Business is defined as the buying and selling at a profit. In simple terms, all business establishments are geared towards profit maximization for the shareholders. The shareholders or owners of the company may derive benefits from the firm in either capital gain through the appreciation of the price of their shares, or through the regular dividends paid out by the firm. The decision on whether to pay out dividends will be dependent on a numbers of factors. Key among them is the development stage of the company. Most established companies have the ability to pay huge dividends since they have invested in almost all the viable options in the market. In the contrary, a fast growing company may re-invest most of its funds and pay lesser dividends. Similarly, a company that would like to attract new investors may lure them into buying the company’s stocks by paying out high dividends.
A number of theories exist, that try to explain the factors that management considers before deciding on the dividends to be paid out. They are outlined below: Famous Economists, commonly known as MM (Modigliani and Miller) developed what is particularly known in finance cycles as the MM theory on dividends. They went on to say that under all circumstances a company will invest all its funds in all the projects that yield a positive net present value, before the remaining funds are distributed to the owners of the company.
The bird in hand theory states that investors would prefer immediate gains in the form of high dividends as opposed to a company using the money to invest in other projects even if these are predicted to give a higher return. Due to the unpredictability of the future and lack of perfect information on the possible returns, investors would thus prefer the payments of huge dividends, as opposed to capital gains since the returns on the investments in these turbulent sectors of the economy may not be guaranteed. They would therefore prefer the bird in hand that to the two in the bush.
The pecking order theory, developed by Donaldsons, states that all the money left after the all the costs have been paid for, should be used to run the company. He advocates for the retention of funds in form of retained capital and urges that since retained earnings and reserves are the best methods and the cheapest as well, the firm should use its retained earnings for regular running of the business.
Different stakeholders in the business will always have differing opinions on how much dividends should be paid out. This results from the fact that we have different types of shareholders. Speculators will only be interested in high short term returns while long-term investors would prefer frequent and steady incomes. Given this scenario, management must identify its calibre of shareholders and look for means of communicating the company’s investment decisions. Low dividends and low share price will give across the impression that the company has had a bad year but in theory the opposite may be true. Low dividends may mean a company has chosen to invest in other projects to generate shareholder wealth.
Payment of dividends will also depend on the returns posted by the company. It’s however, important to note that a company will have made prudent moves if it starts by first investing in all returns that give positive returns. There are several methods of evaluating the returns of investment.
The simplest and most traditional one is the payback period. An investor will consider the length of time that he expects the particular investment to take before he is able to recoup his original investment. This is done against a particular set number of years to determine if the investment meets that particular requirement before is selected for investment. The problem with this method is that it does not take into consideration the time value of money; the fact that money today is not valued as money in 10 years time. The set time for payback is also arbitrarily picked and may not necessarily be decided against any particular criteria.
Accounting rate of return (ARR) measures the accounting profit generated by a particular investment. This method is still unreliable since the time value of money is still ignored.
Perhaps, the most important and frequently used method is the Net Present Value. This method works out cash flows generated by an investment in today's money The major setback of this method is that it assumes that any project with a positive NPV should be adopted. It ignores the fact that the different stakeholders in the organization have differing needs and expectations for the firm.
There are many other methods that can be employed in this regard, including the internal rate of return (IRR).The most important thing to note is t that risk factors should be incorporated before deciding on which method is appropriate for the particular investment choice.
The decision on the amount of dividends paid out will thus be affected by the method of selecting investments and returns posted by the firm. It’s thus important that the needs of all the stakeholders are considered before dividend policies are adopted by firms to avoid conflicts of interests.