Magoosh GRE

Cash payment made on quarterly or semi-annual basic by company to its shareholders.

| November 29, 2012

Introduction

A dividend is a distribution of after-tax profit. It is a cash payment made on quarterly or semi-annual basic by company to its shareholders. At the end of the each financial year every company has to decide (dividend decision) how much amount of earning to be retained by the company and how much amount to be distributed to shareholders. The dividend decision is important because it affects the amount of internally sourced finance available and also affects the return received by shareholders on the shares. Once the company decided to pay dividends, they may establish a somewhat permanent dividend policy, which may show the impact of the investors and the financial markets. Establishing a specific dividend policy is to the advantage of both the company and the shareholder. The distribution of dividends requires the approval of the board of directors and paid out to shareholders a few weeks later. There are several dates between the times the board declares the dividend until the dividend is actually paid. The first date of note is the declaration date which the board of director declares the time or date is announced. The next date of note is ex-dividend date which time investors must have bought the stock to receive the dividend. The investor, who buying the stock after ex-dividend date is not receiving any dividend, record date, is a few days after the ex-dividend date the company close its stock transfer books and make up a list of the shareholder, who will receive the dividend. The final step is payment date which the checks of dividend will send to the shareholders. There are different types of dividend, which are cash or as additional stock which increase the number of shares outstanding and generally reduce the price per share, regular dividend which is paid at regular intervals, or a special dividend which is paid in addition to regular dividend and liquidating dividend which are excess of the retained earning they show on their book.

There exist four main types of dividend policy theories Modigliani and Miller (1961) dividend Irrelevancy theory, Linter and Gordon (bird-in-the-hand) Theory, Signalling properties of dividend and clientele effect.

Is the company’s dividend policy irrelevant to its market value?

One of the financial theorists (Miller and Modigliani, 1961) provides a proposition for dividend policy irrelevance. They assume that perfect capital markets, meaning no taxes or transaction costs exist, the market price has many buyer or seller, and there is costless and feely access to information. Modigliani and Miller state that dividend policy was not one of the determinants of share price .Share value is independent of the level of dividend paid. A firm pay dividend is irrelevant and those stockholders are indifferent about receiving dividend. For example, from the aspect of investor, that the company paid too big dividend, investor could buy more share with the dividend that is over the investor’s expectations. Similarly if the company paid too little dividend, an investor could sell some of the company’s share to reflect the cash flow their expected. Market value of company its cost of capital is independent of its capital structure. According to their argument dividend policy is unaffected and irrelevance of market share price .Should the company pay out to its shareholders or retain that money to make new project.

Modigliani and Miller’s dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock’s dividend

Residual Policy

Modigliani and Miller argued that financial objective is maximise shareholder wealth when the share price is maximised. Shareholders are indifferent between dividends and capital gain. Company is used M & M Residual dividend policy when a company undertake all positive NPV project and paid out the residual as dividend. Alternatively a company with not enough funds to invest new project, paid no dividend and the additional funds can obtain from outside sources. They were arguing that if company followed the best investment policy the value of company is irrelevance to its dividend policy. They also argue that shareholders are also indifferent to the timing of dividend payment because if there were no dividends the market value of company would increase to reflect as future dividend and share price is also increasing resulting from the returns of investment. A dividend policy is irrelevant because shareholders have the ability to create “homemade” dividends that mean that capital gain is not perfect suitable for dividend in cash flow terms. This income is achieved by individuals adjusting their personal portfolios to reflect their own preferences. For example some shareholders prefer to get steady of income are more likely to invest in bonds, which interest payment don’t change ,rather than dividend –paying stock, which value can fluctuate.

Bird-in-the-hand

On the other hands, Lintner (1962) and Gordon (1963) believe that company dividend policies are relevant to their share price. Under conditions of uncertainty and imperfect capital market ,he argued “bird-in-the-hand” theory that investor can reduce the financial risk associated with their investment if the return is received in the form of dividend earlier, rather than capital gain or higher dividends later. On this analysis, current dividend represent less risky than future capital gain. Therefore, company paying higher dividend will be more worth than company paying lower dividend. Dividend policy is one of the importance factors of determining share price. Gorden argued that the payment of current dividends “determine investor uncertainty”. The key assumption, as argued by Lintner and Gordon, is that because of the less risky nature dividends, shareholders and investors will discount the firm’s dividend stream at a lower rate of return, “r”, thus increasing the value of the firm’s shares.

According to dividend growth model, the value of an ordinary share, Po is given by:

Po=D1/(r-g)

Where the constant dividend growth rate is denoted by g, r is the investor’s required rate of return and D1, represent the next dividend payments. Thus the lower r is in relation to the value of dividend payment D1, the greater the share’s value. In the investor’s view, according to Linter and Gordon, r the return from the dividend, is less risky than the future growth rate g.

http://www.oppapers.com/eassys/Bird-In-Hand/536314

Signalling effect of dividend

This theory argued that financial information is asymmetric and managers will always know more than shareholders about the future financial prospects of the company. The dividend declared can be interpreted as a signal from directors to shareholders about the strength of underlying project cash flows. Increasing dividend is usually seen as good news, indicating that the company has positive prospects. The theory of dividend signalling has usually refers to a cash distribution of retain earnings.

 

http://www.jstor.org/pss/2328393

Reference

  • Watson, D. and Head, A. (2010) Corporate finance Principles & Practice.5th edition.

Essex: Pearson Education Limited.

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