Financial Management - DIVIDEND POLICIES
Dividend Irrelevance - DIVIDEND POLICIES
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A firm operating in a perfect or ideal capital market conditions, may many times face the following dilemmas with regard to payment of dividends
Dividend
Irrelevance
A firm operating in a perfect or ideal capital market conditions, may many times face the following dilemmas with regard to payment of dividends
1. The firm has sufficient cash to pay dividends but such payments may erode its cash balance
2. The firm does not have enough cash to pay dividends and to meet its dividend payment needs, the firm may have to issue to new shares
3. The firm does not pay dividends, but shareholders expect and need cash
In the first case, when the firm pays dividends, shareholders get cash in their hands but the firm’s cash balance gets reduced. Though the shareholders gain in the form of such dividends, they lose in the form of their claims on the cash assets of the firm. This can be viewed as a transfer of wealth of the shareholder from one portfolio to another. Thus there is no net gain or loss. In a perfect market condition, this will not affect the value of the firm.
In the second one, the issue of new shares to finance dividend payments results in two transactions – existing share holders gets cash in the form of dividends and the new shareholders part with their cash to the company in exchange for new shares. The existing shareholders suffer an equal amount of capital loss since the value of their claim on firm’s assets gets reduced. The new shareholders gain new shares at a fair price per share. The fair price per share is the share price before the payment of dividends less dividend per share to the existing shareholders. The existing shareholders transfer a part of their claim on the firm to the new shareholders in exchange for cash. Thus there is no gain or loss. Since these two transactions are fair, the value of the firm will remain unaffected.
2. Floatation costs are nil and negligible
3. There are no taxes
4. Investment opportunities and future profits of firms are known and can be found out with certainty – subsequently Miller and Modigliani have dropped this presumption
5. Investment and dividend decisions are independent
Thus, the MM hypothesis reveals that under a perfect market conditions, the dividend policies of a firm are irrelevant, as they do not affect the value and worth of the firm. It further unfolds that the value of the firm depends on its earnings and they result from its investment policy. Therefore, the dividend decision of the firm – whether to declare dividend or not, whether to distribute the earnings towards dividends or retained earnings – does not affect the investment decision.
M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. The dividend plus the “new” stock price after dilution exactly equals the stock price prior to the dividend distribution.
M&M and the total-value principle ensure that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same. Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive
Though the critics of Miller Modigliani hypothesis agree with the view that the dividends are irrelevant, they dispute the validity of the findings by questioning the assumptions used by Miller and Modigliani.
According to them, dividends to matter mainly on account of the uncertain future, the capital market imperfections and incidence of tax.
In a word of uncertain future, the dividends declared by a company based as they are on the judgements of the management on the future, convey the prediction about the prospects of the company. A higher dividend payout may suggest that the future of the company, as judged by the management is very promising. A lower dividend payout thus may suggest that the future of the company as considered by the management may is very uncertain.
An associated argument is that dividends reduce uncertainty perceived by the shareholder investors. Hence they prefer dividends to capital gains. So, shares with higher current dividend yields, other things being equal, attract a very high price in the market. However Miller and Modigliani maintain that dividends merely serve as a substitute for the expected future earnings which really determine the value. They further argue dividend policy is irrelevant.
Due to uncertainty share prices tend to fluctuate, sometimes very widely. When the prices vary, conditions for conversion of current income into capital value and vice versa may not be regarded as satisfactory by the investors. Some investors may be reluctant to sell a portion of their investment in a fluctuating if they wish to enjoy more current income. Such investors would naturally prefer and value more a higher dividend pay out. Some investors may be hesitant to buy shares in a fluctuating market if they wish to get a less current income and therefore they may value more a lower dividend pay out.
Miller and Modigliani assume that a company can sell additional equity at the current market price. However, companies following the advice and suggestions of investment bankers or merchant bankers offer additional equity at a price lower than the current market price. This under pricing practice mostly stems out of market compulsions.
Miller and Modigliani assumption is based on the basis that retained earnings or dividend payouts can be replaced by external
In the absence of transaction costs, dividends and capital gains are equal. In such a situation if a shareholder desires higher current income than the dividends received, he can sell a portion of his capital equal in value to the additional current income required. Likewise, if he wishes to enjoy lesser current income than the dividends paid, he can buy additional shares equal in value to the difference between dividends received and the current income desired. In a real world, transaction costs are incurred. Due to this, capital value cannot be converted into an equal current income and vice versa.
Miller and Modigliani assume that the investors exhibit indifference between dividends and capital appreciation. This may be true when the rate of taxation is the same for dividends received and capital appreciation enjoyed. In real life, the taxes are different on dividends and capital appreciation. Tax on capital appreciation is lower than tax rate on dividends received. Due to this the investors may go in for capital appreciation
A firm operating in a perfect or ideal capital market conditions, may many times face the following dilemmas with regard to payment of dividends
1. The firm has sufficient cash to pay dividends but such payments may erode its cash balance
2. The firm does not have enough cash to pay dividends and to meet its dividend payment needs, the firm may have to issue to new shares
3. The firm does not pay dividends, but shareholders expect and need cash
In the first case, when the firm pays dividends, shareholders get cash in their hands but the firm’s cash balance gets reduced. Though the shareholders gain in the form of such dividends, they lose in the form of their claims on the cash assets of the firm. This can be viewed as a transfer of wealth of the shareholder from one portfolio to another. Thus there is no net gain or loss. In a perfect market condition, this will not affect the value of the firm.
In the second one, the issue of new shares to finance dividend payments results in two transactions – existing share holders gets cash in the form of dividends and the new shareholders part with their cash to the company in exchange for new shares. The existing shareholders suffer an equal amount of capital loss since the value of their claim on firm’s assets gets reduced. The new shareholders gain new shares at a fair price per share. The fair price per share is the share price before the payment of dividends less dividend per share to the existing shareholders. The existing shareholders transfer a part of their claim on the firm to the new shareholders in exchange for cash. Thus there is no gain or loss. Since these two transactions are fair, the value of the firm will remain unaffected.
In the third scenario, if the
firm does not pay dividend, the shareholder can still create cash to meet his
needs by selling a part or whole of his shares at the market price in the stock
exchange. The shareholder will have lesser number of shares as he has exchanged
a part of his claim on the firm to the new shareholder in exchange for cash.
The net effect is the same once again. The transaction is a fair one as there
is no gain or loss. The value of the firm will remain unaffected.
This dividend irrelevance theory goes by the name Miller – Modigliani (MM) Hypothesis as they have propounded the same.
Miller and Modigliani have put forward the view that the value of a firm depends solely on its earnings power and is not influenced by the manner in which its earnings are split between dividends and retained earnings. This view is expressed as the MM – Dividend Irrelevance theory and is put forward in their acclaimed 1961 research work – Dividend policy, growth and the valuation of shares – in the Journal of Business Vol 34 (Oct 1961)
In this work, Miller and Modigliani worked out their argument on the following presumptions:
This dividend irrelevance theory goes by the name Miller – Modigliani (MM) Hypothesis as they have propounded the same.
Miller and Modigliani have put forward the view that the value of a firm depends solely on its earnings power and is not influenced by the manner in which its earnings are split between dividends and retained earnings. This view is expressed as the MM – Dividend Irrelevance theory and is put forward in their acclaimed 1961 research work – Dividend policy, growth and the valuation of shares – in the Journal of Business Vol 34 (Oct 1961)
In this work, Miller and Modigliani worked out their argument on the following presumptions:
1. Capital markets are perfect and investors are rational: information is
freely available, transactions are spontaneous, instantaneous, costless;
securities are divisible and no one particular investor can influence market
prices
2. Floatation costs are nil and negligible
3. There are no taxes
4. Investment opportunities and future profits of firms are known and can be found out with certainty – subsequently Miller and Modigliani have dropped this presumption
5. Investment and dividend decisions are independent
Thus, the MM hypothesis reveals that under a perfect market conditions, the dividend policies of a firm are irrelevant, as they do not affect the value and worth of the firm. It further unfolds that the value of the firm depends on its earnings and they result from its investment policy. Therefore, the dividend decision of the firm – whether to declare dividend or not, whether to distribute the earnings towards dividends or retained earnings – does not affect the investment decision.
M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. The dividend plus the “new” stock price after dilution exactly equals the stock price prior to the dividend distribution.
M&M and the total-value principle ensure that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same. Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive
Drawbacks of MM Hypothesis
Though the critics of Miller Modigliani hypothesis agree with the view that the dividends are irrelevant, they dispute the validity of the findings by questioning the assumptions used by Miller and Modigliani.
According to them, dividends to matter mainly on account of the uncertain future, the capital market imperfections and incidence of tax.
Uncertain Future
In a word of uncertain future, the dividends declared by a company based as they are on the judgements of the management on the future, convey the prediction about the prospects of the company. A higher dividend payout may suggest that the future of the company, as judged by the management is very promising. A lower dividend payout thus may suggest that the future of the company as considered by the management may is very uncertain.
An associated argument is that dividends reduce uncertainty perceived by the shareholder investors. Hence they prefer dividends to capital gains. So, shares with higher current dividend yields, other things being equal, attract a very high price in the market. However Miller and Modigliani maintain that dividends merely serve as a substitute for the expected future earnings which really determine the value. They further argue dividend policy is irrelevant.
Uncertainty and Fluctuations
Due to uncertainty share prices tend to fluctuate, sometimes very widely. When the prices vary, conditions for conversion of current income into capital value and vice versa may not be regarded as satisfactory by the investors. Some investors may be reluctant to sell a portion of their investment in a fluctuating if they wish to enjoy more current income. Such investors would naturally prefer and value more a higher dividend pay out. Some investors may be hesitant to buy shares in a fluctuating market if they wish to get a less current income and therefore they may value more a lower dividend pay out.
Additional Equity at a Lower Price
Miller and Modigliani assume that a company can sell additional equity at the current market price. However, companies following the advice and suggestions of investment bankers or merchant bankers offer additional equity at a price lower than the current market price. This under pricing practice mostly stems out of market compulsions.
Issue Costs
Miller and Modigliani assumption is based on the basis that retained earnings or dividend payouts can be replaced by external
Transaction Costs
In the absence of transaction costs, dividends and capital gains are equal. In such a situation if a shareholder desires higher current income than the dividends received, he can sell a portion of his capital equal in value to the additional current income required. Likewise, if he wishes to enjoy lesser current income than the dividends paid, he can buy additional shares equal in value to the difference between dividends received and the current income desired. In a real world, transaction costs are incurred. Due to this, capital value cannot be converted into an equal current income and vice versa.
Tax Considerations
Miller and Modigliani assume that the investors exhibit indifference between dividends and capital appreciation. This may be true when the rate of taxation is the same for dividends received and capital appreciation enjoyed. In real life, the taxes are different on dividends and capital appreciation. Tax on capital appreciation is lower than tax rate on dividends received. Due to this the investors may go in for capital appreciation
Tags : Financial Management - DIVIDEND POLICIES
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