Dividend Policy Essay Example

Dad, and Priestley (2012, 1834) presented another aspect of dividend policy related to the interdependence between dividend stability, current earnings, and past payouts, often referred to as dividend smoothing.

Despite attempts by economists to understand the motives behind dividend smoothing, including examining theories put forth by Patriarchy, Miller, and Rock, the results have been unsatisfactory (Lambert and Myers 2012, 1769). Lack of both theoretical and empirical information has led to new speculation about possible reasons for the phenomenon, put forth by economists who argue that dividend smoothing occurs due to information asymmetries, such as those highlighted by Kumar (1988) and Brenna and Thacker (1990), as well as agency costs, as cited in Leary and Michaels (2008, 2) by Allen, Bernard, and Welch.

According to a survey conducted by Lambert and Myers (2012, 1769), Allen, Leary, and Michaels suggested that agency cost was a more reasonable factor in explaining dividend policy. The statement was presented within a justified paragraph, surrounded by .

Frankfurter and Wood (2002) aimed to simplify existing theories for better study and comprehension.

Two theories on dividend policy will be presented and analyzed in separate sections. The first theory is based on clientele effects, whereas the second theory is based on signaling models. Each section will provide multiple perspectives and previous research will be examined.

In section two, the paper will discuss the impact of client preferences on dividend policy. This will be followed by an analysis of the signaling model in section three. In the final section, the literature review will be summarized, highlighting key points and significant findings.

Clientele effects

To facilitate understanding of the dividend clientele effects, this study

will utilize the US market as an example.

The companies' client base is determined by their dividend policy, which appeals to groups of investors based on their taxation preferences. Two main categories of investors are 'untaxed institutions' and 'taxed individuals' (Allen, Bernard, and Welch 2000, 2500). This paper aims to investigate the correlation between companies' dividend policy and taxed individuals. The relationship was explored in a survey conducted by Edwin J. Elton and Martin J. Grubber in 1970.

• The first one is related with companies' dividend yield. It is believed that the smaller companies' dividend yield, investors will only gain small percentage n dividend, and should expect larger return on capital gain. The most likely investors on this stock are people who fall in the high tax bracket, and consequently high dividend yield stock should be investors who fall in the low tax bracket.
• The second one is related with the amount of dividend payout.

A hypothesis suggests that companies with high dividend payments have a slower growth rate than those with low payments, making investors in lower tax brackets more attracted to high dividend payment firms. To investigate this claim, a study examined the behavior of all listed stocks on the New York Stock Exchange that paid dividends within 1966-1967.

Research conducted by Elton and Grubber in 1970 showed a positive correlation between shareholders' tax bracket level and dividend yield. This was supported by the observation that as dividend yield increased, shareholders' tax bracket decreased. However, the first decision was criticized due to significant variability in dividend payments among different companies.

The principle of preferring high dividend payouts

over high returns on capital gains applies to both individual and institutional investors, including tax-exempt pension fund companies and foundations. However, some companies may face lower taxes on dividends compared to capital gains, making high dividend payouts more attractive. (Elton and Grubber 1 970, 56).

Additional research on the impact of taxes on clients was being carried out by Franklin Allen, Antonio E. Bernard, and Vivo Welch. Their study centered on two assumptions: "untaxed institutions" and "taxed individuals," and assumed that dividends were a means of drawing in institutions. The study by Allen and team focused largely on how dividend payments entice institutions. Generally, it is accepted that institutions are drawn to Non-Dividend (ND) stocks because they are mostly tax-exempt or largely not subject to taxes.

Institutions are thought to have become more knowledgeable about firms due to the same reason. This increased knowledge enables these institutions to assess companies' quality, which is often reflected in the amount of dividend payments (Allen, Bernard, and Welch 2000, 2500).

In a broader perspective, the discoveries made by Linter, Elton, and Grubber, as well as Allen and his team, are interrelated. However, what is the exact connection between these findings?

• Lintier stated that companies prefer to payout stable dividend with gradual growth.
• Elton and Grubber stated that companies with high payouts tend to experienced more growth compare to companies with low dividend payouts.
• Allen, Bernard and Welch stated that dividend payouts signal quality of firm.

When connecting these three dots, a single line emerges, indicating that dividends are a signal of 'good' management, reflecting the quality of

firms and aiding in forecasting why companies prefer stable dividend payments. This is because reducing dividend payments is seen as a decrease in company performance, according to Lintier (1956), Tangelo and Deadening (cited in Allen, Bernard, and Welch 2000, 2518).

The main shareholders of companies have become constitutions due to the practice of earning untaxed or low-taxed dividends. Institutional investors may view a decrease in dividend payout as negative and sell shares, causing a decline in share price. Companies with high dividends grow faster because institutional investors play a major shareholder role and coexist with the company's quality. This also compels the company to defend or improve its performance to avoid unwanted situations.

Incorporating the clientele effect will enable companies to examine their client base and make appropriate adjustments to their dividend policies to align with their clients' tax preferences.

Signaling model

Managers often refer to undisclosed information regarding future cash flow, which is not available to external shareholders (Apothecary 2007, 6). This ultimately results in different priorities and leads to agency costs. This undisclosed information is related to the possible amount of future free cash flow and the amount paid in evidence.

Lie and Chaos (2008, 674) have determined that the rise of asymmetric information has caused an increase in dividend payments by companies. This conclusion has been drawn through thorough examination by economists and researchers, although it is important to note that there are certain conditions attached to this assertion.

1. Companies truly possess superior quality (Allen, Bernard, and Welch 2000, 2505).
2. Managers are willing to bridge information gap by releasing insider information through dividend payments (Malawi, Rafter, and

Pillar 201 0, 187).

In the signaling model, it is crucial to consider the actual quality of firms. This is because a dividend announcement is commonly interpreted as a positive indication, often leading to an increase in share price (Malawi, Rafter, and Pillar 2010, 187). The responsibility of evaluating a company's true quality typically falls on managers, who subsequently determine the company's dividend policy. Empirical research by Allen and colleagues has demonstrated that companies that are genuinely superior in value and quality tend to employ dividend announcements as a means of signaling, even though capital gains may be a more preferred option.

If managers pay dividends without understanding the true value of their companies, the market may respond by increasing share prices based on incorrect signals. However, once the true value of the companies is revealed, investors may experience disappointment and drawbacks due to taxed dividends. This could lead to selling of shares and wasted capital used for dividends, highlighting poor company value. (Allen, Bernard, and Welch 2000, 2509).

If there are no agency problems, the stated condition will remain valid. However, the introduction of such problems may lead to the manipulation of free cash flow due to the varying preferences of shareholders and managers.

According to Jensen-Neckline, a company using internal equities instead of external equities results in a situation where inside shareholders dominate ownership, leading to reduced agency cost as the insiders' interests are better aligned with those of the company (Kink 2001, 82). Conversely, with external shareholders dominating ownership, monitoring costs for shareholders increase as they need to monitor managers for potential conflicts of interest (Malawi, Rafter, and Pillar 2010, 190).