The case for some dividend
- Signal Effect :-
Investors read signals about the future prospects of the company based on the dividends announced. A high dividend payout may suggest that the management is gung-ho about the future. A low dividend payout may suggest that the management is not very confident about the future.
- Differential tax rates :-
In actual practice tax rates are not same for dividends and capital gains. The effective tax on long term capital gains is lower than that of on dividends and on short term capital gains is higher than that on dividends. The dividend payout decision will, therefore depend on personal and corporate taxes. When personal tax rates are higher than corporate tax rates, a firm will have an incentive to reduce dividend payouts and if personal tax rates are lower than corporate tax rates, then firm will have an incentive to payout any excess cash as dividends.
- Flaw in homemade dividend:-
Stock prices tend to fluctuate wildly at the bourses. In a fluctuating market investors looking for current income may be reluctant to sell a part of their shares; instead they would prefer receive high dividends. Similarly investors looking for low dividends will be hesitant to buy shares in such a market; instead they would prefer a low payout ratio. This makes it difficult for an investor to convert current income into equity and vice versa.
- Clientele effect:-
Different Investors have different preferences so they lined up behind companies that match their preferences .Thus high payout companies will have investors seeking high dividends and low payout companies will have investors seeking low dividends. Each company hence attracts clients with a certain requirement. This is called clientele effect. The implications are simple: One, firms get investors they deserve! TWO, once set, it will be difficult for the firm to change its dividend policy.
- Transaction Cost:-
In absence of transaction costs, dividends and capital gains are interchangeable but in actual practice, transaction costs are incurred.
For example, a share worth $120 may fetch a net amount of $118 after transaction cost and $122 may be required to buy a share worth $120.
Due to transaction costs, shareholders who have a preference for current income would prefer a higher payout ratio and shareholders who have a preference for deferred income would prefer a lower payout ratio.
- Mental Accounting:-
Consider the example: Option 1: You received $5000 as dividend and spend it .Option 2: The company does not pay dividend, so you sell a part of your share for $5000 and spend it. Subsequently, the price of the share
goes up. In such a case most investors will feel cheated in the case of option 2 though in both cases the loss is identical! It’s all a frame of the mind.
The case of high dividend payout
- Agency Cost :-
Managers may not share all available information with shareholders. Hence shareholders need to set up an independent mechanism to monitor and find out what the managers are upto. This cost of setting up this mechanism is called agency cost. When high dividends are regularly paid the company may be raising capital frequently from the primary markets.
Consequently, capital market players such as financial institutions and banks will be monitoring the performance of the managers. In such a case
shareholders need not to incur agency cost
- Prior Claim :-
A dividend payout means the money is paid out to shareholders. Legally, lenders have prior claims over a company’s internal cash flows. The payment of dividend changes this pecking order in favor of shareholders as they receive cash flows before the principal is redeemed .The shareholders
comes ahead of lenders.
- Uncertainty :-
In uncertain times, investors would prefer current payout to distant payouts. Clearly a bird in the hand is worth two in the bush.in such a situation future dividends may be discounted at a higher rate. Consequently firms paying dividends earlier will command a higher value.
The case for low dividend payout
- Additional equity at lower price :-
MM model assumes that a firm can sell additional equity at prevailing market price. But reality is otherwise. Companies offer additional equity at a discount to current market price to entice investors to invest. Such under- pricing makes a rupee of retained earnings more valuable than a rupee of dividend.
- Issue costs (low cost of retained earnings) :-
MM model assumes that a rupee of dividends can be perfectly substituted by a rupee of external financing. This is possible if there is no issue cost. But in actual practice, companies have to incur issue expenditure to raise money. Hence the amount of external financing will be greater than the amount of internal financing for a capital expenditure.
- Capital rationing :-
MM model assumes that the investment policy of firms is independent of their financing policy and the firms invest up to the point where rate of return is equal to cost of capital. In actual practice, the investment policies of firms are subject to rationing. Some firm consciously impose restrictions to invest more than their retained earnings. Other firms may be unable to obtain the required money for their proposed investment because investors are unwilling to lend. Hence dividend becomes relevant. A firm which has several investment opportunities and which is unable to raise money from outside would like to lower the payout.
For further reading – http://www.studyfinance.com/lessons/dividends/