Mark Fielding-Pritchard Dividend Policy Mark Fielding-Pritchard mefielding.com
DIVIDEND THEORIES There are three main categories advanced: Dividend relevance theories Dividend irrelevance theories Dividend & uncertainty mefielding.com
Theories Identify 3 Types of Shares Given three types of firms or scenarios of firms the model can be summarized as follows: Growth firm: there are several investment opportunities (r > k) and the firm can reinvest earnings at a higher rate r than that which is expected by shareholders k. thus they wil maximize value per share if they reinvest all earnings. Normal firm: there aren’t any investments available for the firm that are yielding higher rates of return (r = k) thus the dividend policy has no effect on market price. mefielding.com
Theories Identify 3 Types of Shares Declining firm: there aren’t any profitable investments for the firm to reinvest its earnings, i.e. any investments would earn the firm a rate less than its cost of capital (r < k). The firm will therefore maximize its value per share if it pays out all its earnings as dividend. mefielding.com
Dividends Irrelevance The propagators of this school of thought were Modigliani and Miller They state that the dividend policy employed by a firm does not affect the value of the firm. They argue that the value of the firm is dependent on the firm’s earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence. mefielding.com
Assumptions of M-M hypothesis Perfect capital markets, i.e. investors behave rationally, information is freely available to all investors, transaction and floatation costs do not exist, no investor is large enough to influence the price of a share. Taxes do not exist; or there is no difference in the tax rates applicable to both dividends and capital gains. The firm has a fixed investment policy The risk of uncertainty does not exist, i.e. all investors are able to forecast future prices and dividends with certainty and one discount rate is appropriate for all securities over all time periods. mefielding.com
Conclusions of the model A firm which pays dividends will have to raise funds externally in order to finance its investment plans. When a firm pays dividend therefore, its advantage is offset by external financing. This means that the terminal value of the share declines when dividends are paid. Thus the wealth of the shareholders – dividends plus the terminal share price – remains unchanged. Consequently the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends. Thus the shareholders are indifferent between the payment of dividends and retention of earnings. mefielding.com
Criticisms? Presence of Market Imperfections: Tax differentials (low-payout clientele) Floatation costs Transaction and agency costs Information asymmetry Diversification Uncertainty (high-payout clientele) Desire for steady income No or low taxes on dividends mefielding.com