Dividend Policy

Dividend policy has been seen as one of the important decisions of the company's management; it affects the value of shares and the value of the company. In emerging market, due to asymmetric information, investors often rely on the dividend as a signal that the company's prospects for the future. Therefore, establishing a specific policy of dividend is considered as advantage for both the shareholders and the company.

First of all, I will mention dividend policy in a perfect capital environment. According to Merton Miller and Franco Modigliani (1961), in a perfect market (no taxes, no issuance costs, transaction costs and stock information costs), dividend policy does not affect to value of shareholders' equity. The underlying assumption of this view is that investment decisions are not influenced by the company's dividend policy. Therefore, in this case, the investment policy of the company is the most important because it determines the future income stream of the company and decides the value of the company. And the income stream which is split between dividends and retained earnings does not matter. However, if compare this view with the actual situation of the stock market, I can see the contradiction. The fact that the dividend increase is generally considered as good information which leads to an increase in stock price, and vice versa when companies reduce or not pay dividends, the stock price will further decline. Thus, the dividend policy may contain information and can be regarded as a signal about the development ability in the future of the company. However, in reality, almost all companies are trying to maintain a stable dividend. Therefore, dividend policy should not really be a positive signal for the future. Investors began to consider external factors such as the income by cash which the company can use to pay dividends.

On the other hand, Miller and Modigliani's view is based on a perfect capital market assumption. In fact, dividends and capital gains are taxed; the issuance and trading of securities have to bear costs and information asymmetry between company managers and investors. First of all, almost economists agree that in a world without taxes, the investors will be indifferent to receiving dividends or capital gains. But in reality, income from dividends is taxed higher than income from capital gains. So the logic would conclude that investors may not like to receive dividends. This will be reflected in the stock price. Other factors are constant; the stock price of the company paying the dividend is less than the stock price of the company retains earnings for reinvestment. Moreover, the higher the dividend payment also means that companies have to raise capital when needed capital from outside investors. Then the company must bear the cost of issuance and ownership dilution (when issued shares). These costs may cause the company does not want to pay high dividends. Therefore, before decide about dividend policy, companies need to consider many factors such as investment ability, business risks, requirement of shareholders and so on.

Capital Structure

Capital structure mentions to methods of generating sources of capital in order to businesses can purchase assets and physical means as well as maintain operating activities. In general, a suitable capital structure is considered as the most important decisions with business not only because the needs of maximizing benefits from individuals and organizations who related to operations of the business, but also due to this decision could impact to the capability of enterprises in the competitive environment. As normal, a company can raise capital from two main sources: equity financing or debt financing, even combine both of them.

In terms of raising capital through equity financing, the company usually uses the way to issue ordinary shares. This method is expected to bring higher benefits and returns; however, it seems to be more risky than debt financing. The main advantage of equity financing is the owners of business have without obligations to return capital. But, the expenses of this method will higher too much due to the company has to spend money to issue shares and satisfy investors.

On the other hand, debt financing method is cheaper (due to tax-deductible and lower cost). Moreover, it is also less risky and lower expected returns because of this method forces to pay interest and return initial capital for investors and shareholders. However, there are still risks exist in this method which can bring dangerous to business. Firstly, cost of capital is not stable; it depends on many outside factors, such as the market values, the trust of investors in company’s ability to raise capital or the expectation of company. Besides, if the company use debt finance method, they have to paid loan every year, although it will be successful or unsuccessful year. It could lead to credit rating of business will be affected and the higher the risk company must face with bankruptcy. The value of shareholders also due to this reason will decrease.

Under the traditional view, in the beginning, if WACC decreases and gearing increases, it will lead to an increasing share price and value of company. Then, in optimal level where the company can gain optimal capital structure, if the gearing continues raise, the risks also increase follow that.

In contrast with traditional view, Modilligani and Miller (1958) gave opposite ideas and theory about capital structure. They assumed that the capital market is perfect, so there will be no transaction costs, taxation is ignored and the risk is evaluated by the volatility of cash flows. From that, they argued that there is no relationship between capital structure and WACC as well as capital structure can not affect to WACC. As a result, the optimal capital structure also not exists and the value of company depends on business risk. However, the perfect markets will not exist in the real world and their assumptions is not suitable and reality. In fact, the company should borrow money in a reasonable level. Moreover, owners of company must consider other factors which can affect to the borrowing decisions, for example, the ability to loan, risks in reinvestment, operating as well as effective strategy.