Joanna Woronko 23316, WSB Gdansk Advanced Corporate Finance “The dividend decision is unimportant to the well-being of a company.” Discuss. Once a year many financial managers and owners of corporations meet with a hard nut to crack. They have to decide what part of the earned net profit could be spend on dividends and what part on financing and investments that bring about growth of the company. On the one hand high dividends may be often a sign for shareholders of financial soundness of the company, it can cause a potential growth in the future and positively affect the price of shares on the stock exchange. It can be called a signal effect. Dividend increase sends a good news about cash flow and earnings while dividend decrease sends bad news for investors. On the other hand inappropriate dividend decisions may force a company to take a borrowing decision and in a consequence bring some extra costs of debt. All in all owners have to find a point of balance between dividends and retaining profits. However as Fisher Black wrote twenty years ago: ”The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don't fit together”. Why dividend policy is in fact so complicated? All theories of dividend policy that arose over the years speculate around two main directions: relevance and irrelevance of dividend policy. Is dividend policy a crucial factor in formation of corporate value? If so, how dividend policy affects the market value of the firm? What happens to the value of the firm if dividend increases or if stays constant? To understand better dividend policy would be even worth to explain what the phrases means. Dividend could be defined as a distribution of value to shareholders. Dividend policy concerns mainly the decision: to pay cash dividend now or to pay an increased dividend at a later stage. The dividend could be even paid in a form of stock which don not give investors liquidity but bring capital profits. In very simple words dividend policy is a trade- off between retaining earnings on the one hand and paying out cash dividend and issuing new shares on the other. (Brealey, Meyers, 2003:439) There would be no problem with the dividend decision if we lived in an ideally simple world with perfect marketplace as Modigliani and Miller assumed in 1961 in their theory of dividend irrelevance. In a perfect capital market there is no taxes, no transactions costs, no flotation costs. Informations are also free of costs and widely available for investors which behave rationally. Modigani and Miller controlled and compared the value of the firm when dividends are paid and are not paid. Based on the conditions above and elaborated model they proved that there is no matter for shareholder if they get the profit from dividend or from the growth of share price. According to their model dividend policy pursued by the company does not have any impact on either the cost of equity or the market value of the shares. Dividend irrelevance theory presented by Modigani and Miller is one of the fundamental theories but also one of the most controversial because of totally unrealistic assumptions. (Bernstein, Fabozzi, 1998:10) As a response to M&M theory a number of conflicting theoretical models have been determined. One of the counterpoint was developed by Myron Gordon and John Lintner. It is called “Bird in the hand fallacy”. According to Gordon and Lintner a decrease of dividends paid to shareholders leads to an increase of the cost of capital of company. Based on the adage that a bird in the hand is worth two in the bush, their theory states that investors prefer the certainty of expected dividend payments rather than the possibility of substantially higher future capital gains. There is nothing surprising in that because dividend payment is much less risky. Moreover their theory suggests that whole earnings generated by the company should be spend on paying dividends while funds for investments may be created by an issuance of new shares. This may be a reason why investors observe and chose mainly those firms which pay regular dividend. As a result it can be considered that dividend decision is relevant for overall value of the company because it affects the market value of shares. The phenomenon is called in later studies the Clientele Effect. Through the demand for the dividend paying stock prices of the stock are growing up and in the same time the value of the firm is increasing. Owing to this fact the hypothesis in the topic is hardly accepted. Last but not least theory which confirms the influence of dividend policy for well-being of company is theory about tax consequences created by H. Litzenberger and K. Ramaswamy. Their theory is based on the difference between the level of tax rate on capital gains and dividend income. It is said that investors because of such difference would like a firm to retain earnings rather than spend them on dividends. Investors are even more willing to pay more for shares of the company which decides to pay lower dividend and hold the rest of earning rather than shares of company with a high dividend payout. It is recommended in this case to pay dividend as low as possible. The theory was exemplified on the stock market in USA before 1986. When the rate of dividend tax was about 50% the tax of capital gains was only 20%. The distinction of 30% effectively discouraged investors from buying high pay- out shares.(Brealey, Meyers, 2003:451) Corporate dividend policy has been the subject of very intensive theoretical modeling and empirical examination. But in view of the above-mentioned theories and arguments it can not be defined if the dividend decision have an impact on the value of a company or not. It is even very hard to unambiguously determine whether the lower or higher dividend is better for a company but certainly financial managers and owners of the company have to take dividend decision into consideration in their management strategy. References: Bernstein, Peter L., Fabozzi, Frank J. (ed.) (1998) 'The dividend puzzle' In: Streetwise: The Best of the Journal of Portfolio Management, Princeton University Press. Brealey, Richard A., Myers, Stewart C., (2003). 'The dividend controversy' In: Principles of Corporate Finance. 7th edition. The McGraw-Hill Companies. Teorie i modele polityki dywidend [Online] Available: http://www.governica.com/ (3 Jan 2014)