Question is attached - Business Finance- Dividend policy- 1. Discuss the view that dividend policy is a more detail and has no impact on a firm to its shareholders. 2. Discuss the arguments supporting...

Business Finance
1. Discuss the view that dividend policy is a more detail and has no impact on a firm to its shareholders.
Solution to question 1:
Dividend Policy is more detail and does not/has no impact the value of firm:
 Dividend is the part of earnings that is distributed to the shareholders as periodic income. Sometimes companies not distributed its profit and use this money for its growth opportunities. Capital structure designed on the basis of dividend distribution. If company does not announce dividend and invest all the profit to meet the financial need, the proportion of debt becomes lower in capital structure. Dividend decision has inverse relationship with the retained profit. If payout ratio (profit distributed to total earnings ratio) is 40%, then the retained earnings will be 60% of total earnings. So, if payout ratio is high, then retained earning will be lower. Company takes the decision on dividend distribution to just maximize the wealth of its shareholders.
A company may not choose to pay any dividend to its shareholders in any of the following circumstances –
· If the company has any upcoming projects which requires certain investment and the firms capital budgeting choose to undergo financing through retained earnings
· If the management of the company believe that the company would earn a higher return than the investors expect in order to keep its money intact.
· If the company does not have surplus cash i.e. the liquidity position of the company does not warrants payment of any dividend to its shareholders.
Due to any of the above factors the company may not pay dividend to its shareholders.
The dividend can be of two types:
1. Cash dividend: When the payment of dividend to shareholders is made in cash. The cash divided can also be of three types:
A. Regular / normal dividend, which is paid out of periodic profits set aside by the company for this purpose. This can paid quarterly, annually or at any defined frequency.
B. Special dividend: the company pays the special dividend when the financial position of company allows it payment of one-time extra dividend to its shareholders.
C. Liquidating dividend: It is paid when company close out its business and distribute the assets to its shareholders.
2. Stock Dividend: A Company can issue fully paid shares to its shareholders as bonus shares. This is being done by the capitalization of reserves/profits of the company. This form of dividend results in increase in number of outstanding shares and hence, reduces the earning per shares. This type of dividend in not sticky in nature I.e. issuance of bonus share does not require regular issue in future as well.
Many theories and policies have been developed on dividend policy. Dividend policy refers to the method or policy adopted by the company about the declaration and payment of dividends to its shareholders. The company may pay dividend in form of cash / stock  or may not pay dividend for certain period of time to it shareholder. Further, dividend paying company may choose to pay same amount of dividend per share (say $1 per share) or same percentage of earnings per share as dividend (known as payout ratio – say 50% DPS of EPS) or increasing /decreasing amount of dividend period-to-period basis. The policy would depend on many internal factors like internal fund requirements to finance its prospective development or growth opportunities, desired capital structure, availability of investment opportunities. Some external factors like statutory requirements, taxation regulations, clientele effects etc. will also affect the dividend policy of a company.
Dividend policy can be significant factor in determining the value of firm. Different investor perceives same type of dividend policy with different view.
However, Modigliani- Millar (MM) argued that the dividend policy of a firm is irrelevant and will not impact its value. In a perfect market where there is no transaction cost or taxes, the dividend policy will not alter the cost of capital to the company and also its value. This is commonly known as ‘Dividend irrelevance’ theory. MM theory is based on these assumptions:
A. There are not transaction cost
B. No taxation
C. Market is perfect and all investor are well informed.
D. There are not floatation cost to the issuance of new shares
E. Shares can be split (or reverse split) into any parts
F. Profits of the company are known and investment decision are taken firmly
If all above assumptions are satisfied, then dividend policy will not have any impact on the cost of capital of the company and resulting its value.
They explained it by putting examples. Suppose a company has budget of its capital expenditures. Its capital structure and debt-equity ratio are at optimal stage. (i.e. where the overall cost of capital for the company is lowest). So, for financing its capital expenditure it can either use its reserves or may pay reserves as dividend to shareholder, but issue new shares to get the funds. If the company pays dividend and issues new shares to finance its budgeted capital expenditure, the value of newly issued shares would offset the value of dividends paid. For example, a company’s share is trading at $50 in the market. The company needs $ 5,00,000 to finance its capital expenditures. The company decides to pay its whole profits as dividends, say $5 per share. Therefore, the company would need issuance of new shares for financing its capital requirements. Here, the payment of dividend would reduce the price of share from $50 to $45. Each shareholder earlier had worth of $50 assets when the dividends were not paid, but now the value of share would fall to $45 and $5 would be in hand of shareholders. Hence, the shareholder would have same assets. Further, the value of company from increase of share would have been offset by the reduction in price due to payment of dividend.

 MM put one more thesis of ‘Home-made dividend’ in favor of its dividend irrelevance theory. According to this argument, if the shareholder wants /needs income, he/she can get it by selling the shares of company (even when no dividend is paid by the company). When he/she has excess liquidity (due to higher dividend payoff by the company), he/she can purchase share of company. So, the dividend policy of company does not impact the shareholder’s value to the company. Shareholders are not concerned with the dividend policy of the company. Rather, they can make their own dividend, as & when they want. Suppose, in above example, a shareholder of 1000 shares of company who desired $500 income, would sell 10 shares ($500/$50) and get the liquidity. Conversely, if the shareholder has $500 of excess fund, he could purchase new 10 shares of the company. Therefore, the overall value of the company (Based on market price) is not impacted, whether the company pay low dividend (may not pay dividend) or pay higher dividends.
MM’ dividend irrelevance theory has limited significance in the current world. In the real world, the market is not perfect and there are transaction cost, taxation in almost all markets. So, in case of homemade dividend, the shareholder may not get the full amount of sale proceeds due to transaction cost or taxation implications. Further, some investor prefers regular payment of dividend, rather than accumulating reserves. So, the dividend policy chosen by company impact the value perceived by investor and resulting cost of capital.
It is not necessary on part of the companies to pay dividends. Paying any common stock cash dividends depends upon the dividend policy of a company and other factors like excess profits earnings, availability of excess cash, opportunities of investments available etc. Some financial analysts claim that little or no dividend payout is more favorable to the investors. Their dividend policy model is based upon the assumption that retained earnings are the only source of finance for a company. Thus if a firm distributes away all its earnings as dividend, it will not be able to invest in positive N.P.V projects, hence the opportunity costs of paying dividend is the return on the projects sacrificed. In fact the optimum dividend policy should depend upon the comparison between rate of return required by the shareholders also known as equity capitalization rate or overall capitalization rate i.e. Re and IRR of a project i.e. return on an investment. The argument against dividend is based on the belief...