Question

When an organization decides on a new financial policy and to pay a dividend they affect internal operations and signal to external parties.

Part I: What impact will different dividend payout levels have on an organizations capital structure? Explain and be specific.

Part II: When a company decides to pay a dividend what possible signaling might it be conveying to investors, creditors, and the industry competitors? Be specific and provide an example for each respective party.

Answer 1

Part 1: Impact of Dividend Payout on Capital Structure:

• The study found that dividend payout ratio, capital structure (leverage), company growth has a positive effect on firm value . Research on the effect of financial performance in this case Capital Structure on the value of the company shows inconsistent results.
• The firm's value is determined by earnings power from the company's assets. Positive results show that the higher earnings power, the more efficient the asset turnover and / or the higher dividend obtained by the company . This has an impact on increasing the value of the company. Research conducted by Ulupui found the results that dividend has a significant positive effect on stock returns in the next period. Therefore, dividend is one of the factors that influence the value of the company. The difference in the results of this study shows that there are other factors that also influence the ROE relationship with the company's value.
• Modigliani and Miller in DeAngelo et al. stated that on the irrelevance of dividends, a number of theories have been put forward for a perfect capital market. One important theory that has been widely researched in the literature and has received supporting evidence is agency theory.
• According to Jensen agency theory, dividend policy is determined by agency costs arising from ownership and control divergences. Because of agency costs, managers may not always adopt dividend policies that maximize shareholder values. Instead, they might choose dividend policies that maximize their own personal benefits.The empirical relationship between dividends and market values in the corporate valuation model developed by Olsen (1989) has been at the forefront of financial research over the past decade. Ross, found that dividends have a positive influence on company valuations in the UK. Giner and Rees in Ross , found that for the United States and Spain. The positive impact of dividends on company valuations can be attributed to the fact that managers' information signals about future profitability. A typical econometric approach for the study above is to use observation samples taken from many companies over a period of time, with estimates based on OLS techniques (where all years are considered identical). An implicit assumption made in this methodology is that the explanation of variables in the company's valuation model follows a stationary process. Research by Miller and Rock ,proposed that adjusting the signal of changes in future dividends in the future cash flows expected by the company, and in the value of the company. A number of studies have attempted to measure market response to changes in dividends.
• Capital structure affects the value of the company. The results of this study support the Signaling theory where companies that are experiencing rapid growth certainly become positive information for investors in investing. Companies that are experiencing growth are always being hunted by investors to invest their funds in the company so that ultimately the stock price increases and the value of the company will automatically increase. On the other hand, dividend policy with a relatively small value does not have a large impact on increasing the value of the company. The amount of dividends paid with a small value can no longer give a positive signal about the actual condition of the company so the dividend policy becomes less informative. Therefore, changes in dividend policy significantly influence changes in company value.

Part 2: If Company Pay Dividend:

• It has been recognized by various research studies that a dividend policy could make significant impact on corporate future value when established and carefully followed. The goal of wealth maximisation is widely accepted goal of the business as it reconciles the varied,often conflicting ,interest of the stakeholders. The interest in shareholders value is gaining momentum as a result of several recent developments: • The threat of corporate takeovers by those seeking undervalued, under managed assets • Impressive endorsements by corporate leaders who have adopted the approach • The growing recognition that traditional accounting measures such as EPS and ROI are not reliably linked to the value of the company’s shares • Reporting of returns to shareholders along with other measures of performance in business press. • A growing recognition that executives’ longterm compensation needs to be more closely tied to returns to shareholders. The “shareholders value approach” estimates the economic value of an investment (e.g shares of a company, strategies, mergers and acquisitions, capital expenditure) by discounting forecasted cash flows by the cost of capital. These cash flows, in turn, serve as the foundation for shareholder returns from dividends and share price appreciation. A going concern must strive to enhance its cash generating ability. The ability of a company to distribute cash to its various constituencies depends on its ability to generate cash from operating its business and on its ability to obtain any additional funds needed from external sources. Debt and equity financing are two basic external sources. Borrowing power and the market value of the shares both depend on a company’s cash generating ability. The market value of the shares directly impacts the second source of financing, that is, equity financing. For a given level of funds required, the higher the share price, the less dilution will be borne by current shareholders. Therefore, management’s financial power to deal effectively with corporate claimants also comes from increasing the value of the shares. This increase in value of shares can be brought about by rewarding shareholder with returns from dividends and capital gains. The most famous statement about the relationship between dividend policy and corporate value claimed that, in the presence of perfect markets, “given a firm's investment policy, the dividend payout policy it chooses to follow will affect neither the current price of its shares nor the total return to its shareholders” However, "market imperfections as differential tax rates, information asymmetries between insiders and outsiders, conflicts of Sujata Kapoor, JBS, JIIT,Dec’ 2009 9 interest between managers and shareholders, transaction costs, flotation costs, and irrational investor behavior might make the dividend decision relevant” The relevance of dividend policy to corporate value is due to market imperfections. Shareholders can receive the return on their investment either in the form of dividends or in the form of capital gains. Dividends constitute an almost immediate cash payment without requiring any selling of shares. On the contrary, capital gains or losses are defined as the difference between the sell and buy price of shares. Friction costs are one of the market imperfections and are further distinguished in transaction costs, floatation costs and taxes. Another market imperfection is that of information asymmetries between the insiders (e.g. managers) and the outsiders (e.g. investors). Agency conflicts, stemming from the different objectives of company's stakeholders, form the third market imperfection. Finally, there are some other issues that are related to dividend policy and cannot be placed among the previously mentioned imperfections.