DIVIDEND POLICIES AND DECISIONS :WHY PAY DIVIDENDS

WHY PAY DIVIDENDS

The main theories are:

1. Residual dividend theory

Under this theory, a firm will pay dividends from residual earnings i.e. earnings remaining after all suitable projects with positive NPV has been financed.

It assumes that retained earnings is the best source of long term capital since it is readily available and cheap.  This is because no floatation cash are involved in use of retained earnings to finance new investments.

Therefore, the first claim on earnings after tax and preference dividends will be a reserve for financing investments.

Dividend policy is irrelevant and treated as passive variable.  It will not affect the value of the firm.  However, investment decisions will.

Advantages of Residual Theory

1. Saving on floatation costs

No need to raise debt or equity capital since there is high retention of earnings which requires no floatation costs.

2. Avoidance of dilution of ownership

New equity issue would dilute ownership and control.  This will be avoided if retention is high.A high retention policy may enable financing of firms with rapid and high rate of growth.

3. Tax position of shareholders

High-income shareholders prefer low dividends to reduce their tax burden on dividends income.

They prefer high retention of earnings which are reinvested, increase share value and they can gain capital gains which are not taxable in Kenya.

ii) MM Dividend Irrelevance Theory

Was advanced by Modiglian and Miller in 1961.  The theory asserts that a firm’s dividend policy has no effect on its market value and cost of capital.

They argued that the firm’s value is primarily determined by:

·         Ability to generate earnings from investments

·         Level of business and financial risk

According to MM dividend policy is a passive residue determined by the firm’s need for investment funds.

It does not matter how the earnings are divided between dividend payment to shareholders and retention.  Therefore, optimal dividend policy does not exist.  Since when investment decisions of the firms are given, dividend decision is a mere detail without any effect on the value of the firm.

They base on their arguments on the following assumptions:

1.      No corporate or personal taxes

2.      No transaction cost associated with share floatation

3.      A firm has an investment policy which is independent of its dividend policy (a fixed investment policy)

4.      Efficient market – all investors have same set of information regarding the future of the firm

5.      No uncertainty – all investors make decisions using the same discounting rate at all time i.e required rate of return (r) = cost of capital (k).

iii) Bird-in-hand theory

Advanced by John Litner (1962) and furthered by Myron Gordon (1963).

Argues that shareholders are risk averse and prefer certainty.  Dividends payments are more certain than capital gains which rely on demand and supply forces to determine share prices.

Therefore, one bird in hand (certain dividends) is better than two birds in the bush (uncertain capital gains).

Therefore, a firm paying high dividends (certain) will have higher value since shareholders will require to use lower discounting rate.

iv) Information signaling effect theory

Advanced by Stephen Ross in 1977.  He argued that in an inefficient market, management can use dividend policy to signal important information to the market which is only known to them.

Example – If the management pays high dividends, it signals high expected profits in future to maintain the high dividend level.  This would increase the share price/value and vice versa.

Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the value of the firm.  The theory is based on the following four assumptions:

1. The sending of signals by the management should be cost effective.
2. The signals should be correlated to observable events (common trend in the market).
3. No company can imitate its competitors in sending the signals.
4. The managers can only send true signals even if they are bad signals.  Sending untrue signals is financially disastrous to the survival of the firm.

v) Tax differential theory

Advanced by Litzenberger and Ramaswamy in 1979

They argued that tax rate on dividends is higher than tax rate on capital gains.Therefore, a firm that pays high dividends have lower value since shareholders pay more tax on dividends.

Dividend decisions are relevant and the lower the dividend the higher the value of the firm and vice versa.

vi) Clientele effect theory

Advance by Richardson Petit in 1977

It stated that different groups of shareholders (clientele) have different preferences for dividends depending on their level of income from other sources.

Low income earners prefer high dividends to meet their daily consumption while high income earners prefer low dividends to avoid payment of more tax. Therefore, when a firm sets a dividend policy, there’ll be shifting of investors into and out of the firm until an equilibrium is achieved. Low, income shareholders will shift to firms paying high dividends and high income shareholders to firms paying low dividends.

At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has.  Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors.

vii) Agency theory

The agency problem between shareholders and managers can be resolved by paying high dividends.  If retention is low, managers are required to raise additional equity capital to finance investment.Each fresh equity issue will expose the managers financing decision to providers of capital e.g bankers, investors, suppliers etc.Managers will thus engage in activities that are consistent with maximization of shareholders wealth by making full disclosure of their activities.

This is because they know the firm will be exposed to external parties through external borrowing.  Consequently, Agency costs will be reduced since the firm becomes self-regulating.

Dividend policy will have a beneficial effect on the value of the firm.  This is because dividend policy can be used to reduce agency problem by reducing agency costs.The theory implies that firms adopting high dividend payout ratio will have a higher due to reduced agency costs.