Essay on Dividend Payout policy

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There is proven evidence that depicts the importance manager’s place upon their company’s dividend payout policies. In their eyes it is seen as imperative that a consistent level of dividend per share is maintained to prevent inadvertent suggestions of reduced performance. Due to the need to present stability and avoid cuts to payouts managers will often look to external capital for funding investments rather than reduce internal cash and cutting dividends. This emphasis managers put on keeping a consistent payout policy is contradictory to the theory put forth by Franco Modigliani and Merton Miller (MM). MM’s theory of dividend irrelevance was put forth in a 1961 issue of the Journal of Business. The article entitled “dividend policy, growth and the valuation of shares” suggests that under certain assumptions (namely perfect capital markets, rational behaviour from investors and set investment plans for companies) payout policy selected by managers will have no bearing on shareholder wealth and is therefore irrelevant. The “irrelevance” comes as a result of there being a trade-off between the issuing of dividends and the repurchasing of shares depending on whether the company is raising or lowering payout. Due to one of the assumptions being a specific investment and borrowing plan, any additional funds required for dividends can only be attained through share issues. Similarly if dividends are being lowered the only use for the extra capital is through share buy-backs. Both of these alternatives create a $0 net effect to shareholder wealth (Miller & Modigliani, 1961).

The glaring criticism for MM’s theory is that the assumptions underlining the chosen payout policy being inconsequential are themselves arguably irrelevant. However the fact that the assumptions are unrealistic does not denigrate the utility of the theory in regards to identifying how payout policies affect shareholder wealth. It is because perfect capital markets free from taxes, transaction costs and information costs do not exist that MM’s theory can be utilised as a start point for the greater explanation as to what elements within the market affect payout policy. The theory can assist in the understanding of why companies take a particular approach to dividend policy and what could be the subsequent consequences for shareholder wealth (Cohen & Grace, 2009). For example back in June 2010 after the oil spill in the Gulf of Mexico BP announced a cut to its dividend for that year. As previously mentioned managers prefer to avoid this option due to the negative share price affects often associated with reductions. It would appear however that BP, facing political pressure and fearing further public image decline thought the issuing of profits in a time of disaster may cause shareholder wealth to take a major hit as a result of greater backlash (Denning, 2010). This decision however can be shown to be ill conceived and potentially counter-productive through utilisation of MM’s theory to illustrate the affects market imperfections have on share price reactions to dividend decisions.

A key reason why the decision to reduce dividends could negatively impact shareholders is due to the subsequent information costs from unintentionally signalling new information to investors regarding future performance. MM’s theory assumes there are no signalling effects present in the market. However because this is not possible the reverse confirms the related information costs are a primary reason to consider dividend policy. The reduction of dividends typically creates a negative share price reaction. This is because the manager is perceived to have internal information in relation to future cash flows and therefore a dividend reduction would suggest these cash flows would be in decline. The BP situation could align with this hypothesis, as shareholders recognise a reduction in payout may be the company bracing for the impact of the clean up costs and impending legal
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