Before talking about dividend payout theories, lets talk about first dividend and the dividend payout. Dividend is a part of profit which is distributed among the shareholders and dividend payout is related to the policy of a company that specifies the quantity of net income paying in the form of dividends to the shareholders.
When a company is making effective cash flows from its operations, still there are some important cash outflows that will come in the path of making dividend policy for the shareholders like,
- Purchase of new building or machinery.
- Investment in a new project that seems effective.
- Regular payments to debt holders in form of interest.
- Finally the payment of dividends to the shareholders.
There are some other important questions in the payment of dividend to the shareholder like,
- What should be the form of dividend payment because it can be paid in either cash or stock?
- The regularity of time interval between dividends should also be focused as dividend can be paid on annual, quarter, month or random basis.
- The effect of dividend payout on the value of a company is also considered in making policy.
Dividend Payout Theories
Below are four, but most common dividend payout theories, which are important for you know about them.
1- M-M Irrelevance Theory
M-M Irrelevance dividend payout theories are the extension of the ideal case theory of Capital Structure presented by Millar & Modigliani. It states that the dividend payout is irrelevant to the value of the company. It is clear that the value of a company is not affected by the types of cash outflows it made. Rather, it is influenced by the sum of the cash inflows and the riskiness of the company. Moreover Irrelevance Theory shows that the investors are also not influenced by the decision of the management of the company regarding the way of giving the return either in the form of dividend yield or in capital gain yield.
2- Bird in Hand Theory
Bird in hand theory is presented by Gorden & Linter and is much practical in nature. It states that the company should try to pay the higher dividend in order to increase its wealth or value. The reason behind this is that the dividend income is considered to be more regular, immediate and least risky in comparison with the capital gain income which is not certain. So, the dividend payout should be kept high by the company.
3- Tax Preference Theory:
Tax Preference dividend payout theories are opposite to the Bird in Hand Theory. In this theory the element of tax is focused in order to give return to shareholders. The company should pay the least amount of dividend to the shareholders because the income tax on dividend income is much higher than on the capital gain income. So, the management of the company should keep a higher portion of retained earnings in order to maximize the shareholder’s wealth.
4- Signaling Theory:
Signaling dividend payout theories are related to the spread of signals about the health and future income of the company. If the management of a company pays relatively higher dividend to the shareholders, then it would transmit positive signals in the market about the future earnings of the company. So investors are more willing to invest in the shares of the company and in this way the trading of the shares is enhanced.
Different Factors Influencing Dividend Policy
- Clientele Effect:
It is the psychology of the investors that they prefer some kind of stock based upon the dividend policy of the relative company. Some investors like to invest in those stocks that give them some regular income while the others prefer to invest in the stocks that are growth oriented. So when the company changes its dividend policy, its shareholders are directly affected.
- Agency Costs:
The expenditure and decisions of the managers are scrutinized by the shareholders. For this purpose, the shareholders incur agency costs to keep check on the management of the company that either it is wasting the money in irrelevant expenses or not. The higher dividend payout is also demanded, so that the managers should concern the capital market for external financing. It automatically balances their extra spending/expenses.
- Regal Restrictions:
Following are some of the legal restrictions on making a dividend policy.
- Debt Agreements:
Bond Indentures and Loan Contracts bound the management of the company in the payout of the dividend to the shareholders, if the income or working capital of the company is not sufficient. Therefore the management of the company has to pay the interest payments first then any dividend.
- Capital Rule Impairment:
In this rule the dividends should not be kept higher than the retained earnings that are shown on the balance sheet of the company.
- Payment of Cash Dividends in Cash Only:
The cash dividends are paid with cash only. If the cash is not sufficient to pay the proposed dividends, then the company should sell its assets or raise a loan for the payment.
Residual Dividend Model
Residual Dividend Model gives the directions in setting the optimal dividend payout policy of a company. For this purpose, the company sets its dividend payout for long term period and then calculates back the dividends in the short terms.
Steps Involved in the Residual Dividend Model:
The following steps are taken in the application of RDM by a company.
- The future cash flows, earnings and capital budget etc, are made for the next five years. But keep the expected cash flows underestimated in order to fulfill the conservatism concept.
- Find the optimal capital structure or debt ratio for the upcoming five years in order to determine the required equity of the company.
- The debt should be financed through the retained earnings if possible because the cost of acquiring an external loan is much higher than the utilization of retained earnings.
- Finally the remaining portion is termed as “residual” earnings which are used to set the dividend payout for the long run period. Split this large portion of the dividend into regular, steadily increasing short term dividend payouts.
In this way the optimal dividend policy is set which is much safer to promote the speed in the value of the company and its shareholder wealth.