Optimal Dividend Policy
There are a number of arguments supporting the other view that dividends are relevant as they do affect the value of the equity share. If, therefore, dividends are more than just a means of distributing unused profits, dividends policy becomes more than a positive variable determined solely by investment opportunities. The firm could affect shareholder’s wealth by carrying its dividend payout ratio, because the investor is not indifferent between current dividends and capital gains expected out of retained earnings. As a result, there can be optimal dividend policy.
The possible causes of shareholder preference for current dividends may be (a) resolution of uncertainty and risk, (b) informational content of uncertainty and risk, (b) informational content of dividends (c) desire for current income, and (d) transaction, costs. According to Myron J. Gordon, investors do not value equally current dividends and retention of earnings, with the present or future dividends, capital gains, or both. Not only that the present value of future streams of income would be less, but they also prefer the early resolution of uncertainly and risk associated with the future and are willing to pay a higher price for share that promise the greater current income. other things held constant. This argument is closely related to the information to content of dividends.” Because they communicate information to investors about the firm’s profitability. Ezra Solomon, therefore, contends that in an uncertain world dividends may offer tangible evidence of the firm’s ability to generate cash and ,as a result, the firm’s dividend affects share price as it speaks louder than a thousand words.” Another aspects of uncertainty question involves shareholders who have a preference for current dividends as we have seen earlier in this lesson. The argument that such investors as we have seen earlier in this lesson. The argument that such investors can sell part of their holding periodically to obtain current income does not hold good only because of the risk and uncertainty association of share prices. but also because the periodic sale of shares involve “inconvenience and transaction costs” is the form of brokerage fee; etc.
All these arguments supports the view that dividends is relevant, investors do prefer current income relative to the retention of earnings, and dividend policy does affect the shareholders wealth, According to this school of thought, dividends rather than retained earnings are the decision variables. Hence, an optimal dividend policy can be framed keeping all these facts in view. However, the capital budgeting theory of dividends (as financing decision, as explained by Walter’s formula. cannot be ignored for at least three reasons, namely, (i) cost of retained earning is lower than cost of equity-unless. of course, a firm can borrow low-cost debt despite raising the payout ratio; (ii) corporate savings are an important instrument of capital formulation and industrial growth and (iii) the differential tax effect on dividends and capital formulation and industrial growth and (iii) the differential tax effect on dividends and capital gains (low incidence of tax on capital gain) is quite strong for many shareholders and creates a preference for the retention of earnings in the firm.
To conclude, we can say that though empirical evidence on the relevance of dividends has been little more than suggestive, many companies behave as if dividends to matter and can affect shareholders wealth. As Lindsay and Sametz put it.” the only generalization about payout policy that seems quite safe to make is that a cut in absolute dividends is likely to depress the price of the stock it usually signals either a decline of earning power or the inability to borrow.”