CORPORATE FINANCE

Corporate Finance

Corporate Finance

Introduction

A number of researchers have provided insights, theoretical as well as empirical, into the dividend policy puzzle. However, the issue as to why firms pay dividends is as yet unresolved. Several rationales for a corporate dividend policy have been proposed in the literature, but there is no unanimity among researchers. Everyone, however, agrees that the issue is important, as dividend payment is one of the most commonly observed phenomenon in corporations worldwide.

The issue of dividend policy is important for several reasons. First, researchers have found that a firm uses dividends as a mechanism for financial signaling to the outsiders regarding the stability and growth prospects of the firm. Secondly, dividends play an important role in a firm's capital structure. Yet another set of studies have established the relationship between firm dividend and investment decisions. According to the "residual dividend" theory, a firm will pay dividends only if it does not have profitable investment opportunities, i.e., positive net present value projects.

Further, a firm's stock price is affected, among other things, by the dividend pattern. Firms usually do not like to reduce or eliminate dividend payments [Woolridge and Ghosh, 1988, pp. 49-53 and 1991, pp. 88-91], hence, they make announcements of dividend initiation or increases only when they are confident of keeping up with their good performance. Moreover, because the success of a financial manager is tied to the maximization of shareholder wealth (and firm value), hence s/he must understand the dynamics of dividend policy. Indeed, the market value of a firm is dependent upon its stock price. One of the most popular models for stock valuation (the dividends discounting model or DDM) relies upon the assumption that the firm will pay dividends until eternity.

Determination of Dividend Policy

Miller and Modigliani [1961] view dividend payment as irrelevant. According to them, the investor is indifferent between dividend payment and capital gains. Black [1976] poses the question again, "Why do corporations pay dividends?" In addition, he poses a second question, "Why do investors pay attention to dividends?" Although, the answers to these questions may appear obvious, he concludes that they are not. The harder we try to explain the phenomenon, the more it seems like a puzzle, with pieces that just do not fit together. After over two decades since Black's paper, the dividend puzzle persists.

Some researchers emphasize the informational content of dividends. Miller and Rock [1985], for instance, develop a model in which dividend announcement effects emerge from the asymmetry of information between owners and managers. The dividend announcement provides shareholders and the marketplace the missing piece of information about current earnings upon which their estimation of the firm's future (expected) earnings is based. The latter, of course, determines the current market value of the firm. In this respect, we can clearly see the role played by dividends. The dividend announcement provides the missing piece of information and allows the market to establish the firm's current earnings. These earnings are then useed in predicting future ...