Chapter investors are indifferent between dividends and capital

Chapter 2: Literature review

In this paper are examined the
economic and behavioural factors affecting corporate dividend policy, applying
both theoretical and empirical approaches. This chapter reviews the theoretical
and empirical literature considering corporate dividend policy. To have a
complete understanding regarding corporate dividend policy and how it is
determined, literature review covers standard corporate finance theories under
the assumption of entirely rational and self-interested agents. In addition to
standard theories, in this chapter are considered behavioural finance theories
and psychological biases affecting the corporate dividend policy. The primary
goal of this literature review is to present different theoretical and
empirical findings commenting on their results. The first section of the
literature review represents a brief outline of the existing standard corporate
finance theories considering dividend decisions. Researchers identified most
popular theories concerning dividend policy. In this literature review, these
theories presented as following: dividend irrelevance theory; dividend
signalling theory; agency costs; tax clientele effect; life-cycle theory;
catering theory. Second section outlines an executive compensation factor third
section presents the board size and structure factor and fourth section
presents the discussion on a behavioural factors. 

2.1.1 Dividend Irrelevance Theory

Before publication of the
M&M theory, dividend theory was mainly based on the “bird-in-the-hand”
argument. Dividend irrelevance theory was firstly proposed by Miller and
Modigliani (1961). Papescu and Visnescu (2011) state that M&M theory is
considered as the accepted capital structure theory. According to this theory,
the primary determinants of a firm’s value are earnings power and degree of
business risk. In other words, the theory proposes that firm’s value depends on
the investment decisions. Miller and Modigliani state that corporate dividend
policy does not affect firm’s cost of capital or price of firm’s shares.
However, there are some assumptions under which this theory holds. These
assumptions summarised as follows:

1)    No differences in tax (between dividends
and capital gains)

2)    No transaction costs

3)    Symmetric information

4)    There is no conflict between managers and
shareholders

5)    All investors are price takers

The M&M theory also argues
that investors are indifferent between dividends and capital gains. Dividend
irrelevance theory is supported by studies of the leading researchers. Works of
Hess (1981), Miller (1986) and Bernstein (1996) give empirical evidence in
support of the M&M theory. Despite the significant influence of the M&M
theory on the financial theory, DeAngelo and DeAngelo (2007) believe that the
theory is irrelevant. They believe that dividend policy has a more significant
influence on firm’s value than M theory considers it.  The M theory was criticised by DeAngelo
and DeAngelo (2006). They challenge unrealistic assumptions of the M
theory, including perfect and frictionless markets. The M theory also
faced criticism from researchers who did not agree with unrealistic nature of
the theory. On the basis of the Black and Scholes’s (1974) work, Ball et al.
(1979) proposed an empirical study of the effect of dividends on firm’s value.
In this study Ball et al. failed to find evidence supporting M theory.
Partington (1985) found a relationship between dividend payments and share
price. According to the study of Baker, Farelly and Edelman (1985), based on a
survey of 318 respondents, chief financial officers agree that there is a
correlation between dividend policy and common stock prices. Inconsistency with
the dividend irrelevance theorem is showed by Siddiqi (1995) and Casey and
Dickens (2000). Another survey, conducted by Baker and Powell (1999), showed
that CFOs of the US firms believe in a correlation between dividend policy and
firm’s value as well as its cost of capital.

However some economists
believe in dividend irrelevance theorem, it is worth to mention that
assumptions of the theory are almost impossible to meet in a real world and it
leads to a conclusion that most probably the value of the firm is dependent on
the corporate dividend policy.

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