The basic theories of dividend policy

THE BASIC THEORIES OF DIVIDEND POLICY

The article examines the main theories of dividend policy of joint stock companies, their content, the main constraints. The behavior of investors, their expectations with regards to dividend payments and receipt of future income are described.

The financial managers must remember that the company's goal is to achieve maximum shareholder value, deciding on the amount of funds to be distributed among the shareholders. Various theoretical studies examine the formation of the optimal dividend policy. There are three leading theories of investor behavior depending on the amount of the dividend:

• 1)    the dividend irrelevance theory, according to which conducted by the company policy on optimization of the proportions between consumption and profit capitalization has no influence on the share price, or the cost of assets of the company. Main developments in the framework of this theory were made in 1961 by Franco Modigliani and Merton Miller. They put forward the idea that the so-called "clientele effect", according to which, the shareholders increasingly prefer the stability of dividend policy than receiving any significant irregular income. Scientists also claimed that a firm's value depends only on the profits which made by its assets, not how the profit the company will distribute between dividend and reinvestment (1, С. 149).

His theory of F. Modigliani and M. Miller was accompanied by a significant number of restrictions: no taxes on legal and physical persons, there are no costs of issue and transaction costs; the investment policy of the corporation is independent of the dividend; investors and managers have identical information about future prospects. Limitations of data scientists are unrealistic and cannot be met in practice (2, С. 3).

• 2)    the theory of preference dividends (or "bird in the hand"): the main conclusion of the previous theory that dividend policy does not affect the value of the company.

Michael Gordon and John Lintner argue that dividend policy has a direct impact on the total wealth of the shareholders. The main argument held by the founder of the theory of M. Gordon, is that investors (based on the principle of risk minimization) always prefer current dividends to possible future gains in the market value of the shares. The theory based on the idea of maximization of dividend payments rather than capitalization of earnings. In addition, current dividend payments reduce the level of uncertainty investors in regards to the profitability of investing. Thus they are satisfied with a smaller rate of return on invested capital, which leads to an increase in the market value of equity. On the contrary, if the dividend is not paid, the uncertainty increases, which leads to lower market valuation of equity.

• 3)    the theory of minimization of dividends (or the "tax preference theory") is developed by N. Litzenberger and K. Ramaswamy. According the theory the effectiveness of dividend policy is determined by the possibility of minimizing tax payments for the current and upcoming payments to the owners. Due to the fact that in the West, the taxation of dividends generally higher than future income (including tax rates, factor current value of money), the preferred capitalization of dividends. However, such a policy may not suit many small shareholders who need current payments.

So, all three listed approaches to the problem of formulating the dividend policy provide managers with conflicting recommendations. And even a lot of the conducted research are unable to provide definitive results, what policy to choose, because it's impossible to find a group of joint-stock companies, which would differ only to the dividend policy. Moreover, it should be noted, that investors, in turn, prefer firms with stable, predictable activities in the field of payment of income to shareholders. But they have varying degrees prefer higher or lower dividends, and their view on the long term of the company is different.

These theories are interrelated and are to provide:

• 1)    maximize total wealth of shareholders;

• 2)    appropriate financing of current and investment activities of the corporation.