StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Why Companies Pay Dividends - Literature review Example

Cite this document
Summary
The review "Why Companies Pay Dividends?", based on dividend literature, discusses why companies pay dividends; why investors pay attention to it; do dividends affect an organization’s value and how do managers use dividends in the organizational financial management…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER91.7% of users find it useful
Why Companies Pay Dividends
Read Text Preview

Extract of sample "Why Companies Pay Dividends"

Why companies pay dividend? I. Introduction Dividends are defined as the income paid by investments and that both bonds and stocks can pay for it. (Tyson 2006, p. 215) When a firm declares and issues a dividend to its shareholders, this payment is not tax deductible and, instead, the receipt of it generally is considered to be taxable income to the shareholders.(Frenczy 2008, 8-21) These also underscore that since the firm that issued the dividends did not receive offsetting deduction, tax is paid both at corporate and individual levels as a consequence. Dividends are often compared with capital gains, the mutual funds that have made gains to be distributed to the investors. The different tax treatment between dividends and capital gains however generally work against the former. A number of companies pay dividends and in some, it is a given in the way their organizations are run. This paper will explore why anyone cares about it at all. Specifically, this paper will address the questions why companies pay dividends; why investors pay attention to it; do dividends affect an organization’s value and how do managers use dividends in the organizational financial management; among others. The idea is to identify whether dividends have any bearing or effect on an organization particularly in terms of equity and firm value. Summary of Literature Review The review on the current dividend literature provided in the following section is particularly focused on the areas related to the positive and negative characteristics of dividends to business organizations. Such outline of studies was aimed at determining how other scholars answered the question posed by this paper. The review summarizes the current studies and research on dividends policy, particularly. An important dimension to the review, however, which would have a pivotal effect on this paper as a whole was the passage of the Jobs and Growth Tax Relief Reconciliation Act. II. Literature Review The corpus of literature available in regard to corporate payout policy and dividends is extensive. However, this review would focus on two major areas: why do dividends matter for corporations and does it matter how business organizations distribute cash to its shareholders. Miller and Modigliani are considered to be the authorities in regard to framing dividend questions in their finance research. They, particularly focused on how dividend policy is considered a choice between financing with internal equity or financing with external equity. In their study, Miller and Modigliani offered proof that dividends do not matter in a world that is characterized by perfect markets. The fundamental rationale of their argument is that firm values are determined by choosing optimal investments. There has been numerous studies undertaken designed to empirically test Miller and Modigliani’s theory. These, however, such as those studies undertaken by Kalay and Michaely (2000), remained inconclusive. Of course, it is important for any attempt at credible examination of the significance of dividends for organizations if there is no credible approach to dividend calculation. Burton Beam and John McFadden offered a process in their book called Employee Benefits (2001). Here, they focused on using the “experience rating model” because the method supposedly achieves the ultimate degree of premium equity among shareholders. (p. 401) Since Miller and Modigliani’s irrelevant dividend argument is based on perfect markets, what happens in the more real cases of imperfect markets? Albarran, Chan-Olmstead and Wirth (2006) discussed this with their four market imperfections and their impacts to dividend: 1. Taxes the tax differential between dividends and capital gains argues for an inverse relationship between dividends and shareholder value or stock price. 2. Transaction costs: the existence of transaction costs argue for the retention of profits and the use of this internally generated equity rather than external equity for the company. (A specific example that demonstrates this variable is what Benjamin Graham and David Dodd called as the “plowback earnings” (p. 382) in American dividend policies. Here, by withholding dividends or by paying small parts or the withheld dividends’ earnings, corporations acquire more money. This has been made possible because dividend policies in America are permitted to be arbitrary and selfishly determined. 3. Imperfect Information: Since investors do not have access to company information, it argues for a positive relationship between dividends and stock price. 4. Market restrictions: Many institutional investors cannot buy stocks unless they pay a dividend. Also, there are individual investors who will not buy stocks unless they pay dividends. As a result, dividend paying stocks broadens the market demand for dividend paying securities and creates a positive relationship between dividend and stock price. (p. 147) S.R. Vishwanath offered a discussion on how dividends may be bad for an organization. One of the arguments he presented in this regard is that dividends are taxed at a higher rate than capital gains in many countries. He said that the tax on capital gains will be paid only when the investors sell shares and so a company that pays no dividends should be more attractive to investors than a similar company that pays dividends. (p. 598) Because of the tax disadvantage of dividends, it made sense for companies to analyze how they view and use dividends. It is interesting to note that despite the tax disadvantage (as illustrated by Vishwanath, for instance) there are corporations who continually do so. There are two main reasons for this as offered by financial economists. Cordes, Ebel and Gravelle (2005) wrote about them: The first – known as the traditional view – argues that dividends offer nontax benefits to shareholders that offset their apparent tax disadvantage… The second explanation or “tax capitalization” view assumes that dividends offer no nontax benefits to shareholders relative to retained earnings. (p. 213) Cordes, Ebel and Gravelle also added that corporations have no alternative to dividends like share repurchases for distributing funds to shareholders. Their discussion of these arguments included several actual examples and case studies that underscored the points they made. One of the most updated work in regard to the trend on dividends and dividend policy is those by Grullon and Michaely (2002). These authors cited, for instance, that there is a large decrease in the number of firms paying dividends and that the number of corporations buying back their shares has increased dramatically in the past 40 years. This work appeared to reflect the significance of dividends for firms today. Unfortunately, Grullon and Michaely’s study – as was the majority of literature on the subject - was undertaken before the enactment of the Jobs and Growth Tax Relief Reconciliation Act in 2003, wherein the tax rate differential between dividend and capital gains was removed. This law changed the rules on the taxation of dividends. Dividends were taxed at a rate as high as 38.6 percent and long-term capital gains were subject to a maximum tax of 20 percent in the previous law. The 2003 legislation radically reduced those figures. For those in the 15 percent bracket or less and those with taxable income of $65,100 or less, the tax rates on dividends has been slashed to zero and that regardless of ones income, the maximum rate on dividends has been capped at 15 percent. (Schnepper 2008, p. 425) And so, obviously this changes the dynamics on how dividends are perceived in terms of its value to business organizations. For instance, one school of thought posited that because the 2003 tax reforms introduced tax cuts for direct retail investors and institutions investing funds for retail investors such as mutual funds, a likely expectation would be for firms with relatively large holdings of retail investors to initiate or increase dividends. Fundamentally, dividends and capital gains should also be perfect substitutes for each other today as taxes are now eliminated as differing factor. All in all, there is still a lack of literature, particularly those offering empirical evidence, on this aspect and that this paper will attempt to cover the gap. Also, the widespread emphasis on the tax model for the analysis on dividends – why it is preferable or not in comparison with other payout schemes – deserves to be reexamined. This emphasizes the fact that the body of literature tends to focus on general theories to explain the importance or “unimportance” of dividends. More corporation-specific models must be analyzed to determine the value of dividends for organizations. References Albarran, A Chan-Olmstead, S and Wirth, M 2006, Handbook of media management and economics, New York: Routledge. Beam, B and McFadden, J 2001, Employee Benefits. Dearborn Trade Publishing. Cordes, J Ebel, R and Gravelle, J 2005, Encyclopedia of taxation and tax policy. The Urban Institute. Ferenczy, I 2008, Employee Benefits in Mergers and Acquisitions. Aspen Publishers Online. Graham, B and Dodd, D 2008, Security Analysis: Principles and Technique. McGraw Hill Professional. Grullon, G and Michaely, R 2002, Dividends, share repurchases, and the substitution hypothesis. Journal of Finance, 57, 1649-1684. Kalay, A and Michaely, R 2000, Dividends and taxes: A Reexamination. Financial Management, 29:2, 55-75. Miller, M and Modigliani, F 1961, "Dividend Policy, growth and the valuation of shares," Journal of Business 34:411-433. Schnepper, J 2008, How to Pay Zero Taxes 2009. McGraw Hill Professional. Tyson, E 2006, Personal Finance for Dummies. For Dummies. Vishwanath, S.R. 2007, Corporate Finance: Theory and Practice. SAGE. Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(Why Companies Pay Dividends Literature review Example | Topics and Well Written Essays - 1250 words, n.d.)
Why Companies Pay Dividends Literature review Example | Topics and Well Written Essays - 1250 words. https://studentshare.org/business/1559952-why-companies-pay-dividend
(Why Companies Pay Dividends Literature Review Example | Topics and Well Written Essays - 1250 Words)
Why Companies Pay Dividends Literature Review Example | Topics and Well Written Essays - 1250 Words. https://studentshare.org/business/1559952-why-companies-pay-dividend.
“Why Companies Pay Dividends Literature Review Example | Topics and Well Written Essays - 1250 Words”. https://studentshare.org/business/1559952-why-companies-pay-dividend.
  • Cited: 0 times

CHECK THESE SAMPLES OF Why Companies Pay Dividends

Irrelevant a Company's Dividend Policy to its Market Value

Discuss the Proposition that a Company's Dividend Policy is Irrelevant to its Market Value Dividend irrelevance theory basically signifies that an issuance of dividends must have little or no impact on stock price.... hellip; The assumption is that dividends not paid are reinvested by the company to generate more profit, thus higher stock values” (Dividend Irrelevance Theory n.... “Dividend policy refers to the decision regarding the magnitude of the dividend payout, the percentage of earnings paid to the stockholders in the form of dividends....
7 Pages (1750 words) Essay

Paying of Dividends by the Firms

Why some companies pay dividends while some others do not?... Does it matter whether or not firms pay dividends?... However, it seems that some companies do not pay dividends even though they are run profitably.... This paper will specifically discuss what happens whether or not firms pay dividends.... Hence, those concerns would not pay dividends.... Companies that do not pay dividends may use the saved money to invest in a new project, acquire new assets, repurchase their shares that have been sold to outsiders, or even to buy out a running company....
6 Pages (1500 words) Essay

Dividend Policy and Share Price

hellip; Findings: Share prices are positively influenced by earnings per share and dividends per share while negatively influenced by dividend yield and dividend payout.... Conclusion: dividends influence stock prices of listed firms on the Hong Kong Stock Exchange thus supporting the dividend relevance theories.... Contribution: This paper contributes to the literature on dividend puzzle by providing a perspective from an emerging market on the debate and supporting the relevance of dividends....
15 Pages (3750 words) Essay

The dividend discount models

ariable Growth model: This model is most reliable for firms with unstable but moderating growth rates, and which pay dividends that equal FCFE or where FCFE are difficult to estimate.... … The Dividend Discount Models mainly predict the dividends, and net present value of a common stock.... According to this method, the value of a dividend is the sum of all future dividends.... Three types of discount models predict future dividends or value of a stock as outlined below....
3 Pages (750 words) Essay

Dividend Policy in Publicly Traded Companies

The paper “Dividend Policy in Publicly Traded Companies” analyzes the dividend policy of a firm, which depends on several factors like Firms Financial needs, future growth plans and earnings, and investment opportunities, investors need for income or dividends.... hellip; The author states that dividends are the earnings distributed to the shareholders by a firm.... One is through the capital gains of the shares bought and through dividends paid by the company....
3 Pages (750 words) Assignment

Nokia and Motorola

There is a need for investors to forecast on possible earnings in the future using historical data of a company, we therefore analyze the two companies comparing the dividends paid, share prices, future growth and strategies, financial ratios and profitability. … Nokia Company emerged in 1995 in Finland, today it the largest company in Finland employing a large number of workers on the other hand Motorola was formed in 1928.... The two companies are quoted in the London stock exchange and using the financial ratios and historical dividends paid we will be in a position to determine which is the best investment option....
7 Pages (1750 words) Case Study

A Theory of Dividends

It is true that there are some companies that do not pay dividends.... In the constant dividend system, companies pay sum constant amount as dividend every year irrespective of the profit range while in the constant ratio system, they adopt a constant ratio on earnings.... This research paper “A Theory of dividends” examines the strong relationship existing between the dividend and share prices in relation to some important theories and their practicability....
42 Pages (10500 words) Dissertation

Does it matter whether or not firms pay dividends

Being paid on an annual or quarterly basis, a majority of companies pay dividends to the shareholders while others retain their entire profit and reinvest....  Mature companies pay dividends and still retain more profits for reinvesting.... The discussion seeks to answer the questions: Does it matter whether or not firms pay dividends?... Even though reinvesting back the profit is vital for the future expansion of the company, it significantly matters whether firms pay dividends....
5 Pages (1250 words) Essay
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us