Firms are generally free to select the level of dividend they wish to pay to holders of ordinary shares, although factors such as legal requirements, debt covenants and the availability of cash resources impose some limitations on this decision. It is thus not surprising that the empirical literature has recorded systematic variations in dividend behaviour across firms, countries, time and type of dividend.
Dividend theories
The transaction cost theory Firms may incur costs in distributing dividends while investors may incur costs in collecting and reinvesting these payments. Moreover, both firms and investors may incur costs when, due to paying dividends, the firm has to raise external finance in order to meet investment needs. Indeed, the transaction costs incurred in having to resort to external financing, is the cost of dividend in. In contrast, however, it may be argued that dividend are beneficial as they save the transaction costs associated with selling stocks for consumption purposes . Either way, if there are additional transaction costs that are associated with paying or not paying dividends, then dividend policy should impact earnings expectations and hence share price and firm value.
Tax theories
Another cost associated with dividend payments is taxes. The tax hypothesis proposes that corporate tax on distributions and taxes on dividends in the hand of investors are important costs to be considered when deciding on a dividend policy. More specifically, the difference between tax on dividends and on capital gains should be considered as well as the difference between corporate tax on distributed and on retained earnings. For example, if corporate tax on distributions is higher than that on retained earnings, this may reduce expected earnings of a firm that pays dividends relative to a firm that does not. Similarly, if dividends in the hands of shareholders are taxed higher than capital gains, investors should evaluate expected returns on an after tax basis and share prices will vary inversely with the firm’s payout level
The traditional argument in favour of dividend is the idea that dividends reduce risk because they bring shareholders’ cash inflows forward. Although shareholders can create their own dividends by selling part of their holdings, this entails trading costs, which are saved when the firm pays dividends. The risk reduction or bird in the hand argument is associated with Graham and Dodd (1951) and with Gordon (1959) and it is often defended as follows. By paying dividends the firm brings forward cash inflows to shareholders, thereby reducing the uncertainty associated with future cash flows. In terms of the discounted dividend equation of firm value, the idea is that the required rate of return demanded by investors (the discount rate) increases with the plough-back ratio. Although the increased earnings retention brings about higher expected future dividend, this additional dividend stream is more than offset by the increase in the discount rate. This argument overlooks the fact that the risk of the firm is determined by its investment decisions and not by how these are financed. The required rate of return is influenced by the risk of the investments and should not change if these are financed from retained earnings rather than from the proceeds of new equity issues. As noted by Easterbrook (1984), in spite of paying dividends the firm does not withdraw from risky investments, thus the risk is merely transferred to new investors.
The signalling theory
A more convincing argument in favour of dividends is the signalling hypothesis, which is associated with propositions put forward. It is based on the idea of information asymmetries between the different participants in the market and in particular between managers and investors. Under such conditions, the costly payment of dividend is used by managers, to signal information about the firm’s prospects to the market.
The agency theory of dividend
Another argument in favour of generous dividend payments is that this shifts the reinvestment decision back to the owners. The underlying assumption is that managers may not necessarily always act as to maximise shareholders’ wealth. The problem here is the separation of ownership and control which gives rise to agency conflicts
