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Question:

Discuss about the Corporate Payout Policy.
 
 

Answer:

Introduction:

This report has been prepared to analyze the relevant and irrelevant theory of dividend policy. The relevancy of dividend policies has been analyzed in the real world. The rationales of irrelevant theories have been studied to understand the concept. Dividends are the key element to analyze the value of the firm in the market.  

Dividend Relevancy:

According to the Gordon (1959), dividend is very important for an organization as well as investors to make decision about the investment in the company. He conducted a research and explains that the market value of securities is continuous flow of the dividends in future and it is rewarded accordingly.  

Dividends of a company are the main factors checked by the investors before investing in that company. Gordon explained that before investing the amount in an organization the following points are always considered by an investor:

  • Obtain dividend
  • Obtain earnings
  • Obtain earnings and dividend both

Through a study, it has been found that the dividend of an organization influences the firm’s value on a great level.  More, it has also found that with the increment in retained earning the required rate of return get increase.  So an organization must enhance the dividend to lower the required rate of return.  Fisher (1961) also explained that the dividend offer by an organization to its shareholders makes a better impact over the firm’s value.

Rationales of using non dividend payout policy:

Miller and Modigliani approached this concept firstly. They published a model named by “M-M model” and explain that the value of a firm never rely over the dividends. They argues that in a perfect capital market, the dividend offered by the company do not make an impact over the value of the firm (DEEPTEE and ROSHAN, 2009).

Non dividend payout policy depict that the value of firm relies over the current and future cash flows of the company. It depicts that the value of a firm relies over the investment and financing decision of a company in a finest capital structure not in the dividend and its policies (Brav et al, 2005).

This theory depict that investor could earn the money by selling out the shares to other and enjoy the profit earned through selling on higher price. This theory depict that if company would retain the earning more than there will be many project in which company could invest the amount and earn more profits (Black and Scholes, 1974). Hence the profitability of company would enhance and the share price of company will also increase.

Such as if the profitability of company would increase, company will buy back the shares in higher price and thus the shareholder will get a benefit or shareholders could sell the shares in the market to earn the profit.  

 

Dividend paying or non dividend paying stock:

Dividend policies are of 2 types: relevant dividend policy and irrelevant dividend policy. Dividend policies have been approached by Gordon whereas irrelevant dividend policies have been approached by miller and Modigliani.

Both the policies are examined to make an impact over the value of the firm and the investor decision regarding the investment in an organization. Miller and Modigliani argued that the value of a firm never rely over the dividends (CORREIA, C. et al. 2013). They argues that in a perfect capital market, the dividend offered by the company do not make an impact over the value of the firm.

Irrelevant theories are based on many assumptions and this theory directly depict the accountant of the company to not to consider the dividend and take extra care about the investment in new projects so that the profitability of the company could enhance.

Whereas according to the Gordon (1959), dividend is very important for an organization as well as investors to make decision about the investment in the company. Gordon explained that before investing the amount in an organization the following points are always considered by an investor:

  • Obtain dividend
  • Obtain earnings
  • Obtain earnings and dividend both

  Fisher (1961) also explained that the dividend offer by an organization to its shareholders makes a better impact over the firm’s value.

Relevant theories are based on many assumptions and this theory directly depict the accountant of the company must consider the dividend so that the investor could be attracted towards the investment in the organization (Glynn, 1993).

Through the above analysis, dividend paying stocks are most preferable because it offers a dividend on monthly or annually basis whereas for earning the profits in irrelevant theory, investor has to buy that stock.

Evaluation:

If there are 2 companies and both are having the same size of assets and debts but the dividend paying policies of both the companies are different than the dividend paying company would have a higher valuation rather than the non dividend paying company Because if the dividend would be given by the company than the required rate of the company would be less whereas the value of the firm would increase (Davies and Crawford, 2011). This could be explained through the following formula:

 P = {EPS * (1-b)} / (k-g)

whereas if the dividend would not be given by the company than the required rate of the company will enhance and thus the value of the firm would increase. This could be explained through the following formula:

E (?i) = ? 0+ [E (? m) -? 0] β + ? 1(δi -δm)/ δm

So it has been found that for enhancing the value of the firm in normal market, a company must pay the dividend to its shareholders.

Conclusion:

Through the following study it has been found that the dividend and non dividend policy of the company are equally important. It depend upon the nature of the company, operations of the company and shareholders of the company that which policies are better for the firm. It has been analyzed that for enhancing the value of the firm in normal market, a company must pay the dividend to its shareholders.

 

References:

Black, F. and Scholes, M. 1974. The effects of dividend and dividend policy on common stock price and returns. Journal of financial economics.

Brav, A., Graham, J.R., Harvey, C.R. and Michaely, R., 2005. Payout policy in the 21st century. Journal of financial economics, 77(3), pp.483-527.

CORREIA, C. et al. 2013. Financial Management. 7th Edition. Cape Town: Juta andCompany Ltd.2.

Davies, T. and Crawford, I., 2011. Business accounting and finance. Pearson.

DEEPTEE, P. and ROSHAN, B. 2009. Signaling Power of Dividends on firms futureProfits A Literature Review. Evergreen Energy- Interdisciplinary Journal, pp.1-9.

Fisher. 1961. Fundamentals of Corporate Finance. 5th Edition.Berkshire.McGraw-Hill Companies, Inc.

Glynn, J.J., 1993. Public sector financial control and accounting.

Miller, M. and Modigliani, F. 1961. Dividend policy, growth and the valuation of shares. Chcago Journals, Vol 4.p.p. 411-433

OR

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