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.