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Theories of Dividend Policy

Theories of Dividend Policy

Dividend policy dictates the amount and timing of dividend payments. Two groups of financial theorists have different opinions on the dividend policy, with one group claiming that the dividend policy is irrelevant to shareholders. In contrast, another group claims that dividend policy does matter to a company’s shareholders. Normally, the significance of dividends is associated with the belief that investors value a unit of dividend more than an equal amount of uncertain capital gain.

Dividend Policy Does Not Matter

Modigliani and Miller argued that under perfect market assumptions, a company’s dividend policy should have no impact on shareholder wealth or its cost of capital. The dividend decision is independent of a company’s financing and investment decisions. According to the MM assumptions, there is no difference between share repurchases and dividends as they are all ways a company returns cash to shareholders. A company would distribute more cash in the form of dividends to its shareholders if its current cash flows were more than what they need for positive NPV projects. In a world with no transaction costs or taxes, if shareholders need income, they could construct their dividend policy by selling enough shares to create the desired cash flows. This concept is known as the ‘homemade dividend.’

The irrelevance argument does not argue that dividends are not relevant to share value, but that the actual dividend policy is irrelevant. Due to market imperfections, however, MM’s dividend policy irrelevance propositions have some problems, namely:

  • Both the individual and the company incur transaction costs.
  • If the share price declines, shareholders will be forced to sell more shares to create the same income stream of dividends.

Dividend Policy Matters: Bird in the Hand Argument

Financial theorists such as Myron Gordons have argued that due to the low level of risk that dividends have, shareholders will prefer a dollar of dividends to a dollar of potential capital gain from reinvesting earnings. Assuming that capital gains are riskier than the same amount of dividends, the argument is that a company that pays dividends will have a lower cost of capital, which translates to a higher share price. However, MM contends with this argument because increasing dividend payouts do not affect the risk of future cash flows.

Dividend Policy Matters: The Tax Argument

In most countries, income from dividends is taxed at higher rates than capital gains. An argument can be made that in countries with a high tax rate on dividend income than capital gains, investors will prefer companies that pay low dividends and reinvest earnings in more profitable opportunities. Growth in earnings that is more than the opportunity cost of funds would lead to higher share prices. A company lacks growth opportunities that would use retained earnings; it could distribute its funds through share repurchases. Some countries have laws that require companies to distribute excess earnings as dividends making it complicated to have a zero-payout ratio.

Question

The ‘bird in the hand theory’ implies that:

  1. Dividend policy matters.
  2. Dividend policy is irrelevant.
  3. High tax rates matter.

Solution

The correct answer is A.

The theory suggests that dividend policy matters.

B is incorrect. The bird-in-hand theory suggests that dividend policy is relevant.

C is incorrect. Taxes are not covered in the bird in the hand theory.

Reading 16: Analysis of dividends and Share Repurchases

LOS 16 (b) Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action.

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