Dividend Policy 1

I.

INTRODUCTION
In corporate finance, the finance manager is generally thought to

face two operational decisions: the investment (or capital budgeting)

and

the

financing

decisions.

The

capital

budgeting

decision

is

concerned with what the real assets the firm should acquire while the
financing

decision

is

concerned

with

how

these

assets

should

be

financed. A third decision may arise, however, when the firm begins to
generate profits. Should the firm distribute all proportion of earned
profits in the form of dividends to the shareholders, or should it be
ploughed back into the business? Presumably, in taking any course of
action, managers should concentrate on how to maximize the wealth of
shareholders for whom the firm is being managed. Managers must

not

only consider the question of how much of the companys earnings are
needed for investment, but also take into consideration the possible
effect of their decisions on share prices (Bishop et al., 200).

The issue of dividend policy remains one of the most contested

issues

in

finance.

The

study

of

dividend

policy

has

captured

the

attention of finance scholars since the middle of the last century.

They have attempted to solve several issues pertaining to dividends
and

formulate

theories

and

models

to

explain

corporate

been

enduring

dividend

behavior.

The

dividend

enigma

has

not

only

an

issue

in

finance, it also remains unresolved. Almost three decades ago Black

(1976) described it as a puzzle, and since then an enormous amount

Dividend Policy 2
of research has occurred trying to solve the dividend puzzle. Allen
Bernardo and Welch (2000, p.2499) summarized the current consensus
view when they included Although a number of theories have been put
forward

in

the

literature

to

explain

their

pervasive

presence,

dividends remain one of the thorniest puzzles in corporate finance.

Consequently,

several

questions

arise

regarding

dividends

and

dividend policies as a whole. One of these questions would be, Why do

firms

pay

dividends?.

This

is

question

most

of

the

people,

especially those who own a part of a company or a stock holder of that

company, usually ask. They think that for every dollar they receive in
dividends, thats one less dollar the firm can use to reinvest in new
assets or products. And the firm might end up borrowing more money or
issuing new shares to invest in capital projects because its giving
them dividends. What some of them dont like about dividends is this:
If they receive a dividend check, they have to pay taxes on it. Theyd
just as soon have the firm keep the money and reinvest it wisely. Or
maybe use it to buy back shares of stock, so the price of their shares
will rise.

How do dividends affect the value of a company? Or do they not

affect it at all? Why do some firms pay dividends while others dont?
These and other related topics are the subject of this research/ term
paper.

Dividend Policy 3
II.

BACKGROUND OF THE STUDY

A. DEFINITIONS
1. What are Dividends?
Corporations earn profits, but they do not distribute all of
it. Part of it is ploughed back or held back as retained earnings.
Those

retained

corporate

earnings

are

then

distributed

to

stockholders as dividends. Dividends are paid either in cash and are

typically issued quarterly. They may be paid only out of retained
earnings and not from invested capital such as capital stock or the
excess received over stock par value. In general, the more stable a
companys earnings, the more regular its issue of dividends.

Dividends also represent a critical piece of the financial

system because of their role in determining the value of stocks. The
relationship between dividends and value can be viewed from the
perspective of an individual investor or from that of the market as
a whole. (Lasher, 2008 p. 599).

a. The

Individual

Perspective

An

individual

buys

stock

because he or she expects an acceptable return from dividends

and from the receipts when the shares eventually are sold.
Todays price is the present value of those future cash flows
discounted at the appropriate rate for an equity investment in
the company. If an investor plans to hold a stock for n
years, these ideas can be written as follows.

Dividend Policy 4
Equation 1:

Where:

P0

todays stock price

Di =

dividend in the ith year ( i = 1, 2, . . . , n)

Pn

the selling price of the stock in the nth year

the expected return on equity

b. The Whole Market View Developing the above equation to come

up with the whole market focus, we simply replace Pn with the
present value of the remaining dividends stretching infinitely
into the future. The buyer in year n would have a model in
mind similar to equation 1, and replacing Pn with that model
would conceptually push the selling price further into the
future. This mental process can be applied as many times as
possible to get the eventual selling price infinitely distant
in time, at which point its present value would be zero. Thus,
we could work with a model that had an infinite dividend
stream rather than a finite stream followed by a price.

Although some academic factions have argued that dividend

does not affect the value of the firm, still other groups of
academics have argued that dividends are the only factor that
determines

firm

value.

This

shows

up

in

Gordons

dividend growth model for a share of common stock:

constant

Dividend Policy 5

Equation 2:

According to the Gordon model, if the firm increases its

cash dividend, the price of its stock will increase. Remember,
however, that any increase in the dividend is a reduction in
retained earnings, which causes a lower growth rate, g, for the
firm. According to the model, a lower growth rate reduces the
firms stock price, so the optimal dividend policy must balance
the effects of these two variables to maximize the stock price.

In managing a firms capital structure, financial managers

are

concerned

with

raising

funds

in

least-cost

manner.

Ironically, while the process of raising funds is going on, funds

also

are

dividends.

being
On

distributed
the

to

surface,

shareholders
the

whole

in

the

operation

form

of

appears

counterproductive and a waste of time (if not money). It may be

simpler to raise funds when they are needed and pay dividends
only

when

excess

funds

are

available.

Indeed,

many

financial

managers follow such an approach, but many do not. Obviously,

paying dividends is a complex issue and, as is the case for
optimizing capital structure, is not easily resolved. Winger &
Mohan (1991, p.553) examined two broad dividend strategies: (1)
treating dividends as residuals, that is, funds available from
internal earnings that cannot be reinvested profitably within the

Dividend Policy 6
firm; and (2) establishing specific dividend-paying policies that
are maintained even if internal earnings cannot sustain them.

2. What is a Dividend Policy?

The theoretical issues surrounding the dividends, are, as yet,

unresolved and most likely will remain that way in the future.
However, the behavior of many companies indicates that they believe
that dividends are relevant. A large number of firms, probably a
majority, adopt a specific dividend policy.

Dividend

Policy

is

the

decision

firm

makes

to

pay

out

earnings or retain them for reinvestment in the firm. The term

"dividend

policy"

also

refers

to

"the

practice

that

management

follows in making dividend payout decisions or, in other words, the

size and pattern of cash distributions over time to shareholders"
(Lease et al., 2000, p. 29). If it pays out dividends, company must
determine the amount to pay out and the amount to retain. Two
questions drive a firms dividend policy: Does the dividend policy
have an effect upon the firms value? If so, will the firm try to
achieve an optimal payout ratio by attaining an ideal dollar payment
per share? These questions have sparked debate between practitioners
and academicians for many years. Practitioners see an optimal level
of dividend payout, whereas some academic factions have argued that
dividend policy does not affect the value of the firm at all.

Dividend Policy 7
A companys dividend policy is important for the following
reasons (Shim & Siegel, 2007 p.337):

1. It bears upon investor attitudes. For example, stockholders

look unfavorably upon the corporation when dividends are cut,
since

they

associate

the

cutback

with

corporate

financial

problems. Further, in setting a dividend policy, management

must

ascertain

and

fulfill

the

objectives

of

its

owners.

Otherwise, the stockholders may sell their shares, which in

turn may bring down the market price of the stock. Stockholder
dissatisfaction

raises the

possibility that

control of

the

company may be seized by an outside group.

2. It impacts the financing program and capital budget of the
firm.
3. It affects the firms cash flow position. A company with a
poor liquidity position may be forced to restrict its dividend
payments.
4. It lowers stockholders equity, since dividends are paid from
retained earnings, and so results in a higher debt-to-equity
ratio.

If

companys

cash

flows

and

investment

requirements

are

volatile, the company should not establish a high regular dividend.

It would be better to establish a low regular dividend that can be
met even in years of poor earnings.

Dividend Policy 8
At this point you may ask, how do firms pay dividends? Firms
can disburse dividends in many forms, but most make quarterly cash
payments. For example, Exxon paid total dividends of $2.91 per share
in

2011,

in

quarterly

installments

if

$0.72,

$0.72,

$0.72,

and

$0.75. The dividend payment procedure for the first quarter includes
several steps as indicated in Figure 1.

Figure 1: Dividend Payment Procedure

The dividend declared on April 27 is payable on June 1 to

owners of record as of May 12. However, to be an owner of record by
may 12, an investor must have purchased shares by May 9.

Relevant dates associated with the dividend are as follows:

1. Declaration Date This is the date on which the board of
directors declares the dividend. On this date, the payment
of the dividend becomes a legal liability of the firm.
2. Record Date This is the date upon which the stockholder is
entitled to receive the dividend.
3. Ex-dividend Date The ex-dividend date is the date when the
right to the dividend leaves the shares. The right to a

Dividend Policy 9
dividend stays with the stock until 2 days before the date
of record. That is, in the second day prior to the record
date,

the

right

to

the

dividend

is

no

longer

with

the

shares, and the seller, not the buyer of that stock, is the
one who will receive the dividend. The market price of the
stock

reflects

that

it

has

gone

ex-dividend

and

will

decrease by approximately the amount of dividend.

4. Payment Date This is the date when the company distributes
its dividend checks to its stockholders.

Dividends

are

usually

paid

in

cash.

cash

dividend

is

typically expressed in dollars and cents per share. However, the

dividend on preferred stock is sometimes expressed as a percentage
of par value. Some companies allow stockholders to automatically
reinvest their dividend in corporate shares instead of receiving
cash. The advantage to the stockholder is that he or she avoids the
brokerage fees associated with buying new shares. However, there is
no

tax

advantage

since

the

stockholder

income taxes on the dividend received.

must

still

par

ordinary

Dividend Policy 10
B. BACKGROUND HISTORY

The issue of corporate dividends has a long history and, as

Frankfurter and Wood (1997) observed, is bound up with the development
of the corporate form itself. Corporate dividends date back at least
to the early sixteenth century in Holland and Great Britain when the
captains of sixteenth century sailing ships started selling financial
claims to investors, which entitled them to share in the proceeds, if
any, of the voyages3. At the end of each voyage, the profits and the
capital

were

distributed

to

investors,

liquidating

and

ending

the

ventures life. By the end of the sixteenth century, these financial

claims

began

to

be

traded

on

open

markets

in

Amsterdam

and

were

gradually replaced by shares of ownership.

It is worth mentioning that even then many investors would buy

shares from more than one captain to diversify the risk associated
with this type of business.

At the end of each voyage, the enterprise liquidation of the

venture ensured a distribution of the profits to owners and helped to
reduce the possibilities of fraudulent practice by captains (Baskin,
1988). However, as the profitability of these ventures was established
and became more regular, the process of liquidation of the assets at
the conclusion of each voyage became increasingly inconvenient and
costly. The successes of the ventures increased their credibility and
shareholders became more confident in their management (captains), and

Dividend Policy 11
this was accomplished by, among other things, the payment of generous
dividends (Baskin, 1988). As a result, these companies began trading
as going concern entities, and distributing only the profits rather
than the entire invested capital. The emergence of firms as a going
concern initiated the fundamental practice of firms to decide what
proportion of the firms income (rather than assets) to return to
investors

and

produced

the

first

dividend

payment

regulations

(Frankfurter and Wood, 1997). Gradually, corporate charters began to

restrict the payments of dividends to the profits only.

The ownership structure of shipping firms gradually evolved into

a joint stock company form of business. But it was chartered trading
firms more generally that adopted the joint stock form. In 1613, the
British East India Company issued its first joint stock shares with a
nominal value. No distinction was made, however, between capital and
profit (Walker, 1931, p.102). In the seventeenth century, the success
of this type of trading company seemed poised to allow the spread of
this form of business organization to include other activities such as
mining, banking, clothing, and utilities. Indeed, in the early 1700s,
excitement about the possibilities of expanded trade and the corporate
form saw a speculative bubble form, which collapsed spectacularly when
the South Sea Company went into bankruptcy. The Bubble Act of 1711
effectively slowed, but did not stop, the development of the corporate
form in Britain for almost a century (Walker, 1931).

Dividend Policy 12
In the early stages of corporate history, managers realized the
importance of high and stable dividend payments. In some ways, this
was due to the analogy investors made with the other form of financial
security then traded, namely government bonds. Bonds paid a regular
and

stable

interest

payment,

and

corporate

managers

found

that

investors preferred shares that performed like bonds (i.e. paid a

regular and stable dividend). For example, Bank of North America in
1781 paid dividends after only six months of operation, and the bank
charter

entitled

the

board

of

directors

to

distribute

dividends

regularly out of profits. Paying consistent dividends remained of

paramount importance to managers during the first half of the 19th
century (Frankfurter and Wood, 1997, p.24)

In addition to the importance placed by investors on dividend

stability, another issue of modern corporate dividend policy to emerge
early in the nineteenth century was that dividends came to be seen as
an important form of information. The scarcity and unreliability of
financial data often resulted in investors making their assessments of
corporations
earnings.

In

through
short,

their

dividend

investors

were

payments
often

rather
faced

than

with

reported

inaccurate

information about the performance of a firm, and used dividend policy

as a way of gauging what managements views about future performance
might be. Consequently, an increase in divided payments tended to be
reflected in rising stock prices. As corporations became aware of this
phenomenon, it raised the possibility that managers of companies could
use dividends to signal strong earnings prospects and/or to support a

Dividend Policy 13
companys

share

price

because

investors

may

read

dividend

announcements as a proxy for earnings growth.

To

summarize,

the

development

of

dividend

payments

to

shareholders has been tied up with the development of the corporate

form

itself.

Corporate

managers

realized

early

the

importance

of

dividend payments in satisfying shareholders expectations. They often

smoothed dividends over time believing that dividend reductions might
have unfavorable effects on share price and therefore, used dividends
as a device to signal information to the market. Moreover, dividend
policy is believed to have an impact on share price. Since the 1950s,
the

effect

of

dividend

policy

on

firm

value

and

other

issues

of

corporate dividend policy have been subjected to a great debate among

finance scholars. The next section considers these developments from
both a theoretical and an empirical point of view.

III. TYPES OF DIVIDEND POLICY

A finance managers objective for the companys dividend policy

is to maximize owner wealth while providing adequate financing for the
company (Shim 7 Siegel, 2001 p.338). When companys earnings increase,
management does not automatically raise the dividend. Generally, there
is a time lag between increased earnings and the payment of a higher
dividend.

Only

when

management

is

confident

earnings will be paid at the higher rate.

that

the

increased

Dividend Policy 14
Below are the various and most common types of dividend polices.

1. Stable Dividend Policy Many companies use stable dividendper-share

policy

since

it

is

looked

upon

favorably

by

investors. Dividend stability implies low-risk company. Even

in a year that the company shows a loss rather than profit the
dividend should be maintained to avoid negative connotations
to current and prospective investors. By continuing to pay,
the shareholders are more apt to the loss as temporary. Some
stockholders

rely

on

the

receipts

of

stable

dividends

for

income. And according to Shim & Siegel (2007 p.338), a stable

dividend policy is also necessary for a company to be placed
on

list

of

securities

in

which

financial

institutions

(pension funds, insurance companies) invest. Being on such a

list provides greater marketability for corporate shares.

Managers
expect

to

resist

maintain

increasing
the

increase

dividends
in

the

if

they

future.

do

If

not

firms

hesitate to raise dividends too quickly, they positively abhor

the prospect of reducing dividends, for several reasons (Lee
et. al, 1997 p.470). First, many individuals and institutions
require large cash flows from their investments. For example,
retired
dividend

people

in

payments.

lower

tax

Second,

brackets
managers

generally
often

covet

resist

high

reducing

dividends also because a cut in dividends may be interpreted

by the investment community as a signal of trouble with the

Dividend Policy 15
firm or a result of poor management. Even if the reduction is
intended

to

allow

the

firm

to

pursue

an

attractive

opportunity, it may adversely affect stock prices. A third

reason

involves

investors

are

the

legal

bound

by

list.
the

Many

large,

prudent

man

institutional
rule,

or

by

legislation, to buy only securities that are included on the

legal list. One criterion of the list is a long history of
continued

dividend

payments

without

dividend

reductions.

Therefore, a firm that reduces or omits a dividend payment

faces the risk of being ineligible for purchases by certain
institutional investors.

stable

fulfilling

dividend

prophecy (Lee

policy

can

become

et.al, 1997

sort

p.470). An

of

self-

unexpected

rise or reduction in dividends can have an announcement effect

on the firms share price. An increase in dividends may lead
investors to perceive a promising future and share price may
increase. A drop in dividends may lead investors to fear a
less promising future, resulting in a drop in share price.

2. Constant Payout Ratio Policy With this policy, a constant

percentage

of

earnings

is

paid

out

of

in

dividends.

For

example, a company may pay half of its earnings in dividends.

Of course, a policy such as this makes dividends as volatile
as earnings. Because net income varies, dividends paid will
also vary using this approach. The problem this policy causes

Dividend Policy 16
is that if a companys earnings drop drastically or there is a
loss,

the

dividends

paid

will

sharply

curtailed

or

non-

existent. And in years of negative earnings, the policy must

be

abated

since

dividends

cannot

be

less

than

zero.

This

policy will not maximize market price per share since most
stockholders

do

not

want

variability

in

their

Dividend

Plus

dividend

receipts.

3. A

Compromise

Policy/

Stable

Year-End

Extra

Policy This is somewhat of a combination of the other two.

The idea is to establish a minimum dividend in relation to a
companys long-run earnings, supplemented by an extra year-end
dividend during superior earning years.

Moreover, this is a compromise between the policies of a

stable dollar amount and a percentage amount of dividends is
for

company

to

pay

low

dollar

amount

per

share

plus

percentage increment in good years. While this policy affords

flexibility,

it

also

creates

uncertainty

in

the

minds

of

investors as to the amount of dividends they are likely to

receive. Stockholders generally do not like such uncertainty.
However,

the

policy

may

be

appropriate

when

earnings

vary

considerably over the years. The percentage, or extra, portion

of the dividend should not be paid regularly; otherwise it
becomes meaningless.

Dividend Policy 17
4. Residual-dividend

Policy

When

companys

investment

opportunities are not stable, management may want to consider

a fluctuating dividend policy. With this kind of policy the
amount of earnings retained depends upon the availability of
investment opportunities in a particular year. Dividends paid
represent

the

residual

amount

from

earnings

after

the

dividend

policy

was

companys investment needs are fulfilled.

IV.

THEORIES ABOUT DIVIDEND POLICY

The

previous

statements

established

that

bound up with the development of the corporate form itself. It was

seen that the emergence of dividend policy as important to investors
was,

to

some

extent,

driven

by

the

evolving

state

of

financial

markets. Investing in shares was initially seen as analogous to bonds,

so regularity of payments was important. It was also seen that in the
absence of regular and accurate corporate reporting, dividends were
often preferred to reinvested earnings, and often even regarded as a
better

indication

accounts.

However,

of

corporate

as

financial

performance
markets

than

published

developed

and

earnings

became

more

efficient, it was thought by some that dividend policy would become

increasingly

irrelevant

to

investors.

Why

dividend

policy

should

remain so evidently important has been theoretically controversial.

Three main contradictory theories of dividends can be identified.

Some argue that increasing dividend payments increases a firms value.

Dividend Policy 18
Another

view

claims

that

high

dividend

payouts

have

the

opposite

effect on a firms value; that is, it reduces firm value. The third
theoretical approach asserts that dividends should be irrelevant and
all effort spent on the dividend decision is wasted. These views are
embodied in three theories of dividend policy: high dividends increase
share value theory (or the so-called bird-in-the- hand argument),
low

dividends

increase

share

value

theory

(the

tax-preference

argument), and the dividend irrelevance hypothesis. Dividend debate is

not

limited

dividend

to

these

three

have

been

policy

approaches.
presented,

Several

which

other

further

theories

increases

of
the

complexity of the dividend puzzle. Some of the more popular of these

arguments
content

include

of

the

dividends

residual

theory

(signalling),

the

of

dividends,

clientele

information

effects,

and

the

agency cost hypotheses.

However, I only limit my scope to these four (4) most important

theories of Dividend Policy.

1. Residual Theory of Dividends

The

most

easily

understood

theory

of

dividend

payment

determination is called the residual theory. As the name implies,

this theory holds that firms pay dividends out of earnings that
remain after its financing needs. These are funds for which the firm
has no immediate use. The procedure for a residual dividend policy
follows several steps (Lee et al., 1997 p.469):

Dividend Policy 19
1.1. Determine the firms optimal capital budget.
1.2. Determine

the

amount

of

equity

needed

to

finance

that

budget.
1.3. To the extent possible, use the firms retained earnings to
supply the needed equity.
1.4. Distribute any leftover earnings as dividends.

The basic assumption of residual theory is that shareholders

want the firm to retain earnings if reinvesting them can generate
higher

rates

reinvesting

of

return

their

than

dividends.

the
For

shareholders
example,

if

could
a

obtain

corporation

by
can

invest retained earnings in a new venture that generates 18% rate of

return,

whereas

investors

can

obtain

return

of

only

10%

by

reinvesting their dividends, then stockholders would benefit more

from the firm reinvesting its profits.

The residual theory of dividends also maintains that companies

should

pay

dividends

only

when

cash

flows

cannot

be

invested

profitably within the firm. This approach is a logical extension of

the

unlimited

funds

assumption

in

capital

budgeting

and

is

incorporated in project evaluation techniques employing the cost of

capital. Companies do follow the residual approach to some degree.
In 1989, for example, many corporations had accumulated considerable
amounts of cash from cutbacks, restructuring, and implementation of
other cost-saving measures. Consequently, dividend increases were

Dividend Policy 20
substantial during that year as corporations could not reinvest the
internally generated cash flows profitably.

And according to Lasher (2008 p.605), The residual theory has

an intuitive appeal, but it isnt the way most companies work. Most
management sees a value in dividends and set them aside first rather
than last. Further, most companies can come up with a virtually
unlimited number of capital projects that look good on paper. As a
result, a firm that truly adhered to the residual theory might never
pay a dividend.

Whether
matter

of

firms

actually

question.

Such

practice
theory

the

would

residual
imply

theory

erratic

is

dividend

payments, especially for fast-growth companies. Firms do seem try to

stabilize their dividend-payout rates, so analysts do not place much
faith in the residual theory.

2. Dividends as Irrelevant
Being

assigned

irrelevant

regarding

irrelevance

theory

depends

the

specific

on

risk

residual

creating

of

dividends

earning

class

or

and

role,

increasing
argues

characteristics
not

on

dividends

how

its

company

that
of

its

stream

are

termed

value.

companys
assets
of

The

value

and

earnings

its
is

apportioned among dividends and reinvestment. The position endorsed

by most theorists is that dividends should matter very little to
stock price if they matter at all (Lasher, 2008 p.601).

Dividend Policy 21

Franco Modigliani and Merton Miller also pioneered this view,

and it is similar in nature to their view that capital structure is
irrelevant.

Specific

irrelevant.

However,

dividend
given

policies,
that

firms

then,
adopt

should
such

also

be

policies,

Modigliani and Miller argue that a clientele effect will develop,

which means that certain dividend policies will attract certain
types of investors (clientele). For example, companies with generous
dividends

attract

investors

seeking

high

current

income

(such

retirees), where companies with low payouts appeal to investors

seeking price appreciation.

However according to Al-Malkawi, Rafferty,Pillai (2010), prior

to the publication of Miller and Modiglianis (1961, hereafter M&M)
seminal paper on dividend policy, a common belief was that higher
dividends increase a firms value. This belief was mainly based on
the so-called bird-in-the-hand argument, discussed in more detail
shortly. Graham and Dodd (1934), for instance, argued that the sole
purpose for the existence of the corporation is to pay dividends,
and firms that pay higher dividends must sell their shares at higher
prices (cited in Frankfurter et al., 2002, p.202). However, as part
of a new wave of finance in the 1960s, M&M demonstrated that under
certain assumptions about perfect capital markets, dividend policy
would be irrelevant.

Dividend Policy 22
Given that in a perfect market dividend policy has no effect
on either the price of a firms stock or its cost of capital,
shareholders wealth is not affected by the dividend decision and
therefore they would be indifferent between dividends and capital
gains. The reason for their indifference is that shareholder wealth
is affected by the income generated by the investment decisions a
firm makes, not by how it distributes that income. Therefore, in
M&Ms world, dividends are irrelevant. M&M argued that regardless of
how the firm distributes its income, its value is determined by its
basic earning power and its investment decisions. They stated that
given a firms investment policy, the dividend payout policy it
chooses to follow will affect neither the current price of its
shares nor the total returns to shareholders (p.414). In other
words,

investors

calculate

the

value

of

companies

based

on

the

capitalized value of their future earnings, and this is not affected

by whether firms pay dividends or not and how firms set their
dividend policies. M&M go further and suggest that, to an investor,
all dividend policies are effectively the same since investors can
create homemade dividends by adjusting their portfolios in a way
that matches their preferences.

M&M

based

their

argument

upon

idealistic

assumptions

of

perfect capital market and rational investors. The assumptions of a

perfect

capital

market

necessary

for

the

dividend

irrelevancy

hypothesis can be summarized as follows: (1) no differences between

taxes

on

dividends

and

capital

gains;

(2)

no

transaction

and

Dividend Policy 23
flotation costs incurred when securities are traded; (3) all market
participants have free and equal access to the same information
(symmetrical

and

costless

information);

(4)

no

conflicts

of

interests between managers and security holders (i.e. no agency

problem); and (5) all participants in the market are price takers.
Given

the

importance

of

M&Ms

argument

in

the

dividend

policy

debate, the following section provides their proof of irrelevancy.

3. Dividends as a Bird in the Hand

In

purely

theoretical

world,

the

irrelevance

theory

is

difficult to contradict. However, in the real world of risk and

uncertainty, it must confront certain obstacles. To begin with, many
shareholders do not have such strong loyalties to companies that
they themselves assured that their managements will invest funds
more profitably than they themselves can. An internal investment may
take years to recover its cost and begin showing profits. Obviously,
considerable risks exist, and the situation is described as the
proverbial bird in the bush. In contrast, dividends are funds
available now, the bird in the hand. Given a choice, one could
argue that shareholders have a preference for dividends and that
dividend policies are indeed relevant and important. This view is
supported by empirical evidence showing a string connection between
changes in the market values of firms and changes in their dividend
policies.

For

example,

company

might

announce

substantial

increase in it as annual dividend, which then leads to a substantial

increase in the market price of its stock.

Dividend Policy 24

One alternative and older view about the effect of dividend

policy on a firms value is that dividends increase firm value. In a
world of uncertainty and imperfect information, dividends are valued
differently

to

retained

earnings

(or

capital

gains).

Investors

prefer the bird in the hand of cash dividends rather than the two
in the bush of future capital gains. Increasing dividend payments,
ceteris

paribus,

may

then

be

associated

with

increases

in

firm

value. As a higher current dividend reduces uncertainty about future

cash flows, a high payout ratio will reduce the cost of capital, and
hence increase share value. That is, according to the so-called
bird-in-the hand hypothesis (henceforth BIHH) high dividend payout
ratios maximize a firms value.

M&M (1961) have criticized the BIHH and argued that the firms
risk is determined by the riskiness of its operating cash flows, not
by the way it distributes its earnings. Consequently, M&M called
this argument the bird-in-the-hand fallacy. Further, Al-Malkawi et
al.

(2010),

cited

that

Bhattacharya

(1979)

suggested

that

the

reasoning underlying the BIHH is fallacious. Moreover, he suggested

that the firms risk affects the level of dividend not the other way
around. That is, the riskiness of a firms cash flow influences its
dividend payments, but increases in dividends will not reduce the
risk of the firm.

Dividend Policy 25
4. Low Dividends Increase Stock Value (Tax-Effect Hypothesis)

The M&M assumptions of a perfect capital market exclude any

possible tax effect. It has been assumed that there is no difference
in tax treatment between dividends and capital gains. However, in
the real world taxes exist and may have significant influence on
dividend policy and the value of the firm. In general, there is
often a differential in tax treatment between dividends and capital
gains,

and,

return,

the

dividends.
managers

because

most

influence

Taxes

respond

may
to

of
also

this

investors
taxes
affect
tax

are

might

interested
affect

the

supply

preference

in

in

their
of

after-tax

demand

dividends,

seeking

to

for
when

maximize

shareholder wealth (firm value) by increasing the retention ratio of

earnings.

The tax-effect hypothesis suggests that low dividend payout

ratios lower the cost of capital and increase the stock price. In
other words low dividend payout ratios contribute to maximizing the
firms

value.

This

argument

is

based

on

the

assumption

that

dividends are taxed at higher rates than capital gains. In addition,

dividends are taxed immediately, while taxes on capital gains are
deferred until the stock is actually sold. These tax advantages of
capital gains over dividends tend to predispose investors, who have
favorable tax treatment on capital gains, to prefer companies that
retain most of their earnings rather than pay them out as dividends,
and

are

willing

to

pay

premium

for

low-payout

companies.

Dividend Policy 26
Therefore, a low dividend payout ratio will lower the cost of equity
and increases the stock price. Note that, this prediction is almost
the exact opposite of the BIHH, and of course challenges the strict
form of the DIH.

In many countries a higher tax rate is applied to dividends as

compared to capital gains taxes. Therefore, investors in high tax
brackets might require higher pre-tax risk-adjusted returns to hold
stocks with higher dividend yield. This relationship between pre-tax
returns on stocks and dividend yields is the basis of a posited taxeffect hypothesis.

Brennan (1970) developed an after-tax version of the capital

asset pricing model (CAPM) to test the relationship between tax
risk-adjusted returns and dividend yield. Brennans model maintains
that a stocks pre-tax returns should be positively and linearly
related to its dividend yield and to its systematic risk. Higher
pre-tax risk adjusted returns are associated with higher dividend
yield stocks to compensate investors for the tax disadvantages of
these returns. This suggests that, ceteris paribus, a stock with
higher dividend yield will sell at lower prices because of the
disadvantage of higher taxes associated with dividend income.

Dividend Policy 27
V.

FACTORS THAT INFLUENCE DIVIDEND POLICY

A firms dividend policy is a function of many factors, some of

which

have

been

described.

Other

factors

that

influence

dividend

policy according to Shim & Siegel (2007 p.339) are as follows:

1. Company growth rate A company that is rapidly growing, even if

profitable, may have to restrict its dividend payments in order
to keep needed funds within the company for growth opportunities.
2. Restrictive covenants Sometimes there is a restriction in a
credit agreement that will limit the amount of cash dividends
that may be paid.
3. Profitability

Dividend

distribution

is

keyed

to

the

profitability of the company.

4. Earnings stability A company within stable earnings is more
likely to distribute a higher percentage of its earnings than one
with unstable earnings.
5. Maintenance of control Management that is reluctant to issue
additional common stock because it does not wish to dilute its
control of the firm will retain a greater percentage of its
earnings. Internal financing enables control to be kept within.
6. Degree of financial leverage A company with a high debt-toequity ratio is more likely to retain earnings so that it will
have the needed funds to be kept within.
7. Ability to finance externally A company that is capable of
entering the capital markets easily can afford to have a higher

Dividend Policy 28
dividend payout ratio. When there is a limitation to external
sources of funds, more earnings will be retained for planned
financial needs.
8. Uncertainty

Payment

of

dividends

reduces

the

chance

of

uncertainty in stockholders minds about the companys financial

health.
9. Age and size The age and size of the company bear upon its ease
of access to capital markets.
10.

Tax

penalties

Possible

tax

penalties

for

excess

accumulation of retained earnings may result in high dividend

payouts.

VI.

OTHER TYPES OF SHAREHOLDER DISTRIBUTIONS

In the main, we are concerned with cash dividends when the topics
of dividend policy are discussed. However, there are other types of
shareholder distributions the we should understand.

1. Stock Dividends A stock dividend is the issuance of additional

shares

of

stock

to

stock

holders.

stock

dividend

may

be

declared when the cash position of the firm is inadequate and/or

when the firm wishes to prompt more trading of its stock by
reducing

its

market

price.

With

stock

dividend,

retained

earnings decrease but common stock and paid-in capital on common

stock increase by the same amount. A stock dividend, therefore,
provides no change in stockholders wealth (Lasher, 2008 p.340).

Dividend Policy 29
Stock dividends increase the shares held, but the proportion of
the company each stockholder owns remains the same. In other
words, if a stockholder has 2% interest in the company before a
stock dividend, he or she will continue to have a 2% interest
after the stock dividend.

2. Stock Split A stock split involves issuing a substantial amount

of additional shares and reducing the par value of the stock on a
proportional basis. A stock split is often prompted b a desire to
reduce the market price per share, which will make it easier for
small investors to purchase shares.

The similarities between a stock dividend and a stock split are:

2.1. Cash is not paid.
2.2. Shares outstanding increase.
2.3. Stockholders equity remains the same.

3. Stock

Repurchases

Treasury

stock

is

the

name

given

to

previously issued stock that has been purchased by the company.

Buying
Since

treasury

stock

outstanding

is

shares

an

alternative

will

be

fewer

to

paying

after

stock

dividends.
has

been

repurchased, earnings per share will rise (assuming net income is

held constant). The increase in earnings per share may result in
a higher market price per share.

Dividend Policy 30
To

stockholders,

the

advantages

arising

from

stock

repurchase include the following (Lasher, 2007 p.341): (1) If

market price per share goes up as a result of their purchase,
stockholders can take advantage of the capital gain deduction.
This assumes the stock is held more them one year and is sold at
a

gain.

(2)

Stockholders

have

the

option

of

selling

or

not

selling the stock, while id a dividend is paid, stockholders must

accept it and pay tax.

VII. CONCLUSION

The conclusion is that we dont really have a conclusion. No

one knows with certainty whether paying more or less in dividends
generally increases or decreases stock prices. Most practicing
financial professionals feel dividends have a positive effect on
prices. Scholars tend to say that notion cant really be proven.

The literature on dividend policy has produced a large body

of theoretical and empirical research, especially following the
publication of the dividend irrelevance hypothesis of M&M (1961).
No general consensus has yet emerged after several decades of
investigation, and scholars can often disagree even about the
same empirical evidence. In perfect capital markets, M&M asserted
that the value of a firm is independent of its dividend policy.
However, various market imperfections exist (taxes, transaction
costs, information asymmetry, agency problems, etc) and these

Dividend Policy 31
market imperfections have provided the basis for the development
of various theories of dividend policy including tax-preference,
clientele effects, signaling, and agency costs.

This

paper

began

with

an

overview

of

the

evolution

of

corporate dividend policy. It was noted that dividend policy has

been bound up with the development and history of the corporation
itself. Although numerous studies have examined various issues of
dividend

policy,

they

have

produced

mixed

and

inconclusive

results. Perhaps the famous statement of Fisher Black, cited by

Al-Malkawi et al., (2010), about dividend policy "the harder we
look at the dividends picture, the more it seems like a puzzle,
with pieces that just do not fit together" (Black, 1976, p. 5) is
still valid.

VIII. REFERENCES

Dividend Policy 32

1. Books:

Lasher, W.R. (2008). Practical Financial Management Fifth Edition.

Ohio, USA.

Lee, C.F., Finnerty, J.E., Norton, E.A. (1997). Foundations of

Financial Management. St. Paul, Minnesota, USA.

Shim, J.K, Siegel, J.G., (2007). Schaums Outline of Financial

Management Third Edition. McGraw-Hill Companies, USA.

Van Horne, J.C. (2002). Financial Management & Policy 12th Edition.
New Jersey, USA.

Winger, B.J., Mohan, N. (1991).Principles of Financial Management.

New York, USA.

2. E-References:

Al-Malkawi, H.N., Rafferty, M., Pillai, R. (2010). Dividend Policy:

A Review of Theories and Empirical Evidence. Retrieved from
http://www.eurojournals.com/ibba_9_14.pdf

Allen, F., Michaely, R. Dividend Policy. Retrieved from

http://finance.wharton.upenn.edu/~rlwctr/papers/9414.pdf

Dividend Policy 33

Kothari, V., Dividend Policy. Retrieved from

http://www.vinodkothari.com/tutorials/dividend%20policy.pdf

Kuhlemeyer, G.A. (2004), Dividend Policy (Power Point Slides).

Retrieved from
wps.pearsoned.co.uk/wps/media/objects/.../0273685988_ch18.ppt

Robert H. Smith School of Buisness, Dividend Policy. Retrieved from

http://www.rhsmith.umd.edu/faculty/gphillips/courses/bmgt640/dividen
d.pdf