Written by Carl R.
Even though there are numerous academic studies on dividend policy, the topic has been one of the most controversial topics in the finance sector. With continuous debates and ongoing research on the effect of dividends on a firm’s characteristics, the dividend picture appears as a puzzle, where the pieces fail to fit together (Black, 1976). With contradictory theories and views emerging to explain the effect of dividend payouts on the company’s value, the academic literature has divided dividend theories into two broad categories, namely: the irrelevance theory and value-relevance theory. While the irrelevance theory suggests there is no relationship between dividends and a company’s value, the value-relevance theory claims that dividend payouts have a significant effect on firm value. The aim of this essay is to discuss both views and determine whether dividends have any influence on the company value.
The foremost dividend irrelevance theory was suggested by Merton Miller and Franco Modigliani (M&M) in 1961 and until this day, this theory remains one of the most popular frameworks in the financial literature (Baker, 2009). As per this theory, Miller and Modigliani argued that under the ideal circumstances of a perfect capital market, certainty and rational investor behaviour, the dividend payment is not related to a company’s value. It assumes that an ideal financial market is free from conflicts of interest between managers and shareholders and gives equal access to all information to its investors. It further claims that under ideal circumstances, no transaction costs exist while buying and selling shares and there is no difference between the tax rates for dividends and capital gains. Eventually, this theory suggested that dividends have no noticeable effect on the value of a firm.
Based on the M&M theory, Black and Scholes (1974) examined 25 companies listed on the New York Stock Exchange for a period starting from 1936 to 1966 to study the relationship between the share returns and dividend yields. Using the Capital Asset Pricing Model, it was found that the difference in the dividend yields had no effect on the differences in the stock returns. Thus, their findings supported the dividend irrelevance theory. On the other hand, Ball and Brown (1979) tested the impact of dividends on the share prices of Australian companies for a period starting from 1960 to 1969 with the help of a cross-sectional regression model and claimed that the dividend policy was relevant. Furthermore, Baker and Powell (2000) surveyed 603 listed US chief finance officers (CFOs) and found that 90% of respondents did not agree with the M&M irrelevance theory.
In contrast to the irrelevance theory, several value-relevance theories were further suggested. One of the popular theories in this field is the Bird in Hand Theory proposed by Myron Gordon (1963) and John Lintner (1962). This theory works on the logic that a bird in the hand is always preferred to two in the bush and claims that investors perceive dividend paying companies as less risky. Hence, the cost of equity of such companies is lower, which directly affect the value of the company. It concluded that as investors are willing to pay a higher price for firms with dividend payments, dividends help in maximising the value of the firm. Based on Lintner’s theory, Baker et al., (2002) investigated the behaviour of managers of US companies and concluded that dividend policy produced a significant impact on share prices.
Another value-relevance theory is the Signalling Theory which argues that a firm’s management has more private knowledge about the firm’s current and future situations as compared to the outsiders. Thus, managers are likely to use dividends as specific signals to investors such as expectations of future growth and profitability (John and Williams, 1985). This explains why dividends tend to be smoother than earnings of the company. It further supported the Lintner (1956) research and showed how dividend payouts could be value creating.
Additionally, the Agency Theory asserts that dividends are one of the mechanisms that reduces agency costs arising due to asymmetric information between investors and managers. If a company does not pay out dividends, it retains more earnings, and investors must be confident that the management will reinvest these earnings wisely. However, since there is information asymmetry between managers and investors, there is no perfect trust and for this reason investors place a higher value on dividends. Thus, according to the agency theory, companies with generous dividend policies are likely to have a positive boost in value (Rozeff, 1982; La Porta et al., 2000). Similarly, Tax related theories were developed by Brennan (1970) and Litzenberger and Ramaswamy (1979), where they argued that investors whose dividend income is taxed higher than capital gains might prefer shares with either low dividends or with no dividends at all.
Numerous empirical studies have been conducted to test these theories in practice. For example, Hussainey et al. (2011) examined the relationship between dividend policy and the changes in share prices on the British Stock Market. The evidence collected showed that the dividend payout ratio had a negative correlation with the security price changes. However, Profilet and Bacon (2013) studied the impact of financial factors on the overall securities’ price instability and using the ordinary least squares regression model they determined that dividend payment had a positive impact on the stock returns.
In summary, it can be concluded that dividend theories have different views on value implications of the dividend policy of a company. Whereas the classical irrelevance theory suggests that dividends should not impact the value of the company, it is still based on a number of significant assumptions that do not hold in real life. Even though some studies empirically confirmed the theory, many studies support the alternative value-relevance theory.
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