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
• 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.