Management Coursework

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For each question, it is essential that you demonstrate evidence of having read more widely than the core textbooks.
Remember to critically discuss the issues you raise and provides example for the points that you make through referring to practical examples and empirical studies on the topic.

Answer

How Is It Possible That Dividends Are So Important, Yet at The Same Time Dividend Policy Is Irrelevant?

Contents

Introduction. 2

The Controversial Nature of the Dividend Policy. 2

Is Dividend Policy Relevant?. 2

Factors That May Lead To a Low Dividend Payout 3

Factors That May Lead To a High Dividend Payout 4

Conclusion. 4

References. 5

Introduction

Dividends constitute one of the main cash outlays for contemporary corporations. Questions regarding how corporations should use to decide on dividend payouts have greatly contributed to the ongoing debate on dividend policy. In the discussion on dividend policy, firms set out to answer the question of whether the firm should pay out the money to shareholders or invest it for them.[1] The surprising suggestion in economic logic and scholarly research is that dividend policy does not matter. In this suggestion, dividend policy is simply equated to the question of capital structure. In this research, it is always easy to identify the main elements, but the complexity of interactions among those elements makes it difficult for a definite answer to be arrive at. The aim of this paper is to investigate why it is possible that dividends are so important, yet at the same time dividend policy is irrelevant. In this critical discussion, practical examples and empirical studies are referred to for purposes of illustrating the main points.

The Controversial Nature of the Dividend Policy

            Dividend policy is a highly controversial subject. On the one hand, many reasons may be highlighted to explain the importance of dividend policy. On the other hand, many claims that are being made regarding dividend policy do not make any economic sense. Nevertheless, corporate finance experts continue to view dividend policy as an important issue. The main concern is whether financial managers are wasting time by worrying about dividend policy or everyone else is missing an important point in the ongoing discussions.

            The controversy begins at the point where financial experts acknowledge that there are good reasons why corporations should authorize high dividend payouts and there are equally good reasons why they should authorize low dividend payouts. At this point, it is important to point out that there are different kinds of dividends, which include regular cash, special, extra, and liquidating dividends, as well as various ways through which firms pay dividends to their shareholders. In many cases, firms put into consideration these two factors in propounding their arguments in support of their preferred dividend policy.

Is Dividend Policy Relevant?

            The question of whether dividend policy is relevant is at the heart of the controversy that this paper seeks to unravel. To begin with, it is obvious that dividends do matter. Corporations pay dividends in cash, and the entire process tends to be much publicized, complete with fanfare. For example, in July 2004, Microsoft, a leading multinational corporation specializing in computer operating systems, made a special dividend payment of $32.6 billion, attracting global acclaim while at the same time triggering celebrations among shareholders.[2] Thus, it is a good thing for the idea of dividends to be promoted. After all, individuals and corporate entities invest in shares of various with the objective of getting a return on investment in the form of dividends. However, to make decisions regarding dividend payouts, companies must put in place a dividend policy that guides them in making a decision on the percentage of its total earnings that should be paid out to shareholders as dividends.

            A discussion on the irrelevance of dividend policy should ideally begin with an assessment of the relevance of dividends themselves. In this regard, it is false to say that dividends are irrelevant. This is because investors always prefer high dividends to low dividends. Whenever there is an increase in dividend per share at a specific date is raised, while it is held constant at all other dates, the stock price automatically rises. This is simply because of the corresponding increase in the present value of future dividends. To accomplish this action, a firm must make management decisions that lead to improvement in cash flow through improved productivity, strengthened marketing strategies and increased tax savings.

            On the other hand, dividend policy may seem relevant or irrelevant depending on the real-life case being analyzed. Meanwhile, at the default level, dividend policy, unlike dividends, cannot by itself lead to an increase in dividend at a specific date while simultaneously keeping it at the same level at all the other dates.[3] What dividend policy merely does is to establish a trade-off between the dividends that are paid out at one date and those that are paid out at a different date. This means that the dividend’s present value remains unchanged except for slight adjustments arising from time value. In this explanation, dividend policy is irrelevant since the company’s current value remains unchanged whether managers decide to lower or to raise the current dividend payout. However, this is a simplistic explanation that does not put into consideration certain factors that may arise in real-world situations leading to fundamental changes in the conceptualization of dividend policy. To be more precise, these real-world factors may influence the decision by companies to use dividend policy as a guide for deciding on whether to execute a low or high dividend payout.

Factors That May Lead To a Low Dividend Payout

            The main factors that may influence a company’s decision to provide a low dividend payout include flotation costs, taxes, and restrictions on dividend payouts.[4] Floatation costs come into perspective when a company puts into consideration a situation whereby it is being compelled to sell some of its new stock in order to pay dividends. Since it can be expensive to sell new stock, it means that the decision results in a stock that is of lower value. A good practical example involves an assessment of two corporations that are identical in all ways with the only exception being that one decides to pay out dividends that represent a higher percentage of its overall cash flow. The other firm’s equity ends up growing faster because plowing back more profits. In case these two corporations were to retain all their similarities, then the one that pays higher dividends would at one point have to play catch-up by selling some of its new stock. To avoid the expensive process of selling its stock, the corporation may end up revising its dividend policy with a view to facilitate lower payouts.

            Tax policy influences dividend policy because it is normally targeted at dividend income as well as capital gains.[5] In most cases, individual shareholders tend to be subjected to tax rates that are higher than capital gains tax. This constitutes a break from the past, whereby dividends were being taxed as just any other income. On the other hand, there has been a reduction in capital gains tax. Companies that promote the idea of a low dividend payout tend to reinvest the dividends rather than making payouts to shareholders, thereby increasing overall firm and equity value. If all things were to remain constant, shareholders would expect capital gains that are higher during the next dividend payout period. Similarly, restrictions on dividend payouts also influence corporate leaders to pay out lower dividends to shareholders. For example, some state laws in the United States prohibit firms from making dividend payouts whenever the percentage allocated as dividends exceeds the retained earnings of the firm.

Factors That May Lead To a High Dividend Payout

            Despite the much-discussed concept of irrelevance of dividend policy, firms continue to be affected by a number of factors to pay a high dividend payout. The two main factors to be put into consideration at this point are the need to maintain the current income and benefits arising from higher dividend payouts. Some people, in most cases the elderly, are often willing to overlook numerous attenuating factors in order to keep receiving a high dividend yield. For such people, no amount of dividend policymaking is likely to persuade them to change their minds.

            Similarly, some tax benefits may accrue from a decision by a company to pay high dividends. In this case, one of the beneficiaries is corporate investors, who tend to receive tax breaks by owning stock in other corporations. For this reason, high-dividend payouts tend to favor corporate investors. This is one of the reasons why corporations have ended up taking the position of the leading holders of stock in many economies, including that of the United States. The issue of tax exemption has also been on the limelight as a major driving force for companies that pay out high dividends. For example, governments tend to exempt certain types of funds from taxation simply because they aimed at providing assisting to others, with one example being pension funds.

Institutions that deal in these funds are discouraged in law to invest in companies that have a poor record of paying out dividends to shareholders. Moreover, the investors who handle such funds tend to face restrictions on the portion of the funds that they can spend, a factor that strongly influences them to invest in stocks with high dividend yield in an attempt to achieve some spending ability. Moreover, endowment fund investors tend to invest in huge amounts of stock in an attempt to establish a high level of current income attributed primarily to dividend payments. Additionally, there are other investors who, for some reason, desire to have current income from dividends, and are thus willing to continue paying dividend tax. In other words, all these factors influence dividend payouts whether an individual company has developed a specific dividend policy or not.

Conclusion

In conclusion, dividends are important because they bring about changes in firm value but dividend policy is irrelevant because it does not bring about changes in firm value. Moreover, dividend policy remains irrelevant because it is always being inevitably influenced by real-world factors in the contemporary non-perfect market conditions such as floatation costs, taxes, restrictions on dividend payments, the need to maintain the current income, and benefits arising from higher dividend payouts. Once these factors manifest themselves, it becomes virtually impossible for a dividend policy to be relied on as a basis for decision-making. In other words, the conditions make dividend policy irrelevant. This is because they tend to be the dominant force that influences how firms pay out dividends.

References

Al-Deehani, T ‘Determinants of Dividend Policy: The Case of Kuwait’, Journal of Economic & Administrative Sciences’, vol. 19, no. 2, 2003, pp. 59 -76.

Al-Malkawi, H, M Rafferty & R Pillai, ‘Dividend Policy: A Review of Theories and Empirical Evidence’, International Bulletin of Business Administration, no. 9, 2010, pp. 171-200.

Amidu, M, ‘How does dividend policy affect performance of the firm on Ghana stock exchange?’ Investment Management and Financial Innovations, vol. 4, no. 2, 2007, pp. 103-112.

Hussainey, K, CO Mgbame & AM Chijoke-Mgbame, ‘Dividend Policy and Share Price Volatility: UK Evidence’, Journal of Risk Finance, vol. 4, no. 1, 2010, pp. 1-21.

Li, K, & X Zhao, ‘Asymmetric Information and Dividend Policy’, Financial Management, vol. 5, 2008, pp. 673-694.

Moore, S, & P Kerpen, ‘Show Me the Money! Dividend Payouts after the Bush Tax Cut’, CATO Institute Briefing Papers, no. 88, 2004, pp. 1-9.


End Notes

[1] K Hussainey, CO Mgbame & AM Chijoke-Mgbame, ‘Dividend Policy and Share Price Volatility: UK Evidence’, Journal of Risk Finance, vol. 4, no. 1, 2010, pp. 1-21.

[2] S Moore, & P Kerpen, ‘Show Me the Money! Dividend Payouts after the Bush Tax Cut’, CATO Institute Briefing Papers, no. 88, 2004, p. 4.

[3] T Al-Deehani, ‘Determinants of Dividend Policy: The Case of Kuwait’, Journal of Economic & Administrative Sciences’, vol. 19, no. 2, 2003, p. 63.

[4] K Li, & X Zhao, ‘Asymmetric Information and Dividend Policy’, Financial Management, vol. 5, 2008, p. 690.

[5] M Amidu, ‘How does dividend policy affect performance of the firm on Ghana stock exchange?’ Investment Management and Financial Innovations, vol. 4, no. 2, 2007, pp. 103-112.

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