CORPORATE DIVIDEND POLICIES

Corporate Dividend Policies

Corporate Dividend Policies

Question 1

The dividend decision is an integral part of the firm's strategic financing decision. It essentially involves a firm's directors deciding how much of the firm's earnings, after interest and taxes (EAIT), should be distributed to the firm's ordinary shareholders in return for their investment in the firm, and how much should be retained to finance future growth and development.

If an optimal dividend policy does exist then clearly managers should concern themselves with its determination; if it does not, then any dividend policy will do, as one policy will be equal to another.) The theory of dividend irrelevancy was perhaps most elegantly argued by its chief proponents, Modigliani and Miller (usually referred to as M&M) in their seminal paper in 1961 (Miller and Modiglianni 1961 pp 15-225). In the same manner in which they argued for capital structure irrelevancy M&M assert that the value of a firm is primarily determined by its ability to generate earnings from its investments and by its level of business and financial risk. They argue that dividend policy is a 'passive residual' which is determined by a firm's need for investment funds. According to M&M's irrelevancy theory, it therefore does not matter how a firm divides its earnings between dividend payments to shareholders and internal retentions (Ross; et.al. 2008 pp 245-311). In the M&M view the dividend decision is one over which managers need not agonise, trying to find the optimal dividend policy, because an optimal dividend policy does not exist. M&M built their dividend irrelevancy theory on a range of key assumptions, similar to those on which they based their theory of capital structure irrelevancy.

Jose and Stevens (2004 pp. 651-662) have demonstrated that, assuming perfect capital market conditions, a firm's dividend decision is irrelevant; dividend policy has no influence on share value. Therefore, in a perfect market, it does not matter whether a firm has a dividend policy or not.

It is argued that clienteles have no effect on an individual firm's share value as long as there are enough shares widely available in the capital markets to satisfy the needs of various clienteles. A firm's share value may also be affected by other market imperfections such as information asymmetry, where the information content or signalling effect of dividends seems to be relevant (Arnold 2005 pp 85-99).

Question 2

It should be noted that the dividend decision and dividend policy relate only to ordinary share capital. (Asquith and Mullins 2003 77-96)The payment of preference share dividends is not considered part of a firm's dividend policy, as the level of, or method of calculating, the preference dividend is fixed in advance by the terms and conditions of the original preference share offer. Once a dividend policy has been formulated, setting out the amount and timing, etc. of dividend payments, it should be followed with stability and consistency as its guiding principles. As we shall discuss later, changes to a firm's dividend policy can be interpreted in various ways by the ...