Relevance of Dividend Policy
Generally, the firms pay dividend and view such dividend payments positively. The investors also expect and like to receive dividend income on their investments. The firm not paying dividends may be adversely rated by the investors thereby affecting the market value of the share. The basic argument of those supporting the dividend relevance is that because current cash dividends reduce investor’s uncertainty, the investors will discount the firm’s earnings at a lower rate. Ke, thereby placing a higher value on the shares. If the dividends are not paid then the uncertainty of shareholders/investors will increase, raising the required rate, ke, resulting in relatively lower market value of the share and the value of the firm. The market price of the share will increase if the firm pays dividends, otherwise it may decrease. A firm must therefore pay dividend to shareholders to fulfil the expectations of the shareholders in order to maintain or increase the market price of the share.
Two models representing this argument are discussed below:
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Shareholders look into the capability of companies to initiate a dividend. Dividends are payments made by a company to a shareholder usually after a company earns a profit (Wikipedia 2007 [online]). Since dividends are money divided to shareholders after a profit, it is not considered a business expense but a sharing of recognized assets among shareholders. Dividends are either paid regularly or can be called out anytime. Consequently, a dividend policy is a set of company rules and guidelines used to decide how much the company will pay out to its shareholders (Investopedia 2007 [online]).
A dividend policy is first known as a heavy factor in a company’s stock value. However, more scholars are suggesting that corporate dividend policies do not matter and should not matter in a company’s stock value (Investopedia 2003 [online]). Arguments against dividend policies start from the fact that investors can create their own dividends on other investment option. A wise investor can look at more stable bonds to earn a return of investment rather than a dividend policy that can fluctuate. Secondly, earning from dividends is taxed higher than capital gains (Investopedia 2007 [online]). For these reasons, investors are not lured to relative corporate dividend policies of companies as an accurate value of their stock.
Some companies believe that a no-dividend policy is just as sound as companies with a dividend policy. Companies without a dividend policy can use their profit earnings to reinvest and expand the company shares or buy assets. Having a dividend policy foregoes these opportunities.
For people who value profit certainty of a company, a sound dividend policy is important. It follows that a high and regular corporate dividend policy means that companies have a benchmark for doing well. Therefore, more dividends can equate to the overall health of the company. Dividend policies are more valuable to small companies or cooperatives with excess cash and a few good projects where the net present value of these projects is positive. Meanwhile companies, without excess cash but have several good projects where NPV is also positive will only derail the undertaking of current projects. While a good corporate dividend policy is equated to excess cash, the value of the company is not hinged on the value of dividends as there are other indicator’s of a company’s performance.
There are different kinds of dividend policies. First, residual dividend policy is a method of distribution where dividends are paid after all the requirements for capital are met. Thus, dividends are computed from the residual cash after spending on new capital goods. The aim of this dividend policy is to decide if there is enough money left after all costs are met.
A cyclical policy or stable policy is a regular dividend payout usually given every quarter. A cyclical dividend policy is set at a fixed fraction of quarterly earnings while a stable policy is set as a fraction of yearly earnings. This produces certainty for investors that they get regular income for their investments.
In the end, the value of dividend policies falls on investor decisions. While there are contrasting views of its usefulness, the most important factor is achieving the best bang-for-buck.
Investopedia Staff. (2003). How and Why Do Companies Pay Dividends?. Available: http://www.investopedia.com/articles/03/011703. Last accessed 18 October 2007.
Investopedia. (2007). Dividends. Available: http://www.investopedia.com/terms/ d/dividendpolicy.asp. Last accessed 18 October 2007.
Wikipedia. (2007). Dividends. Available: http://en.wikipedia.org/wiki/Dividend. Last accessed 18 October 2007.