Does a dividend policy matter?

Topics: Dividend, Dividend yield, Stock market Pages: 5 (1574 words) Published: March 26, 2014
That report is a detailed review of dividend policy and whether or not could affect the market value of the company. When companies make profits, managers have to decide either to reinvest those profits for the good of company or either they could pay out the owners (shareholders) of the firm in dividends. Once they decide to pay dividends they may possibly establish a permanent dividend policy, which is the set of guidelines a company uses in order to decide how much of its profits it will pay out to shareholders in dividends and that decision depends on the preferences of existing and new investors and the situation of the company now and in the future (Garrison, 1999). There are various limitations that may affect firm’s decision and must consider when paying dividends to shareholders such as Legal Limitations where added net realised profits is the only way to pay dividends, Liquidity where managers has to consider the effect that future dividend payments may have on liquidity, Interest Payment obligations where if the gearing (level of debt) is high then the available funds for dividends should be reduced and Investment Opportunities where a company could invest in attractive projects rather than to pay more dividends (Watson and Head, 2007). There are two theories related to dividend, the Irrelevance Theory suggested that dividend policy it is not relevant to security valuation and the Relevance Theory, suggested that it is relevant and affect the value (Bar-Yosef and Kolodny, 1976). Below will see those theories. IRRELEVANCE THEORY

Modigliani & Miller (1961) through the Irrelevance Theory stated that share value depends on corporate earnings, which reflect the investment policy of the company, depends only on investment decisions and it is independent of the level of dividend paid. First of all that theory assume that capital markets are perfect, there are no transactions costs associated with converting shares into cash by selling them and firms can issue shares without incurring flotation or transactions costs to raise equity, whenever needed (Damodaran [Internet source]). Another assumption that Modigliani & Miller made is that there are no taxes at either a corporate or personal level associated with dividend and informations are freely available to all investors. Continuing with the assumptions Modigliani & Miller stated that in a perfect capital market there are no conflicts of interests between managers and security holders, which is known as the Agency Problem. Shareholders, actually, own a company but managers are the ones who make the business run and decide. The agency problem arise because manager’s interests are different from shareholder’s interests and that is for the reason that managers may prefer to invest in unprofitable projects for their own benefit and that may incur some costs in order to manage the manager’s behaviour (Ming and Ming, 2013). Modigliani and Miller argues that rational investors, in other words those who prefer their wealth maximization, do not care whether they receive dividends on their shares or investing retained earnings in new opportunities, they have identical borrowing and lending rates and were apathetic to the timing of dividends. Furthermore shareholders can simply sell some of their shares for cash, if dividend are too small. According to Modigliani and Miller a company’s choice of dividend policy is a choice of financing strategy and the investment decision is separate from the dividend decision (Watson And Heat, 2007). They also argued that investors calculate the value of companies based on their future earnings capitalized value and is not affected by the dividends that a company pay and neither how dividend policies are set from company. RELEVANCE THEORY

On the other hand we have the Relevance Theory of Lintner (1956) and Gordon (1959), who argued that dividends are preferred to capital gains due to their certainty, which means that an investor...
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