Dividend Decision Policy Assignment Help




The Dividend Decision is a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company's stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay.

There are three main factors that may influence a firm's dividend decision:

  • Free-cash flow
  • Dividend clienteles
  • Information signalling

Free-Cash Flow

Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects.

Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision.

Formula(NPV)

Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

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where

  • t - the time of the cash flow
  • i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.)
  • Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t. For educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus) the investment.

The result of this formula if multiplied with the Annual Net cash in-flows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose.

Dividend Clienteles

A particular pattern of dividend payments may suit one type of stock holder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximise its stock price and minimise its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxation-based clienteles for certain types of dividend policies. key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxation-based clienteles for certain types of dividend policies.

Marginal

A marginal tax rate is the tax rate that applies to the last dollar of the tax base (taxable income or spending),[1] and is often applied to the change in one's tax obligation as income rises:

To calculate the marginal tax rate on an income tax

  • Let m be the marginal tax rate.
  • Let t be the tax liability
  • Let i be the taxable income.
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For an individual, it can be determined by increasing or decreasing the income earned or spent and calculating the change in taxes payable. An individual's tax bracket is the range of income for which a given marginal tax rate applies. The marginal tax rate may increase or decrease as income or consumption increases, although in most countries the tax rate is (in principle) progressive. In such cases, the average tax rate will be lower than the marginal tax rate: an individual may have a marginal tax rate of 45%, but pay average tax of half this amount. In a jurisdiction with a flat tax on earnings, every taxpayer pays the same percentage of income, regardless of income or consumption. Some proponents of this system propose to exempt a fixed amount of earnings (such as the first ten thousand dollars) from the flat tax. In a revenue neutral situation in jurisdictions with progressive taxation regimes, where imposition of a "flat tax" would target neither an increase nor decrease in the total tax revenue, the net effect of the flat tax would be to shift a significant portion of the tax burden from wealthier tax brackets to less wealthy tax brackets.

In economics, marginal tax rates are important because they are one of the factors that determine incentives to increase income; at higher marginal tax rates, some argue, the individual has less incentive to earn more. This is the foundation of the Laffer curve, which claims taxable income decreasing as a function of marginal tax rate, and therefore tax revenue begins to decrease after a certain point. Public discussion of "high taxes" may refer to overall tax rates or marginal taxes. Marginal tax rates may be published explicitly, together with the corresponding tax brackets, but they can also be derived from published tax tables showing the tax for each income. It may be calculated noting how tax changes with changes in pre-tax income, rather than with taxable income. Marginal tax rates do not fully describe the impact of taxation. A flat rate poll tax has a marginal rate of zero, while a discontinuity in tax paid can lead to positively or negatively infinite marginal rates at particular points.

Information signalling

A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm's future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends.

When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information that may provide a clue as to the firm's future prospects. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm's ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.


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