Theory INTRODUCTION Dividend decision of the firm is yet another crucial area of financial management.(The important aspect of dividend policy is to determine the amount of earnings to be distributed {o shareholders and the amount to be retained in the firm. Retained earnings are the most significant internal sources of financing the growth of the firm. On the other hand, dividends may be considered desirable from shareholders’ point of view as they tend to increase their current return. Dividends, however, constitute the use of the firm’s funds. Dividend policy involves the balancing of the shareholders’ desire for current dividends and the firm’s needs for funds for growth. | ES IN DIVIDEND POLICY In theory, the objective of a dividend policy.should-be-to maximize a shareholder's return so that the value of his. investment is maximized. Shareholders’ return consists ‘of two components: dividends and capital gains. Dividend policy has a direct influence on these two components of return. Let us consider an example to highlight the issues underlying the dividend policy, Payout ratio—which is dividend asa percentage of earnings or dividend per share a5 a percentage a“ Soe Perea ae eee concept vis-a-vis the dividend policy, Retentio is a0 pe Gay inca parent pees abe ree companies, Low Payout Company and High Payout Company, both have a return on equity (ROE) of 20 per cent. Assume that both companies’ equity consists of one share each of Rs 100. High Payout Company distributes 80 per cent while Low Payout Company distributes 20 per cent of its earnings as dividends. As you may recall ‘growth rateis the procluct of return on equity (ROE) times, retention ratio (8) Growth = ROEx Ret g=ROEXb For Low Payout Company, the growth rate is: §=0.20%0.80 = 0.16 or 16% For High Payout Company the growth rate will be: £=0.20x0.20 =0,04 0r 4% It may be seen from Table 17.1 that High Payout’s dividend is initially four times that of Low Payout’s‘Table 17.1: Consoquences of High and Low Payout Compani Dividend Theory 421 ’ Policies High Payout Gompany. T 00.00 20.00 4.00 2 104,00 20.80 4.16 3 108.18 21.63 4.32 4 112.48 22.50 4.50 5 116.98 23.40 4.68 10 142.33 28.47 5.69 8 173.17 34.63, 6.92 20 210.68 42.14 8.43 Low Payout Company 1 100.00 20.00 4.00 16.00 2 116.00 23.20 4.64 18.56 3 134.56 26.91 5.38 21.53 4 156,09 31,22 8.24 24.98 5 161.07 36.21 724 28,97 10 380.30 76.06 15.21 60.85, 5 798.75 159.75 81.95 127.80 20 1,677.65 335.53 e771 208.42 DIVRS ply 4s) 6 7 8 9 1011 1213 18 15 16 17 18 1920 Year Figure 17.1: Dividend per share under High and Low Payout Companies’ Policies However, over a long period of time, Low Payout overtakes High Payout's dividend payments. As shown in Figure 17.1, in our example, fourteenth year onwards Low Payouts dividend exceeds that of High Payout. Note that Low Payout retains much more than High Payout, and aS a consequence, Low Payouts earnings, dividends westment are growing at 16 per cent while -that of High Payout's at 4 per cent only. ‘Actow- payout p it higher share price because ita fS earnings growth. Investors of growth companies will realize their return mostly in the form of capital gains (resulting from the appreciation in the share value). Dividend yield—dividend per share divided by the market price per share—will be low for such companies. The impact of dividend policy on future capital gains is, however, complex. Capital gains occur in distant future, and therefore, many people consider them uncertain. It is not sure that low-payout policy will necessarily lead to higher prices in reality. It is quite difficult to clearly identify the effect of payout on share price, Share price is a reflection of so many factors that422. Financial Management current dividends, more retained earnings and hi ital gains, and perhaps higher market price (Gaia poles pas rete ometgae wis elas current earnigs.)Dividends in most countries are taxed more than capital gains. Therefore, it is quite plausible that some investors would prefer high-payout companies ‘while others may prefer low-payout companies. What does dividend policy imply{Paying dividends involves outilow of cash. The cash available for the payment of dividendsis affected by the firm’s investment and financing decisions. A decision to incur capital expenditure implies that less cash will be available for Sieg eo ig eee ae ares Ses “affects dividend decision. Ifthe firm’s values ris it because of the investment decision or the dividend decision? Given the firm’s capital expenditure, and that it does not have sutficient internal funds to pay dividends, it can raise funds by issuing new shares. In this case, the dividend decision is not separable from the firm’s financing decision. The firm will have a given amount of cash available for paying dividends, given its investment and financing decisions. Thus/a dividend decision involves a trade-off between the retained earnings and issuing new shares. Jt isessential to separate the effect of dividend changes from the effects of investment and financing decisions. Do changes in the dividend policy alone affect the value of, the firm? What factors are important in formulating a dividend policy in practice? (On the relationship between dividend policy and the valie of the firm, different theories have been advanced, These theories can be grouped into two categories {@) theories that consider dividend decision tobe irrelevant and (b) theories that consider dividend decision to be an active variable influencing the value of the ffgm. Jn the latter, there are two extreme views, that is dividends are good as they increase the shareholder value: idends are bad since they reduce the shareholder value. The following is the critical evaluation of some important theories representing, these points of views. HECK YC R CONCE any 1. Define payout ratio, retention ratio and dividend yield. 2. How do high payout and low payout policies affect future earnings, dividends and growth? 3. What is meant by dividend policy? DIVIDEND RELEVANCE: WALTER'S MODEL Professor James E. Walter argues that the choice of dividend policies almost always affect the value of the firm? His model, one of the earlier theoretical works, shows the Jepportance: Scie lationship Bets he firm’s rate of return, 7, and its-cost of capital, k, in at will maximize the wealth of shareholders. Walter’s model is based on the followigyesepnsp tions. _9 Internal financing The firm finances all investment through retained earnings; that is, debt or new equity is not issued. Constant return and cost of capital The firm's rate of return, r, and its cost of capital, k, are constant. os 100 per cent payout or retesffion Allcarnings are either distributed as dividends or reinvested internally immediately. Constant EPS and DIV Beginning earnings and dividends never change. The values of the earnings per share, EPS, and the dividend per share, DIV, may be changed in the model to determine results, but any given values of EPS or DIV are assumed to remain constant forever in determining a given value. Vw Infinite time The firm has a very long or infinite life. Walter's formula to determine the market price per share is as follows: DIV , r(EPS~DIV)/k eae : a) where P= market price per share DIV = dividend per share EPS = earnings per share firm’s rate of return (average) k = firm's cost of capital or capitalization rate Equation (1) reveals that the m is the sum of the present value of two sources of in @ the present value of the infinite stream of constan _dividends, DIV/k and (ii) the present value of the infinite ‘stream. OF capil ;, fy (EPS - DIV)/K]/k. When the firm retains a perpetual sum of (EPS — DIV) at r rate of return, its present value will be: r (EPS ~ DIV)/k. This ‘quantity can be known as a capital gain which occurs when ceamings are retained within the firm. Ifretained earnings occur every year, the present value of an infinite number 1. In India, there is no personal tax on dividends and longeterm capital gains on shares while the short-term capital gains on shares are taxed at 10 per cent. However, companies are liable to pay 15 per cent ax and 3 per cent surcharge on distributed profits (dividends). 2, Walter, James E., Dividend Policy: Its influence on the Value of the Enterprise, Journal of Finance, 18 May, 1963, p. 280-91. 3, Francis, Jack Clark, Investments: Analysts and Management, McGraw Fill, 1972, p. 344of capital gains, r (EPS - DIV)/k, will be equal to: [r (EPS =DIV)/E]/&. Thus, the value of a shate is the present value ofall dividends plus the present value of all capital gains as shown in Equation (1) which can be rewritten as follows: IV + (r/ (EPS DIV) k ILLUSTRATION 17.1: ic Tans He maneat ‘To illustrate the offect of different dividend policios on the value of share respectively for the growth firm, normal firm and declining firm, Table 17.2 is constructed, ‘Table 17.2 shows that, in Waltor’s model, the optimum, dividend policy depends on the rrm's Tate of return, F and its cost of capital, k, Walter's View on the optimum dividend—payout ratio 8 €xplained in the next section.* Q) wth Firm: Internal Rate more than ‘Opportunity Cost of Capital (r> k) Growth firms are those firms which expand rapidly because of ample investment opportunities yielding returns higher than the opportunity cost of capital (r >). Picea shen a which. i= Righer than the rate expected by shareholders (K). They. ‘wills maximize the value per share if they follow a policy cofretaning all earnings eaieaalinaeainest Itean be ‘seen from Table 17.2 that the market value per share for the growth firm is maximum (Le., Rs 150) when it retains 100 per cent earnings and minimum (ie., Rs 100) if it distributes all earnings. Thus, the optimum payout ratio for a growth firm is zero. The market value per share P, increases as payout ratio declines when r > k : Normal Firms: Internal Rate equals Opportunity Cost of Capital (r= k) Most of the firms do not have unlimited surplus- ‘generating investment opportunities. After exhausting, super profitable: opportunites nomial firms azn. thet investments rate_of return equal to the cost. of capi For normal firms with r= k, the dividend policy has noeffect ‘market value per share in Walter's model. aan ede “fom Table 172 that the Market value per share for the normal firm is same (.e., Rs 100) for different dividend-payout ratios. Thus, there is no unique optimum payout ratio for a normal firm. One dividend policy is as good as the other. The market value per share is not affected by the payout ratio when r= k. Declining Firms: Internal Rate less than Opportunity Cost of Capital (r< K) Declining firms do not have any profitable investment ‘opportunities to invest the earnings. would -earnon.their investments rates of return less. than the ‘minimum rate required (r k Distribute all earnings when ) on the other hand, Walter’s model indicates that, if the firm’s earnings are E,, they should be distributed because r- k. The value of a share will increase j retention ratio, inereases under the ¢ ofr > k However, itis Not clear as to what the value of b should be to maximize the value of the share, P,. For example, if b = k/r, Equation (6) reveals that denominator, k - br =.0, thus making Py infinitely large, and if b = 1, k — br becomes negative, thus making P, negative. These absurd results are obtained because of the assumption that r and k are constant, which underlie the model. Thus, to get the ‘meaningful value of the share, according to Equation (6), the value of b should be less than k/r. Gordon's model is illustrated in Illustration 17.2. Let us consider the data in Tablo 17.3. The implications of dividend policy, according to Gordon’s model, are shown respectively for the growth, the normal and the declining, firms and the Value of the Firm 2 = br =0.60.08 = 0.088 10(1 =0.6) 0.100.048 RS 77 (0.06 Rs 100 0.01 9. Dobrovolsky, Sergi P., The Economics of Corporation Finance, MeGraw Hill, 1971, p. 58. 10. Ibid, p. 56. AL bid.It is revoaled that under Gordon's model: % The market value of the share, P,, increases with Sthe-retontTOW FaTIO; 5, FOF firms with growth ‘opportunities, i.e., when r> k The market value of the share, Py, increases with the payout ratio, (1 = b), for declining firms with rk,_ ,for = 1, 2, ... because of increasing uncertainty in the future. As the discount rate increases with the length of time, a low dividend payment in the beginning will tend to lower the value of share in future. When the discount rate is assumed to be increasing, Eq. (G) can be rewritten as follows: _ DV, , DI, | DN, ei ORK O+ky yk) DV, yak i) ‘where Py is the price of the share when the retention rate, bis zero and k, > k,_,. Ifthe firm is assumed to retain a fraction b of earnings, dividend per share will be equal to (1-5) EPS, in the first year. Thus, the dividend per share is expected to grow at rate g = br, when retained earnings are reinvested at r rate of return. The dividend in the second year will be DIV, (1+)? = (1b) EPS, (1+ br), in the third year DIV, (1 +g)’ = (1-2) EPS, (1 + br)’ and so ‘on. Discounting this stream of dividends at the corresponding discount rates of k,, k;... we obtain the following equation: DIV,G+g)' , DIVG+g) |, DIVA+s)" +k a+ky +h) ay nfact, kent oat lh Osh ume 12, Kirshman, John, E,, Principles of Inestment, McGraw Hill, 1993, p. 737; ef. in Mao, J.C.T., Quantitative Analysis of Financial Decision, % Macmillan, 1969. 13. Graham, Benjamin and David L. Doda, Security Analysis; McGraw Vil Ine, 1st ed, 1934, p.327.428 Financial Management where P, is the price of the share when the retention rate bis positive, ic., b > 0. The value of P, calculated in this way can be determined by discounting this dividend stream at the uniform rate, K,, which is the weighted average of kj! p,—DMAl+ 9), DIV+sy ,, DIVA+3)" +k) +R a+ky DIV, _ (1-)EPS, ae? air @ Assuming that the firm’s rate of return equals the discount rate, will P,be higher or lower than P,? Gordon's view, as explained above, is that the increase in earnings retention will result in a lower value of share. To emphasize, he reached this conclusion through two, assumptions regarding investors’ behaviour: (i) investors are risk averters and (ii) they consider distant diviclends, as less certain than near dividends. On the basis of these assumptions, Gordon concludes that the rate at which an investor discounts dividend stream increases with the futurity of this dividend stream, If investors discount distant dividend at a higher rate than near dividends, increasing the retention ratio has the effect of raising the average discount rate, K, or equivalently lowering share prices. ud [ineorporiting uncertainty into his model, _Gordon concludes that dividend policy’affects the value ‘of the share. His reformulation of the model justifies the behaviour of investors who value a rupee of dividend income more than a rupee of capital gains income. These investors prefer dividend above capital gains because dividends are easier to predict, are less uncertain and less risky, and are therefore, discounted with a lower discount rate;! However, all do not agree with this view. CHECK YOUR CONCEPTS DIVIDEND IRRELEVANCE: ee MILLER-MODIGLIANI (MM) HYPOTHESIS: According to Miller and Modigliani (MM), under a perfect market situation, the dividend policy of a firmisirrelevant, as it does not affect the value of the firm.!* They ar that the the firm depends OF the tone ae ‘résuilt from its investment policy. Thus, when investment 14 Ma, james C7, Quafntice Analysis of Fania Deco, Macmillan 1969, p48 15. Fran« 0p cit, 1972, p. 354, 16. Miller, Merton H. and Modigliani, France, Dividend Policy, Growth and Valuation of the Shares, Journal of Business, XXIV (October 1961), pp. 411-33. decision of the firm is given, dividend decision—the split of earnings between dividends and retained earnings—is of no significance in determining the value of the firm, A firm, operating.in perfect capital market conditions, may face one of the following three situations regarding the payment of dividends: _%—The firm has sufficient cash to pay dividends. %&_The firm does not have sufficient cash to pay dividends, and therefore, it issues new shares to finance the payment of dividends. “_ The firm does not pay dividends, but shareholders “need cash. (‘Th the first situation, when the firm pays dividends, shareholders get cash in their hands, but the firm's assets reduce (its cash balance declines). What shareholders gain in the form of cash dividends, they lose in the form of their claims on the (reduced) assets. Thus, there is a transfer of wealth from one shareholders’ pocket to another pocket. There is no net gain or loss. Since it isa fair transaction under perfect capital market conditions, the wealth of shareholders will remain unaffected. \C-lirfe second situation, when the firm issues new shares to finance the payment of dividends, two transactions take place. First, the existing shareholders get, cash in the form of dividends, but they suffer an equal amount of capital loss since the value of their claim on assets reduces. Thus, the wealth of shareholders does not change. Second, the new shareltolders part with their cash to the company in exchange for new shares ata fair price pershare. The fair price per share is the share a ~The payment < is less div er share to the existing shareholders. The existing shareholders transfer a part of their claim (in the form of new shares) to thenew. shareholders in exchange for cash. There is no net gain or Jess; Both transactions are fair, and thus, the value of the firm will remain unaltered after these transactions. In the third situation, if the firm does not pay any dividend a shareholder can createa home-made dividend by selling a part of his/her shares at the market (fit) price in the capital market for obtaining cash, The shareholder will have less number of shares. He or she has exchanged a part of his claim on the firm to a new shareholder for cash. The net effect is the same as in the case of the second situation. The transaction is a fair transaction, and no one loses or gains. The value of the firm remains the same, before or after these transactions. Consider an example. ler he The Himgir Company Limited currently has 2 crore outstanding shares selling at a market price of Rs 100 per share. The firm has no borrowing. It has internal fundsavailable to make a capital expenditure (Capex) of Rs 30 crore. The Capex is expected to yield a positive net present value of Rs 20 crore. The firm also wants to pay a dividend per share of Rs 15. Given tho firm's Capex plan and its policy of zero borrowing, the firm will have to issue new shares to finance payment of dividends to its shareholders. How will the firm’s value be affected () if it does not pay any dividend; (i) if it pays dividend per share Rs 15? ‘The firm’s current value is: 2 x 100 = Rs 200 crore. After the Capex, the value will increase to: 200 + 20 Rs 220 crore. I the firm does not pay dividends, the value per share will be: 220/2 = Rs 110. Ifthe firm pays a dividend of Rs 15 por share, it will entirely utilize its internal funds (15 x 2 = Rs 80 crore), and it will have to raise Rs 40 crore by issuing new shares to undertake capex. The value of a share after paying dividend will be: 110 - 15 = Rs 95. Thus, the existing shareholders get a cash of Rs 15 por share in the form of dividends, but incur a capital loss of Rs 15 in the form of reduced share value, They neither gain nor lose. The firm will have to issue: 30 crore/95 = 31,57,895 (about 31.6 lakh) shares to raise Rs 30 crore. The firm now has 2.916 crore shares at Rs 95 each share. Thus, the value of the firm remains as: 2.316 x 95 = Rs 220 crore. The crux of the MM dividend hypothesis, as explained above, is that shareholders do not necessarily depend on dividends for obtaining cash. In the absence of taxes, flotation costs and difficulties in selling shares, they can get cash by devising “home-made dividend” without any dilution in their wealth. Therefore, firms paying high dividends (i.., high-payout firms), need not command higher prices for their shares. A formal explanation of the MM hypothesis is given in the following pages. ’s hypothesis of irrelevance is based on the {olfowing gssumptions:!” ferfect capital markets The firm operates in perfect capital markets where investors behave rationally, information is freely available to all, and transactions and flotation costs do not exist. Perfect capital markets also imply that no investor is large enough to affect the market price of a differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains G/ Investment policy The firm has a fixed investment. licy. ae risk Risk of uncertainty does not exist. That is, investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r = k =k, forall Under the MM assumptions, r will be equal to the discount rate, k, and identical for all shares. As a result, 17, Francis, op. it, 1972 Dividend Theory 429 the price of each share must adjust so that the rate of rettirh, whieh is composed of the rate of dividends and capital gains, on every share willbe equal ta the discount rate and be identical for all shares. Thus, the rate of return fora ‘fecagiarchelia re ‘one year may be calculated as follows: where P) is the market or purchase price ee 0, Py is the market price per share at time 1 and DIV, is divitiend per share at time 1. As hypothesized by MM, r should be equal forall shares. [itis nots, the low-return yielding shares willbe sold by investors who will purchase the high-return yielding shares. This process will tend to reduce the price of the low-retum shares and increase the prices of the high-return shares. This switching or arbitrage will continue until the differentials in rates of relum are eliminated. The discount rate will alsobe equal for all firms under the MM assumptions since there are no risk differences. From MM’s fundamental principle of valuation described by Equation (13), we can derive their valuation model as follows: _ DIV +2 eer DIV, +P, _ DIV,+P, ary +h since r=k in the assumed world of certainty and perfect markets. Multiplying both sides of Equation (14) by the ‘number of shares outstanding, n, we obtain the total value of the firm if no new financing exists: DIV, +R) Pai TS ey oo If the firm sells m number of new shares at time 1 ata price of P,, the value of the firm at time 0 will be: n(DIV, +P,)-+mP, —mP, (14) nP,= G48 _ADIV, +n, +mP —mP, fs G+h) _ nDIV, +n m)B— mB, ta a+) MMs valuation Equation (16) allows for the issue of new shares, unlike Walter's and Gordon's models. ‘Consequently, a firm can pay dividends and raise funds toundertake the optimum investment policy (as explained in Figure 17.1). Thus, dividend and investment policies are not confounded in the MM model, like Walter’s and Gordon’s models. As such, MM’s model yields more ‘general conclusions. The investment programmes of a firm, in a given period of time, can be financed either by retained earnings or the issue of new shares or both. Thus, the amount of new shares issued will be: Me Ute)mr 430. Financial Management mB, =1,—-(X,—nDIV,)=1,—X, + DIV, 07) where 1, represents the total amount of investment during the first period and X; is the total net profit of the firm during the first period. By substituting Equation (17) into Equation (16), MM showed that the value of the firm is unaffected by its dividend policy, Thus, np, DIV +(n-+m)R ~ mP, (+8) _nDIV, +(n-+m)P, - (I, —X, +nDIV,) is +k) (n+ mP-1+X, a+k (A firm which pays dividends will have to raise funds externally to finance its investment plans. irgument, alicy deca not aegd the" wealth of hs olde, is na in i ba ee, advantage is offset by external financing. This means that the terminal value of the share (say, price of the share at first period if the holding period is one year) declines when dividends are paid. Thus, the wealth of the Shareholders—dividends plus terminal price—remains unchanged. As a result, the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends. Thus, the shareholders are indifferent between payment of dividends and retention of earnings. -) ‘The Vikas Engineering Co. Ltd., currently has one lakh outstanding shares selling at Rs 100 each. The firm has net profits of Rs 10 lakh and wants to make new investments of Rs 20 lakh during the period. The firm is also thinking of declaring a dividend of Rs 5 per share at the end of the current fiscal year. The firm's opportunity cost of capital is 10 per cent. What will be the price of the share at the end of the year if (i) a dividend is not declared: (if) a dividend is declared. (iif) How many new shares must be issued? ‘The price of the share at the end of the current fiscal year is determined as follows: DIV,+2, AB P= P0+k)-DI, ‘The value of P, when dividend is not paid is: P, = Rs 1001.10) 0 = Rs 110 ‘The valuo of P, when dividend is paid is: P, = Rs 100(1.10) —Rs 5 = Rs 105 It can be observed that whether dividend is paid or not the wealth of shareholders remains the same. When the dividend is not paid the shareholder will got Rs 110 by way of the price per sharo at the end of the current fiscal year. On the other hand, when dividend is paid, the shareholder will roalizo Rs 105 by way of the price per share at the end of the current fiscal year plus Rs 5 as dividend. ‘The number of new shares tobe issued by the company— to finanes its investments is determined as follows mP, =1—(X-nDIV,) 105m = 2,000,000 —(1,000,000 ~500,000) 1,500,000 ,500,000/ 105 = 14, 285 shares. YOUR CONC 1. Explain the concept of ‘homemade dividend’. 2, Explain the crux of MM’s argument about dividend irrelevance. 3. What are the assumptions of MM’s dividend irrelevance argument? RELEVANCE OF DIVIDEND POLICY UNDER MARKET IMPERFECTIONS ‘The MM hypothesis of dividend irrelevance is based on simplifying assumptions as discussed in the preceding section. Under these assumptions, the conclusion derived by them is logically consistent and intuitively appealing, But the assumptions underlying MM’s hypothesis may not always be found valid in practice. For example, we_ ‘may not find capital markets to be perfect in reality; there may exist issue costs; dividends may be taxed differently than capital gains; investors may encounter difficulties in selling their shares, Because of the unrealistic nature of the assumptions, MM's hypothesis is alleged. to lack. practical relevance) This suggests that internal financing and external financing are not equivalenf. Dividend policy of the firm may affect the perception of shareholders and, therefore, they may not remain indifferen se dividends and capital gains. The following are the situations where the MM hypothesis may go wrong. Uncertainty and Shareholders’ Preference for Dividends Many believe that dividends are relevant under conditions of uncertainty. It is suggested that dividends resolve uncertainty in the minds of investors and, therefore, they prefer dividends than capital gains. As explained earlier, Gordon and others have referred to the argument that dividends are relevant under uncertainty as the bird-in- the-hand argument. Gordon asserts that uncertainty increases with the length of time period. Investors are risk averters and, therefore, prefer near dividends to future dividends. Thus, future dividends are discounted at a higher rate than near dividends. This implies that the discount rate increases with uncertainty. As a result, afirm paying dividends earlier will command a higher value thana firm which follows a policy of retention. This view implies that there exists a high-payout clientele who values shares of dividend paying more than those which do not pay dividends. The uncertainty arguments not very convincing. MM argues that even if the assumption of perfect certainty is, dropped from their hypothesis, dividend policy continues to be irrelevant. They contend that the market prices of two firms with identical investment and capital structure policies and risk cannot be different because they follow different dividend policies. These firms will have the same cash flows from their investments despite the differences in dividend policies. The risk (uncertainty) of the firms’ shareholders is alike, given the similarities of their risk and investment and capital structure policies. Dividend policy does not change the amount and risk of cash flows from investments; it simply splits these cash flows into idend payments and retained earnings. ‘The current receipt of money in the form of dividends is considered safer than the uncertain potential gain in the future. The reason for this safety is that it is cash in hand rather than that it is dividend income and not a 1 gain. The shareholders can sell some of their shares to obtain current cash if a firm does not distribute dividends. The risk-return trade-off will make shareholders to expect lower returns from those firms that have high-payout ratios. Let us emphasize again that given a firm's investment and capital structure policies, paying dividends does not affect the firm's or shareholders’ risk. Thus the difference between current dividends and the future capital gains does not alter the firm's value under the efficient market conditions. However, there may still exista high-payout clientele, not because current dividends are safer, but because some shareholders need a steady source of income, or because some will prefer to receive dividends as early as possible since some firms do not provide reliable information about their investments and earnings. Yet another reason for shareholders preferring current dividends maybe their desire to diversify their portfolios according to their risk preferences. Hence, they would like firms to distribute earnings. They will be able to invest dividends received in other assets keeping, in mind their need for diversification. Under these circumstances, investors may discount the value of the firms that use internal financing. \ Transaction Costs and the Case against Dividend Payments MM argues that internal financing (retained earnings) and external financing. (issue of shares) are equivalent. This, implies that when firms pay dividends, they can finance Dividend Theory 431 their investment plans by issuing shares. Whether the firm retains earnings or issues new shares, the wealth of shareholders would remain unaffected. This cannotbe true since the issue of shares involve flotation or issue costs, including costs of preparing and issuing prospectus, underwriting fee, brokers” commission, etc. No flotati costs are involved if the earnings are retained. The presence of flotation or transaction costs_makes the ‘external financing costlier than the internal financing via sh retained carni ius, if flotation costs are considered, the equivalence between retained earnings and new share capital is disturbed and the retention of would be favoured over the payment of dividends. vin practice, dividend decisions seem to be sticky Ries continue paying same dividends, rather increasing it, unless earnings decline, in spite of need for funds. Under the MM hypothesis, the wealth of a shareholder will be same whether the firm pays dividends or not {If a shareholder is not paid dividends and she desires iohave current income, she can sell the shares held by her. When.the shareholder sells her shares to satisfy her desire.for.current.income, she. will have to pay ‘This fee is more for smallsales.-Further, it share holdings. Some emerging markets are juid, and many sharésarenot frequently traded. of the transaction costs and inconvenience associated with the sale of shares to realize capital gains, shareholders may prefer dividends to capital gains! Information Asymmetry and Agency Costs and the Case for Dividend Payments {(Managersin practice may not share complete information With shareholders. This gap between information available with managers and what is actually shared with shareholders is called information asymmetry. This leads to several agency problems, viz., conflicts between managers and shareholders/Managers may not have enough incentive to distfose full information to shareholders. They may act in their own self-interest and take away the firm’s wealth in the form of non-pecuniary benefits. Shareholders incur agency costs to obtain full, information about a company’s investment plans, future cavaldta ety ected! dividend? payments, eto The shareholders—managers conflict can be reduced through. ring which includes bonding contracts and limiting, the power of managers vis-}-vis allocation of wealth and managerial compensation.'® However, monitoring involves costs that are referred to as agency coats. Ba “SFdividend allocates resources to shareholders, and thus, alleviates the need for monitoring and incurring agency costs. ‘The high-payout policy of acompany helps to reduce the conflict arising out of information asymmetry.” It is in 18. Jensen, M.C. and WH. Meckling, Theory ofthe Firm: Managerial Behaviour, Agency Costs and Ownership Structure, Journal of Financial Economies, October 1976, 19, Rozeff, M., Growth, Beta and Agency Cost as Determinants of Dividend Payout Ratios, Journal of Financial Research, Fall 1982, pp. 249-58.432. Financial Management argued that Companies which pay high dividends -gularly may be raising capital more frequently from the primary markets. Therefore, the actors in primary markets like the financial institutions and banks would be monitoring the performance of these companies. If the professionals in the banks and financial institutions continuously do such monitoring, shareholders need not incur monitoring (agency) costs.) ~_ Dividend payout also allocates financial resources in favour of shareholders as against lenders. Lenders have prior claims over a company’s cash flows generated internally. The payment of dividend changes this priority in favour of shareholders as they receive cash flows before the loan principals of lenders are redeemed. Thus, we observe that from the point of view of agency costs, shareholders would generally prefer payment of dividend. ifferential: Low-Payout and High-Payout Clientele Ny ‘s assumption that taxes donot exist is far from reality. investors have to pay taxes on dividends and capital gains. But different tax rates are applicable to dividends and capital gains. Dividend income is generally treated as the ordinary income, while capital gains are specially treated for tax purpo8esJin most countries, the capital gains tax rate is lower than the marginal tax rate for ordinary income: From the tax point of view, a shareholder in high tax bracket should prefer capital gains over current dividends for two reasons: (i) the capital gains tax is less than the tax on dividends, and (fi) the capital gains ta payable only when the shares are actually sold. The effect of the favourable tax differential in case of capital gains will result in tax savings. As a consequence, the vaitte of the share should be higher in the internal financing case than in the external financing one. Thus, the tax advantage of capital gains over dividends strongly favours a low- ividend payout policy. This implies that investors will pay more for low-dividend yield shares, Tax differential should attract tax clienteles. investors in high-tax brackets should own low-payout shares, and those in low-tax bracket should own high-payout shares. In reality, most investors may have marginal income tax rate higher than the capital gains tax rate. Thus, dividends, on an average, are considered bad since they will result in higher taxes and reduction in the wealth of shareholders. Tax differential generally favour low-payout clientele. Consider an exainple. Two identical firms X and Y have different dividend policy. Both have after tax profit, Pof Rs 100. X pays 100 per cent dividend. Y does not pay any dividend and shareholders get capital gains. Assume further that capital gains from shares held at least for one year are taxed at 20 per centand marginal income tax rate is 40 per cent. Suppose Y's shareholders are in highest tax bracket and pay tax on dividend income at 40 per cent. X's shareholders will receive dividends of Rs 100 and thei after-tax dividend income will be: 100 “(1 ~ 0.40) = Rs 60. Y's shareholders will realize capital gains of Rs 100 and their after-tax capital gains will be: 100 x (10.20) = Rs 80. Y's shareholders are better off as they have tax advantage. Since the after tax equity income of Y's shareholders is higher than X’s shareholders and since both firms are identical in all other respects, Y's equity price will be higher. To match capital gain of Re 1 of Y's shareholders, X's shareholders should receive dividend of Rs 1.33: After-tax dividend = After-tax capital gain (10.40) Div = (1 -0.20) DIV = 0.80/0.60 = 1.33 IE X’s shareholders get dividend of Rs 1.33 and Y's shareholders get capital gain of Rs 1, both will have after- tax income of Rs 0.80. If a tax system favours capital gains to dividend income, there may still be several investors who are in lower tax brackets. These investors investing in shares will prefer dividend income rather than capital gains. Thus, there may exist high-payout clientele. Ina tax system that treats dividends more favourably than capital gains, shareholders in high tax brackets will also prefer receiving dividends rather than capital gains. Under this taxsystem, dividends will be considered good and it will generally attract high-payout clientele. This situation prevails currently in India. There is no tax on dividend income in the hands of shareholders (both individuals and~ companies), but companies are required to pay dividend distribution tax at 15 per cent on dividends paid to shareholders, Short-term capital gains are faxed is the ‘hands of sharetotdersat 10-per cent. As a result of this system, shareholders in India will prefer to receive current dividends rather than capital gains. Since companies paying dividends are required to pay additional tax, this taxation system may create a conflict between shareholders and companies. Companies would like to Pay no or low dividends to save additional tax while shareholders would like to have more dividends as they have no tax liability on the dividend income. If the objective of the companies is to maximize the wealth of shareholders, the tax system augurs for paying higher dividends. Andia is an exception where dividends are not taxed but capital gains are. In most countries, ax systems favour capital gains with no or low tax rates as compared to dividends. Thus, the preference for low-payout or high- payout shares will depend on the tax status of the individual investors.|(See Exhibit 17.1 for the different tax systems regarding dividends and capital gains.) Neutrality of Dividend Policy: The Black-Scholes Hypothesi {We have just explained that the benefits of dividends for shareholders are that they satisfy their desire for current income, avoid the need tosellshares, and incur transaction costs and signal the firm’s prospects and risk allowingEXHIBIT ‘Taxes AND “1h DIVIDENDS Shareholders! earnings are taxed differendly in different countries. We can identify the following four tax systems regarding the taxation of shareholders’ earnings: © Deuble taxation: Under this syscem, shareholders’ earnings are taxed twice; first the corporate taxis levied oon profits at che level of the company, and then, the after-tax profits distributed as dividends are taxed as ‘ordinary income in the hands of shareholders. Most countries have a higher marginal tax rate for dividend income than capital gains. The wealthy shareholders with high personal tax races will prefer capital gains to dividends. A number of countries such as USA follow the double (or two-tier) taxation system. India practised this system until the change in the tax laws in 1997, © Single taxation: Under this system, shareholders’ carnings are taxed only once at che corporate level Dividends received by shareholders are exempe from tax. India currently follows this system. Companies in India pay tax on their profits ac about 31 per cent, and they will have to pay additional tax at 15 per cent on the after-tax profits distributed as dividends to shareholders. Shareholders, both individuals and corporates, do not pay taxes on the dividend income, However, they do pay tax on short-term capital gains. ‘The marginal personal tax rate ranges from 10 to 30 per cent (plus education cess) and short-term capital ‘gain tax rate is 10 per cent. Under this system, all investors will prefer dividends. In India, long-term ‘capital gins arealso txexempt. A capital gain is ceated as long-term if the share was held for atleast one year before it was sold. © Splitrate taxation: Under this system, corporate profits are divided into retained earnings and dividends for the purpose of taxation. A higher tax rate is applied to retained earnings and a lower rate co earnings distributed as dividends. Shareholders pay eax on dividends and capital gains. This system, but fora lower tax rate on dividend, is similar t© double eaxation system. Tax-exempt and low-tax paying shareholders ‘would prefer dividends while shareholders in high tax brackets will prefer capital gains © Imputation taxation: Under this system, shareholders earnings are not subjected to double taxation. A company pays corporate tax on its earnings. Shareholders pay personal taxes on dividends but get full or partial tax relief forthe tax paid by the company. In Australia, shareholders ger full tax relief while in Canada they get partial relief. Under full tax relief, a tax-exempt shareholder or a shareholder, who has a petsonal tax rate lower than the comporate tax rate, will get a cax refund. Dividend Theory 433 > them to make choices with regard to their investment portfolios. The cost of dividends is the higher tax on dividend. Black and Scholes argue that shareholders trade off the benefits of dividends against the tax loss. Based on the trade-offs that shareholders make, they could be classified into three clienteles: () clientele that considers dividends are always good (i) a clientele that considers dividends are always bad and (iif) a clientele that is indifferent to dividends. Shareholders in high tax brackets may belong to high-payout clientele since in their case the tax disadvantage may outweigh the benefits of dividends. On the other hand, shareholders in low tax brackets may fit in to low-payout clientele as they may suffer marginal tax disadvantage of dividends. Tax- exempt investors are indifferent between dividends and capital gains, as they pay no taxes on their income. In a real-world situation, all three clienteles exist as taxstatus and need for current incomes of investors differ. ‘There are several hundreds of companies that ‘supply’ dividends to meet the demand of the three types of clienteles. Black and Scholes argue that since the supply of dividends and demand for dividends match, there will be no gains if a firm changes its dividend policy; the investors have already made their choices or there already ‘exist opportunities for shareholders to shift from one firm to another. How will companies determine whether change in dividend policy will affect their share prices? This is an empirical question and a difficult question to answer, given the problems with statistical techniques. However, the Black-Scholes hypothesis shows that the tax disadvantage of dividends is not so great as made out by some academicians 1. Give two reasons for shareholders preferring current dividend over capital gains. 2, What are MMs arguments against uncertainty in the context of current 2s. future dividends (capital gains)? 8. What are transactions costs? How do they affect dividend policy? 4. In the context of dividend policy, explain the influence of information asymmetyy and agency costs? 5. How do tax differentials create high-payout and low- payout clientele? What is meant by the tax neutrality of dividend? INFORMATIONAL CONTENT OF DIVIDENDS Itis contended that dividends are relevant because they have informational value. A company can make statements about its expected earnings growth to inform shareholders in order to create a favourable impression ‘on them. However, these statements would be paid better