends to attract low taxes and opt for capital gains that attract less
Residual Dividend Theory
Clientele Effect
The dividend clientele effect was initially proposed by M & M and later by Elton and Gruber
(1970). The theory asserts that high dividend paying stocks are held by people who are in the low
tax bracket while the low paying dividend stocks are held by people in the higher tax brackets
while Corporations go for high payouts stocks.
Information Effect
Relevant information may lead to increase or the decrease of security price. For example, after
favourable announcement on the company performance and positive reports on a firm’s earnings
the stock prices may rise. Negative results may occur if the information is unfavourable. To
reduce the effect of information, the company should adopt a strategy entails the build-up of
expectations before the official announcement.
Agency Costs
Specific Company costs are directly related to a number of additional covariates that includes
company liquidity governance structures and information asymmetry and other forms of
monetary compensation. The agency theory concludes that monetary compensation increases the
agency disagreement while limited stock options and incentives lower the conflicts. (Ang, Cole

3 Dividend Policies and Payments

and Lin, 2000) Companies that have high liquidity rates and also low information asymmetry
displays lower margins or degree of related agency costs. (Jensen, 1986) The payment of
dividends presents an example of the concept of the classic agency situation as its weight is felt
by the various claimants. Dividend payments policies can be applied to reduce the agency costs.
It also reduces the cash available to manager’s perquisite consumption and other arbitrary
investment opportunities. Without extra cash available for investments the managers are
compelled to seek general investment financing from the financial capital markets which have
stringent management policies that encourages managers to be more disciplined in financial
Expectations Theory
Investors usually make forecasts on expected future rates of interest before deciding to invest in
bonds. There those who will invest in long term bonds hoping that interest rates will fall or
reduce will those hoping the interest rates will raise invest in short term bonds or securities. The
yield curve will be affected depending on the group that has more weight. (McLaney 2003) The
expectation theory indicates that a rising or an increasing yield curve only occurs when the
economy is experiencing positive growth and the interest rates are rising or expectations are that
they will rise as consumers and business people borrow more to finance their options or expand
their businesses. A falling yield curve is a result of weak economy or a recession and the rates
are mostly expected to fall. . (Mehrling 2005)
Where taxes are applicable in the MM Proportion 1, the total value of the unlevered
company is equal to its earnings before taxes and interest which eventually adds up as the cost of
equity. The value of unlevered company is equal to the company of unlevered firm with its
additional taxes capitalized eventually at the cost of its debt. (Burgess 2006)
Trade-off theory points at the optimal capital structure being attained at the point where its
marginal distress costs exceed its marginal tax advantage from the additional debt in the MM
model. The Trade-off theory is only applicable if the shareholders allow the manager to make
informed decisions and also the opportunity to decide the best dividend policy for the company
and the method of payments. (Scott Jr, H., 1976)
Compelling managers to conform to the wishes of the shareholders eventually denies the
company the benefits of tax advantages that would ordinarily be applicable to the advantage of
the company and finally to the shareholders. (Taylor & Duyn, 2002)
Payment of dividends will also deny the shareholders the advantages of participating in stock
splits as they are normally issued as alternatives to dividend payments. (Brealey and Myers
1991) Stock dividend refers to the extra money that’s payable to the owner of each share that he
owns. For instance, a stock worth $20 per share may earn $1 per share. The major reason for
issuing out dividends is that it induces the share prices in the market. Stock split occurs if a firm
has 200 million common stock shares each at $12 per share then it can split it to 400 million
shares each trading at $6 per share. (Myers 1984) The reduction in the price of a share increases
its marketability by making it attractive and affordable to large group of potential investors.
(Dewatripont and Tirole 1994)

4 Dividend Policies and Payments

Managers are mostly well informed of company operations and financial status than the investors
or the shareholders. When they are denied the opportunity to put into practice the best policies
for the company then the company may start making losses or alternatively they may eventually
use the information for their own benefit. (Tofallis 2008) Most managers and even shareholders
who are interested in good returns for their investments would prefer a 2-1 stock split than a
100% dividend. The total value of the shares increases by 50% instead of the onetime payment
of 100% dividend. This normally occurs with shares that are highly priced and the management
is interested in making them affordable and also marketable. (Baker, Powell & Veit 2001)
However, Specific Company costs are directly related to a number of additional covariates that
includes company liquidity governance structures and information asymmetry and other forms of
monetary compensation. The agency theory concludes that monetary compensation increases the
agency disagreement while limited stock options and incentives lower the conflicts. (Ang, Cole
and Lin, 2000) Companies that have high liquidity rates and also low information asymmetry
displays lower margins or degree of related agency costs. (Jensen 1986)
B) If the shareholders allow the manager to pay dividends and also invest in approved projects
then the manager can make some decisions that may contribute positively to the growth of the
company. Forceful payments of dividends may lead to losses to the company especially when it
would be prudent to invest in capital projects. (Brealey & Myers 2002) However, the Bird in the
hand theory, which is related to the dividend’s relevance theory led to Gordon and Lintner
assertion that capital gains are less certain than dividends and investors go for cash dividends
than capital gains. This makes the stocks that pay better dividends to be highly valued.
(Frankfurter, George & Wood 2003)
The idea is to shift the benefit from the business to the shareholders and the chances of this being
achieved are increased by lowering the cost of capital and increasing the money available to
carry out business with greater profits (Marsh 1982) (Barges 1982) The shareholders can only
guarantee these actions if they are interested in achieving positive results for company and not if
they have sinister motives. (Brigham 1989)
The signalling Theory MM assumes that the investors and interested parties including the
managers have similar information. Where most of the information are mutual, shareholders also
assumes that firms will issue new stock where shares are overvalued and issued. Where
undervalued stocks are issued it indicates lower FCF, unwillingness to commit to increased debt
financing service. (Jensen 1986) Leverage-decreasing events indicates overvalued stock and vice
versa which is supported by empirical data (Roberts 2003)
The signalling theory in its pecking order hypothesis confirms that companies will most likely
choose from the following arrangement of funding sources to maintain overall financial stability
where there are no profits and consequently no dividends but the company needs to invest. )
(Luenberger 1997) The first choice is retained earnings, extra cash debt issuance, and stock
issuance. Big companies use less debt because they can source funds easily internally (equity)
These contradicts the trade off theory that suggests high debts because of low rates of defaulters
and the need for tax incentives. For companies that utilize all their earnings in an effort to tame
their managers, it would be very difficult to gain from such decisions or even have the
opportunity to make such decisions because the retained earnings would be nonexistent.
(Graham & Harvey 2001)

5 Dividend Policies and Payments

Prior to the changes that were introduced in the year 2003 in the US, the high rate of taxes
discouraged the payments of dividends and most companies preferred recycling the profits in
exchange of more shares in the respective companies. The decisions of the management cannot
be wholly ignored by the shareholders as the dividend policy also depends on the performance of
the company, its profitability and the availability of funds to generate more income. The major
objective of any successful organization is to maximize its earnings while targeting its sales and
minimizing costs. Any measure that can extend and guarantee the achievement of any of these
objectives will definitely draw the attention of the strategic managers. If the shareholders
interfere with these processes then the company is destined to fail. (Artill 2006)
Finally to sum up all the theories and the dividend policies, it requires sound judgement both
from the management and the shareholders to create a successful company. The willingness to
allow the managers to have a free hand in making progressive decisions for the company is
critical to ensure positive growth and expansion of the company.

Ang, J., Cole, R. & Lin, J., 2000, Agency costs and ownership structure, Journal of Finance 35,
Artill, P., 2006, Financial Management for Non-specialists (4 th Ed). London, Financial Time
Prentice Hall
Black, F., 1996, ‘The dividend puzzle’ Journal of Portfolio Management Special Issue pp8-12
Baker, H.K., Powell. G.E. & Veit, T., 2001, “Factors influencing dividend policy decisions of
NASDAQ firms”, The Financial Review, pp 19-38
Baker, H.K. and Powell, G.E., 2000, “Determinants of corporate dividend policy: a survey of
NYSE firms” Financial Practice and education 9, pp 29-40
Black, F. (1996) ‘The dividend puzzle’ Journal of Portfolio Management. Special Issue pp8-12
(Reprint from 1976)
Burgess, K., 2006, Pressure building for public companies to adopt private equity tactics some
institutional investors are questioning whether companies should put up more resistance to
approaches from buy-out firms and use some of their typical methods to create value. Financial
Times-London Edition.
Brealey, R. A and Myers, S.C., 1991, Principles of Corporate Finance. 4th Ed. New
York: McGraw-Hill, 1991.
Brigham, E. F., 1989, Fundamentals of Financial Management. 5th ed. Chicago: Dryden

6 Dividend Policies and Payments

Barges, A., 1982, The Effect of Capital Structure on the Cost of Capital, Prentice-Hall, Inc.,
Brealey, R. A. and Myers, S., 2002, The Principal of Corporate Finance (7 th Ed). London,
McGraw-Hill International
Dewatripont, M., and Tirole, J., 1994, A theory of debt and equity: Diversity of securities and
manager-shareholder congruence. The Quarterly Journal of Economics, 109(4), 1027-1054.
Emery, D. R. and Finnerty, J. D., 2004, Corporate Financial Management (3 rd Ed). London,
Prentice Hall.
Frankfurter, M, George and Wood B. G., 2003, “Dividend Policy Theory and Practice”,
Academic Press.
Graham, J.R. & Harvey, C.R., 2001, The theory and practice of corporate governance: evidence
from the field. Journal of Financial Economics 60 (2001) 187- 243
Jensen, M., 1986, “Agency costs of free cash flow, corporate finance and takeovers”, American
Economic Review, vol. 76, pp. 323–9
Luenberger, D., 1997, Investment Science. Oxford University Press.
Litzenberger, R.H. & Ramaswamy, K., 1982, The Effects of Dividends on Common Stock Prices
or Information Effects? The Journal Of Finance, Vol.37, issue 2, pages 429-443, May 1982.-
10.111/j.1540-6261.1982.tb03565.x Retrieved 30 April 2012.
Lumby, S. and Jones, C., 2003, Corporate Finance: Theory and Practice (7 th Ed). London:
Marsh, P., 1982, The choice between equity and debt: An empirical study. The Journal of
finance, 37(1), 121-144.
Miller, M.H., & Modigliani, F., 1961, Dividend policy, growth and the valuation of shares,
Journal of Business, vol.34, no.4, pp.411-433.
Modigliani, F. & Miller, M., 1958, The cost of capital, corporation finance and the theory of
investment.The American economic review, 48(3), 261-297.
Myers, C., 1984, The Capital Structure Puzzle, The Journal of Finance. 39 (3)
Mehrling, P., 2005, Fischer Black and the revolutionary Idea of Finance. Hoboken: John Wiley
& Sons, Inc.
Mullins, David W., 1982, Does the capital asset pricing model work? Harvard Business Review,
January – February 1982, 105-113.

7 Dividend Policies and Payments

McLaney, E. J., 2003, Business Finance: Theory and Practice (5 th Ed). London: Pearson
Education Ltd.
Roberts, A., 2003, Highest scores may not be most efficient ratings. Financial Times- London
Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 1998, Management of Company Finance (7 th
Ed). International Thomson Business Press.
Scott Jr, H., 1976, A theory of optimal capital structure.The Bell Journal of Economics, 33-54.
Tofallis, C. (2008). “Investment Volatility: A Critique of Standard Beta Estimation and a Simple
Way Forward”. European Journal of Operational Research 187
Taylor, A and Duyn V., 2002, Companies & Finance UK: Financial Times-London Edition

All Rights Reserved, scholarpapers.com
Disclaimer: You will use the product (paper) for legal purposes only and you are not authorized to plagiarize. In addition, neither our website nor any of its affiliates and/or partners shall be liable for any unethical, inappropriate, illegal, or otherwise wrongful use of the Products and/or other written material received from the Website. This includes plagiarism, lawsuits, poor grading, expulsion, academic probation, loss of scholarships / awards / grants/ prizes / titles / positions, failure, suspension, or any other disciplinary or legal actions. Purchasers of Products from the Website are solely responsible for any and all disciplinary actions arising from the improper, unethical, and/or illegal use of such Products.