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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 companys 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...…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…
References
Amidu, M. (2007). How does dividend policy affect firm performance? A Ghanaian case. Investment Management and Financial Innovations, 4(2), 103-112.
Brav, A., Graham, J., Harvey, C., & Michaely, R. (2005). Payout policy in the 21st century. Journal of Financial Economics, 77(3), 483-527.
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