AFIN 253 Financial Management Name: QIN LIU ID:42670314
Question
The dividend discount model tells us that the value of a firm is equal to the present value of its expected dividend payments.
Does this mean that these firms are worth nothing? Discuss with reference to academic research and theory.
Answer
723 words
It does not mean the firms are worth nothing when firms have never paid dividends and have no intention of doing so.
The dividend policy has a significant influence on shareholders’ investment to gain more profits. The optimal dividend policy of a corporation relies on capital gains and they always would like to quit dividend now for future returns, they realize the risk which is associated with delay of returns as well (Adeoti& Oladipo, 2013). Meanwhile, investors are attracted to various companies which can provide them with their desired dividend pattern. When the companies change their policies, investors will readjust their inventories accordingly. (King & Mervyn, 1977). However, Gordon (1962) also proposes that investors have a predilection for current dividends and the dividend policy of a corporation and its market value have a direct correlation. What’s more, Gordon demonstrates that investors do not want to encounter risks even though less risks to current rather than future dividends or capital gains.
What’s more, the corporations enable the value of shares to be maximized by paying dividends even though the funds could be replaced as retained earning and subsequently distributed to shareholders which would allow them to be taxed more favorably as capital gains. (Martin &Jerry, 1983). Meanwhile, dividends are taxed at rates changing up to 70 percent and nearly 40 percent for individual shareholders. In contrast, retained earnings mean no consistent tax liability, and the retained earnings is taxed only with the rise in the share value while the stock is sold and then at least 60 percent gaxi is untaxed. ( Feldstein & Martin, 1983). Moreover, Elroy, Paul and Mike (2002) also examined that the contributions to returns provided by capital gains and dividends from 1900 to 2000. They found that while year-to-year performance was driven by capital appreciation, long-term returns were largely driven by reinvested dividends.
Some investors believed that the dividend payout methods are beneficial for the shareholders to invest in the firm. Succeeding earnings growth associates with high dividend payout ratios. High cash dividends reduce retained earnings, whilst high stock dividends effectively dilute subsequent earnings, both are assumed to go against the future earnings growth of a company (Chin-Sheng, Chun-Fan &Szu-Hsien, 2009). Meanwhile, the payout ratio is also used in a number of different situations. Because most analysts evaluate growth in earnings rather than dividends, payout ratio is used in to assess dividends in the future (Cyert and March, 1993).
Some investors consider that shareholders have some influences on dividend payments. Shleifer, Vishny (1986) and Allen, Michaely (2003), discuss that corporate block investors are attracted to dividend-paying firms. Allen, Bernardo, and Welch pay an attention on clientele of duty-free institutions who are neutral between dividends and capital gains, their model predicts that both firm’ dividend policies and large-block shareholders’ investment decisions affected by the shareholders’ dividend tax status. Elton and Gruber (1970) find that exdividend day stock returns are decreasing in a stock’s dividend yield, which they interpret as evidence supporting tax-based dividend clienteles. Elton and Gruber note that investors in the highest yield stocks exhibit a preference for dividends over capital gains, a preference they attribute, at least partially, to corporations’tax preference for dividends.
However, some companies still have no intention to pay dividends to the