Dividend policy decision Essay
Dividend policy decision
Dividend policy decision is one of the important decisions of corporate finance. A dividend policy should be such that it maximizes the shareholders wealth and provides adequate financing to the firm. A firm with fluctuation dividend policy is considered risky by the investors. (Shim & Siegel, 1998) Usually a stable dividend payout policy is maintained by companies. Leverage which is given by total debt/total assets, is negatively related to the dividend payments, that is higher the leverage in the firms capital lower is the dividend paid.
Companies with less debt and sizeable tangible assets usually pay more dividends as it is usually stable. (Aivazian & Cleary, 2003) However, this has been contradicted by the signaling theory which says that the company’s which have high dividend payout ratio tend to be financed by debt and company’s which have low dividend payout ratio are more inclined to be financed by equity. (Chang & Rhee, 1990) The agency theory and tax preference theory suggests that there is a positive relationship between the institutional ownership and the dividend payouts.
(Jenson, Solberg & Zorn 1992) However, both numbers of shares owned by institutional investors as well as proportion of institutional ownership does not significantly affect the dividend payout ratio. This is because the companies will not have to enter the capital markets for additional funds if they are owned by institutional investors which mean less compliance procedures and monitoring by the external authorities. On the other hand signaling theory advocates a negative relationship between the proportion of institutional ownership and dividend payments.
There is a strong positive relationship between the profitability that is the Return on equity and dividend payments. The return on equity is given by net income/ shareholders equity. The higher the income would mean firms would have more money to distribute as dividends, and this would also convey better performance. (Ho, 2003). A firm with high business risk is inclined to pay lower dividends and the firm with stable earnings and low risk would pay high dividends.
This is because the firm would be more likely to go bankrupt than a firm with low business risk as the earnings and liquidity position is not predictable. The agency theory of dividend policy says that there is a negative relationship between fixed asset ratio given by fixed asset by total assets and dividend payout ratio. The more money is blocked in the tangible fixed assets, the less is available to fund short term assets, which can be used as collateral security to finance the short term borrowings.
The firms would not be able to have access to short term loan and would therefore depend on the retained earnings to meet the short term requirements. Firms which have high liquid assets would pay more dividends than firms with less liquid assets. Liquidity position of a company is measured by current assets / current liabilities. High cash availability would enable firms pay more dividends. Moreover if the liquidity position is high the probability of bankruptcy also reduces. Large firms would pay more dividends as they would have easy access to capital markets than small firms.
As large firms are more diversified and less susceptible to financial distress, they pay more dividends to the shareholders than the smaller firms (Gul & Kealey 1999). The higher the growth opportunities the higher is the possibility of firms distributing low dividends. The profits would be retained by the firms in order to finance the expansion plans. Market to book value ratio is used as a proxy for growth opportunities. Hence, there is a negative ratio between market to book vale and dividend payments.
Thus we find that all the factors play a role in formulation dividend policy. Some have significant impact while others factors may not have a considerable effect. Reference: Aivazian, V. , Booth I. , Cleary S. , (2003) Do emerging markets firms follow different dividend policies from the US firms? Journal of financial research, 26(3) pp. 371-387 Chang, R. P. , Rhee, S. G. , (1990) The impact of personal taxes on corporate dividend policy and structural decision, Financial management, 19(2) pp. 21-31 Gul, F. A. , Kealey, B. T.
, (1999) Investment opportunity set and corporate debt and dividend policies of Korean companies, Review of quantitative finance and accounting, 13(4) pp. 401-414 Ho, H. , (2003) Dividend Policies in Australia and Japan, International Advances in economic research Jensen, G. , Solberg, D. , Zorn, T. , (1992) Simultaneous determination of insider ownership, debt and dividend policies, Journal of financial quantitative analysis, pp 247-263 Shim, Jae K. , Siegel, Joel G. , (1998) Schaum’s outline of theory and problems of financial management, McGraw-Hill Professional, USA