Priya & Mohnasundari, Apeejay- Journal of Management Sciences and Technology, 3 (3), June - 2016

ISSN -2347-5005

Dividend Policy and Its Impact on Firm Value: A

Review of Theories and Empirical Evidence
Dr. P. Vidhya Priya
Associate Professor
Department of Management Studies,
Kongu Engineering College,
Perundurai, India
Dr. M. Mohanasundari
Assistant Professor
Department of Management Studies,
Kongu Engineering College,
Perundurai, India
monasobee@gmail.com

Abstract: The Empirical and theoretical research on dividend policy has produced an extensive volume of
literature.The research are categorized into two different schools of thought, the first is that dividend policy of a
firm has an impact on its value and the second is that dividend policy of the firm has no impact on firm value.
Even after several years of research no consensus has emerged, and scholars do not even agree upon with the
same empirical evidence. This study provides with a complete understanding of dividends and dividend policy by
reviewing the theories and their explanations of dividend policy including both dividend relevance and
irrelevance theory of Miller and Modigliani, tax-preference,bird-in-the-hand, clientele effects, signaling and
agency costs hypotheses. This study also attempts to present the important empirical studies on corporate
dividend policy. However, due to the continuing nature and extensive array of the debate about dividend policy
which has hatched a vast amount of literature that grows by the day, a full-fledged review of all debates is not
feasible.
Key Words: dividend, dividend policy, review, theories

I. INTRODUCTION
The prime objective of financial management in organizations is to maximize its value to the owners and
the shareholders. Though this is challenged by many researchers, the value here often understood to be
reflected in the company’s share price. According to Barman if dividends are the key indicator of share
price and then share price is the key indicator of firm value,so as to maximize shareholders wealth, the
company should adopt a dividend policy that will increase the share price [1]. When a company makes
profits, it can either decide to retain the profits for investments in new projects or pay out to the
shareholders as dividends.

Dividend policy refers to the set of rules or norms that a company follows to decide how much of its
profit it will pay out to shareholders. However, the choice of paying dividends is ultimately decided by
the board of directors of the company, and once dividends have been declared, it becomes a debt to the
firm and cannot be overturned easily [2]. There are various forms and ways in which dividends can be

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paid; a company may decide to pay dividends in the form of cash once or twice in a year or declare bonus
shares. According to Erasmus, from an investor’s perspective, it is not only the level of dividend payment
that may be imperative, but also the stability of dividend payments for a considerable period [3]. Thus,
management should be cognizant of the fact that unanticipated changes in dividend payments could
alienate existing and potential investors [3]. Unstable dividend policy may have an adverse investors’
perception of the company performance in the financial markets.

This paper intends to provide an understanding of dividend policy by reviewing the existing theories on
dividend policy and their empirical findings. Furthermore, the paper examines the empirical studies
carried out by investigating the relationship between dividend policy and firm value as measured by its
share price and company performance.

II. THEORIES ON DIVIDEND POLICY

A. Introduction
When it comes to dividend theories, there are two foremost schools of thought, the first is that dividends
have an impact on firm value and the second is that dividends do not have an impact on firm value. This
section presents a review of existing theories on dividend policy and their empirical evidence. The
theories on dividend policy are divided into two groups main that include dividends relevant theories and
dividends irrelevant theories. It was seen that the beginning of dividend policy as important to investors
was, to some extent, determined by the evolving state of financial markets. Investing in shares was
initially seen as comparable to bonds, so consistency of dividend payments was important. It was also
seen that in the absence of regular and precise corporate reporting, dividends were often preferred to
retained earnings, and often even observed as a better sign of corporate performance than published
earnings accounts. However, as financial markets developed and became more efficient, it was thought by
some researchers and academicians that dividend policy would become increasingly irrelevant to
investors. Dividend policy remaining evidently important for researchers has been a theoretically
controversial.

Three main opposing theories of dividends can be acknowledged. Some argue that increasing dividend
payments increases a firm’s value. Another view claims that high dividend payouts have the opposite
impact on a firm’s value; means, it reduces the firm value. The third theoretical approach emphasizes that
dividends should be irrelevant and all effort spent on the dividend decision is wasted. These views are
incarnated in three theories of dividend policy: high dividends increase the share price theory (‘bird-in-

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the- hand’ argument), low dividends increase share price theory (argument of the tax-preference), and the
dividend irrelevance hypothesis. Dividend debate is not narrowed to these three approaches. Several other
theories of dividend policies have been existing, which further intensifies the complexity of the dividend
puzzle. Some of the very popular of this dividend policy theory include the information content of
dividends (signaling), the clientele effects, and the agency cost hypotheses.

i. Dividends irrelevant theories

a. The Miller and Modigliani (M-M) model: Erstwhile to the publication of the influential paper by Miller
and Modigliani, it was extensively accepted that the more dividends a firm pays, the greater the value of a
firms [4]. According to Allen and Michaely , this is resulting from the extension of the discounted
dividends approach to firm value [5]. Theory states that the value of the firm (VO) at date 0, if the first
expected dividends are paid after a year, can be calculated as follows:

Where, Dt is the dividends paid by the firm at the end of period t

r1= the required rate of return
Gordon [6] as cited by Allen and Michealy [5], has claimed that the investors’ required rate of return r1
would increase as a result of increased retained earnings. Gordon felt that higher r1 would dwarf this
effect although future dividend stream would probably be higher as a result of the increase in investment
(i.e., Dt would grow faster) [6]. The reason for the increase in r1 would be higher uncertainty concerning
cash flows due to the delaying of the dividend stream.

The M-M model (1959) disagreed with this relevance dividend theory view and pointed out a rigorous
framework for analyzing dividend policy [4]. Miller and Modigliani investigated the impact of dividend
policy on share price of the firm [7]. They exhibited that given a perfect capital market; a firm’s dividend
policy will not impact the firm’s value. The basic idea underlying their argument is that firm value is
determined by firm its present and future cash flows (i.e. a firm’s capital investment decisions). M-M
(1961) showed that shareholder wealth is not affected by the dividend decision alone, and also argued that
the investors would naturally be indifferent to the choice between dividends and capital gains. M-M (1961)
further claimed that if investors needed income, they can essentially create their own homemade dividend
policy by selling their existing equity shares. As cited in Malkawi et al , M-M (1961) upheld that in their
perfect world, dividends are irrelevant. M-M (1961) pointed out that regardless of how the firm

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distributes its earnings; its value is basically determined by its earning power and its investment decisions
[8].

According to M-M (1961), the irrelevance dividend policy argument was based on two basic assumptions
i) Perfect capital market and ii) Rational investors. In the perfect capital market, all traders have equal and
perfect information about the current share price and all other relevant characteristic of shares. In this
perfect capital markets there are no transaction fees, breakage fees, taxes and other cost. Second, perfectly
rational investor’s preferences are indifferent as to whether a given increment to their wealth is in the
form of cash (dividend income) or gain in market price of the share (capital gains). Thirdly they base their
argument on the idea of perfect certainty, which indicates complete assurance on the part of every
investor as to future investment decisions of the firm and the future profits of every corporation. Because
of this assurance, there is no need to distinguish between equity share and debenture as a source of
finance [7].

According to the MM Hypothesis of dividend irrelevance, “the value of a firm is basically determined by
the firm’s investment and financing decisions. Dividend decision has no role in increasing or decreasing
the value of the firm” [1]. The conclusion of this theory is that management should not burden itself much
about dividend policy when it comes to firm value, as the decision of whether to pay or not pay dividends,
has no impact on the value of the firm.

Empirical evidence of the M-M model: The M-M hypothesis is based on a perfect capital market
assumption. In reality, markets are imperfect. Soothing the assumption of a perfect market, Black and
Scholes investigates to see whether dividend policies are relevant and have an impact on increasing or
decreasing firm value [9]. Black and Scholes instituted a portfolio of 25 common stock listed on the New
York Stock Exchange (NYSE) to investigate the relationship between dividend yields and stock returns
[9]. The underlying model used was the Capital Asset Pricing Model. After the 25 portfolios were
constructed, five years of past data was used to estimate the standard deviation beta (β) and dividend yield
was calculated for all the stocks that had at least five years of past data.

In reckoning the dividend yield of a security, Black and Scholes model used dividend paid to the
shareholders in the previous five years, and the market price at the end of every year for the same five
years. The securities were ordered on estimated yield from maximum to minimum, and separated into five
groups. The result of the model did not prove that differences in dividend yield lead to differences in
stock returns. Thus it looked like the dividend policy have no impact on the stock prices [9]. Black and

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Scholes results are consistent with the dividend irrelevance theory which states that dividend policy has
no impact on the firm value.Over years of researches, four main theories of dividends relevancy have
been existing: The bird-in-hand hypothesis, signaling theory,tax preference and agency cost theory.

b. Bird in Hand Theory: Myron Goldon and John Lintner developed the bird in the hand theory [10].
They argue that there is a relationship between dividend payout and the firm’s value. Since investors
value capital gains as risker than dividend, firms have to have a higher dividend payout ratio tomaximize
the share price. In other words, high dividend payout upsurges the stock price [11].
The fact of the matter is the risk of a firm is determined by the risk of its cash flows generated by its
investments, which cannot be changed by dividend policy; therefore, the bird in hand explanation may not
hold factual. In other words, the risk of a firm cannot be reduced by an increase in the dividend payments
[12]. Generally, the bird in hand justification for dividend significance is rejected by most of the financial
economics literatures.

Empirical evidence of the Lintner Model: In contour with Lintner’s study a research was carried out by
[13]. The study investigated the corporate managers of NASDAQ firms that regularly pay cash dividends
to determine their insights on dividend policy and the relationship between dividend policy and firm value
to observe how they view dividend policy. The sample size was 188 firms. The main result of the survey
indicated that NASDAQ managers believed that dividend policy affects firm value as reflected in shares
price, and concluded as dividend policy matters [13]. Further findings point out that more than 90 percent
of managers agreed that a firm should dodge increasing its regular dividend if it expects to reverse the
dividend decision in a year or so. The firms should attempt to maintain stable dividend payment.

Furthermore, the Baker et al, revealed that the majority of managers thought that the market places
greater value on stable dividends than stable pay-out ratios. More than 60 percent agreed that the firm
should set a target dividend pay-out ratio and periodically adjust its current pay-out toward the target. All
these findings are in line with Lintner’s (1956) behavioral description of the dividend setting process [10].

Further findings reveal that 90 percent of managers agreed with the statement that an optimum dividend
policy strikes a balance between present dividends and capital gains that maximizes the share price. More
than 80 percent of managers agreed that a firm should articulate its dividend policy to produce maximum
value for its shareholders and 65 percent agreed that a change in a firm’s cash dividend will have an
impact on its value. Based on this evidence Baker et al concluded that managers generally perceive that
firms today set dividend payments in line with that put forth by Lintner.

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c. Signaling Hypothesis: Signaling Hypothesis argues that there is an existence of asymmetric

information between managers and shareholders. Modigliani Miller Hypothesis assumed that in a firm,
information is available for insiders and outsiders are same; but managers may have information pertinent
to the value of the firm which outside investors do not have (Robinson, 2006) [11]. This information gap
illuminates the way managers use dividend declaration as a signal which expresses valuable information
about future performance of the firm to investors. signaling hypothesis argues that the shareholders may
construe an increase in dividend payment as a signal of future profitability; hence in a positive reaction,
the share price will rise and vice versa. [14]. Signaling hypothesis of dividend policy is supported and
cited by many researchers such as Bhattacharya [12] and Miller and Rock [15].

Empirical evidence of the signaling theory: Kaestner and Liu [16]examine the information content of
dividend announcements and found strong support for the cash-flow signaling hypothesis. They pointed
out that on average the stock price response is positively and significantly related to the size of dividend
payment. They further infer that the market perceive dividend payments as a significant source of
information about the performance of the firm.

DeAngelo et al [17] analyzed the signaling theory of dividends. In order to evaluate the empirical
significance of dividend signaling, they investigated the signaling content of dividend decisions made by
managers of 145 firms listed on the New York Stock Exchange (NYSE) whose annual earnings decreased
after nine or more consecutive years of growth. In their sample of 145 firms, 68.3% of managers
increased dividends in Year 0, which is the year that the firm’s earning started declining after a
consecutive years of growth in profit . They were not able to establish that the sample manager’s dividend
decision in the year of the earnings decline (year 0) is a useful signal of future earnings prospects.

According to DeAngelo et al, [18] there was no indication that Year 0 dividend increases are associated
with favorable future profit of the firm. They further showed that the evidence shows that there are three
other factors which explain the favorable dividend actions of the firms studied are not informative signals
about future earnings prospects. The three factors they identified are the overoptimistic approach of the
managers; secondly, very modest resource commitments by the firm and thirdly, to certain extent,
manager’s inefficiencies. On the whole their study offers almost no support of the signaling hypothesis.
DeAngelo et al, in their conclusion stated that they found that the dividend signaling is empirically
insignificant and they pose a difficult challenge to the opposite view that dividend signaling is a fairly
important determinant of corporate dividend policy [18].

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Benartzi et al [19] did a further research to examine the implications of dividend signaling. The study
investigated whether the changes in dividends have information content about future earnings. 1025
organizations listed New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) is the
constituent of their sample. They concluded that there is a strong lagged and contemporaneous correlation
between dividend changes and earnings (Dividend go up when there is an increase in earnings) from the
empirical data but they were unable to find much evidence of a positive relationship between dividends
earnings and future earnings changes.

d. Agency Costs and Free Cash Flow Hypothesis: Modigliani and Miller approach assumes that there is
no conflict between managers and shareholders [7]. However, in reality, this assumption may not hold
true since managers’ interest and the shareholders interest are not exactly the same. Therefore, the
shareholders may incur agency cost, causing potential conflict between manager and shareholder. The
agency costs theory put forward that increasing dividends is one way of decreasing the agency costs. By
paying more dividends the level of reserves and surplus will reduce and firms have to search for fund
from external financing. The agency cost elucidation for dividends has been reinforced by previous
empirical studies [20]. Furthermore, Easterbrook stated that higher dividends will reduce the available
free cash flow for managers; managers will be entrusted with the job of raising funds from external
sources. Shareholders can prevent managers from acting in self-interest besides monitoring them at low
cost [21].

Empirical evidence of the agency theory: La Porta et al [22] in his research investigated agency cost
hypothesis. They studies 4103 companies from 33 countries around the world. These countries are
grouped into two, based on legal protection provided to minority shareholders as countries that provide
good legal protection for minority shareholders and countries where shareholders had poor or no legal
protection. The authors then used cross-sectional analysis for these two groups to study the agency
approach to dividend policy. Two models are used to analyze the influence of investor protection on
dividends payout; one being outcome model and the other is the substitute model. According to the first
model, dividends are an outcome of the strong and effective legal protection available in that country to
the shareholders, which helps minority shareholders to receive dividends from corporate insiders. In the
second model, they pointed out that dividends are a substitute for effective legal protection, which enables
firms in low or unprotected legal environments to establish a reputation of following healthier dividend
policy among the investors. The author’s findings are in line with and also in support of the agency cost
hypothesis. La Porta et al concluded that agency approach is highly significant in understanding of
corporate dividend policy world over [22].

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Rozeff study also offers empirical evidence of the agency cost hypothesis. 1000 firms from 64 different
industries were taken as samples for this study [20]. This paper justifies an optimal dividend payout by
engaging to two market imperfections, agency costs and the transaction cost associated with issuing
external finance. He presented the cost minimization model which aims at finding out if dividend payout
ratios are consistently related in the predicted direction to variables which are proxy for agency cost and
transaction costs of external financing. His findings are in line with the hypothesis that outsiders demand
a higher payout if they own a higher fraction of the common equity than if their ownership is more
dispersed. In Addition to this, he argued that increased dividend payout lower agency costs but is sure to
raise the transaction of external financing [20].

e. Tax-Effect Hypothesis [23]: The Modigliani Miller Hypothesis assumes that dividends and capital
gains have no difference with respect to taxes. However, in practice, taxes may have influence on
dividend payments and more importantly, on the value of a firm. The tax preference hypothesis advocates
a low level of dividend payouts is desirable so as to maximize the value for shareholders. This argument
is based on the dividends are taxed at a higher rate and that too immediately when compared to capital
gains, which are postponed until the stock is sold. The advantages of tax for capital gains motivate
investors to prefer firms that retain their earnings rather than pay dividends. As a result, a low level of
dividends will raise the stock price.

Empirical evidence the Tax Factor (Clientele effect): Y-T Lee et al [24]did a comprehensive study to
analyze the tax induced clientele effect. Their study was based on companies listed in Taiwan stock
exchange where capital gains tax is zero and share repurchase was prohibited until 2000. They found
solid evidence of clientele effect. In analyzing investors’ reaction to dividend changes, they pointed out
that institutions as a group display an insignificant response to dividends changes, however individual
investors appear to respond in the direction predicted by the clientele hypothesis. High net worth
individuals (who are in higher tax bracket) reduces their net buying after dividends increase and increase
their net buying after dividends decrease, while less wealthy individuals do the opposite.

Overall the Y-T lee et al study provides proof that Taiwanese shareholders arrange themselves into
dividend clientele, whereby highly taxed individuals tend to hold stocks in firms that pay low or zero
dividends and they trade shares of the firms that increase dividend payout. On the other hand individuals
and institutions who fall under lower tax brackets tend to hold stocks of the firms that pay high dividends
[24]. Furthermore, when Taiwan legalized share repurchase, they found that firms with higher

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concentration of highly taxed high net worth shareholders engaged in share repurchases. The authors
pointed out that tendency to engage in activities like repurchase are significantly related to the proportion
of a firm’s shareholders in higher tax brackets” [24].

Divergent to Y-T Lee et al provided a strong empirical evidence on tax induced clientele effect, Lasfer
[25], Hotchkiss and Lawrence [26] in their research could not find such a strong evidence between
dividends and tax. Lasfer’s investigation shows that companies frame their dividend policies to reduce
their tax liability and to optimize their after tax return of their shareholders. Lasfer [26] concluded that
there was no strong evidence of a tax-induced dividend effect. On the other hand Hotchkiss and Lawrence
[26] state that their results contradict with literatures which concludes that tax based dividend clienteles
are not important, based on the fact that dividend changes do not amount to enormous changes in total
institutional ownership (See also Michaely, Thaler and Womack, 1995 [27]; Binay, 2001 [28]; Grinstein
and Michaely, 2002 [29]).

III. CONCLUSION

This study reviewed the existing theories on dividend policy and their empirical findings. From the
reviewed literature, it can be established that dividend policy theories have divergent relevance between
management and the shareholders arising from opposing interests. Management is primarily focused on
the objective growth of the organization while the shareholders are focused on the shareholders wealth in
terms of share price that determine their return on investment. The empirical studies reviewed show a
positive relationship between dividends payout and firm value. Although abundant theories and empirical
evidence have attempted to illuminate why dividends are paid, their results are still inconclusive. This
study conclude with statement “the harder we try to understand the dividend decisions by firm , the more
it seems like a puzzle, with pieces that just do not fit together”

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