1. Saving on floatation costs
No need to raise debt or equity capital since there is high retention of earnings which requires no floatation costs.
2. Avoidance of dilution of ownership
New equity issue would dilute ownership and control. This will be avoided if retention is high.
A high retention policy may enable financing of firms with rapid and high rate of growth.
3. Tax position of shareholders
High-income shareholders prefer low dividends to reduce their tax burden on dividends income.
They prefer high retention of earnings which are reinvested, increase share value and they can gain capital gains which are not taxable in Kenya.
ii) MM Dividend Irrelevance Theory
Was advanced by Modiglian and Miller in 1961. The theory asserts that a firm’s dividend policy has no effect on its market value and cost of capital.
They argued that the firm’s value is primarily determined by:
Ability to generate earnings from investments
Level of business and financial risk
According to MM dividend policy is a passive residue determined by the firm’s need for investment funds.
It does not matter how the earnings are divided between dividend payment to shareholders and retention. Therefore, optimal dividend policy does not exist. Since when investment decisions of the firms are given, dividend decision is a mere detail without any effect on the value of the firm.
They base on their arguments on the following assumptions:
No corporate or personal kites
No transaction cost associated with share floatation
A firm has an investment policy which is independent of its dividend policy (a fixed investment policy)
Efficient market – all investors have same set of information regarding the future of the firm
No uncertainty – all investors make decisions using the same discounting rate at all time i.e required rate of return (r) = cost of capital (k).
iii) Bird-in-hand theory
Advanced by John Litner (1962) and furthered by Myron Gordon (1963).
Argues that shareholders are risk averse and prefer certainty. Dividends payments are more certain than capital gains which rely on demand and supply forces to determine share prices
Therefore, one bird in hand (certain dividends) is better than two birds in the bush (uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value since shareholders will require to use lower discounting rate.
MM argued against the above proposition. They argued that the required rate of return is independent of dividend policy. They maintained that an investor can realize capital gains generated by reinvestment of retained earning, if they sell shares.
If this is possible, investors would be indifferent between cash dividends and capital gains.
iv) Information signaling effect theory
Advanced by Stephen Ross in 1977. He argued that in an inefficient market, management can use dividend policy to signal important information to the market which is only known to them.
Example – If the management pays high dividends, it signals high expected profits in future to maintain the high dividend level. This would increase the share price/value and vice versa.
MM attacked this position and suggested that the change in share price following the change in dividend amount is due to informational content of dividend policy rather than dividend policy itself.Therefore, dividends are irrelevant if information can be given to the market to all players.
Dividend decisions are relevant in an inefficient market and the higher the dividends, the higher the value of the firm. The theory is based on the following four assumptions:
The sending of signals by the management should be cost effective.
The signals should be correlated to observable events (common trend in the market).
No company can imitate its competitors in sending the signals.
The managers can only send true signals even if they are bad signals. Sending untrue signals is financially disastrous to the survival of the firm.
v) Tax differential theory
Advanced by Litzenberger and Ramaswamy in 1979
They argued that tax rate on dividends is higher than tax rate on capital gains.Therefore, a firm that pays high dividends have lower value since shareholders pay more tax on dividends.
Dividend decisions are relevant and the lower the dividend the higher the value of the firm and vice versa.
In Kenya, dividends attract a withholding tax of 5% which is final and capital gains are tax exempt.
vi) Clientele effect theory
Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different preferences for dividends depending on their level of income from other sources.
Low income earners prefer high dividends to meet their daily consumption while high income earners prefer low dividends to avoid payment of more tax. Therefore, when a firm sets a dividend policy, there’ll be shifting of investors into and out of the firm until an equilibrium is achieved. Low, income shareholders will shift to firms paying high dividends and high income shareholders to firms paying low dividends
At equilibrium, dividend policy will be consistent with clientele of shareholders a firm has. Dividend decision at equilibrium are irrelevant since they cannot cause any shifting of investors.
vii) Agency theory
The agency problem between shareholders and managers can be resolved by paying high dividends. If retention is low, managers are required to raise additional equity capital to finance investment.Each fresh equity issue will expose the managers financing decision to providers of capital e.g bankers, investors, suppliers etc.Managers will thus engage in activities that are consistent with maximization of shareholders wealth by making full disclosure of their activities.
This is because they know the firm will be exposed to external parties through external borrowing. Consequently, Agency costs will be reduced since the firm becomes self-regulating.
Dividend policy will have a beneficial effect on the value of the firm. This is because dividend policy can be used to reduce agency problem by reducing agency costs.The theory implies that firms adopting high dividend payout ratio will have a higher due to reduced agency costs.