Impact of Dividend Policy on Company

A dividend is a part of the profit that is distributed among the shareholders. When there is more profit, it increases the dividends which, in turn, increase the stock price of the firm and vice versa, when there is less profit it decreases the dividend payment and the stock price.

Dividend Policy and Stock Value:

Dividend Irrelevance Theory: This theory purports that a firm’s dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.

Optimal Dividend Policy: Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price.

Dividend Relevance Theory: The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm’s value.

Litzenberger and Ramaswamy (1982) showed that dividend policy influences investor behaviors as a result of disparity in taxation on dividends and capital gains. The authors believed that investors prefer low-dividend businesses since the amount of taxes payable is minimized. Jensen and Meckling (1976) stated that there is a tradeoff in the form of agency costs between having more or less insider ownership. Agency costs are created whenever the manager also controls an outsider’s investment besides her own, because there is a fundamental conflict of interest.

The next underlying theory is the pecking order theory which was first introduced by Donaldson (1961) and modified by Myers and Majluf (1984). The Pecking Order Theory relates to a company’s capital structure. The theory states that managers follow a hierarchy when considering sources of financing. The pecking order theory arises from the concept of asymmetric information which causes an imbalance in transaction power. Company managers typically possess more information regarding the company’s performance, prospects, risks, and future outlook than external users such as creditors (debt holders) and investors (shareholders). Therefore, to compensate for information asymmetry, external information users demand a higher return to counter the risk that they are taking. As opposed to external financing, internal financing is the cheapest and most convenient source of financing.

Another underlying theory for dividend policies is the signaling theory that was firstly introduced by Spence (1973) and it is useful for describing behavior when two parties (individuals or organizations) have access to different information sources as sender or receiver and both parties act differently. Dividend signaling is a theory that suggests that company announcements of dividend increases are an indication of positive future results. Increases in a company’s dividend payout generally forecast a positive future performance of the company’s stock. In the finance area, the reporting principle shows that the shift in dividends will give shareholders an indication of the future profitability of the business and perceptions of management. Management will not increase dividends unless it is certain that future earnings will meet the dividend increase. The decline in dividend payout is considered a negative signal because investors will think that the company’s future earnings are going to decrease.