by The advocates of this school of thought argue that the dividends have no impact on the share price or market value of the firm. The argue that the shareholders do not differentiate between the present dividend and the future capital gains and are basically interested in higher returns either earned by the firm by investing the profits in future profitable investments.
They believe that the profits are distributed as dividends only if no adequate investment opportunities for investments for the business.
Residuals theory of Dividends
The theory is based upon the assumptions that since the external financing has excessive costs and may not be available to the firm. The firm finances its investment by retained earnings or by retaining earnings. The retaining earnings are that portion of profits that is not distributed to the investors.
The residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed. With the residual dividend policy, the primary focus of the firm’s management is indeed on investment, not dividends.
Thus the firm’s decision to pay the dividends is influenced by:
- The investment opportunities available to the business
- The availability of the internal funds. If the internal funds are excessive and all the investments are finances the residual is paid as dividends.
Thus, the divided policy is totally passive in nature and has no influence on the market price of the firm.
Modigliani and Miller (MM) Approach
This theory was proposed by Franco Modigliani and Merton Miller in 1961 who argued that the value of the firm is determined by the basic earning power, the firm’s risk and not by the distribution of earnings. The value of the firm therefore depends on the investment decisions and not the dividend decision. However, their argument was based on some assumptions.
Assumptions of MM hypothesis
- The capital markets are perfect and all the investors behave rationally.
- There are no taxes and flotation costs and if the taxes are there then there is no difference between the dividends tax and capital gains tax.
- No transaction costs associated with share floatation.
- The firm’s investment policy is independent of the dividend policy. The effect of this assumption is that the new investments out of retained earnings will not change and there will not change in the required rate of return of the firm.
- There is perfect certainty by every investor as to future investments and profits of the firm. Thus investors are able to forecast earnings and dividends with certainty.
The MM hypothesis is based upon the arbitrage theory. The arbitrage process involves switching and balancing the operations. Arbitrage leads to entering into two transactions which exactly balance or completely offset the effect of each other.
Tax Differential View of Dividend Policy
The tax differential view of dividend policy is the belief that shareholders prefer equity appreciation to dividends because capital gains are effectively taxed at lower rates than dividends when the investment time horizon and other factors are considered. Corporations that adopt this viewpoint generally have lower targeted payout ratios, or a long-term dividend-to-earnings ratio, as dividend payments are set rather than variable.
Every company has the responsibility to act in the best interests of its owners, the shareholders. That includes putting any leftover cash to its highest and best use. In some cases, the tax differential view of dividend policy is a reason for a company to adopt a growth strategy rather than a value strategy. In other words, they serve their shareholders’ tax needs by plowing leftover cash back into capital expenditures and other ways to grow the company (and therefore the stock value) rather than giving leftover cash back to the shareholders in the form of dividends.
It is important to note, however, that the difference in capital gains tax rates and dividend tax rates is the key here. The larger the difference between the tax rates, the larger the incentive to trade one policy for the other.
Gordon & Linter’s Theory
The bird in hand is a theory that says investors prefer dividends from stock investing to potential capital gains because of the inherent uncertainty associated with capital gains. Based on the adage, “a bird in the hand is worth two in the bush,” the bird-in-hand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains.
Myron Gordon and John Lintner developed the bird-in-hand theory as a counterpoint to the Modigliani-Miller dividend irrelevance theory. The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding stock arise from dividends or capital gains. Under the bird-in-hand theory, stocks with high dividend payouts are sought by investors and, consequently, command a higher market price.
Bird in Hand vs. Capital Gains Investing
Investing in capital gains is mainly predicated on conjecture. An investor may gain an advantage in capital gains by conducting extensive company, market, and macroeconomic research. However, ultimately, the performance of a stock hinges on a host of factors that are out of the investor’s control.
For this reason, capital gains investing represents the “two in the bush” side of the adage. Investors chase capital gains because there is a possibility that those gains may be large, but it is equally possible that capital gains may be nonexistent or, worse, negative.
