Dividends Pay Out Policy

THE RELEVANCE OF PAYOUT POLICIES

The Relevance of Payout Policies

Is dividend policy irrelevant?

The dividend irrelevancy theory advanced by Modigliani and Miller argues that dividend pay-out has no effect on firm value and hence, dividend policy is irrelevant (Amidu, 2007). The theory argues that excess cash inflows could instead be reinvested into the company to stimulate future growth. Proponents of dividend pay outs argue that dividend-payment creates an impression of honesty among investors, it indicates that the company is generating real earnings, and minimizes the risk of overinvestment in projects with negative net present value (NPV) (Amidu, 2007). However, in my view, dividend policy is irrelevant for two major reasons.

First, investors will usually create their own cash flows regardless of the company’s dividend policy. Every investor expects a certain amount in dividends. If the pay-out policy is such that the investor receives a higher dividend than they expect, they can use the surplus to purchase more stock in the company. Alternatively, if they receive lower dividends than they expect, they could sell some of their shares and end up with the same cash flow to match what they expected. Secondly, regardless of the dividend policy, the after-tax rate of return on dividends will often be the same (Amidu, 2007). If a company has a high dividend policy, investors will have to pay more in taxes, and hence, the company’s stock price has to be low so as to maintain the after-tax rate of return that investors expect (Amidu, 2007). Ultimately, therefore, the dividend policy is irrelevant.

Are there more efficient ways to provide a return on capital to shareholders?

There are more efficient ways of providing a return on investors’ capital. One of the common alternatives to cash dividends is share repurchase or buy back (Brav et al., 2005). In a share buy-back, the issuing company reduces its outstanding shares by purchasing its own shares (Brav et al., 2005). The repurchased stock are then retired or held back as non-circulating (treasury) stock. Like cash dividends, share repurchase also mitigates against overinvestment in non-profitable projects by taking away the surplus cash inflows. A second alternative to dividends is a bonus issue, which involves issuing additional shares at an agreed rate to the company’s existing shareholders free of charge as a way of increasing shareholder value. Stock splits are also an alternative to dividends that involve dividing the company’s outstanding shares into multiple units, which helps reduce the shares’ fair value, thus making them more attractive. All three alternatives help provide a return on capital for shareholders.

How should managers use this information to make decisions about how to return capital to shareholders?

In summary, if a company fails to pay dividends and instead ploughs the same back to produce higher future returns by expanding operations and increasing efficiency, then the management can pay low dividends without negatively affecting shareholder value as shareholders would develop their own cash flows to offset the low dividend. At the same time, if the company ends up producing lower future returns by say earning little or investing in non-profitable projects, then it could increase shareholder value through more efficient alternatives such as share repurchase, stock splits, and bonuses.