Chapter investors are indifferent between dividends and capital

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Last updated: June 1, 2019

Chapter 2: Literature reviewIn this paper are examined theeconomic and behavioural factors affecting corporate dividend policy, applyingboth theoretical and empirical approaches. This chapter reviews the theoreticaland empirical literature considering corporate dividend policy. To have acomplete understanding regarding corporate dividend policy and how it isdetermined, literature review covers standard corporate finance theories underthe assumption of entirely rational and self-interested agents.

In addition tostandard theories, in this chapter are considered behavioural finance theoriesand psychological biases affecting the corporate dividend policy. The primarygoal of this literature review is to present different theoretical andempirical findings commenting on their results. The first section of theliterature review represents a brief outline of the existing standard corporatefinance theories considering dividend decisions. Researchers identified mostpopular theories concerning dividend policy.

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In this literature review, thesetheories presented as following: dividend irrelevance theory; dividendsignalling theory; agency costs; tax clientele effect; life-cycle theory;catering theory. Second section outlines an executive compensation factor thirdsection presents the board size and structure factor and fourth sectionpresents the discussion on a behavioural factors.  2.1.

1 Dividend Irrelevance TheoryBefore publication of theM&M theory, dividend theory was mainly based on the “bird-in-the-hand”argument. Dividend irrelevance theory was firstly proposed by Miller andModigliani (1961). Papescu and Visnescu (2011) state that M&M theory isconsidered as the accepted capital structure theory. According to this theory,the primary determinants of a firm’s value are earnings power and degree ofbusiness risk. In other words, the theory proposes that firm’s value depends onthe investment decisions. Miller and Modigliani state that corporate dividendpolicy does not affect firm’s cost of capital or price of firm’s shares.

However, there are some assumptions under which this theory holds. Theseassumptions summarised as follows:1)    No differences in tax (between dividendsand capital gains)2)    No transaction costs3)    Symmetric information4)    There is no conflict between managers andshareholders5)    All investors are price takersThe M&M theory also arguesthat investors are indifferent between dividends and capital gains. Dividendirrelevance theory is supported by studies of the leading researchers. Works ofHess (1981), Miller (1986) and Bernstein (1996) give empirical evidence insupport of the M&M theory. Despite the significant influence of the M&Mtheory on the financial theory, DeAngelo and DeAngelo (2007) believe that thetheory is irrelevant.

They believe that dividend policy has a more significantinfluence on firm’s value than M theory considers it.  The M theory was criticised by DeAngeloand DeAngelo (2006). They challenge unrealistic assumptions of the Mtheory, including perfect and frictionless markets. The M theory alsofaced criticism from researchers who did not agree with unrealistic nature ofthe 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 shareprice. According to the study of Baker, Farelly and Edelman (1985), based on asurvey of 318 respondents, chief financial officers agree that there is acorrelation between dividend policy and common stock prices. Inconsistency withthe dividend irrelevance theorem is showed by Siddiqi (1995) and Casey andDickens (2000).

Another survey, conducted by Baker and Powell (1999), showedthat CFOs of the US firms believe in a correlation between dividend policy andfirm’s value as well as its cost of capital. However some economistsbelieve in dividend irrelevance theorem, it is worth to mention thatassumptions of the theory are almost impossible to meet in a real world and itleads to a conclusion that most probably the value of the firm is dependent onthe corporate dividend policy.


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