Study on the Issues of Dividend Policy Finance Essay

Dividend policy has been an issue of interest in financial literature since Joint Stock Companies came into existence. Dividends are commonly defined as the distribution of earnings (past or present) in real assets among the shareholders of the firm in proportion to their ownership. Dividend policy connotes to the payout policy, which managers pursue in deciding the size and pattern of cash distribution to shareholders over time. Managements' primary goal is shareholders' wealth maximization, which translates into maximizing the value of the company as measured by the price of the company's common stock. This goal can be achieved by giving the shareholders a "fair" payment on their investments. However, the impact of firm's dividend policy on shareholders wealth is still unresolved. The area of corporate dividend policy has attracted attention of management scholars and economists culminating into theoretical modelling and empirical examination. Thus, dividend policy is one of the most complex aspects in finance. Three decades ago, Black(1976) in his study on dividend wrote, "The harder we look at the dividend picture the more it seems like a puzzle, with pieces that just don't fit together". Why shareholders like dividends and why they reward managers who pay regular increasing dividends is still unanswered. According to Brealey and Myers (2002) dividend policy has been kept as the top ten puzzles in finance.

Paying Dividends

The most pertinent question to be answered here is that how much cash should firms give back to their shareholders? Should corporations pay their shareholders through dividends or by repurchasing their shares, which is the least costly form of payout from tax perspective? Firms must take these important decisions period after period (some must be repeated and some need to be revaluated each period on regular basis.) Dividend policy can be of two types: managed and residual. In residual dividend policy the amount of dividend is simply the cash left after the firm makes desirable investments using NPV rule. In this case the amount of dividend is going to be highly variable and often zero. If the manager believes dividend policy is important to their investors and it positively influences share price valuation, they will adopt managed dividend policy. The optimal dividend policy is the one that maximizes the company's stock price, which leads to maximization of shareholders' wealth. Whether or not dividend decisions can contribute to the value of firm is a debatable issue. Firms generally adopt dividend policies that suit the stage of life cycle they are in. For instance, high- growth firms with larger cash flows and fewer projects tend to pay more of their earnings out as dividends. The dividend policies of firms may follow several interesting patterns adding further to the complexity of such decisions.

Why should one invest for long term?

Long term investing is the last thing on the minds of active traders in the stock market. For most traders, the greatest lure of volatility in the market is the possibility of generating big returns in a short amount of time. Passive investing, be it through mutual funds, index funds, ETFs, or even some long forgotten buy and hold stock one has owned for years in an ignored account somewhere, is as incomprehensible to the traderA as obsessively analyzing a stock's price chart to determine short term areas of support and resistance is to the long term investor. And yet, the active traders can learn a thing or two from the long term investor. It may seem counterintuitive, to suggest that short term instruments such as stock options or any money market instrument be associated in any way with a long term horizon, but there are a number of powerful advantages toA investing for the long haul, advantages that anyone interested in creating wealth would consider: Long term investing makes it easier to focus on only high quality companies.A The quality here can be related to the predictability in the price fluctuation of the stock in medium to long term. And securities short term horizon, we learn through painful experience, are not always as predictable or as well-behaved as their charts suggest. Long term investing gives you time to recover if your position moves against you in the short term.A Short term investor or traders require not only that you be right about what a particular stock will do, but that you also be right on the timing. However, the long term investor, however, only has to be right on the first part.

By excluding near term timing requirements, the long term investor has the luxury of being protected against short term volatility or market irrationality. The long term bias of the stock market is higher.A  Long term, the outlook for most solid investments is relatively certain. Invest inA quality companiesA at reasonable prices and then wait. In almost every case, one will have good returns and a substantially higher net worth than if one would invest money in a money market account. Illustration Scenario 1A - Assume you make a $10,000 investment in a safe and stable stock paying a 3% dividend. And assume two other things - that the dividend grows by just 5% a year and that you spend the dividends rather than reinvest them. After 30 years, your original investment would be generating a 12.35% annual dividend. And, thanks to the power of compounding, assuming the dividend continued growing 5% annually; the dividend rate based on your original investment would be accelerating. Wait another five years and the rate jumps from 12.35% to 15.76%. Double digit income with below average risk and no effort on your part. This is a decent return, however, based on conservative assumptions. First, we didn't reinvest the dividend (in which case our returns would really benefit from the power of compounding). Second, we assumed a very conservative 5% dividend growth rate. Third, we started with a fairly low dividend base of just 3%. And, if we were willing to wait 30 years or more while doing absolutely nothing, we still came out pretty good.

Why should the company pay dividend?

There are primarily two source of income for investors in stocks - buy at low and sell it at a higher price in future or earn a consistent stream of dividend for a long duration. In the later case return is compounded by reinvesting the dividend in the stock. Moreover, there can be gains from capital appreciation. However, whether the company pays dividend depends on both the capacity of the company - small or large - and the company's fundamentals.

How companies pay dividend?

Key terms related to dividend: Declaration Date:A The date on which the board of directors of a company announces the amount of the next stock dividend and its ex-dividend, record and payment dates. Ex-Dividend Date:A The date on which, or after, the stock trades without a dividend. So if you buy the stock on or after the ex-dividend date, you will not receive the next dividend. If you sell a stock before the ex-dividend date, you will not receive the dividend (the buyer will receive the dividend). If you sell after the ex-dividend date, you will receive the dividend (the buyer will not). Record Date:A The date the company determines the list of shareholders who qualify for the stock dividend. To be a shareholder of record, you must own the stock at least one day before the ex-dividend date. Payment Date:A The date on which the stock dividend is paid to shareholders of record, in the form of a dividend check, or a credit to your account. The price of the stock increases steadily by the amount of the dividend until the date of record, then drops by the same amount on the ex-dividend date. This happens because investors are willing to pay more if they are expecting to receive the dividend, which offsets the increased price. Moreover, open buy and stop sell orders are also usually reduced by the dividend amount on the ex-dividend date.

Do higher yield stocks give higher return?

Security analysts utilize a concept they call the total return of an investment. The total return of a common stock is simply the sum of (or difference between) the stock's dividend return and the average annual appreciation (or depreciation) in the price of the stock over some period of time. If a stock's dividend return is 10%, but it depreciates in value an average of 5% per year, its actual return or "total return" is only 5% per year; and, on the other hand, if a stock's dividend returns is 5%, but its price appreciates an average of 10% per year, its average total return is 15% per year. Clearly, it would seem better, in the long-run, to try to maximize the "total return" on one's investments, rather than to try to maximize dividend return alone. Many investors prefer securities with high dividends in the belief that these high dividends imply more efficiently employed funds. There are, however, two basic reasons why such may not be the case:

Growth Companies vs Mature Companies

The first reason concerns the type of company represented by a stock with a high dividend yield. Almost without exception, such companies tend to be in mature, troubled, or declining industries. The reason their current yields are so high is usually a combination of two factors: The dividend payout is high in relation to the company's earnings; this is so because the company does not have sufficiently attractive investment opportunities of its own in which legitimately to reinvest its shareholders' earnings, and so it pays out most of its earnings to its shareholders. The price of the stock is low relative to the dividend because of the investment community's perception that the prospects for the company are poor and/or the element of risk is inordinately high. In contrast, a stock with a lower current dividend yield usually has this lower yield for the two opposite reasons: The investment opportunities for the company seem so promising that the board of directors determines it in the best interest of the shareholders to plow back the greater part of earnings into the expansion of the company's business; hence, the dividend payout is small as a percentage of total earnings. The price of the stock is relatively higher, reflecting the investment community's assessment that the prospects for the company are indeed promising and/or the element of risk is small. Those investors, who invest in lower-dividend-paying securities, over a period of time, are actually apt to receive more in total dividends than those investors who invest in high-dividend-paying issues. That is because the rate of dividend paid by a company typically increases at a rate commensurate with increases in earnings. Though the lower-dividend stock investor may receive a smaller dividend than the high-dividend stock investor initially, the former's dividend is apt to increase over time to exceed the latter's dividend quite substantially. It is not uncommon for the lower-dividend stock investor to observe that, though his current yield on present value is low, his current yield on original cost is very high. This is far less apt to be a claim by the high-dividend stock investor.

Tax preferences for Long term Capital Gains

The second reason lower dividend, higher-appreciation stocks may be more efficient investment vehicles than higher-dividend, lower-appreciation stocks concerns the way dividends and capital gains are taxed in a taxable account. As per Indian taxation, short-term capital gains, the investor will be taxed depending on the tax slab relevant to that investor after he has added the capital gain to his annual income. But if the transaction was levied with Securities Transaction Tax (STT), his gain will be taxed 10%.A Whereas, forA long term capital gains, investor will be taxed at 20%. But if the transaction was levied with STT, investor need not pay any tax on your gain. In case of long term capital gains, you can either calculate your capital gain using an indexed acquisition cost, or you can choose not to opt for indexing. In short, from a personal income tax perspective, capital gains income may be much more tax-efficient than dividend income. It should finally be noted that, for those investors who use the cash flow from their investments as a source of livelihood, capital gains income can constitute every bit as legitimate a source of cash flow as dividend income. If one deliberately purchases a lower-dividend stock instead of a high-dividend one in the hope of realizing a capital gain, he should have no compunctions about spending a part of whatever capital gain he realizes for the same purposes that he would otherwise have spent the incremental dividends. Moreover, historically, those investors willing to forego some current dividend income for greater capital gains potential have, indeed, generally enjoyed capital gains considerably in excess of the dividend income they sacrificed to pursue the gains. In short, the after-tax rates of "total return" on their portfolios have usually exceeded, by wide margins, the after-tax rates of "total return" of the portfolios of those who sought to maximize dividend yield alone.

Why investor should invest in high dividend stock?

Traditionally some of the best stocks available in the market are the ones that has offered dividend. And the best dividend stocks belong to those companies that has regularly paid dividend to all its shareholders for many years at a stretch without break, however, such forms of stock are the safest for long term investments. These are known to appreciate steadily in value over the years. Historically such dividend paying stocks offer better return and carries minimum risk, than the so called growth funds. Firstly, dividends allow investors to attainA positive returnsA even in a bearish market. Secondly, dividends allow investors toA further do well inA investmentA returnsA when bull market return. By virtue of the preceding two points, a dividend paying stockA lowers the risk of investing.A This is reflected in the lower volatility in the stock prices of these stocks. No wonder stocks that offer regular dividends consistently are by and large stable and mature than those that don't and whose price patterns fluctuate too frequently. Such volatile shares, however potential, are difficult to read because of their erratic behavior and therefore are beyond the comprehension of novice who enters the stock market. In such situations one has to depend upon so called "expert" brokers and fund managers for advice provided they are reputed with a long standing. Shares that offer dividends consistently are less prone to be volatile even when the markets are turbulent. These are the ones which are most lucrative amongst conservative investors who have very little appetite to stake their hard earned money. Although the value of such shares do not rise and fall heavily like most growth funds, their value continues to rise surely and steadily even when the markets are sluggish or choppy. In the long run, after several years such dividend paying shares outperform most of the other forms of investment in the share market sowed in the initial stage at the same time.

If the investor had wisely reinvested the dividends too on a regular basis, then at the end of say ten or twenty years, the amount earned after selling those shares at current market rates would fetch a considerable sum that is the reason for such dividend paying stocks having remained the safest and best bet amongst investors with long term objectives. However such stocks especially of Blue chip companies come at a price, unless one had wisely brought them when the markets were down such as during recession. Also one must have enough funds at the time of initial investment to be able to diversify the investment in thick over a large diversified dividend paying stocks of reputed companies from various potential sectors, be it energy, infrastructure, finance, defense, food, security, FMCG (short for fast moving commercial goods) etc. Moreover, capital gain need to be realized before one can reinvest for compounding returns, but a consistent dividend paying stock means thatA dividends received can be reinvested for compounded gains.A In addition, there is still capital appreciation in the long run as more investors are attracted to stocks that pay dividends. These stocks also benefit from tax treatment which is very favorable, because these stocks are not taxed on the basis of ordinary income. High dividend stocks will usually give a better yield and return than a Certificate of Deposit or a money market account. High dividend stocks can help make your investment portfolio much stronger, simply because it contains these stocks.

How do we know company is paying sufficient dividend?

There are three approaches to check if a company is paying sustainable dividends: Payout Ratio:A Compare the dividend to earnings in the most recent period to see if too much it is being paid out. A 67% (two-thirds of earnings - the upper limit) payout ratio can be used as a Rule of Thumb. This is to say that that one should avoid companies that pay out more than two thirds of their earnings. Treat 67% as the upper limit. Average Payout Ratio:A Compare dividends to normalized or average earnings over time. Long Term Expected EPS Growth Rate:A Check how much the company could have paid in dividends, allowing for the reality that firms have to reinvest money to grow their earnings.

How do we select a company paying consistent dividend?

Finding quality high dividend stocks does not have to be extremely complex, but it does require a massive amount of research on each stock, going back into history for fifteen to twenty years. This will allow you to ensure that the proposed stock is a quality high dividend stock that meets all your investing criteria. These stocks will not make you rich overnight, but these stocks will usually pay between five and fifteen percent dividends, which can be combined with compound interest to make you rich over an extended time period if the high dividend stocks are chosen right. The following can be few of the criteria to identify right dividend yielding stocks, which would yield stable returns in the long run, not only through reinvestment of the dividend yield but also from capital appreciation: Simple business:A The fewer the moving parts the fewer things that can go wrong and sap cash intended for dividend payments. Focus on companies doing one or two things that you can understand, as opposed to massive corporations with dozens of operating segments. Steady demand:A Given the Great Recession, the first thing we need to verify is demand for a company's products. After all, a company needs a steady stream of cash coming in to afford to pay it out to shareholders. Usually try to stick to industries or sectors with recession-proof or recession-resistant demand (food, alcohol, tobacco, health care, etc.). High cash balance:A Cash is king, especially when it comes to maintaining a dividend. Consider it insurance against any unexpected slowdowns. At a minimum, insist on enough cash to cover one quarter's worth of dividends.

Debt Servicing Capacity:

Minimal need for credit:A Securing credit in this market is extremely difficult. Accordingly, focus on companies that do not need to raise significant amounts of capital through credit. Remember, too, when interest rates rise, so do interest payments for companies that rely on a significant amount of debt. So it's also important to focus on companies with reasonable or low debt balances, however may vary from one industry to another. This insures interest payments won't sap money intended for us. Cash flow positive:A If a company's not generating cash each quarter, the only way to pay a dividend is by borrowing or tapping into cash reserves. Such practices are not sustainable over the long term. Eventually, the dividend will be cut. Earnings buffer:A Insist on a dividend payout ratio (annual dividends/annual net income) of 80% or less. A company paying out 100% of earnings has no sufficient room in the event of a slowdown. If business suffers, so will the dividend. Though the above list is not exhaustive, however, the above criteria can be starting point to narrow down on the potent dividend yielding stock. Furthermore, more analysis can be done on the basis of company's fundamentals.

Can paying more dividends make a company more attractive?

There is varying degree of disagreement about the answer to this question. One of the most widely used prepositions in corporate world is Miller-Modigliani - dividends are neutral and cannot affect returns. While there are many theorists who adhere to this theory, however, there are many other who believe declaration of dividends by firms is signal towards better future earnings. Dividends do not matter: The Miller-Modigliani Theorem: Firms those pay more dividend tend to offer less price appreciation and deliver the same total return to its stakeholders. This is because firms creates value from what it investment in - plant, machinery or raw material and whether these return deliver higher or lower returns. If a firm which pay more in dividend can issue new shares in the market and raise capital and take exactly the same that it would have if it would have not paid the dividend, its overall value should be unaffected by the dividend policy. For this proposition to hold, the investor should also be indifferent between dividend and capital appreciation. The assumption needed to arrive at the proposition that dividends do not affect value may seem so restrictive that one will be tempted to reject it without testing it, after all, it is not costless to issue new stock and dividends and capital gains have historically not been taxed at the same rate. That would be a mistake, however, because the theory does contain a valuable message for investors. A firm that invests in poor projects that make substandard return cannot hope to increase value to its investor by just offering them higher dividends. Alternatively, a firm with a great investment may be able to sustain its value even it does not pay any dividend.

Dividends are good: The Clintele and Signaling Stories There are academics who believe dividends are good and can increase firm value: Some investor like dividends: Given vast diversity of individuals and institutional investors in the markets, it is not surprising that, over time, stockholders tend to invest in firms whose dividend policy meet their investment requirement. Stockholders in high tax brackets who do not need cash flows from dividend payments tend to invent in companies that might be paying low dividend but have high capital appreciation potential in short run. However, on the flip side, there are stockholders, with capital preservation motives, need to invest in companies those pay consistent dividend. Market view dividends as signals: Financial markets examine every action a firm takes for implication for the future. When firms announce changes in dividend policy, they are conveying information to markets, whether they intend to or not. By increasing dividends, firms commits to paying these dividends in long term. These positive signals should therefore lead investors to buy these stocks, which, in turn, increase the price of the stock. Decreasing the dividends is a negative signal, largely because firms are reluctant to cut dividends. Thus, when a firm takes this action, markets see it as an indication that this firm is in substantial and long-term financial trouble. Consequently, such action leads to a drop in stock price. Some managers cannot be trusted with cash: Not all companies have a good investment and competent management. If a firm's investment prospects are poor and its managers are not viewed as careful custodians of the stockholder wealth, paying dividends will reduce the cash in the firm and thus the likelihood of wasteful investments.

Other School of Thought

We look into the possible links between dividend policy and stock price behavior in case of Indian corporate sector. In order to establish the relation, if it exists at all, analyzing the relationship between dividend-retention ratio and stock-price behavior while controlling the variables like size and long-term debt-equity ratio of the firm is required. The analysis is based on the fixed-effect model, as these perform statistically better than random effects and pooled OLS model. The dividend policy of a firm is the choice of financial strategy when investment decisions are made. There are a number of factor effecting the dividend policy decision viz. investor's preference, earnings, investment opportunities; annual vs. target capital structure, flotation costs, signaling, stability & Government policies and taxation. Signaling is one of the crucial factors that influence the market. Dividends may convey information about the company, and hence the possibility of its influence on the stock market. A large dividend payment reduces risk and thus influence stock price and is considered a proxy for the future earnings. The influence of dividend policy on stock price volatility can be analyzed through four basic models The duration effect The rate of return effect, The arbitrage pricing effect The informational effect The following control variables should be considered while testing its significance Operating earnings The size of the firm The level of debt The payout ratio The level of growth It is also sometimes suggested that dividend yield and payout ratios to vary inversely with common stock volatility, but it ignores the nature of the dividend & its impact on the share price and whether market is more volatile to high dividend yield share than normal share.

Existing Theories

Indian stock market is one of the most volatile stock market. A study by the then RBI Governor Y.S.Reddy in 2003 suggest that the percentage of companies paying dividends has declined from 60.5 percent in 1990 to 32.1 percent in 2003 and that only a few firms have consistently paid the same levels of dividends. It further goes on to implicate that the dividend-paying companies are more profitable, large in size and growth doesn't seem to deter Indian firms from paying higher dividends. The tradeoff or tax-preference theory does not appear to hold true in the Indian context, suggesting no significant influence of changes in tax regime on dividend behavior. Modigliani and Miller (1961) proposed the absence of any significant impact of the dividend policy on the value of shares since its impact is offset exactly by other means of financing. It however assumes perfect market conditions, neglecting taxes, transaction cost or asymmetric information. In a perfectly competitive market both company and shareholders invest in the same assets, which does not make a difference for the economy as a whole. There is another school of thought that states the fair value of a stock should be equal to the stock-dividend per share and the difference between the discount rate and the long-term dividend growth rate, which inherently assumes a constant growth rate at constant discount rate. Fama (1998) advocates maximization of the total firm value i.e. debt plus equity. This also inherently assumes efficient capital market, one which may not be true in case of emerging markets. Thirumalvan & Sunita (2005) examined the signaling effect of Stock repurchases and Dividend announcements.

They observed an upward trend of share price movement after the dividend announcement. But the positive signaling existed only for a day or two after the announcements, after which the extent of positivism of shares started declining. According to Sen and Ray (2003) dividend pay-out is the single important factor affecting stock price, followed by earning per share which has very weak impact on the share prices. Black and Scholes in 1974 stated uninformed demand for dividends can result from dividend decisions which in turn derive from imperfections viz. taxes, transaction costs and institutional investment constraints. Due to the dominance of joint stock corporations & the associated characteristics of separation of ownership & control, sole motive of corporation has been maximization of rate of return on capital. Nevertheless, the shareholders generally prefer stable dividend rates & that the effect of taxes is only on the preference of the shareholders, the richer classes prefer low dividends and high retained earnings. The opposite is applicable in the case of middle income group of shareholders. The management behavior can be classified as Active: sufficient profit retentions to satisfy the firm's long-term needs such as investment demand & liquidity needs etc. Passive: aims at increasing the market value of the firm & the market price of shares. The clustering of stock-holders in companies according to their preferences is clientele effect. Thus the firm gets the type of investor they deserve and will have difficulty in changing an established dividend policy, even though it makes sense. The market value of a firm can be expressed a function of net profits, and the ratio of dividends to Retained earnings. The Electricity, Food and Beverage and Non-metallic justify the use of the fixed firm effect model whereas Textile, Mining and Other services do not. The stock return, as a function of net profit and dividend-retention ratio with two control variable such as size & debt-equity ratio of the firm were used establish the relationship of dividends and stock return. The findings display statistical significance and linearity with the industry classifications i.e. dividend retention ratio is positively related with the stock-returns. But in case of aggregate data the regression lacks statistical significance establishing no relationship. As the firm go for more debt, its value is affected by stock-return. Size of the firm remains consistently positive but in many cases it turns out to be insignificant, it cannot be generalized against variable size. So we can conclude that dividends have impact on the stock-return in Indian corporate sector, which is industry specific.

Conclusion

From above observations we can see that, there exists a correlation between the dividend yield and the log normal growth of the stock provided all the data points are from the same sector. But there hardly exists any significant correlation when this relationship is tested across the complete sector. Thus, hypothesis that consistent dividend paying stocks perform better is holds true when considered for a particular sector but fails when whole market is taken into consideration. There are various reasons for the hypothesis to fail for market. First, dividends tend to lag behind earnings, that is, increases in earnings are followed by increases in dividends and decreases in earnings sometimes by dividend cuts. Second, dividends are "sticky" because firms are typically reluctant to change dividends; in particular, firms avoid cutting dividends even when earnings drop. Third, dividends tend to follow a much smoother path than do earnings. Finally, there are distinct differences in dividend policy over the life cycle of a firm, resulting from changes in growth rates, cash flows, and project investments in hand. Especially the companies that are vulnerable to macroeconomic vicissitudes, such as those in cyclical industries, are less likely to be tempted to set a relatively low maintainable regular dividend so as to avoid the dreaded consequences of a reduced dividend in a particularly bad year. Dividend decisions are recognized as centrally important because of increasingly significant role of the finances in the firm's overall growth strategy. The objective of the finance manager should be to find out an optimal dividend policy that will enhance value of the firm.

It is often argued that the share prices of a firm tend to be reduced whenever there is a reduction in the dividend payments. Companies generally prefer a stable dividend payout ratio because the shareholders expect it and reveal a preference for it. Shareholders may want a stable rate of dividend payment for a variety of reasons. Risk averse shareholders would be willing to invest only in those companies which pay high current returns on shares. The class of investors, which includes pensioners and other small savers, are partly or fully dependent on dividend to meet their day-to-day needs. Similarly, educational institutions and charity firms prefer stable dividends, because they will not be able to carry on their current operations otherwise. Such investors would therefore, prefer companies, which pay a regular dividend every year. This clustering of stockholders in companies with dividend policies that match their preference is called clientele effect. Thus, we can observe a part of investors that are highly attracted to towards consistent dividend paying stocks while other part of investors prefers stock providing high returns. These two classes of investors are not mutually exclusive but at the same time, they are not the same class of investors since both have varying propensity towards the risks associated with the stocks. Thus, we can finally conclude that, consistent dividend paying stocks do not necessarily perform well across the market but it can be the case for individual sector.

Cite this page