Corporate finance has been the topic of legion surveies with changing readings economic experts and investors have sought to explicate the correlativity between the corporate policies and their impact on company value. Consequently there are many theories and much literature turn toing this subject, but possibly the most controversial issue has been dividend policy and how this can supply valuable information to future investors and current stockholders. Harmonizing to Black ( 1976, p. 8 ) “ the harder we look at the dividend image, the more it seems like a mystifier with pieces that merely do n’t suit together. ” To ease the apprehension of this essay it is of import to specify the significance of dividend policy and capital addition. The former is defined by Brealey & A ; Myers ( 2003, p. 154 ) as “ the tradeoff between retaining net incomes on the one manus and paying out hard currency and publishing new portions on the other ” , and the latter can be defined as the positive difference between purchase monetary value and selling monetary value of an plus.
Although some economic experts have held that dividend policy is irrelevant under certain conditions and premises, others have shown strong grounds for the importance of this policy in doing investing determinations, some related with market deformations and current monetary values of portions, others with the ability to foretell future net incomes of companies. Therefore, this essay is an effort to show that the dividend policy adopted by a company can supply utile information for doing investing determinations. However, given the complexness of the issue and the trouble of doing accurate anticipations about future net incomes of companies, there is no consensus on the impact of dividend policy on net incomes.
In order to show this, foremost there will be a treatment of the cogency of the theoretical accounts based on perfect market premises given the current conditions that companies and investors must confront. The 2nd subdivision will analyze different theories of investor behavior and will demo that in some instances bargainers can predictably impact dividend policies and these policies in bend provide valuable information to the market. Finally, grounds for and against the thought that dividend policy can be used to foretell future net incomes of companies will besides be discussed.
One of the cardinal statements against the thought of obtaining utile information on dividends and dividend alterations is the work realized by Miller & A ; Modigliani ( 1961 ) . Assuming perfect capital markets, rational behavior and perfect certainty, they conclude that dividend policy is irrelevant to the value of the company. This subdivision will concentrate on the first premise, which affirms that there are no dealing costs, all types of investors have the same information and there is no difference between the revenue enhancement rate on dividends and capital additions. Under these conditions the expected benefit will be the same for all fiscal assets because the demand for higher-yielding assets pressured monetary values upward and therefore it will extinguish the opportunity of acquiring a better return ( Miller & A ; Modigliani, 1961, p. 412 ) . Given that companies are apathetic between financing their investing programs with equity or debt, dividend policy is irrelevant under these premises.
Although this decision seems clear and precise, it is based on strong premises that are non ever valid in world. Markets, peculiarly emerging 1s, have a figure of deformations and accordingly do dividend policy, to certain extent, relevant. These can be categorized harmonizing to the basic premises of perfect capital markets: different revenue enhancement rates, dealing costs and information dissymmetries.
First, there are different revenue enhancement rates for accomplished capital additions and dividends, harmonizing to Black ( 1976, p. 9 ) :
In a universe where dividends are taxed more to a great extent ( for most investors ) than capital additions, and where capital additions are non taxed until realized, a corporation that pays no dividends will be more attractive to nonexempt single investors than a similar corporation that pays dividends.
There is so some grounds for the presence of such deformations, for illustration the instance of the U.S. where dividends are taxed more to a great extent than capital additions. Contrary to outlooks, companies under this revenue enhancement government have a stronger penchant for paying dividends ( Allen, Bernardo & A ; Welch, 2000, p. 4 ) . Therefore there are other factors discussed below with greater influence on corporate fiscal policies that require investors to take this cost.
Second, the being of dealing costs affects both companies and investors. They affect the former because of the cost involved to obtain the resources needed to pay certain degree of dividends antecedently compromised or to detain profitable undertakings for the concern due to restrictions in the sum of available hard currency ( Bhattacharya, 1979, p. 262 ) . They affect the latter by the costs involved selling their portions to raise financess to finance ingestion instead than having dividends ( Manos, 2001, p. 31 ) . Although the consequence of these costs is non clear because they are antonyms, their presence can finally impact outlooks of future hard currency flows and thereby the value assigned to portions.
Last, there are information dissymmetries between different groups of investors and between investors and directors. In the former instance this phenomenon will stand for an advantage for the more informed investors when it is carry oning a redemption because they have better cognition on future undertakings of the company and therefore of the value of portions. Consequently uninformed investors will prefer dividends to redemptions ( Allen, Bernardo & A ; Welch, 2000, p. 2 ) . In the latter directors have privileged information about the house ‘s chances and this is communicated to the market by assorted agencies. One of them is the dividend policy and, since there is a refusal to cut down the dividend rate, additions are made merely if there is safety to be sustained over clip. This implies that dividend alterations may incorporate valuable information ( Black, 1976, p. 10 ) .
Another point related with information dissymmetries among investors is mentioned by Allen, Bernardo & A ; Welch ( 2000, p. 4 ) . Harmonizing to them institutional investors, given their size, have greater inducements to be informed and to place companies with good public presentation. In add-on, these investors are non taxed on dividends. Consequently houses have an inducement to pay more dividends and pull them. This seems to explicate the penchant shown by the companies to pay dividends alternatively of redemptions. A farther account is given by Barclay & A ; Smith ( 1988, pp. 76-77 ) . Harmonizing to them redemptions are an chance for directors to profit themselves at the disbursal of stockholders due to information dissymmetries. Therefore, repurchases seem the most expensive agencies to administer the excess of the house, so that investors have a stronger penchant for dividends.
A clear illustration of the effects of information dissymmetries can be seen in the instance of emerging markets. Harmonizing to Travlos, Trigeorgis & A ; Vafeas ( 2001, p. 109 ) in developing states where, unlike developed states, companies aim to bring forth the necessary credibleness to raising capital in a scenario characterized by the “ deficiency of believable agencies for the airing of fiscal information ” . There is grounds of a positive reaction in the market to growing in the dividends rate and this could be the consequence of the companies intentions “ to bridge the information dissymmetry spread with investors via their dividend policy ” . In amount, it seems clear that while the market is smaller and less developed, there are more inefficiencies in the airing of information. Hence, is enhanced dividend policy as a agency of communicating between directors and market. However it is ill-defined whether investors use this information decently and whether abuse of this can take to other chances. Therefore, it is of import to analyze the investor behavior.
A cardinal statement in favor of the relevancy of dividend policy is the sometimes irrational behavior from investors that affect stock monetary values and therefore bring forth inefficiencies in the market. Shiller ( 2000, pp. 149-150 ) described three utile experiments. The first one realized by societal psychologist Asch ( 1952, cited in Shiller, 2000, p. 149 ) attempted to show the power of societal force per unit area over single determinations. For this intent created groups of people with several members antecedently prepared to give incorrect replies to obvious inquiries, as a consequence of this a 3rd of the clip the new members gave wrong replies. Asch interpreted this consequence as a effect of societal force per unit area. The 2nd one realized by psychologists Deutsch and Gerard ( 1955, cited in Shiller, 2000, p. 150 ) was a discrepancy of Asch ‘s experiment where persons answered the inquiries anonymously, but cognizing the group ‘s responses, the consequences were the same a 3rd of the clip the new members gave incorrect replies. The psychologists concluded that a big proportion of people act believing that the other Acts of the Apostless can non be incorrect, “ responding to the information that a big group of people had reached a judgement different from theirs, instead than simply the fright of showing a contrary sentiment in forepart of a group ” . The 3rd and concluding experiment was performed by Milgram ( 1974, cited in Shiller, 2000, p. 150 ) , in which a antecedently prepared victim was having electric dazes by a new member. The latter, seeing the agony of the ‘victim ‘ asked to halt the experiment. However, the leader of the experiment refused and in many instances the ‘perpetrator ‘ continued. This was interpreted “ as showing the tremendous power of authorization over the human head ” . As a consequence, Shiller ( 2000, p. 151 ) concludes that people trust in the sentiment of the bulk and the governments on the topic even when these contradict their ain strong beliefs, particularly in a complex issue as the portions value. This type of behavior seems to be the account to certain phenomena observed in fiscal markets such as the market overreaction caused by alterations in the planetary economic scenario, or specifically to alterations in dividend rates.
However, economic experts have held that investors behave rationally. As Miller & A ; Modigliani ( 1961, p. 427 ) pointed out an single investor acts believing that other people have rational behavior. In other words they ever prefer more wealth independent of how they get it. Furthermore, an single investor believes that other investors think that he has a rational behavior. Finally, the writers assume that all bargainers comply with these conditions, therefore giving rise to the construct of “ symmetric market reason ” . These premises imply that each person maximizes his wealth and is apathetic to dividend policy, and “ that he believes the same thing to be true of all other participants in the market ” ( Baumol, 1963, p. 113 ) . Furthermore, harmonizing to Miller & A ; Modigliani ( 1961, p. 428 ) , an investor who thinks that another will move irrationally will take a scheme that, without this premise, would look irrational. Therefore, Miller & A ; Modigliani accept the possibility of irrational behavior among market participants, and this remains an unfastened treatment on the influence of this unreason on the value of the information contained in dividend policy.
A farther theory was developed by Figlewski ( 1979 ) analyzing the wagering market in Equus caballus races. This was chosen because of its similarities with fiscal markets. There is much historical information available, specializers produce public studies and different types of betters exist. The consequences obtained indicate that, in this specific market, the procedure of incorporation of public information is efficient and thereby this does non stand for any aid for doing accurate anticipations. This, extrapolated to the fiscal markets, implies that rational speculators counter the effects of irrational. Hence, market deformations related information and behavior are eliminated and therefore the possibility to ‘beat ‘ the market.
However, it seems clear that his statement is built on grounds based on a market that, despite being similar, is less complex. Harmonizing to De Long et al. ( 1990 ) in the existent universe rational investors have inducements to follow it instead than antagonize irrational behavior. In other words, and given that an irrational investor for changing grounds sells at a low monetary value and buys at a higher monetary value, a rational speculator will anticipate that the consequence of irrational guess in the market travel the stock monetary values off from their existent values. Hence, a rational investor would hold inducements to go on purchasing despite the fact that the portions are overvalued. Because he knows that due to the irrational investors those monetary values continue to lift. These attitudes seem uncover that market complexnesss are higher than expected and bring forth an ambiance of uncertainness where investors must do their determinations.
Furthermore, Baumol ( 1963 ) associated this uncertainness with the relevancy of dividend policy because, given this state of affairs, bargainers should look for logic signals on the market. He showed a clear illustration of this: the addition in stock monetary values experienced when the first U.S. manned satellite orbited the Earth despite its irrelevancy to the value of houses. Then, one could infer that the market interprets this type of nonsubjective signals and incorporates them into their ratings at least temporarily. In add-on, the general position is that the portions of low-payout companies suffer a decrease in their value ( Miller & A ; Modigliani, 1963, p.432 ) . The account behind this phenomenon seems to be that the rate of dividends is taken by the market as one of the aforesaid nonsubjective signals ( Baumol, 1963, p.114 ) . This clearly demonstrates that bargainers influenced by their frights or optimism overreact to the reaching of new information, which includes alterations in dividend policy. In effect, investors have the possibility of doing impermanent net incomes analyzing these intelligence and expecting the irrational market behavior. Further scrutiny, nevertheless, is required in order to find whether dividend policy can supply information about future net incomes of companies.
There has been much treatment whether dividend policy can signal the hereafter, a figure of surveies have attempted to show that there is a positive correlativity between dividend alterations and future net incomes alterations. Harmonizing to Bhattacharya ( 1979, p. 261 ) dividend policy non merely provides utile information to stockholders but besides is sent deliberately by directors that “ optimise the after-tax nonsubjective map of stockholders, perchance because their ain inducement is tied to the same standard ” . In add-on, he assumes that lone directors manage the information about hard currency flow and therefore there is a nexus among the information disseminated and future net incomes. Nissim and Ziv ( 2001 ) went farther and developed a theoretical account that demonstrate a positive and important correlativity between dividend additions and future profitableness for a period of at least four old ages after the alteration occurs. However, they did non happen important correlativity between dividend lessenings and future profitableness. Consequently, they argue that these consequences are justified by the duty to be conservative in accounting, acknowledging losingss in progress and net incomes merely when they are realized. These consequences together with the information provided by Bhattacharya ( 1979 ) show some grounds to back up the hypothesis that dividends can convey information to foretell future net incomes.
However, although Nissim and Ziv ( 2001 ) demonstrate with empirical grounds the cogency of their theoretical account, there are others that non merely differ from these consequences but besides demonstrate the antonym. This diverseness of results seems to be explained by the different premises and variables used in the procedure of patterning the job. The survey presented by Benartzi, Michaely & A ; Thaler ( 1997 ) illustrates this contradiction ; their findings show that there is an undistinguished correlativity between dividend alterations and future net incomes. However, they recognize an consequence in the portion value on the proclamation. Harmonizing to them this implies that investors act believing that dividends convey information about the hereafter, this decision is related to the consequences obtained in the old subdivision because suggests that investors behave irrationally. Finally, they suggest that dividend policy reflects what has occurred and “ if there is any information content in this proclamation, it is that the concurrent alteration in net incomes is lasting instead than transitory ” ( Benartzi, Michaely & A ; Thaler, 1997, p.1032 ) . On the same line of logical thinking, Garret & A ; Priestley ( 2000 ) show that dividend policy is non utile to foretell future net incomes. Furthermore, they argue that dividends provide information merely about the positives alterations from current net incomes. The grounds shown by these surveies discards the possibility of anticipating the future profitableness of companies based on dividend policy. However, they recognize the being of correlativity between dividend policy and lasting net incomes and in the instance of Garret & A ; Priestley ( 2000 ) a lagged stock monetary value alteration. It seems that the contention is non closed.
Another interesting point of position is the part of Koch & A ; Sun ( 2004 ) , they hypothesize that alterations in dividends are explained by “ the continuity of past net incomes ” , this implies that there is a slowdown in the market to integrate the information supplied by houses. The job faced by this research is that finds a negative correlativity between monetary value alterations and past net incomes in the instance where positive net incomes are followed by a lessening in dividends. By and large the pieces of research that have addressed this issue seem to meet the same restriction, non all the instances can be explained with the theoretical account without doing premises that are rapidly countered by the undermentioned surveies. Therefore, the reply to the quandary of signalling seems ill-defined, in other words we can non confirm or govern out with certainty that the dividend policy can be used to foretell future net incomes.
In decision, this essay has attempted to show that dividend policy under certain fortunes can convey utile information to the market leting investors to enrich their analysis of the value of the companies. Despite the fact that some economic experts argue that dividend policy is irrelevant, the grounds showed weakens the premises on which this averment is based. Transaction costs and different revenue enhancement rates undermine the foundations of the theory of perfect capital markets. Furthermore, information dissymmetries and irrational behavior generate a dynamic and unsure environment where investors seek to happen some nonsubjective marks. As a consequence dividend policy takes a important value within a scope of fiscal indexs that can be used to do investing determinations.
However, although the utility of dividend policy for doing investing determinations seems clear, because of deformations in fiscal markets and investor behavior, it is non a powerful tool for anticipation and hence seems to necessitate to be supplemented with more market information. Furthermore, there is a deficiency of lucidity about its relationship to future net incomes and this uncertainness leaves open the possibility for future research turn toing this issue.