Dividend Payout Theories and Policies on Capital Structure - Coursework Example

Q1. Dividend Payout Theories and Policies on Capital Structure Student’s Name Institutional Affiliation Yes. A more profitable company identifies all the outstanding projects that the company should not miss. Dividend payout are the earnings that are paid to the stockholders. They are paid in the form of a dividend on the net income or capital of the given company. However, the rest of the money that is not issued to the investors is plowed back to the firm as retained earnings (Brealey, Myers & Allen, 2017). The investors will seek to invest in a company that may have high dividend payout ratios. The higher the dividend ratio, the higher the growth of the company. The dividend payout ratio is given by the following formulae dividends per share out of earnings per share which break down to (dividends- preference share dividend)/ net income. Obviously, the dividend payout ratio measures and ascertains the percentage of the net income that the ordinary shareholders get in a given year. The decision of paying dividends is relevant to a firm since most of the investors will plow the capital in the form of shares in a company that has a steady and constant cash flows and high dividends. In the light of pecking order theory which states that the cost of financing in any given entity or business increases as there is information asymmetry (Hiller, Westerfield, Jaffe & Jordan, 2013). Bearing in mind that a good financial mix uses the debt capital in its structure, it shows that the capital structure is altered since most of the funds used under this model are internal. The internal funding is mostly from the retained cash or shares from investors. With the knowledge that this theory tries to prioritize the sources of capital. Pecking order theory is best when one is investing in the intangible assets such as the shares. Thus, the firm should adhere to the pecking order theory of the capital structure to ensure that the decisions made are profitable to the entity. The theory explains more on the relationship between the debt and profitability which is inverse in nature. It is because the most preferred financial mix is from internal funding. To avoid such sudden changes, the dividend payout is targeted and adapted (Miglo, 2011, p. 1-27). Pecking theory has the implications that the debt is favored over the equity funding in such that small sized company are on capital dominance and large companies on issuance of debentures and shares at IPO If the entities issues are advertised, it generates weaker market reactions (Antweiler, Werner & Murray, 2006). It affects the dividend payout ratio and the profits of a given investment. In a nutshell, the dividends explained in various theories according to their relevance in a company. The dividends are vital in any wealth maximizing firm since there must be a good balance in dividends and retained earnings. Thus, at a certain point, the dividends are relevant to a firm according to relevant dividend theory. By having an optimal payout ratio is best since it gives a high MPS. Part (ii) A good payout policy is best for the investors. The policy seeks out to answer all the decisions about this. If we are rewarding the shareholders what is the best method of reward in the ultimate goal in due to maximizing the wealth of the shareholders (Lumby & Jones, 2015). These are the guidelines that a company uses to make its decisions against a portfolio of equities. There are two theories that explain the dividend payout policy, dividend irrelevance theory, and Dividend relevance theory. There are three main approaches to the dividends, residual, stability or a mixture of the two. The residual dividend policy has the facts of being that the policy relies on the internally generated equity to finance its operations (Baker &Smith, 2009, p. 1-18) Therefore, the dividends will be issued as the residual equity after all the projects capital requirements are met. The aim of these companies is to try and maintain the debt to equity ratio before making any dividend issuance to the shareholders (Baker &Smith, 2006, p. 1-18) Apparently, this type of policy increases the shares volatility and in dividend payments and shareholders see it not desirable at all. The model is based on three distinctive bases of; investment opportunity schedule (IOS), target capital structure and the cost of external financing. Secondly, the dividend stability policy is the policy that ensures there is a regulated flow of dividends to the shareholders. It is the most desirable policy in offering the dividends. The investors are always on this policy since they are assured of the stable dividends. It can be either annually or quarterly. The investors are assured that the fluctuations of the market prices are not related to the earnings. Constant percentage per share is another dividend policy that ensures the company pays a fixed number of dividends per the shares irrespective of the fluctuations in the market. It shows that the dividend payout is fixed and cannot be increased unless one buys more of the shares. The payout policy is also determined by three various ways, one through cash dividends and to share repurchases. The cash dividends are a payout method which involves the money that is paid to the stockholders in a corporation. The dividends here are paid in the form of cash on either yearly, quarterly or monthly basis. By use of this method, the dividends are paid out on per share model. The company tries to distinguish between the regular and the special dividends by either through dividends per share, dividend yield or payout ratio. The other payout method includes the share repurchase. Share repurchase is the act of rebuying the shares at the marketplace. This decision is reached by the management if they think the shares are undervalued. There are three distinctive ways of a repurchase which include, Open market purchases, Fixed price tender offers, and Dutch auctions. However, these form of payout is not allowed in many countries. There are various ways and theories that denote the payout policy. The dividend irrelevance theory. This theory is also known as Modigliani and Miller theory or the MM approach. The theory states that in any perfect market a company is independent of the payout policy (Miller & Modigliani, 1961, p. 411-433) It, suggesting that in a perfect world with no taxes or bankruptcy cost then the dividend policy is irrelevant. It is because it has no effect on the share prices of an entity. Obviously, the investors or the shareholders do not care about the returns from the dividends. The M and M-theory have the following assumptions. The taxes do not exist either being a personal or corporate tax. There are no floatations or transaction costs. The firm can determine its capital budgeting since dividend policy has no implications. Information is free and available to all providing the symmetry of information. Lastly, the leverage has no impact on the cost of capital of any given company. These factors revolve on a perfect world that is much explained by Modigliani and Miller (Harry & Linda, 2006, p. 293- 315) This theory is critiqued so much that in real life the theory is not true. There we are living in the imperfect world where taxes are certainty of all companies; they have to deal with the floatation costs on issuing. There is information symmetry, but the tools are sophisticated. It meaning the information asymmetry according to pecking order prevails.MM believes that the approach stands true theoretically but not true in the practical world. The other theory depicting out the payout policy is the Dividend relevance theory. It is a theory attributed to Gordon and Linter that the shareholders prefer current dividends and there is a direct relationship between the firm’s dividend policy and market value. The theory tries to show out that dividend policies affect the value of the firm and the dividend payout. Apparently, if there is relevance in the dividend, there must be an optimum payout ratio. According to Walters model or relevance, his assumptions were; firms finance its operations by retained earnings, the IRR and cost of capital are constant in a company. The company earnings are either distributed as dividends or are invested again. The earnings do not change. According to Gordon, the firm is all about equity. There is no external financing. The IRR is constant and the cost of capital. There is perpetual earning of a company. Lastly, the corporate taxes do not exist, and there is a constant retention ratio. This model is widely used in to determine the market price of shares using forecasted dividends (Brennan, 2002, p. 1115-1121) In conclusion, the payout policy is relevant, and managers can use it to signal the expectations to the market. In such that the taxes are much more important in the market due to imperfection in marketplaces. Therefore, an optimal payout ratio is set to the investors. And firms adhere to the pecking order theory since they deal with intangible assets. References Antweiler, Werner, and Murray Z. Frank. Do U.S. Stock Markets Typically Overreact to Corporate News Stories? Working Paper, the University of British Columbia and the University of Minnesota. (2006) Baker, H. Kent, and David M. Smith. (2006). “In Search of a Residual Dividend Policy.” Review of Financial Economics 15:1, 1-18. Baker, H. Kent and David M. Smith (2009). Dividends and dividend policy. Residual Dividend Policy.1-18 Brealey, Myers, and Allen. Principles of Corporate Finance 12th edition McGraw-Hill edition (2017) Harry DeAngelo, Linda DeAngelo. (2006). The irrelevance of MM dividend theory. Journal of Financial Economics 79(2) 293- 315. Hiller D., Westerfield, R., Jaffe, J., and Jordan, B. (2013) Corporate Finance, 2 nd European Edition, Berkshire: McGraw-Hill Education. Lumby, S. and Jones, C. (2015) Corporate Finance: Theory and Practice, nine the Edition, Cengage. Michael Brennan. (1971). A note on dividend irrelevance and the Gordon, irrelevance model. The journal of finance 26(5) 1115-1121. Retrieved 2002 Miglo, A. Trade-off, pecking order, signaling and market timing models. Ch. 10 In Capital Structure and Corporate Financing Decisions, Ed. Baker K., and G. Martin. Wiley. (2011) 1-27 Miller and Modigliani (1961). Dividend policy, growth and the valuation of shares. Journal of business. 34, 411-433. retrieved 2000 Read More