Abstract
The
Dividend Decision,
in corporate finance, is a decision made by the directors of a company. It relates to the
amount and timing of any cash payments made to the company's stockholders. The
decision is an important one for the firm as it may influence its capital
structure and stock price. In addition, the decision may determine the amount
of taxation that stockholders pay.
There are
three main factors that may influence a firm's dividend decision:
- Free-cash flow
- Dividend clienteles
- Information signaling
The free cash flow theory of dividends
Under this
theory, the dividend decision is very simple. The firm simply pays out, as
dividends, any cash that is surplus after it invests in all available positive net present value projects.
A key
criticism of this theory is that it does not explain the observed dividend
policies of real-world companies. Most companies pay relatively consistent
dividends from one year to the next and managers tend to prefer to pay a
steadily increasing dividend rather than paying a dividend that fluctuates
dramatically from one year to the next. These criticisms have led to the
development of other models that seek to explain the dividend decision.
Dividend clienteles
A
particular pattern of dividend payments may suit one type of stock holder more
than another. A retiree may prefer to invest in a firm that provides a
consistently high dividend yield, whereas a person with a high income from
employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of
dividend payments, a firm may be able to maximize its stock price and minimize
its cost of capital by catering to a particular clientele. This model may help
to explain the relatively consistent dividend policies followed by most listed
companies.
A key
criticism of the idea of dividend clienteles is that investors do not need to
rely upon the firm to provide the pattern of cash flows that they desire. An
investor who would like to receive some cash from their investment always has
the option of selling a portion of their holding. This argument is even more cogent
in recent times, with the advent of very low-cost discount stockbrokers. It
remains possible that there are taxation-based clienteles for certain types of
dividend policies.
Information signaling
A model
developed by Merton Miller and Kevin
Rock in 1985 suggests that dividend
announcements convey information to investors regarding the firm's future
prospects. Many earlier studies had shown that stock prices tend to increase
when an increase in dividends is announced and tend to decrease when a decrease
or omission is announced. Miller and Rock pointed out that this is likely due
to the information content of dividends.
When
investors have incomplete information about the firm (perhaps due to opaque
accounting practices) they will look for other information that may provide a
clue as to the firm's future prospects. Managers have more information than
investors about the firm, and such information may inform their dividend
decisions. When managers lack confidence in the firm's ability to generate cash
flows in the future they may keep dividends constant, or possibly even reduce
the amount of dividends paid out. Conversely, managers that have access to
information that indicates very good future prospects for the firm (eg. a full
order book) are more likely to increase dividends.
Investors
can use this knowledge about managers' behavior to inform their decision to buy
or sell the firm's stock, bidding the price up in the case of a positive
dividend surprise, or selling it down when dividends do not meet expectations.
This, in turn, may influence the dividend decision as managers know that stock
holders closely watch dividend announcements looking for good or bad news. As
managers tend to avoid sending a negative signal to the market about the future
prospects of their firm, this also tends to lead to a dividend policy of a
steady, gradually increasing payment.
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