Dividend Policy

Topics: Dividend, Dividend yield, P/E ratio Pages: 15 (4977 words) Published: July 15, 2010

The purpose of this paper is to help management must decide on the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash.

The purpose of an optimal dividend policy should be to maximize shareholders’ wealth. This depends on both current dividends and capital gains. Capital gains can be achieved by retaining risome earnings for reinvestment and dividend growth in the future.

Dividend represents a share profit distributed to shareholders of a corporation, according to a certain payout ratio or more precisely according to certain dividend policy. Prudent companies save their cash until opportunities arise for acquisitions that have a real effect on earnings. Barring that, companies can decide to return cash to shareholders through dividends rather than buybacks. Shareholders can then decide for themselves whether to buy more company shares with their dividend income or to use it on something else. Although dividend payments lead to taxes for investors, they give the individual more control than do share buybacks

I- What is “dividend policy”?
Dividend policy decisions about when and how much of earnings should be paid as dividends. Earnings that are paid out as dividends cannot be used by the firm to invest in projects with positive net present values—that is, to increase the value of the firm. The dividend policy that maximizes the value of the firm is said to be the optimal dividend policy. Dividend policy is controversial. Includes these elements:

1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?
Do investors prefer high or low payouts?

There are three theories:
* Dividends are irrelevant: Investors don’t care about payout. * Bird in the hand: Investors prefer a high payout.
* Tax preference: Investors prefer a low payout, hence growth. Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. A-Modigliani-Miller support irrelevance. M & M in the case of perfect markets.M&M argued that dividend policy is irrelevant it doesn’t affect the value of the firm or its cost of capital and there is no optimal dividend policy is as good as any other. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. B- Bird in the hand theory. "Paying out some cash today reduces risk of future payoff uncertainty". Gordon and Linter arguing that dividends are less risky than capital gains, so a firm should set a high dividend pay put ratio and offer a high dividend yield in order to maximize its stock pricewise., a high payout would result in a high P0. C- Tax preference theory: Tax on dividends = tax on income $ tax on capital gains. But tax on dividends must be paid now, while on capital gains would be in the future. Whatever dividends are taxed more heavily than capital gains, firms should pay reinvestment or used to repurchase shares. Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 39.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.

Which theory is most correct?

* Empirical testing has not been able to determine which theory, if any, is correct. * Thus, managers use judgment when...
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