A company has an obligation to maintain financial stability through engagement to its staff, clientele and the shareholders. It ensures this by laying down vital, strategic, financial plans. Cash distribution is a methodology in which a company can achieve this. It is often referred to as the distributions from a company presented to a limited partner investor from monetary resources and in the form of money. The limited partners have a percentage of shareholding in the company; hence, the latter maximizes the opportunities set in place in investing, capital structure and working capital policies. Companies distribute finances to their partners through several procedures that this context looks into; dividends and stock repurchases (Ehrhardt and Brigham, 2008, pg 515).
Overview of Cash Distribution
Cash available for distribution to its investors is derived from operations being carried out in the company (Brigham and Ehrhardt, 2010, pg 560). Decision-making in cash distribution is vital in clueing signals of a company's financial market. The process is influenced by characteristic activities in the macro and micro environment affecting operational activities in the company (Cirman and Konic, 2001, pg 2404). Decisions such as changing capital costs or perceptions of its investors can only be initiated when a company decides to alter its cost of operations.
A company usually has its own optimal policies guiding its cash distribution levels to maximize its intrinsic value. However, it is dependent on the investor's preferences in the yields gained from dividends vs. those of capital. These preferences determine the percentage of net income that shareholders get through dividends or stock repurchases. The percentage is mainly defined as the target distribution ratio. Similarly, investor preferences determine the target payout ratio; percentage of net income remunerated as cash dividend. The target distribution ratio is indirectly proportional to the target payout ratio. Incidentally, a high distribution and payout ratio ensures that a company pays out higher dividends; resulting to little or no stock repurchases. A company is then subjected to low capital gains. The situation differs when the rate of the ratio is reversed (Brigham and Daves, 2009, 598).
However, cash distribution is also affected by other factors. They include constraints on the payment of dividends and on the cost required in finding other alternative sources of capital. As depicted from above, cash distribution is carried out via two main procedures, cash dividends and stock repurchases. Patterns associated with the two procedures have been changing tremendously and this has contributed to stabilizing cash distributions. Effectuated managerial actions help a company in maximizing shareholder wealth in part of the company.
A company's firm value is the summation of all cash flows of already presented and calculated cash flows. As asserted in the capital structure theory, the MM argument (theory of cash distribution) proposes that actual cash flows are unnecessary to utilize since there are potential discounts in dividends, commonly referred to as FCFs (free cash flows). A company's future in the flow of cash is reflected by appraisals in the management; reflecting the decisions of cash flow equity and interpretation by external shareholders (Asquith and Mullins, 2006, pg 27).
Theories of Cash Distribution and Firm Value
In determining the appropriate procedure of maximizing shareholder wealth, it is vital to comprehend the theories associated with cash distribution. There are three major theories stipulating this; the dividend irrelevance theory, the bird in the hand (dividend preference) theory and the tax effect theory. These theories guide in determining investor preferences in dividends vs. gains in capital (Brigham and Ehrhardt, 2010, pg 565).
a) Dividend irrelevance theory
The theory is usually based on the supposition that the amount of dividends is equal or slightly high than the FCF produced by policies of fixed investments. It is applicable in case of company cash retention (Magni, 2010, pg 232). The theory's proponents were Merton Miller together with Franco Modigliani (MM). They argued that firm value is determined by earning power and risks of the company's business; and dependent on produced asset income. The argument is commonly referred to as the MM argument (Brigham and Ehrhardt, 2010, pg 565).
Shareholders are able to come up with their own policy of dividends. This case takes place when a company denies its investors a pay in their dividends. An investor can create a certain percentage of dividends by selling the same percentage of his stock shares. Similarly, if the pay of dividends is more than the investor's expectation, he or she is allowed to purchase more shares amongst the company's stock. Having investors' dividend policy submits the company's dividend policy prone to being irrelevant (Brigham and Ehrhardt, 2010, pg 565).
In support of this theoretical perspective, the argument keeps off taxes and costs incurred by brokerage. Investors in need of extra dividends would subject brokerage costs if the MM propositions were not true. The latter would also pay for taxes levied on capital gains. It is also applicable to shareholders not wiling to have dividends. They pay for tax and brokerage to purchase shares (Brigham and Daves, 2009, pg 598).
b) Bird in the hand theory
It is popularly recognized as the dividend preference theory. This theory asserts that a firm's value can only be maximized through a higher dividend payout ratio since shareholders consider cash dividends less risky than prospective capital gains (Brigham and Ehrhardt, 2010, pg 591). The theory's proponents were Myron Gordon and John Lintner who contended, any risk related to a company's stock declines as dividends increase. It is vital for a company to offer returns to its shareholders, but a form of return in capital gains is rather hazardous. In real life experiences, a bird in the hand has more worth than a bird staying in the bush; hence the name of the theory.
The preference of investors is greatly considered by the company. They prefer dividends and are usually ready to accept lower returns based on equity. Consequentially, higher payouts trim down risk encountered concerning the squandering of cash by managers. This allows for the raising of external funds as compared to a company offering lower payouts. Managers will also not engage in wasteful operation as they are prone to be at public and shareholders' scrutiny. Fewer risks encourage shareholders to accept the quantity of returns, higher or lower, on equity (Ehrhardt and Brigham, 2008, pg 519).
c) Tax effect theory
This theory propels preferences on capital gains. It states that since semi-permanent capital gains are subjugated to less onerous taxes. Shareholders prefer having their respective companies retain earnings other than disbursing to the former as dividends (Ehrhardt and Brigham, 2008, pg 538). Tax rates were reduced on dividends by the Job and Growth Act of 2003. However, stock prices still appreciate after taxation comparatively to dividends. This is because the situation explicates that, for every dollar paid on taxes levied in the future; a lower effectual cost will be then paid today. Secondly, retention of stocks till the life termination period does not impose any tax on capital gains since the beneficiaries can use stock value on the funeral days as a cash basis, hence, getting away from paying tax on capital gains.
Dividends Vs Stock Repurchases
Dividends are distributions acquired from a company's profits and dividends among its shareholders (Tracy and Tracy, 2008, pg 44). Many successful companies have succeeded in supplementing various levels of dividends depending with the financial profit or loss incurred. This is effectuated by the low-regular-dividend-plus-extras policy (Ehrhardt and Brigham, 2008, pg 526). It is greatly advised for a company to maintain dividends since the notion would lower investor confidence, due to its signaling effects; thus impacting negatively on equity cost and stock price. However, problems do arise in situations of cash flow variations. In such instances, a company sets its dividend at lower…