Dividend Relevance

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How accurate is the statement that “The dividend policy of a firm is irrelevant”.

By

Mr. George Ekegey Ekeha

(MBA – Finance, MBA & BCom)

(Lecturer in Corporate Finance & International Finance @ Regent University College of Science & Technology)

Email: ekegey24ge@yahoo.co.uk

March 2009

THIS PAPER IS PREPARED IN RESPONSE TO A RELEVANT QUESTION TO HELP STUDENTS TAKING CORPORATE FINANCE COURSE.

No Part of This Thesis Is To Be Used For Any Purposes, Other Than Academic REFERENCE, Without The Official Consultation With The Author.

TABLE OF CONTENT

1.0 EXECUTIVE SUMMARY2

2.0 DIVIDEND POLICY3

2.1 DIVIDENDS PAYMENTS3
2.2.0 FACTORS AFFECTING DIVIDEND POLICY5
2.2.1 LEGAL RESTRAINTS5
2.2.2 SHAREHOLDERS EXPECTATIONS5
2.2.3 TAXATION6
2.2.4 CASH-FLOW UNCERTAINTY7

3.0 DIVIDEND POLICY RELEVANCY8

3.1.0 EXPLANATIONS OF DIVIDEND RELEVANCE8
3.1.1 THE BIRD-IN-THE-HAND EXPLANATION8
3.1.2 THE SIGNALLING EXPLANATION9
3.1.3 THE TAX-PREFERENCE EXPLANATION10
3.1.4 THE AGENCY EXPLANATION10
3.2.0 INDUSTRY INFLUENCE ON DIVIDEND POLICY11

4.0 THE CLIENTELE EFFECT.12

5.0 CONCLUSION14

APPENDIX I: CORPORATE FINANCE ASSIGNMENT16

APPENDIX II: REFERENCES17

1.0 EXECUTIVE SUMMARY

Various studies suggest that the question of whether dividend policy affects the value of the firm has puzzled researchers and corporate managers for many years. It is evidence that dividend policy is one of the most widely researched topics in finance. Yet, researchers have different views about whether the percentage of earnings that a firm pays out in dividends materially affects its long-term share price, Dempsey et al, (1993).

This essay tried to identify the various studies on the dividend puzzle. It is outlined in this essay that dividend payment by corporate organisations is influenced by various factors. Some of the factors discussed here include legal restrains, shareholders’ expectations, taxation and the cash-flow uncertainty effect. This essay established the fact that these factors play a very vital role in corporate managers’ decision to pay dividend.

On the relevance of the dividend policy, the discussion focused on the Miller and Modigliani’s hypothesis of 1961, which was supported by several other researchers like Miller and Scholes (1978), Jose and Stevens (1989). There were, however some criticisms to Miller and Modigliani’s hypothesis from other researchers like Sterk and Vandenberg (1990), Farrelly, Baker, and Edelman (1986), who believed that there exist some correlation between firm’s dividend policy and its share value.

Finally, the essay discussed the relevance of the clientele effect on dividend policy. The study by Elton and Gruber (1970) was discussed and various criticisms on their findings was also discussed. The essay identified the work of other researchers such as Kalay (1982) and Barclay (1987), who criticised Elton and Gruber (1970). It was however agreed by the researchers that the clientele effect has a relevant correlation on corporate dividend policy.

2.0 DIVIDEND POLICY

Dividend policy is the decision to pay dividend versus retaining funds to invest in the firm. In theory, if the firm reinvests capital now, it will grow and can pay higher dividend in future. Nobel economic laureates Miller and Modigliani empirically, in their 1961 studies, showed that dividend policy should not matter to the value of the firm. While financial theory is unequivocal on the irrelevance of dividend policy in perfect capital markets, there is widespread recognition that payout policy in practice is controversial and not well understood. In the presence of taxes and transaction costs, the payment of a dividend by the firm is regarded as something of a puzzle. Nonetheless, most firms pay dividends. Brealey and Myers (1991, p. 918) list dividend policy as one of their “10 unresolved problems in finance.” Brigham and Gapenski (1991,...
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