The Dividend Irrelevance Theory Finance Essay

The stock market is volatile and portion monetary values change invariably. These alterations in portion monetary values consequences in alterations in stock returns. The returns can be negative or positive. There are many factors that influence stock monetary values. One of them is dividend related determinations.

Dividend determination arises when a company generates net incomes. A suited dividend policy is adopted by the board of managers, concentrating on how much net incomes should be paid to stockholders in the signifier of dividends and how much should be retained in the company to put in positive NPV undertakings ( Alam & A ; Hossain, 2012 ) .

Dividend policy is referred to ”the pattern that direction follows in doing dividend pay-out determinations or, in other words, the size and form of hard currency distributions over clip to stockholders ” ( Lease et al. , 2000 ) . The issue on dividend policy has been discussed in assorted empirical researches for decennaries and its impact on stockholders wealth and company value is still contestable. Two chief theories have stemmed from these researches, viz. the dividend irrelevancy and relevancy theories. A brief description of both theories will be provided in this study.

Furthermore we will analyze the dividend policy of Tesco Plc. and execute an event survey at the ex-dividend proclamation day of the month to find the impact of the proclamation on the company ‘s portion monetary value.

2.1 The Dividend Irrelevance Theory

The dividend irrelevancy theory is constructed on the belief that a house ‘s dividend policy does non hold any impact on the house ‘s value and on stockholders ‘ wealth. The theory argues that a house ‘s value is determined by funding and investing determinations, and hence dividend policy has no influence on the house ‘s value.

In 1961, Miller and Modigliani ‘s survey of dividend policy concluded that a house ‘s value and therefore portion monetary value remains unaffected by the house ‘s dividend policy. Their theory was developed upon certain premises which can be viewed in Appendix A.

M & A ; M argued that investors are more concerned with a house ‘s ability to bring forth wealth through puting net incomes in positive NPV undertakings. They added that if investors want hard currency dividend, they can make so by selling their shareholdings. Their findings were supported by Lease et Al. ( 2000 ) who suggested that investors have desired hard currency flow degrees. Their survey showed that in order to keep this hard currency flow degree, investors could sell their shareholdings and bring forth ‘homemade ‘ dividends

The logic of the irrelevancy theory can non be disputed based on the implicit in premises of the theory. However, many bookmans believe these premises are instead simplistic and do non keep in the existent universe. Thus an alternate theory was developed, the dividend relevancy theory.

2.2 The Dividend Relevance Theory

In 1976, Black described dividend policy as a ”puzzle ” . He questioned the cogency of M & A ; M ‘s theory as houses continue to pay dividends. If dividend policy was irrelevant, why do house pay out hard currency to stockholders when it could hold retained the hard currency ( cheapest signifier of funding ) and put it in honoring undertakings?

Some bookmans therefore believe dividend policy is relevant. Lintner and Gordon ( in Al-Malkawi et al. , 2010 ) , the innovators of the dividend relevancy theory argue that stockholders prefer dividend payments to capital additions. Investors are risk-averse and hence dislike the uncertainness of future capital additions. They prefer take downing their uncertainness degrees by having regular dividend payments. And a decrease in uncertainness besides serves to take down price reduction rate used by investors to value a house, which consequences in a higher house rating.

We can therefore see that the chief statement of the dividend relevancy theory is that stockholders prefer early declaration on uncertainness, for which they will hold to pay a higher monetary value. Thus higher dividend payments will motivate additions in the portion monetary value.

3. An Analysis of Tesco Plc. Dividend Policy

Tesco is one of the universe ‘s largest retail merchants, with its operations crossing across 13 different states. It presently has a market portion of 29.7 % of the UK market ( Kantar World panel, 2013 ) . The company is the lone FTSE 100 company which has managed an addition in its stockholder dividends every twelvemonth since 1984 ( Fool, 2013 ) . The dividend policy of the company evolved in 2006 whereby the CEO of the company announced that the company ‘s aim is for future dividends payment to turn in line with the implicit in net incomes per portion, alternatively of constructing dividend screen whilst presenting strong dividend growing which was the old dividend policy adopted by Tesco ( Annual Report, 2006 ) .

In this subdivision of the study, we will analyze the dividend form of Tesco over a five twelvemonth period and associate the dividend policy of the company to the theory discussed antecedently.

Analysis of Tesco ‘s dividend payments

Table 1: Analysis of EPS & A ; DPS of Tesco Plc.

Old ages

2008

2009

2010

2011

2012

Net incomes per portion ( EPS )

26.61

26.96

29.19

34.25

36.64

% Increase/Decrease

1.32 %

8.27 %

17.33 %

6.98 %

Dividend per portion ( DPS )

10.9

11.96

13.05

14.46

14.76

% Increase / Decrease

9.72 %

9.11 %

10.80 %

2.07 %

Dividend pay-out ratio

0.41

0.44

0.45

0.42

0.40

Retention rate

0.59

0.56

0.55

0.58

0.60

Beginning: Tesco Plc. Annual Report 2012 and ain computations

By looking at table 1 above, we can clearly see that Tesco ‘s dividend policy follows the dividend relevancy theory in that it is paying dividends to its stockholders on a regular footing. The DPS has been turning over the old ages, averaging a growing rate of 7.93 % over the five twelvemonth period. The EPS has grown at an mean rate of 8.47 % over the same period. This confirms the policy adopted by Tesco in 2006 that is to turn DPS in line with addition in EPS.

Beginning: Tesco Plc. Annual Report 2012

An analysis of Tesco ‘s dividend pay-out ratio

Tesco has an mean pay-out ratio of 0.43. The chart below shows that the company supports a changeless pay-out ratio. This may be a positive mark that Tesco can keep a stable dividend pay-out ratio even in instance of major dazes in the market.

Beginning: Tesco Plc. Annual Report 2012 and ain computations

Dividend payment v/s FCF

One review of the changeless pay-out ratio is how sustainable it is. We can find this by analyzing the company ‘s dividend payments against the free-cash flow[ 1 ].

Beginning: Tesco Plc. Annual Report 2009 – 2012 and ain computations

Based on the free hard currency flow ( FCF ) , the dividends look less secure. FCF did non cover dividend payments over the past five old ages. However, Tesco maintained their scheme to increase DPS over these old ages, demoing clearly that direction make non wish to direct the incorrect signals to investors even if the company is non making so good. It seems that it would take a major fiscal prostration for Tesco to reexamine their dividend policy.

4. An Event Study of Tesco Plc.

The intent of this event survey is to find what happens to the stock monetary value at ex-dividend day of the month. If the efficient market hypothesis is taken into consideration, so the stock monetary value will fall by the same sum as the dividend. Otherwise there exists an chance for economic net income.

Our ex-dividend day of the month in this instance is 25th April 2012. We will therefore measure the impact of the ex-dividend day of the month on the stock monetary value 10 yearss prior and after that day of the month. The graph below shows the motion in portion monetary value during the said event window.

Beginning: Yokel Finance

As can be noted, the portion monetary value efficaciously dropped on the ex-dividend day of the month.

For the intent of our event survey, we have collected informations of Tesco Plc. and the FTSE All Share Index from DataStream and Tesco ‘s one-year studies. Monetary value indices have been collected on a day-to-day footing, from 2nd January to 31st December 2012.

A arrested development analysis was run in Minitab which resulted in a additive equation being derived, picturing the relationship between expected return and current market return on the Tesco stocks. The equation is follows:

C1 = – 0.00346 + 0.882 C2

Where C1 = Expected Return,

-0.00346: the y-intercept of the line, and

C2: existent market return on the stock.

Using the above equation we were able to deduce the expected return ( ER ) , unnatural return ( AR ) , cumulative unnatural returns ( CAR ) and t-test through our event window. The consequences are presented below:

Date

Erbium

Argon

Car

T-Test

11/04/2012: -10

0.0070

0.0049

0.0049

0.2275

12/04/2012: -9

0.0155

0.0060

0.0108

0.2802

13/04/2012: -8

-0.0137

0.0021

0.0129

0.0976

16/04/2012: -7

-0.0066

0.0030

0.0160

0.1422

17/04/2012: -6

0.0169

0.0062

0.0222

0.2890

18/04/2012: -5

-0.0229

0.0009

0.0230

0.0402

19/04/2012: -4

-0.0062

0.0031

0.0261

0.1447

20/04/2012: -3

0.0015

0.0041

0.0302

0.1929

23/04/2012: -2

-0.0104

0.0025

0.0328

0.1182

24/04/2012: -1

0.0135

0.0057

0.0385

0.2680

25/04/2012: 0

-0.0264

0.0004

0.0389

0.0188

26/04/2012: 1

-0.0121

0.0023

0.0412

0.1080

27/04/2012: 2

0.0079

0.0050

0.0462

0.2330

30/04/2012: 3

-0.0051

0.0032

0.0494

0.1515

01/05/2012: 4

0.0017

0.0041

0.0536

0.1940

02/05/2012: 5

-0.0068

0.0030

0.0566

0.1412

03/05/2012: 6

-0.0029

0.0035

0.0601

0.1654

04/05/2012: 7

-0.0007

0.0038

0.0639

0.1792

07/05/2012: 8

-0.0035

0.0035

0.0674

0.1619

08/05/2012: 9

0.0083

0.0050

0.0724

0.2352

09/05/2012: 10

-0.0115

0.0024

0.0748

0.1116

Max AR

0.0062

Mini AR

0.0004

Max CAR

0.0748

Min CAR

0.0049

Max t-test

0.2890

Min t-test

0.0188

The consequences are presented diagrammatically below:

As illustrated in table 2 above, unnatural returns could returns could be earned during the event window. The maximal unnatural return that could be earned occurred on the 6th twenty-four hours prior to the proclamation day of the month, with an unnatural return of 0.62 % per portion. The minimal unnatural return was 0.04 % , which occurred on the proclamation day of the month. The cumulative unnatural returns show a maximal occurring on the 10th twenty-four hours after the proclamation day of the month while the lower limit was on the first twenty-four hours prior to the ex-dividend proclamation day of the month.

The information has been simplified in the above chart. We can clearly observe that during our event window, unnatural returns could be earned. This consequences in a positive tendency in cumulative unnatural returns every bit good.

The consequences of the t-test show an undistinguished value at the proclamation day of the month. The maximal value derived from the t-test appears on the 6th twenty-four hours prior to the proclamation day of the month, with a value of 0.2890. The positive tendency in t-test suggests the chance of happening in unnatural returns is instead high.

The unnatural returns show a positive reaction by investors to the dividend proclamation. The assurance of investors is boosted up by the fact that Tesco managed to turn its dividend payment, while besides supplying cogent evidence that they believe in the ability of Tesco to keep a turning concern in the hereafter.

5. Decision

This survey has attempted to explicate how critical dividend policy is in administrations and its consequence on portion monetary value and stockholder value. Dividend determinations have a cardinal function to play on the public presentation of the house and can positively or negatively impact on the aims of the house.

The Efficient Market Hypothesis assumes symmetric information therefore investors can non do unnatural returns on stock monetary value volatility. However, the market is seldom efficient. Information dissymmetry in the market consequences in better-informed market participants to bring forth unnatural returns ( Quresi et al. , 2012 ) .

We have investigated the impact of dividend proclamation on portion monetary value and stock returns of Tesco in this study. Our analysis has prompted us to reason that the proclamation has had a positive consequence of stock returns, as positive unnatural returns could be earned 10 yearss prior and after the proclamation day of the month.