EssaysForStudent.com - Free Essays, Term Papers & Book Notes
Search

Dividend Relevancy

By:   •  Research Paper  •  2,692 Words  •  March 31, 2010  •  1,145 Views

Page 1 of 11

Dividend Relevancy

Introduction.

It is said that there are many reasons for paying dividends and many other reasons for not paying any dividends. The result of this sentence is that dividends are controversial. Dividend it is mainly cash, or other benefits, distribution for earnings. Dividends has following types:

• Regular dividends: those paid by company quarterly, semiannually or annually.

• Extra dividends: paid once and not to repeated

• Special dividends: unlikely to be repeated

• Stock dividends: paid in shares of stocks.

For the long time the debate is hold on how the dividend policy affects company value. Some of the researchers believe that dividends increase investors wealth (Gordon 1959), others suggests that dividends are irrelevant (Miller and Modigliani, 1961 and Miller and Scholes ,1978) while there are still others (Litzenberger and Ramaswamy, 1979) that tends to believe that dividends decrease investors wealth. In 1961 Miller and Modigliani rose the theory that can be summarized as dividend irrelevance. In 1976 Black has disagreed with Miller and Modigliani but instead of offering some alternative theory, rose important questions:, why companies pay dividends , and why the investors pay attention to the dividends. The different views about dividends and their relevance will be discussed in this paper.

Dividend irrelevancy theory.

In year 1961 Merton Miller and Franco Modigliani raised their theory about dividend irrelevance. The theory was based on following assumptions:

1. There are no transactional costs that are associated with converting shares into cash

2. Issuing shares by company incurs no flotation or transaction costs

3. There are no taxes (both on corporate and personal level).

4. Capital market is perfectly efficient.

5. Access to information is costless

6. Rational behavior on the part of participants in the market, valuing securities based on the discounted value of future cash flows accruing to investors

7. Certainty about the investment policy of the firm and complete knowledge of its cash flows

8. Managers act as perfect agents of the shareholders

Under this assumptions Miller and Modigliani pointed that while dividend is relevant, dividend policy is irrelevant. The share valuation in their theory is a function of the level of the corporate earnings and not function of the amount of money paid by the company as dividends. While capital structure of the company is irrelevant, it is investment decisions that are responsible for company profitability and determine its market value. Share valuation has nothing to do with level of the dividend paid by the company. M&M pointed out also that, if the investor is rational, in the sense that he/she always makes decisions that maximize its wealth, is indifferent to the option, whether he/she receives capital gain or dividends. Miller and Modigliani suggests also, that the value of the company will not be affected by amount of the dividends expected from it.

Under given assumptions, company should not concern itself in paying dividends. Instead of paying dividends, money should be invested in all available projects with positive NPV in case to maximize shareholders wealth. In this way company will maximize its market value, and shareholders wealth.

Because financial market is perfect, company can rise every amount of money to finance all desirable investments. After investing in all possible projects with positive NPV it is possible that some internal founds will left. This money can be then paid out as a dividend. If no dividend are paid, that means that all money was invested in projects and value of the company will increase. Investment policy of the company under MM assumptions is shown on fig. 1.

Fig.1 Company investment policy

The company has opportunity to invest in 5 projects. Only three first of them are attractive, because IRR ( internal rate of return) of those projects is greater than cost of equity. The amount of the money needed to invest is in this case OA. If the company has profits OP than all project can be realized from profit and rest money ( AP ) can be paid as dividend. On the other hand, if the company profit is only OP* then the P*A money is raised from capital markets and all deserved projects are taken but no dividend

Continue for 10 more pages »  •  Join now to read essay Dividend Relevancy
Download as (for upgraded members)
txt
pdf