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Firm's net income at the end of period is the key determinant of dividend policy or change

By Syed Furqan Haider Shamsi
Oct 09 - 15, 2000

Dividends; a reward, distributed earnings or the capital stock paid out to the owners. Basically the dividends are the retained earnings which are distributed among the stockholders as their rewards for foregoing their then dues of the money plus the assumption of risk. They are never to be paid out of the invested capital stock as capital stock or the excess received over stock par value. Mookerjee stated that the dividend declaration is so important in some economies that firms are even forced to pay dividends through external finances. Another point of view of some different nature was attributed to Nakamura that firms in India pay dividends by borrowings mainly from banks at subsidized rates rather than their own profit. This is unlike to Pakistan where companies, under Companies Ordinance 1984, can only pay out of their profits. There are certain factors that pertain to this fact that dividends are important to companies. First, it bears upon investor attitude, for example, stockholders look unfavourably upon the corporation when dividends are cut, since they associate the cutback with corporate financial problems. Further, in setting a dividend policy, management must ascertain and fulfil the objectives of its owners, otherwise the stockholders may sell their shares which in turn may bring down the market price of the stock. Stockholders dissatisfaction raises the possibility that an outside group may seize control of the company.

Second, it impacts the financing programme and capital budget of the firm. Third, it affects the firm's cash flow position. A Company with a poor liquidity position may be forced to restrict its dividend payments. Fourth, it lowers stockholders equity, since dividends are paid from retained earnings and so results in a higher debt to equity ratio.

They play an important role in the overall corporate strategy. Unlike interest, dividends are optional payments made at the discrete of the directors, though failure to pay dividends will have an adverse effect on the market value of the firm. The history of dividends is not connected to the recent past. Stock dividends dates back to Elizabethan age among which East India Company was first to declare. Tracking the above debate and the four reasons of the importance of the dividends, the point of the main significance is that if a company's cash flows and investment requirement are volatile, the company should not establish a high regular dividends. It would be better to establish a low regular dividend that can be met even in years of poor earnings. Now this give rise to the main question of the moment that why dividends been regarded as puzzling and controversial for the last few decades?

In this discussion, I will try to highlight the issues and problems involved in the dividend payouts and then narrowing down my debate to controversies present in the literature as to why it is being considered as a controversial issue in many economies.

Theoretically, when we refer to dividend with regard to management, their view about it is greatly of the consent that to maximize the owner's wealth while providing adequate financing for the company. The company should retain earnings rather than distribute them when the corporate returns exceeds the returns investors can obtain on their money elsewhere. Further if the company obtains a return on its profits that exceeds the cost of capital, the market price of its stock will be maximized. Capital gains arising from the appreciation of the market price of the stock has a tax advantage over dividends. On the other hand, a company should not, theoretically, keep funds for investment if it earns less of return than what the investors can earn elsewhere. If the owners have better investment opportunities outside the firm, the company should pay a high dividend. The practicality of the situation is that investors expect to be paid dividends. Psychological factors come into play that may adversely affect the market price of the stock of a company that does not pay dividends. There are also certain factors that influence dividend policy i.e. earning stability, degree of financial leverage, tax penalties, ability to finance externally and profitability of the company. The management spent a considerable time to formulate such policies as the studies of the specialists of the finance theory reveal that there exist the psychological behaviour of investors which certainly play an important role in this regard.

Linter in his extensive studies of dividend policy highlighted that firm's net income at the end of period is the key determinant of dividend policy or change. Ross stated that in the presence of asymmetric information between managers and investors. The former use decision about dividend distribution to convey favourable information to the latter. The investor's point of view about the dividend is largely shaped by the difference between dividends and capital gains. This psychological attitude towards income to them has many evidences in the form of papers and articles involving empirical investigations as well.

Certain controversies can best be described by stating few approaches put forth by various authors.

Gordon et al. Believe that cash flows of a company having a low dividend payout will be capitalized at a higher rate because investors will perceive capital gains resulting from earnings retention to be more risky than dividends.

Miller and Modigliani argue that a change in dividends impacts the price of the stock since investors will perceive such a change as being a statement about expected future earnings. They believe that investors are generally indifferent to a choice between dividends or capital gains.

Weston and Brigham et al. Believe that the best dividend policy varies with the particular characteristics of the firm and its owners, depending upon such factors as the tax bracket, income needs of stockholders and corporate investment opportunities

The management always make decisions in the interest of the owners(stockholders), which include the inclusion of the lowest cost of capital. One view about the above arguments is that dividends not effect the investment and capital structure and therefore there is no net effect on the net cash flows. Referring to Weston's point of view that there is a effect of tax and certain other factors to dividends, when the investor's tax rate on dividends exceeds that on capital gains then investors should prefer reinvestment of earnings in order to maximize their after tax returns. This refers to as nominal adjustments. Actually when earnings decreases for a certain period, the management on the other hand do not decrease the dividend as they are trying to pass the information that these are short lived decrease in earnings and basically switching to a target payout ratio with certain nominal adjustments. That is, despite the intuitive appeal of this tax based argument, the possibility exists that investors are concerned about more than just taxes and are especially concerned about the information content of dividends.

Farrar and Selwyn in this regard used partial equilibrium analysis and assume that individuals attempt to maximize their after tax income. Shareholders have two choices; They can own shares in all equity firm and borrow in order to provide personal leverage or they can buy shares in a leverage firm. Therefore the first choice is the amount of personal versus corporate leverage that is desired. The second choice is the form of payment to be made by the firm. It can pay out earnings as dividends or it can retain earnings and allow shareholders to take their income in the form of capital gains. Capital gains arising from appreciation in market price is subject to a long term capital gain deduction. Only 40 per cent of the gain on the sale of stock that has been held more than 6 months is subject to taxation. Dividends are considered ordinary income and are taxed at full rate. Taxpayers in low tax brackets or those who rely on a fixed income favour greater dividend distribution. The theoretical dispute, therefore, regarding dividend policy relates to investor's psychology in terms of whether earnings should be taken as capital gain or as dividend.

Brennan(1970) extends the work of Farrar and Selwyn into a general equilibrium framework where investors are assumed to maximize their expected utility of wealth. He concluded not much differently from the latter's. He stated that for a given level of risk, investors require a higher total return on a security then the higher its prospective dividend yield is, because of the higher tax rate levied on dividends than on capital gains.