Assumption:
1. No change in investment opportunities and returns on business investment.
2. No change on company capital structure.
- No change on debt to equity ratio.
- No change in gearing ratio.
Modigliani-Miller’s dividend irrelevancy proposition
- The value of company will not affect by capital structure of company.
- The dividend policy of company will not affect the share value, market value and shareholders’ wealth.
- The company should not give up positive Net Present Value project to increase dividend.
Modigliani-Miller’s dividend irrelevancy proposition – the conditions
1. Ignore taxes. (company and personal taxes)
2. Ignore transaction cost.
- When investors buy or sell no need pay any fee.
- No cost of issue new share.
3. Lending and borrowing’s interest rate is same.
4. All parties (company and investors) of market have full information.
5. Investors are indifferent between dividends and capital gains.
- Under the value of dividend unchanged situation, it will not cause shareholders unsatisfied although the company changes the timing to pay dividend to shareholders. (don’t pay dividend to shareholders)
- That is because the shareholders can get the value from capital gain, although do no have dividend.
- Therefore the dividend policy will not affect the shareholders’ wealth.
- Under dividend – irrelevance position, dividend policy will not important.
Dividends as a Residual
- Company only will pay dividend after cover the future investment (required rate of return of the project) and have extra fund.
- Company’s value increase only when the company invest in positive Net Present Value project.
- The shareholders should receive the cash because they can use it to invest in other firms.
Dividend – relevance position
Under this real world the dividend policy of a company can affect the company.
The Clientele Effect
- Investors will attract by company which can fulfill their requirement.
- Different dividend policy of company can attract different kind of investors.
- Therefore each company will build up a dividend policy which can satisfy and retain their shareholders.
- In order to satisfy and retain the type of shareholder that the company target, each company will promote different dividend policy. Such as:
Ø Promote high dividend payment, or
Ø Promote low payout dividend payment, or
Ø Promote stable dividend payment, or
Ø Promote fluctuating dividend payment. (dividend payment depend by company earning, high earning pay high dividend, low earning pay low dividend)
Taxes
- Personal taxes.
- Taxation can affect investors whether prefer get capital gain or get dividend.
- Individual shareholder can sell share by high price with no tax deducted, if they receive dividend pay by company they need to pay tax to government.
- High tax rate will lead shareholders prefer low dividend payment.
- Low tax rate will lead shareholders prefer high dividend payment.
Dividends as conveyors of information
- No full information between shareholders and management term.
- Shareholders are the owner but not manager of a company, shareholder only can get company information from annual report or decision making dividend of the company.
- Therefore, if the company increase the dividend payment will give the shareholders a good signal about the company have favorable prospects.
- Dividends as conveyors of information will cause company:
Ø Promote high dividend payment.
ü Some shareholder will consider that high dividend payment may be will lead to company do no have enough cash to do future investment or invest positive Net Present Value project, it will affect the future firm’s value.
Ø Promote low dividend payment.
ü Some shareholder will consider that low dividend payment can let the company have enough cash to do future investment or invest positive Net Present Value project, it will increase the future firm’s value.
Ø Promote stable dividend payment.
ü Only strong financial background company able to remain stable dividend payment no matter the company gain or less.
Resolution of Uncertainty – Bird-in-the-hand
- Shareholders prefer receive high dividend today than receive in future because future is uncertainty.
- Bird-in-the-hand will encourage the company:
Ø Promote high dividend payment.
ü Shareholders receive high dividend today to do other invest to increase their shareholders’ wealth, because future is uncertainty.
Ø Promote fluctuating dividend payment.
ü Current dividend is better than uncertainty in future, because the shareholders don’t know the company will get earning in future or not.
- The correct way to solve the uncertainty are:
(i) Do no receive high dividend payment today because it will lead to company do no have enough cash to do future investment or invest positive Net Present Value project, it will affect the future firm’s value.
(ii) Increase cost of capital or use high cost of capital.
Owner control (agency theory)
- Many companies will decide to pay high dividend and issuing new shares to raise cash for investment.
- Because no full information between shareholders and management term, therefore shareholders worry management term will invest in negative Net Present Value project or project which is only benefit management term.
- Therefore, shareholders will require high dividend, management term need fund for investment they need to ask shareholders. The shareholders can get the currently information of company.
- Disadvantage of owner control:
Ø Company need to pay transaction cost when issue new share, it will reduce firm’s value.
Ø Shareholders need to pay tax when receive dividend, it will reduce shareholders’ wealth.
- Owner control will cause company
Ø Promote high dividend payment.
ü High dividend payment wills easy shareholders to monitor the management term, because the manager need to provide more information to shareholders when decide to invest new project.
Ø Promote fluctuating dividend payment.
ü Shareholders can get the signal directly base on the dividend payment. If company gain they will receive high dividend. If company loss they will receive low dividend or don’t have dividend.
Scrip Dividends (Share Dividend)
- Company paying share dividend to shareholders not normal cash dividend.
- Advantage of scrip dividends
Ø That cash does not leave the company.
Ø Shareholders can save tax and transaction cost by holding share.
Share Repurchase and Special Dividends
- Share repurchase means company buys back share by its own stock, it can increase EPS, and the share price of company.
- Special dividend is similar to a normal dividend but is usually bigger and paid on a one-off basis.
The two key questions
1. Can shareholder wealth be increased by changing the pattern of dividends over a period of years?
Ans: Yes, but that is not straightforward formula for us to calculate the best pattern. Because there are many different and unpredictable factors will affect it, such as clientele preference, tax system and other.
2. Is a steady, stable dividend growth rate better than one which varies from year to year depending on the firm’s internal need for funds?
Ans: Perform well or bad in no under control. Dividend payment remains stable or fluctuation which one is better and what reason affect it will show in following:
The dividend decision – the four forces
Forces promoting a high dividend payment
(i) Some clienteles
- Shareholders preference, different shareholders have different preference.
(ii) Owner control (agency theory)
- Shareholders require high dividend can let them easy to monitor management team, because manager needs to ask shareholders when need fund for investment. The shareholders can get the currently information of company.
(iii) Uncertainty (bird-in-the-hand)
- Shareholders receive high dividend today to do other invest to increase their shareholders’ wealth, because future is uncertainty.
(iv) Signalling (Dividends as conveyors of information)
- The company increase the dividend payment will give the shareholders a good signal about the company have favorable prospects.
Forces promoting a low payout dividend payment
(i) Tax system
- Different country will have different tax system. High tax rate will lead shareholders prefer low dividend payment
(ii) Some clienteles
- Shareholders preference, different shareholders have different preference.
(iii) High growth potential
- The company has high growth potential therefore need more fund for future investment.
(iv) Unstable earning
- Because of earning in future is uncertainty in order to measure company can save fund when company gain and have enough fund when company loss, company remain low dividend payment may be better.
(v) Avoid future dividend cuts
- If earning increase the dividend payment also will increase, if earning decrease the dividend payment also will decrease, because of future is uncertainty. In order to measure company can save fund when company gain and have enough fund when company loss, company remain low dividend payment may be better.
(vi) Lender agreement restrictions
- Company need to pay interest to debt holders first therefore no enough funds to pay high dividend to shareholders.
(vii) Low liquidity
- Company has no enough cash flow.
Forces promoting a stable dividend payment
(i) Some clienteles
- Shareholders preference, different shareholders have different preference.
(ii) Signalling
- Dividend policy change is difficult to justify whether it is good or bad signal. If investors interpret this signal is positive they will continue invest, if no they may be will quit. In order to avoid this kind of confusing remain stable may be better.
(iii) Avoid future dividend cuts
- If earning increase the dividend payment also will increase, if earning decrease the dividend payment also will decrease. In order to avoid dividend decrease, company will remain stable may be better.
(iv) Stability raises credit standing
- Only strong financial background company able to remain stable dividend payment no matter the company gain or less.
Forces promoting a fluctuating dividend payment
(i) Some clienteles
- Shareholders preference, different shareholders have different preference.
(ii) Owner control (agency theory)
- Shareholders will require high dividend, management term need fund for investment they need to ask shareholders. The shareholders can get the currently information of company. It can avoid manager invest in project which only benefit management term.
(iii) Uncertainty (bird-in-the-hand)
- Current dividend is better than future uncertainty dividend.
(iv) Signalling
- Shareholders can get the signal directly base on the dividend payment. If company gain they will receive high dividend. If company loss they will receive low dividend or don’t have dividend.
Practical constraints to dividend payment
- Legal constraints
- Different country have different tax rate (personal tax in dividend income), therefore every company have different dividend policy.
- Liquidity
- The earnings and cash flow of company is no 100% match, because of accounting profit problem. Therefore dividend payment can not 100% depend on the accounting profit earning.
- Interest payment obligations
- Company need to pay interest to debt holders first before pay dividend to shareholders.
- Investment opportunities
- Low investment opportunity company normally can pay high dividend currently.
A suggested action plan for a dividend policy
(How to decide whether pay high or low dividend)
- Do forecast in “surplus” cash flow, the dividend will only pay without give up positive Net Present Value project.
- Base on the forecast of the company, most of the company will still choice a stable dividend payment because future is uncertainty. Therefore, the company needs to retain some cash in hand for uncertainty future.
- Forecast is no 100% correctly, maintain stable dividend payment if company earning is more than company forecast can pay share dividend.
The firm’s value and shareholders’ wealth will decrease when reject positive Net Present Value project to pay dividend.
Issuing new share will not benefit company because transaction cost will increase cost of capital of company and decrease firm’s value.
Pay dividend will not benefit shareholder because personal tax in dividend pay will reduce shareholders’ wealth.
Share dividend and can avoid paying cash dividend and retain cash in company.
Share repurchase can increase EPS, and the share price of company.
Company will pay dividend only when the company is low opportunity investment.
Most of company will maintain stable dividend payment. There do not prefer formula to calculate the optimal dividend-to-earning ratio.
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