So What Is The Best Kind Of Dividend Policy?

As you may already know, the goal of management is to 'create value for stockholders specifically to maximise shareholder wealth' (Jensen, 2001) and one of the factors that plays a role in achieving this goal is dividend policy. Dividend policy is the 'payout policy that a firm follows in determining the size and pattern of distributions to shareholders over time. Firms will distribute cash to shareholders through cash dividends, share repurchases, and specially designated dividends' (Baker & Weigand, 2015). Managers will have the responsibility to devise the best possible dividend policy for both the company and shareholders.

However, early literature on dividend policy expresses different views on the relationship between cash dividends and firm value. Modigliani & Miller (M&M) (1961) suggest that dividends are irrelevant for firm value and possibly even value destroying, whilst Linter (1965) and Gordon (1959) argue that dividends are an extremely important determinant of a firms value.

According to M&M's model, 'the value of a company is determined by its assets and and the cash flows generated by those assets and not by the way firms distribute cash flows to shareholders'(Baker & Weigand, 2015). They argue that in a perfect capital market (no transaction costs, no market imperfections, no taxation), existing shareholders are only fussed about increasing their own wealth, but will be indifferent as to wether it reaches them via dividend or through capital growth. This therefore means that a company can pay any level of dividend, with any financial shortfalls being solved by a new equity issue, being that it is investing in all +NPV projects. If investors needed cash, they could 'manufacture' their own by selling part of their shareholding. As-well as this, shareholders wanting retentions when a dividend is paid can just purchase more shares with the dividend they have received.

Linter (1965) and Gordon (1959) on the other hand argued that dividend policy is relevant to the share value and that investors prefer to receive dividends rather than invest the value of the dividend into future investments that are uncertain. This is known as the "Bird-in-the-hand" theory. Therefore, as investors prefer dividends, if a certain company were to begin paying low dividends investors may sell those shares and instead invest in a company which hayes out higher dividends. This will therefore cause the initial company's share price to fall.

Inevitably it is up to the management to decide wether they want to follow Modigliani & Millers or Linter & Gordons policy, or perhaps any other theories out there. What you must recall though is that in the real world M&M's assumptions stating that perfect capital markets exist, there is no issue cost for securities and that there is no tax, simply can't happen. Otherwise stock market exchange would be useless since we could assume there would not be any tax evasion or fraud in the financial world to establish M&M's assumption.