Introduction
In financial management, the finance managers primarily make several kinds of decisions including investment decisions, financing decisions, routine decisions and dividend decisions. For this case, the paper focusses on dividend decisions. The paper shall evaluate the theoretical framework and empirical evidence that examines the relationship between the firm’s dividend policy and its market share price.
Quantitative business analytics refers to application of mathematics and statistics to solve business problem. From the definition, it means that one to define the business problem to solve first then apply the relevant techniques. In this case, the paper hopes to understand the relationship between share prices and their movement and the firm’s dividend policy. Share movement is quantitative in nature. Therefore, it is strongly founded in quantitative business analytics context. Therefore, the paper will examine this relationship using predictive modelling thus deploying regression analysis, correlation analysis and one way ANOVA. Since the problem is in business, quantitative business analytics will be facilitative in that it is used to understand the relationship by giving an output which is interpreted in a business context. Therefore, this allows the thesis statement to explore on the relationship between share prices and their movement and the firm divide policy to enhance the foundation of the thesis as opposed to detailing the particulars of the quantitative tools to be used since the paper does not hope to develop new concept in quantitative tools but apply existing quantitative tool to understand a phenomenon.
Discussion
Theoretical Framework
The Bird-in-the-Hand Theory
According to Gordon (102-10) and Lintner (243-69), shareholders prefer to receive dividend payment as opposed to waiting for capital gain that will be realized in the future since the shareholders are risk averse. Therefore, the shareholders view dividends as certain compared to the uncertain capital gain. These are founded on the statement "a bird in the hand is worth more than two in the bush" where the bird in the hand is dividend payment while the bush is the market which will determine the value of future capital gain which in this case is the two birds. The implication of this theory is that the shareholders will be discounting the dividend paid at a lower return of rate, due to the level of certainty, thus a higher net present value (Frankfurter, Bob and James 74-81). As such, this will translate to a higher value. In effect, the shareholders will perceive the capital gain in future to be dissipating thus when discounted, the present value of capital gains will be much lesser, due to uncertainty, compared to the dividend hence preferring the higher valued dividends. These effects will have an effect on the share price market dynamics.
Signaling Hypothesis
Modigliani and Miller's proposition assumes that there is a perfect market thus all the information regarding the firm will be in the public domain. However, the level of transparency that is assumed by Modigliani and Miller cannot be achieved in reality. As such, it means that there will be a natural gap that will exist between the management of the firm and the investors since the management will, in most instances, have information regarding the firm that the investors will not have. Therefore, in an attempt to bridge the gap, the management will use the dividend policy as a tool to communicate the information. According to Pettit (993-1007), the dividend policy of the firm is an instrumental used in conveying the future prospects of the firm to the investors thus serving as a tool to convey private information. Therefore, if a firm is posting consistent growth in its dividend, it would be interpreted to means that the firm is expecting good prospects in the future while a firm that posts consistent decreasing dividend would mean that the future prospects of the firm are not favorable. When such information is relayed to the investors, this will affect the share price of the firm in the market according to the future prospects associated with the dividend policy.
Dividend Irrelevant Theory
The perfect market school of thoughts advanced the dividend irrelevant theory. Pioneered by the chief proponent Modigliani and Miller, the theory argues that the dividend policy of a firm does not affect the value of the firm nor does it affect the firm costs of capital. According to Miller and Modigliani (20), assuming perfect market and rational investors populate the market, the value of the firm is dependent on investment opportunities and not the dividend policy that the firm will adopt. In such a case, even if the organization chooses to pay out all the earnings that it has made in a year, the firm can easily raise any necessary capital markets since the costs that will be associated with the required capital is the same whether the capital is sourced internally or externally (Sethi 41-61). Moreover, the theory argues that that the process of trading is frictionless thus the investor can freely invest their funds or liquidate their investment without incurring any costs. Upholding this assumption of frictionless trading, the immediate effect based on the Modigliani and Miller proposition is that the firms that have low share liquidity will pay higher dividends compared to the shares that have more liquid shares. In a follow-up study on this proposition, Ghosh and Subrata (12) found that there is a strong relationship between the share liquidity and the dividend policy. The study cited that the shareholders were indifferent with regard to the dividend policy of the firm since the dividend policy did not have any effect on the shareholder’s wealth thus there was no motive to hold on to a share (Ghosh and Subrata 12).
Residual Theory
The imperfect market school of thought advanced this theory. According to this theory, an organization will only pay dividends if it has exhausted if it has exhausted all internal investments that are available to the firm Sharan 322). The theory insists that even if the opportunities that are available to the firm require an amount that the firm does not have, the firm should make arrangements to ensure that it acquires the funds in order to invest in these opportunities (Sharan 322). It would follow that the theory argues that if there was no remaining cash flow to pay a dividend, the firm should not declare dividends (Sharan 322). Essentially, the residual theory advocates the views that that the dividend must be the residual after all the investment have been made. Consequently, it is clear that the shareholder is assumed to prefer capital gain as opposed to receiving a dividend return. According to Weston and Brigham (29-50), an investor is deemed to prefer the firm to withhold the earnings and reinvest them if the firm will gain a high required rate of return compared to the required rate of return when the shareholders invest the dividend in an equally risky venture as the one the firm has reinvested the retained earnings. In addition, the theory further postulates that the retained earnings are the preferred source of funding projects for any company. Considering the position advanced by the residual theory, it is clear that the theory stipulates that the dividend policy decision is a passive decision (Sharan 322). The theory is highly inclined to investment rationalism since the internal funding is the cheapest source of finance that a company can utilize. In addition, when the shareholder stand to gain a better return when the firm invests on their behalf, logically, it is only prudent for the shareholder to let the firm invest since the shareholder will have a higher value. Moreover, the theory is supported by the existence of taxes that are in favor of capital gain and payout costs thus making the dividend payout less attractive. This situation enables the firm to have sufficient levels of reserves thus the firm should have a consistent performance irrespective of whether the season is a boom of gloom (Sharan 341). The reserves that are made in higher profitability period will be compensating low reserves in gloom season hence the consistency.
Clientele Effects of Dividends Theories
Investors have varied needs. As such, an investor will prefer to invest in a share that will be contributing to the shareholder’s ability to satisfy their unique needs. Through this needs, the investors will carefully consider the dividend policy of the firm thus aligning their investment with firms that have dividend policies that are in line with their needs (Brigham and Michael 557-580). Therefore, for an investor that favors appreciation of the value of the share, such an investor will be attracted to a firm that has a low payout ratio since the increase in the firm accumulated reserves will enable the firm to fund its growth without incurring excessive costs of capital (Brigham and Michael 557-580). On the other hand, for an investor that prefers the dividends, the firm will be seeking firms that are inclined to pay high dividends. Clientele Effects of Dividends Theories stipulates that each client is as good as the other. Therefore, the effect on the prices will be seen as the firm changes it dividend policies. If a firm is a growth oriented thus attracting a clientele that favors capital gains, in case the firm switches to pro-dividend, the firm will be discouraging investment from the investors that prefer capital gains. The interplay as the pro-dividend acquires shares that have been sold off by the pro-capital gain investor will be driving the share prices movement in the capital markets. The pro-dividend and pro capital gains are highly influenced by the varied taxation that various shareholders are exposed and the costs involved in trading the shares. Naturally, if the tax put the shareholders at a disadvantage in relation to capital gains, it is only logical that such an investor will tend to prefer shares that pay a dividend in order to minimize the tax effect that the investor will bear. On the other hand, if an investor will incur prohibitive trading costs, the investor will be driven to prefer keeping the shares regardless of the dividend policies.
Agency Cost and Free Cash Flow Theory
Agency costs refer to the cost due to the conflicts that will emerge from the agency relationship (Megginson and Scott 868-890). In this case, the focus of the agency relationship is between the management and the shareholders. As such, agency conflict will arise when the management chooses to pursue goals that are not in line with the desires and objectives of the shareholders (Megginson and Scott 868-890). According to Modigliani and Miller, the agency relationship is expected to be a perfect agency relationship meaning that there are no conflicts that may arise. Nonetheless, this is not always the case. The agency costs are primarily borne by the shareholders. Consequently, it follows that when a firm has frequent conflicts in the agency relationship, it follows that the shareholders will be demanding higher dividends. As a result, the firm will use the firm free cash flow to pay out the higher dividends thus limiting the extent to which the management can execute initiatives that are not in line with the shareholders goals (Megginson and Scott 868-890). The situation exposes the firm to the high costs of capital since the firm will be compelled to use external funding as opposed to internal funding due to the high dividend payout expected by the company thus depleting the firm free cash flows. In this way, the value of the firm will be affected thus affecting the market price of the share negatively as the firm will be edging towards an unstainable cost of capital.
Empirical Overview
Numerous studies have been carried out in relation to the effect of dividend policy on the share prices and volatilities. Baker and Smith (115-26) examined 309 industry matched firms. From his analysis, he observed that firms that subscribed to the residual theory are larger, have a low leverage ratio, and are profitable compared to the firms that do not subscribe to the residual theory of dividend policy.
Allen and Michaely (337-429) examined signaling models that are used to understand the price movement as influenced by the respective firm dividend policies. According to their study, they found that signaling models can be used primarily to make two form of prediction. First, the study observes that when an anticipated change in dividend policy is experienced, the share prices are expected to move in the direction of the change in the dividend policy. Second, the model dictates that a change in dividend must be followed by a change in earning which are in the same direction.
According to Bhattacharya (259-270) study, dividends were found to have an effect on the free cash flow of the firm. The study empirically confirmed that a high dividend payout will negatively affect the firm’s free cash flow. Consequently, the firm will result in external funding to take advantage of all the investment available to the firm leading to a high gearing ratio. The high gearing ratio will increase the financing burden the firm carries thus increasing the possibility of corporate failure.
According to Salih (2010), there is a relationship between the firm’s dividend policy and the firm share price. According to this study, the firm market share value is in line with the Gordon model but inconsistent with the Miller and Modigliani proposition on dividend irreverence.
In a follow-up study on Malkawi’s study (44-70), Alnajjar’s study (182-197) study observed that there is a strong relationship between the firm dividend policy and the firm’s size, profitability and growth opportunities. However, there is a negative relationship between the firm dividend policy and the firm’s ownership structure, risk and leverage of the firm. As such, the positive relationship will influence the share price positively while the negative will affect the market share price negatively.
Conclusion
The paper has outlined the relevant theories that focus on the relationship between the company share prices and its dividend policy. In addition, the paper has sampled some of the empirical studies that have focused on the relationship between the share prices and the firm’s dividend policies. Also, since the effect on share price will involve changes in share prices, it is also true that these changes will affect the movement of the price thus they can be used to understand the volatility of the share.
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