Introduction to Corporate Finance

Question: Discuss the proposition that a company's dividend policy is irrelevant to its market value? Answer: Introduction The decision about Dividends is perhaps the third most vital decision that the CFO has to make, the first two being Investment decisions and Financing decisions. The crucial part here is how much profits to be retained and how much to be distributed and how it is going to affect the value of the firm. Dividends either can be paid out of current profits or accumulated profits. The Ratio of Dividend per share to the Market Price per share is known as the dividend yield and the ratio of dividend per share to Earnings Per share is known as the dividend payout. Dividend payout plays a major role in selecting the company for the investment purpose. Dividend is therefore very crucial for the company as it stress on the profitability factor and the stability in the near future (Choi Meek, 2011). Do Dividends drive Market Price? As per the Time Value of Money, the value of any asset is the present value of the future cash flows associated with the asset. With reference to shares, the future cash flows are dividends and its sale value. Thus, it can be argued that the current market price of the share is the present value of all the future cash inflows that includes dividends also. Dividend is a component in the price of the share (Albrecht et. al, 2011) Dividend payout When an investor invests in the equity of any company, it is an opportunity cost for him and on the other hand, it is the cost of equity for the company. Thus, there is a definite linkage between the cost of equity, rate of return and payout ratio. The Rate of return that the company earns is ascertained by computing the Internal Rate of Return on the Investments. Thus, the optimal dividend payout is obtained by studying the relationship between cost of equity and rate of return. The cost of equity can be computed by way of CAPM and Dividend Growth model and the Dividend growth model is the widely used and followed (Choi Meek, 2011). This model is also termed as Gordon Growth dividend model. For all these reasons, the dividend payout is significant in determining the market value of the company. The rationale followed and believed by the investors is that current dividends are more worth than the distant dividends that are in the form of retained earnings. The current dividends decl ared and paid are weighed more and at a higher discount rate. Due to this significance of the current dividends, companies are now focussing on maintaining a long-term target dividend payout ratio that helps them get a good market image that also contributes towards the increase in share market price. Moreover, dividend is an indication that the management is sharing the profit with the shareholders. This is a good indication and helps in building the goodwill of the company (Graham Smart, 2012). Therefore, in the current scenario major emphasis is given on the dividend payout ratio because the shareholders are keen in deriving the returns and companies that pay dividend is always a favourite. In order to maintain this good image and ability to pay dividends year on year, the management perfectly tune the increase in dividends to ensure future ability of the company to pay dividends. For instance, if the earnings have grown by 50%, then the dividends payout will grow only by 20%. This is referred to as an adjustment factor in which the dividends are increased only to the extent maintainable in future years (Horngren, 2013). Optimism and performance Investors also read and anticipate the status of the company from the dividends declared. If a company declares high dividend, then it means that the company is optimistic about the future but if it declares a low dividend, then it reflects that the company is not confident about the future. Thus, the market price also changes accordingly. Moreover, dividend also stress on the efficiency of the company and leads to a better status (Horngren, 2013). The company that has good record of dividend payment is highly appreciated and always a good bet for investment. There are various theories namely the Walter Model, Gordon Model, Graham Dodd Model, Lintner Model, so on and so forth that have supported and contributed towards establishing the relationship between dividends and market price (Libby et. al, 2011). The Gordon growth model is widely used and this model stress on the dividend. It implies that cost of equity is the rate at which the market price in the current scenario and the future dividend are equal. This model projects that the market price of the equity that is present currently and the income that can be derived from the equity along with the dividend that is expected (Northington, 2011). Irrelevance of Dividends Today companies are operating in the world of perfect competition where there are a large number of buyers and sellers and there is no market leader or market driver. There is access to knowledge and information about the market and so investors behave rationally and expect higher returns for higher risks. Investors are able to predict future dividends and future market prices and so the market value of the company depends upon the earnings and not the dividends. The earnings of the company is dependent upon the investment decisions, capital expenditure planned by the company and the value of the firm is ascertained on its earnings and not from the dividends declared by the company (Northington, 2011). Thus, dividend decisions are immaterial in determination of the market value of the company. Fluctuation in the prices of Stock There could be a case where the shareholders gain dividends but the assets of the company depreciate as the cash balance reduces. Therefore, the ultimate value of the investment remains the same and there is no gain or loss. Stock prices fluctuate violently every day. This means that dividends are not the only driving force for the fluctuation in the market price. Various other factors play a major role in influencing the prices (Merchant, 2012). Both external, as well as internal events play a leading role in influencing the prices. The political, economical, and social factors also play a vital role in the fluctuation of the market price, irrespective of the fact whether the company is a high dividend paying one or a low dividend paying one. Variations in preferences The preferences of investors are different and varied. It is like saying that Mr. X likes to have hot coffee whereas Mr.Y likes to have cold coffee. Therefore, if one investor is interested in dividends, another might be interested in capital appreciation, and typically, both of them choose the stocks that match their preferences. The market price of the share is determined by the combination of all these types of investors and so it would not be apt to quote that dividends drive the market price of the share (Davies Crawford, 2012). Hence, it can be said that dividend is not always the chief criteria for an investor. It plays a role but it is not important for every investor. Therefore, preference of an investor plays a determining role. The Market Price of the share is determined by the interaction of the forces of demand and supply and so if one investor Mr.X has current requirement of cash, he might sell out his investments without waiting for the declaration of dividends and vi ce versa (Davies Crawford, 2012). Hence, it can be stated that though dividends are relevant, dividend policies are irrelevant in fixing the market price as the investors also look at the fundamentals of the company, strong management structure, level of success in the business and the future prospects, to name a few factors. Price is influenced by many factors and therefore only a single factor cannot be tagged as vital. If the company has invested in a loss-making project or has erred in any such major area, then it cannot recover its image by just declaring higher dividends (Deegan, 2011). The market price is still dependent on other factors as well. Hence, in such a scenario the dividend model is irrelevant because the investor is not only concerned with the dividend as other factor even comes into picture. The Modigliani Miller Approach has increasingly focussed towards the irrelevance of dividend payout towards share market price (Brealey et. al, 2011). Conclusion In the long run, there is no correlation between dividend payout and stock returns. Dividend is that segment of the profit that is not held by the company and is distributed to the shareholders. It is correctly tagged as the capital of the shareholders. Dividend plays an important role in providing stability to the company because companies that pay dividend have a good record of accomplishment and enjoys profitability. Therefore, companies the investors always vouch for that pay dividend. However, dividend alone cannot determine the market prices as there are plenty of other factors too. Various models help in studying the dividend pattern. Hence, dividend cannot be described as relevant completely neither can be said to be irrelevant. In short, dividend is a crucial factor that projects a good answer for the company but cannot altogether be said as the major determinant. 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