Dividend policy theories (By Munene Laiboni)
1. Introduction:
Dividend policy theories are propositions put in place to explain the rationale and major arguments relating to payment of dividends by firms. Firms are often torn in between paying dividends or reinvesting their profits on the business. Even those firms which pay dividends do not appear to have a stationary formula of determining the dividend payout ratio. Dividends are periodic payments to holders of equity which together with capital gains are the returns for investing in a firm’s stock. The prospect of earning periodic dividends and sustained capital appreciation are therefore the main drivers of investors’ decisions to invest in equity. In this paper, we explore various theories which have been postulated to explain dividend payment behavior of firms.
Major Schools of thought:
At the heart of the dividend policy theories discussion are two opposing schools of thought: One side holds that whether firms pay dividends or not is irrelevant in determining the stock price and hence the market value of the firm and ultimately its weighted cost of capital. In retrospect, the opposing side holds that firms which pay periodic dividends eventually tend to have higher stock prices, market values and cheaper WACCs. The existence of these two opposing sides has spawned vast amounts of empirical and theoretical research.
Scholars on both sides of the divide appear relentless on showcasing the case for their arguments. Several decades since interest in the area was sparked off by Modigliani and Miller (1961), no general consensus has emerged and scholars can often disagree even on the same empirical evidence! The arguments about dividend policy theory are so discordant in modern day research, that at least there is consensus with Black (1976)’s famous words who defined dividend policy as a puzzle: “the harder we