Turkish Tax News
12 May 2016Erdal AYDIN

What is so puzzling about the Motivations behind Dividend Policy? (1)

A Brief Literature Review

Pursuant to Modigliani and Miller’s dividend irrelevance theory, companies’ dividend policies do not have any effect on shareholders’ wealth. Academics have asked why companies pay a significant proportion of their earnings as dividends if it does not affect shareholders’ wealth. In finance literature, this question is known as the “dividend puzzle”.

The presumption that generally constitutes the basis of finance literature is that a company’s directors endeavour to increase shareholders’ prosperity, represented by the company’s market value. In other words, when making decisions intended to maximize shareholders’ wealth, financial directors should aim to balance gains and risks for shareholders via increased stock prices and dividend payouts.

Corporate financial decisions can be split into two main categories: (1) decisions about investments, and (2) decisions about financing. Decisions about investments include defining the type and quantity of the assets that a company wants to keep. In contrast, decisions about financing deal with gaining resources as debt and equity to fund a company’s operations and investments.

Financing decisions have a significant effect on a company’s future financial condition and sustainability. Dividend payments fall under the umbrella of financing decisions and are in fact one of the most important decisions that a company must make.

The term “dividend” refers to payments to company shareholders comprised of a piece of company’s profits, and the company’s managing directors determine the amount of these payments. Furthermore, dividends are considered as the equivalent of an interest payment that would be made to a creditor – a form of compensation for the shareholders’ deferred consumption.

Dividend policy is made up of all of a company’s dividend decisions. It involves judgments regarding how much profit will be given to shareholders as dividend and how much of it will be kept in company accounts for autofinancing. If directors decide to retain more profit in company accounts, shareholders will receive less dividend payouts as investors.

A company’s dividend policy has an impact on its cost of equity, investment decisions, liquidity position, market value and etc. Therefore, directors should be careful in settling the details of a company’s dividend policy.

Expectations of investors in the market may be a determinant of the proportion of profit paid as dividend. Dividend policy should conform with investors’ preferences regarding dividends versus capital gains. These preferencesmight differ according to investors’ expectations. For instance, a mature investor might want to expand his or her portfolio and thus favour future capital gains over dividend payouts. On the contrary, a young investor might prefer dividend payouts – which would be in his or her hands today – to reinvestment for the company’s growth.

In addition, certain other factors have important effects on dividend policy. These include: agency costs, taxation costs, shareholders’ investment preferences, shareholders’ risk perceptions, clientele demands, company size, profitability and growth.

Once a company has settled its dividend policy, it might need to alter it if there are changes in the determinant conditions (which affect the above-mentioned factors). Also, investors might consider any modifications to a company’s dividend policy as signals. For example, if a company announces that it is going to pay more dividends than expected, investors might perceive this as an indicator that the company represents a very profitable investment and that it will therefore further increase dividends in the future. As a result of this positive signal effect, investors might buy more shares. And, due to this growth in demand, share prices might increase. In contrast, if a company pronounces that it is going to pay less dividends than expected, a negative signal effect may occur. As a consequence, the company’s share prices might decrease.

When a company’s investment decisions, capital cost and capital components are stable, the likely effect of its dividend policy on its market value is one of the most debated facets of dividend policy. While some approaches claim that dividend policy does not affect a company’s market value, others posit that dividend policy influences a company’s market value by increasing the market price of shares. The literature can provide greater insight into the effects of dividend policies on companies’ market value.

Theories and Influencing Factors for Dividend Policy

Modigliani - Miller (M&M) Dividend Irrelevance Theory

Modigliani and Miller composed the first noteworthy paper on dividend policy. According to their theory, in a perfect market, dividend policy and dividends do not affect a company’s market value. Rather, a company’s market value depends on its potential for generating future cash flows and the structure of operational risks. In addition, Modigliani and Miller claimed that dividend policy does not make any difference in terms of shareholders’ wealth, a concept referred to as dividend irrelevance theory.

Taking Modigliani and Miller’s dividend irrelevance theory into consideration, many researchers have questioned why companies pay a significant proportion of their earnings as dividends. This question is known in finance literature as the “dividend puzzle”.

Modigliani and Miller’s theory is based on the following assumptions: investors do not pay any taxes or commissions, and they do not bear any bankruptcy costs. In addition, dividend policy is independent of capital budgeting decisions. Also, it is not important if a company keeps profits profitable for growth of company or if it gives profits to shareholders as dividend. Later, Modigliani and Miller improved and corrected their theory, taking taxation effects into account.

Bird in the Hand Theory

This approach, developed by Lintner and Gordon, can be summarised as, “a bird in the hand is worth more than two in the bush”. According to this theory, investors prefer dividends today to capital gains in the future, because they believe it is less risky. According to Lintner and Gordon, uncertainties and other factors create risk by causing share prices to fluctuate. Thus, if shares are held over the long term, capital gains are a riskier proposition. For this reason, dividends that are paid immediately affect a company’s market value.

Agency Theory

Jensen and Meckling looked at how conflicts of interest among shareholders and directors could influence dividend policy. Hence, as their theory concerns agency relationship problems, it is called the agency theory.

According to this approach, although even company directors are agents of shareholders, their actions cannot be totally controlled by these shareholders. Directors always have more information about their companies, and they can put their own welfare ahead of shareholders’ interests.

Easterbrook claimed that an increase in dividends could solve the agency problem. According to him, if a company were to pay more dividends, the cash stock would decrease, and directors would tend to seek external loans. As a result of raised external loan, lenders’ surveillance of directors’ actions would also intensify.

In addition, Jensen and Meckling observed that increased managerial possession of a company relieves agency problems. According to this theory, directors can better realise shareholders’ interests if they are provided with some ownership shares.

Signalling Theory

Signalling theory asserts that decisions about dividends are perceived as indicators regarding a company’s future profitability. For example, if a company pays high dividends, one might interpret this to mean that the company will be even more profitable in the future.

Tax Preference Theory

According to this theory, if dividends are taxed more highly than capital gains, shareholders will choose capital gains over dividends, in order to pay less in taxes. By taking the time value of money into consideration, capital gains give shareholders an advantage, because of the fact that shares are not taxed until they are sold.

Life-Cycle Theory

Fama and French’s life-cycle theory asserts that companies follow a life-cycle and that a company’s particular phase in this life-cycle has an effect on its dividend policy. According to this theory, companies in the growth phase have profitable investment chances but lack sufficient resources to finance them. So, they are not liable to pay dividends. However, companies in the maturity phase do not have many new profitable investment chances. Such companies are therefore more apt to pay dividends.

Catering Theory

The catering theory of Baker and Wurglar assumes that the probability that a company will pay dividends depends on investor preferences. If investors think that companies that pay dividends are better – and thus are willing to pay a higher price to purchase their shares – directors will be more inclined to pay dividends.

In addition to these theories, certain factors have significant effects on dividend policy. Taxes, the clientele effect, cash flows and investment opportunities, company size, growth and profitability all play a role.

Clientele Effect

The clientele effect refers to how a company's stock price moves according to investor reactions to various changes in taxes, dividends and other policies.

Future Cash Flows and Investment Opportunities

Cohen and Yagil claimed that future cash flows and investment opportunities are the most significant factors influencing directors’ dividend rulings.

Company Size

Scott and Martin backed the idea that a company’s size is a significant factor in its dividend policy and that larger companies pay more dividends than smaller ones. However, some researchers have pointed out that Lintner’s sample is basically composed of strong and larger companies that are very inclined to increase dividends.

Company Profitability

John Lintner observed that increases in gains are not continuous over time. Therefore, unless directors believe that future gains are sustainable, they will not change dividend policies to pay more dividends.

Some researchers have found a positive relationship between profitableness and dividend payouts. Dividends are paid from yearly income, therefore it is obvious that more profitable companies can pay higher dividends.

Company Growth

According to Naceur, Goaied and Belanes, when companies increase their investments, shareholders anticipate higher growth. However, in order to realize this growth, companies may need to use some portion of their annual profit. As a result, they might need to reduce dividend payments.

The results of this literature review show that no single theory or factor can completely solve the dividend puzzle in practice. Dividends depend on human behaviours, like shareholders’ demands, directors’ decisions and investors’ expectations. These human behaviours are extremely changeable and sometimes illogical. For this reason, a single theory or variable cannot explain human behaviours. However, directors should alter their companies’ dividend policies in accordance with these varying human expectations.

  • Modigliani, F. and Miller, M. (1961) 'Dividend policy: growth and the valuation of Shares', Journal of Business, 34: pp. 411-33.
  • Black, F. (1976) 'The dividend puzzle', The Journal of Portfolio Management, 2(2): pp. 5-8.
  • McLaney, E. (2011) Business Finance: Theory and Practice, 9th Edition. England: Pearson Education Limited.
  • Baker, H. K. (2009) Dividends and Dividend Policy. New Jersey: John Wiley & Sons.
  • Lintner, J. (1962) 'Dividends, Earnings, Leverage, Stock Prices and the Supply of Capital to Corporations', The Review of Economics and Statistics, 44 (3): pp. 243-269.
  • Gordon, M. J. (1963) 'Optimal Investment and Financing Policy', The Journal of Finance, 18: pp. 264–272. 
  • Jensen, M. C. and Meckling, W. H. (1976) 'Agency Costs and the Theory of the Firm', Journal of Financial Economics, 3(4): pp. 305-360.
  • Easterbrook, F. (1984) 'Two agency cost explanations of dividends', American Economic Review, 74: pp. 650-659.
  • Bhattacharya, S. (1979) 'Imperfect information, dividend policy, and ‘‘the bird in the hand” fallacy', Bell Journal of Economics, 10: pp. 259–70.
  • Kose, J. and Williams, J. (1985) 'Dividends, Dilution, and Taxes: A Signalling Equilibrium', The Journal of Finance, 40: pp. 1053-1070.
  • Litzenberger, R. H. and Ramaswamy K. (1979) 'The Effect of Personal Taxes and Dividends on Capital Asset Prices', Journal of Financial Economics, 7: pp. 163-195.
  • Fama, F.E. and French, K.R. (2001) 'Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?', Journal of Financial Economics, 60: pp. 3-43.
  • DeAngelo, H., DeAngelo, L. E. and Skinner D. J. (1992) 'Dividends and losses', Journal of Finance, 47: pp. 1837-1863.
  • Baker, M. and Wurgler, J. (2004) 'Appearing and disappearing dividends: The link to catering incentives', Journal of Financial Economics, 73 (2): pp. 271-288.
  • Cohen, G. and Yagil, J. (2010) 'Sectorial differences in corporate financial behavior: an international survey', The European Journal of Finance, 16(3): pp. 245-262.
  • Scott, D. F. and Martin, J. D. (1975) 'Industry Influence on Financial Structure', Financial Management, 4: pp. 67-73.
  • Silva, L. C., Goergen, M. and Renneboog, L. (2004) Dividend Policy and Corporate Governance. Oxford: Oxford Scholarship.
  • Lintner, J. (1956) 'Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,' American Economic Review, 46: pp. 97–113.
  • Al-Yahyaee, K., Pham, T., and Walter T. (2006) 'Dividend Policy in the Absence of Taxes', Working Paper, University of New South Wales.
  • Naceur, S. B., Goaied, M. and Belanes, A. (2006) 'On the Determinants and Dynamics of Dividend Policy', International Review of Finance, 6: pp. 1–23.

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