Theory By Challenging The Hypothesis Finance Essay

Dividend policy involves finding of wage out policy that direction follows in finding the hard currency distributions to stockholders over clip ( Lease et al 2000 ) . The theoretical reappraisal underlying dividend payment on its impact on stockholder ‘s wealth can be illustrated in either in footings of dividend irrelevancy and that of dividend relevancy theory. There have been a figure of surveies in this context.

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Van Horne ( 1986 ) explained that the construct of wealth maximization is frequently presented as an acceptable primary end of a house, which means that directors should be ever oriented towards ordinary stockholders. And the house should move on their best to heighten their wealth. Shareholder ‘s wealth can be expressed as the merchandise of figure of portions owned, multiplied by current portion monetary value.


Miller and Modigliani ( 1961 ) suggest that in perfect markets, dividend do non impact house ‘s value. The theory proposes that in a market, there are no imperfectnesss like revenue enhancements or dealing cost and bureau costs. They imply that the full fiscal policy followed by a house is irrelevant for its rating ; all that affairs is the house ‘s portfolio of investing undertakings. Equally long as the house is recognizing the returns expected by the market, it did n’t count whether that return came back to the stockholder ‘s as dividends now. Hence dividend policy is said to be all useless in altering the wealth of stockholder. MM showed that with perfect markets, a house ‘s dividend policy will non impact the house ‘s value. Harmonizing to them, house value is determined by its basic gaining power and concern hazard. The most important apprehension of Miller and Modigliani ‘s analysis is that it distinguishes the state of affairss in which dividend policy can impact the house value. From the position of investors, dividend policy is irrelevant.


Given that fact that MM theory was to a great extent criticized due to their premises which do non truly stand for in existent word, subsequent research were done by other research workers. Some of them came to the decision that MM was right whilst some besides oppose to the theory. Empirical trials on the irrelevancy theory have proven to be really complex to plan and carry on, as stated by Ball et Al. ( 1979 ) .

Black and Scholes ( 1979 ) , in conformity with the dividend irrelevancy theory, analyzed the impact of dividend policy on stockholder ‘s wealth, that is the stock monetary values. They point out on the ability of houses to accommodate dividends to appeal to tax-induced patronages. They based their analysis on 25 portfolios of common stocks listed on the New York Stock Exchange ( NYSE ) . They tested the long tally assessment of effects of dividend output by widening the capital plus pricing theoretical account ( CAPM ) . Their consequences found no important relationship between dividend outputs and stock return. Their survey result the fact that neither high output nor low output payout policy of houses appear to give the feeling that it influences stock monetary values. Miller and Scholes ( 1978 ) , Miller ( 1986 ) and Bernstein ( 1996 ) besides provided grounds through their survey on behalf of the dividend irrelevancy theory.

However, some other empirical researches did non back up the dividend irrelevancy theory by disputing the hypothesis. Stressing on the Black and Scholes survey, Ball et Al ( 1979 ) make an observation on the impact of dividend policy on stock monetary value by utilizing Australian informations from 1960 to 1969. They found that there were no unambiguous grounds to back up the MM theory. Baker, Farrelly and Edelman ( 1985 ) based their survey on 562 houses listed on New York Stock Exchange from three industry groups and came up with decision that dividend policy do impact stock monetary value on the contrary to the dividend irrelevancy theory. Partington ( 1985 ) , who conducted a survey on Australian information, besides reported that there is a positive relationship between dividend payment and portion monetary value. Siddiqi ( 1995 ) and Casey and Dickens ( 2000 ) , who based their rearch on US Bankss, besides did some research work on that peculiar facets and came on the decision that dividend policy affairs in the finding in house ‘s value. Finally Baker and Powell ( 1999 ) , examined the relationship by doing an empirical survey based on 603 CFOs of US houses listed on the NYSE. The bulk of respondents, exactly 90 per centum, do believe that dividend affect house ‘s value.

Tax-Preference Theory

Tax penchant theory is one of the chief theories related to dividend policy in a house. It was foremost developed by Litzenberger and Ramaswamy ( 1979 ) . This theory states that stockholders prefer lower payout companies for revenue enhancement grounds. Harmonizing to them, a rise in the dividend payout ratio would do the stock monetary value to worsen and the cost of equity to lift. If capital additions are taxed at a lower rate than the revenue enhancement on dividends, the stock has a high growing rate becomes more attractive, but on the contrary if the capital addition is equal to the income revenue enhancement on dividends, capital additions the benefit is reduced.



Different empirical research was assigned to prove the revenue enhancement penchant theory. Different consequences were obtained from different surveies.

Black and Scholes ( 1974 ) tested Brennan ‘s theoretical account and did non happen any consequence of revenue enhancement. They found it undistinguished. Miller and Scholes ( 1982 ) disagreed on Litzenberger and Ramasawmy, claiming that short term dividend payment are unsuitable for placing the impact of revenue enhancement interventions of dividends on stock returns. They found that the positive yield- return relation was due to the biasness of information. Further on, Hess ( 1981 ) , who tested the relationship between dividend and stock return from 1926 to 1980, found more or less the same consequences as Miller and Scholes.

Kalay and Michaely ( 2000 ) , who re-examined the Litzenberger and Ramaswamy survey, came up with the a positive and meaningful dividend output coefficient. Poterba and Summers ( 1984 ) besides supported the revenue enhancement consequence hypothesis by utilizing day-to-day and monthly informations. Keim ( 1985 ) , who used a sample of 1718 US fims, besides find a positive relationship between dividend outputs and stock returns. He constructed six portfolios for his survey. Baker et Al. ( 2002 ) besides made a study by questioning 630 NASDAQ houses and found no existent support fot the tax-preference theory.

However, several research workers oppose to the theory proposed by Modigliani-Miller claiming that there are premises which does non use in existent universe. Tonss of imperfectnesss occur in existent and MM does non take these facts into consideration ( Dhanani 2005 ) .

Bird in Hand Theory

The theory of Bird-in-Hand presented by Gordon and Lintner ( 1963 ) was besides among the first to oppose MM theory. Based on the adage that a bird in manus is deserving two in the shrub, the theory states that investors will prefer dividends over the possibility of higher future capital additions. Under the bird-in-hand theory, stocks with high dividend payouts are sought by investors and accordingly command a higher market monetary value. Dividends are said to be less hazardous than capital additions, houses should hence put a high dividend payout ratio and will maximise stockholder ‘s wealth by offering a high dividend output.


The Bird in Hand Theory, who states that dividends are irrelevant, has been challenged by some empirical research done by other research workers. Some agree to the theory whilst some oppose to it.

Fisher ( 1961 ) was for the bird in manus theory as with his findings, he reported that dividends have a much bigger impact on portion monetary values than maintained net incomes. He used informations from Great Britain and based his surveies from 1949 to 1957. His consequences were same as Gordon ( 1959 ) who used sample informations of four industries between 1951 and 1954.

One of the chief statement carried out against the bird-hand theory was done by Modigliani-Miller ( 1961 ) . MM theory is wholly opposite to that of BIHH. They called Gordon and Litner ‘s theory as a bird-in-hand false belief. MM claimed that dividend policy of houses does non act upon the house ‘s cost of capital and that stockholders are unbiased if they gain more dividend or capital additions. Harmonizing to them, the bulk of investors will reinvest in more or less the same house and that company ‘s peril is merely influenced by its hard currency flows from runing assets.

Rozeff ( 1982 ) besides found an opposite relationship between dividends and houses risk. This means that as the hazard of a company ‘s operations rise, dividend payments are besides like to fall. These consequences have besides been confirmed by surveies done by Jensen, Solberg and Zorn ( 1992 ) . Bhattacharya ( 1979 ) besides suggested considered the theory as false belief and he advanced that there is an self-asserting degree of hazard associated with dividends.

Diamond ( 1967 ) , which based his surveies for 255 US houses from eight surveies for 1961 and 1962. He studied the impact of dividends and maintained net incomes on portion monetary values. The latter did n’t happen any specific support that stockholders prefer dividends to maintained net incomes. He besides found that in footings of industries, retained net incomes were preferred more than dividend payments. The consequences obtained from Diamond hence suggest that there is an inauspicious relationship between dividend and house ‘s growing.

Baker, Powell and Veit ( 2002 ) besides made a research on the bird in manus theory. They interviewed directors of NASDAQ houses in order to hold an assessment on the topic. They used questionnaires for their research and their chief inquiry was to cognize whether stockholders favored to hold hard currency dividend today or unsure future net incomes. Their consequences provided no support to bird in manus theory as the bulk ( 54.9 per centum ) preferred future net incomes whilst merely a little measure ( 17.2 per centum ) had a positive oculus on holding hard currency dividend today. Therfore the findings done by the three research workers do non offer any support to the bird in manus theory.

Cientele Theory

Black and Scholes ( 1974 ) and Allen, Bernardo, and Welch ( 2000 ) came up with the patronage theory. It is based on the premise that personal income revenue enhancements are higher than what the company pays. As a consequence, dividends is said to be a relevant variable. High dividend offers higher hazard and since so much of the income is taxed, investors will be loath take that hazard. This will certainly impact stock monetary values. This clientele consequence will forestall any corporation from impacting the market monetary value of portions through the use of the dividend output. Investors are attracted to different company policies, and whenever there is a alteration in that, investor will set their stocks retentions consequently. If the company decreases its dividend, this will compel stockholders to sell their stock and travel to companies offering higher dividend. This will ensue in a autumn in the portion monetary value of the company. The intent of this theory is to foretell the determinations of investors. This will so impact the fiscal determinations of the house.

Empirical Evidence

Many empirical surveies examined the clientele consequence and different consequences were observed.

Haugen and Senbet ( 1986 ) provide grounds in support for the patronage theory by set uping the differences in public presentation of high output and low-yield stocks. Pettit, who based his surveies on portfolios of 914 single stockholders, supply support to the theory. He found a positive relationship between investor ‘s picks and dividend output. Investor s with low hazard tend to prefer high dividend payout. Scholz ( 1992 ) besides observed single investor portfolio and he besides found his consequences consistent with that of the clientele hypothesis.

Peterson and Ang ( 1985 ) found that stockholders have tax-based antipathy to hard currency dividend payments. Richardson, Sefcik and Thompson ( 1986 ) tested the relaitionship between patronages alterations and dividend alterations by proving a sample of 192 US houses and somehow did n’t happen adequate grounds to back up the being of the theory.

Further on, Dhaliwal, Erickson and Trezevant ( 1999 ) used a sample of 133 sample dividend instigators from 1982 to 1995 to prove the theory of tax-induced patronages. They reported that the bulk of the houses resulted in a rise in stockholder ‘s ‘ wealth following dividend induction. Seida ( 2001 ) besides renders empirical support to the patronage theory along with Bajaj and Vijh ( 1990 ) following their survey.

Elton and Gruber ( 1970 ) , who based their survey on portions listed on NYSE from 1966 to 1967, besides presented empirical grounds. They observed portion monetary value behaviour and found portion monetary value diminutions by less than dividend sum on ex-dividend yearss. They besides concluded that investors are likely to prefer capital additions compare to hard currency dividend. However, Kalay ( 1982 ) disagreed on the theory claiming that fringy revenue enhancement rates of stockholders can non be deduced from the monetary value bead ratio. He found the theory insignificant. Further surveies surveies were done refering the patronage theory namey Brown and Walter ( 1986 ) , Hietla ( 1990 ) and Dasilas ( 2009 ) and assorted consequences were found.

Signing Theory

Signing theory, developed ab initio in economic sciences ( Spence, 1973a ) and biological science ( Zahavi, 1975 ) states that alterations in dividend policy convey information about alterations in hard currency flows. Is a device used to pass on information about a house ‘s future chances to investors. Valuable information is conveyed, which stockholders do non hold, about the direction appraisal of a house ‘s future profitableness. This therefore reduces dissymmetry information and stockholders may utilize this as an appraisal on a house ‘s portion monetary value. Dividend policy is hence considered to be relevant on its impact on stockholder ‘s wealth. Much eventful research has focused on explicating a positive impact of dividend on stock market reaction. Built on the content as an information content, other theories were developed to explicate the nature of information content related in a dividend proclamation. Bhattacharya ( 1979, 1980 ) and John and Williams ( 1985 ) theorized that dividend alterations are signals about the current and future hard currency flows. Miller and Rock ( 1985 ) came up with net dividend construct. It is regulated by deducting external funding from entire dividend paid. The proclamation effects of a dividend addition is positive in the sense that it affects stockholder ‘s wealth.

Empirical Evidence

Another theory for which MM theory has been criticized is the Signing theory. Directors who are responsible for looking after the house frequently possesses information about the house ‘s hereafter and present chance which is non available to investors. Compared to the irrelevancy theory, signaling theory provinces that alterations in dividends affect hard currency flows and do convey cherished information to investors about the house ‘s future chance.

Many empirical surveies were observed by different writers refering signaling theory. Baskin and Miranti ( 1997 ) examined that due to an absence of complete and concrete information available to investors, the hard currency flow acts as an indicant for a stockholder for the market rating. MM ( 1961 ) besides stated that alterations in dividends may impact portion procedure. Ang ( 1997 ) and Koch and Shenoy ( 1999 ) observed that market would respond favorably to dividend addition and unfavorably otherwise.

Harmonizing to Lipson, Maquieira and Megginson ( 1998 ) , directors do non come up with dividends until they are certain that those dividends can be fostered by future net incomes. Furthermore, as illustrated in the instance of FPL group ( Soter, Brigham and Evanson, 1996 ) , although dividends act as a signal to the market, in some instances, alterations in dividends may be an undetermined signal.

Asquith and Mullins ( 1983 ) , who use a sample of 168 houses, find that as dividend additions, it has a positive impact on stockholder ‘s wealth. Petit ( 1972 ) observed that dividend convey valuable information and showed that there is a positive reaction to proclamation of a rise of dividend and a negative reaction whenever there is a autumn. He besides added that dividend proclamation transmit more information than in an net incomes proclamation. Woolridge ( 1983 ) besides found that there is a important rise returns in stock return as a consequence of an addition in dividend proclamations.

Michaely, Thaler and Womack ( 1995 ) observe the relationship between dividend and portion monetary value by taking 561 dividend inductions and 887 dividend skip during their survey. They reported that there is an norm of + 7.5 per centum addition in stock monetary value when dividend is announced and al autumn of around 11percent during dividend skips. Bali ( 2003 ) besides came up with same consistence as the old consequence. He reported an norm of 1.17 per centum rise in stock monetary value when dividend rises and a autumn of 5.87 per centum for a autumn.

Amihud and Murgia ( 1997 ) , who used a sample of 200 German houses listed on Frankfurt Stock exchange, observed that alterations in dividends convey information a house ‘s value. They used 255 events when dividend rises and 51 events when there was a autumn of dividend to come up with their survey. Travlos, Trigeorgis and Vafeas ( 2001 ) besides did a survey on signaling theory by taking grounds from an emerging market. They used a sample of 41 statements of an augmentation of dividends and 39 of a autumn on the Cyprus Stock Exchange. They found their consequences consistent to the signaling hypothesis. Nissim and Ziv ( 2001 ) besides observed from their survey that dividend alterations and net incomes are positively related.

Some empirical surveies have yielded confusing consequences like from Watts ( 1973 ) . The latter tested the relationship between future net incomes and degree of dividends. He used a sample of 310 houses from 1946 to 1967. He besides observed the relationship between unforeseen alterations in dividend payments and unnatural alteration in stock monetary values. He concluded that there was a positive impact but the mean significance degree was excessively little. Further on, Benartzi, Michaely and Thaler ( 1997 ) besides finds no comparative impact of dividend on stock monetary value. DeAngelo, DeAngelo and Skinner ( 1996 ) besides supported the fact that no groundss were found.

Agency Theory

An alternate account sing dividend and stockholder ‘s wealth root from bureau theory. Harmonizing to bureau theory, the relentless distribution of hard currency out of the i¬?rm disciplines directors and reduces the extent of bureau costs ( e.g. , Easterbrook, 1984 ) . Dividends may be an optimum manner to cut down dealing costs to stockholders in pull offing their financess. It suggests that dividend policy is determined by bureau cost originating from the divergency of ownership and control. The first instance concerns degree of dividend payments. Harmonizing to Grossman and Hart ( 1980 ) , Easterbrook ( 1984 ) , and Jensen ( 1986 ) , dividend policy can partly work out the bureau struggle between stockholders and the directors which was foremost developed by Jensen and Meckling ( 1976 ) . By diminishing invariably the hard currency controlled by directors, dividend makes it more rough for directions to prehend stockholder ‘s wealth through unsupervised activities. This will guarantee directors to maximise stockholder ‘s wealth instead than utilizing the financess for their private benefits. ( De Angelo et al. 2006 ) . Lang and Linzenberger ( 1989 ) segregated stockholder ‘s reaction to alterations in dividends by directors suspected of over puting. Dividends may restrain direction ‘s ability to put beyond the degrees that stockholders desire. Agrawal and Jayaraman ( 1994 ) examined otherwise at analyzing the hypothesis of how dividends reduces the opportunities for directors to utilize the hard currency flows for their personal usage. By comparing dividend constabularies of debt free house to comparable houses, they came to the decision that dividend payout of all equity houses were higher than that of leveraged houses. They besides came up with the consequence that houses with high shareholding have lower payout ratios than that with low shareholdings. These consequences serve as a mean to cut down the struggle between directors and investors sing free hard currency flow. Easter Brook ( 1984 ) states that dividend may diminish bureau cost associated with separation of ownership and control. He argued that dividend payments oblige directors to raise financess in fiscal markets more on a regular basis compared when they were non paying dividends. Dividend payment force directors to run into outside professionals like attorneies and bankers. When dividends are paid, direction is being professionally examined closely, and hence dividend paying directors have really few opportunities to move in their self involvement as opposed to the stockholder ‘s involvement.

Empirical Evidence

The statement refering bureau costs theory has been loosely addressed in many empirical researches. Different research workers had different consequences.

Rozeff ( 1982 ) used a big sample of US houses over a five twelvemonth period from 1974 to 1979. His survey dealt with a arrested development theoretical account where the entire dealing costs and bureau costs are minimized. It is to be known as a cost minimisation theoretical account. His consequence found that the bureau cost theory is relevant after happening positive relationship between scattering of ownership and dividend payout ratio. Dempsey and Laber ( 1992 ) , who extended the rearch of that of Rozeff by taking figures from 1981-1987 besides found bureau costs to be relevant.

Jensen, Solberg and Zorn ( 1992 ) based their research on 565 houses in the twelvemonth 1982 and 632 houses in 1987. He utilized a three-stage least squares to analyze the relationship and found the insider ownership be negatively related to that of dividend ratio. Their consequence were hence consistent with that of the bureau cost theory. Holder, Langrehr and Hexter ( 1998 ) besides observed that figure of stockholders positively affected payouts. Furthermore, Saxena ( 1999 ) who based his research on a sample of 235 unregulated and 98 regulated houses from 1981 to 1990, provide grounds that bureau costs is a critical determiner of steadfast dividend policy.

La Porta et Al. ( 2000 ) researched on a sample of about 4000 companies from 33 states. He proposed an result bureau hypothesis. He concluded that with higher protection to investor, stockholders are basking a much greater power than the directors of the house to extract free hard currency flow through dividend payments. His consequences hence supported the bureau theory.

On the other manus, other empirical surveies found little or no support to the bureau cost hypothesis. Denis, Denis and Sarin ( 1994 ) used a sample of 5992 increased dividends and 785 reduced dividends from 1962 to 1988 and found a negative relationship between dividend output and Tobin ‘s Q ratio. Lie ( 2000 ) besides found limited support to the bureau theory as he found that neither small particular dividends nor a rise in dividend could clear up the overinvestment job. Yoon and Starks ( 1995 ) besides reported from their survey that the bureau hypothesis is irrelevant.

Other Theories

Jensen ( 1986 ) came up with the theory known as Free Cash Flow Hypothesis. Harmonizing to him, free hard currency flows exist when there are extra financess left over after taking all positive NPV undertakings into history. The theory predicts that if there is unexpected dividend payment, stock monetary values will increase. It associates an addition in dividend with less free hard currency flow and therefore less inclination to over-invest. High sum of payout will ensue in a lessening of free hard currency flows accessible to troughs and this confines the imperium edifice attempt of directors. Rising purchase, which consequences in an addition in everyday involvement payment, is another manner to diminish the sum of hard currency under direction control.

Healy and Palepu ( 1988 ) showed that houses that distribute dividends have important addition in their annual net incomes. Firms that do non administer dividends have a important autumn in their one-year net incomes for atleast one twelvemonth and twelvemonth of dividend alteration. The same effects are seen even after one twelvemonth of the proclamation whether to administer dividends or non. They besides believe that response from stock monetary value to dividend proclamations are positively related to net incomes alterations.


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