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Are Theories Of Dividend Payment Applicable In The Real World

1957 words - 8 pages

Introduction
Dividends are the distribution of profits in the company. It depends on the type of dividend policy made by companies. Dividend policy will affect the behaviours and attitudes of investors towards the company. Many economists or financial experts have constructed different theories to interpret the effects of a dividend policy to the society. But these theories are contestable since they are not tested in the real world. Managers’ decision on determining the size and time of a company’s next dividend payment is also important for both companies and shareholders. They will affect the company to distribute an appropriate amount of dividends in a right time. This essay will discuss whether theories of dividend payment, such as the dividend irrelevance and signalling effects are applicable in the real world. It will then describe some key factors that managers should consider on deciding the time and size of a company’s next dividend payment. Finally, it will conclude with the significance of a company’s decision on dividend payments.

Discussion of availability of theories in real world
Many theories such as the dividend irrelevance, tax and clientele effects and information content and signalling effects are controversial in financial studies. Economists often argue whether they are applicable and reliable in reality. Miller and Modigliani’s (1961) dividend irrelevance theory would be the typical one. MM suggested shareholders are indifferent with the changes of dividend policy in the company. The dividend policy of a firm will not affect the present value of its shares and shareholder’s wealth. A firm’s value depends on the profitability of its assets and its investment projects but not how it is “packaged for distribution” (Miller and Modigliani, 1961: 414). Moreover, they indicated that investors would make homemade dividends by offsetting the amount they paid for the stock and reducing the effects of dividend policy. In addition, investors were rational who would choose to invest in plentiful pay-outs with their tax-preferences, which represented the “clientele effect” (Miller and Modigliani, 1961: 432). This theory is argued by DeAngelo and DeAngelo (2006) that MM’s theory assumes that companies are constrained to fully distribute free cash flow as dividends to shareholders. But they neglected retention issues and pay-out policy is relevant when there are retentions since companies will limit the size of dividends. Ross, Westerfield, Jaffe and Jordan (2008) also contested that personal tax will greatly affect investor’s decision and limit the wealth of shareholders.
However, the tax and clientele effect in MM’s theory seems true in reality. In the clientele effect, investors with high tax rates are attracted by low dividend firms and the vice versa. They will only invest in firms that have dividend policies matched with their tax preferences (Kinkki, 2001). A report of Financial Times in 2012 (Mackenzie, 2012) reflected that...

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