Why Do Firms Pay Dividends? Justifications for Dividend Payments and Firm Value Implications

International Journal of Research and Scientific Innovation (IJRSI) | Volume VI, Issue V, May 2019 | ISSN 2321–2705

Why Do Firms Pay Dividends? Justifications for Dividend Payments and Firm Value Implications

Dr. Friday Kennedy Ozo¹, Dr. Anthony Odinakachukwu Nwadiubu²

¹Department of Accountancy/Business Administration/Banking and Finance, Alex Ekwueme Federal University Ndufu-Alike, Ebonyi State, Nigeria
²Dean, Faculty of Management Sciences, Eastern Palm University, Imo State, Nigeria

Abstract – Under the assumptions of perfect capital market and investor rationality, Miller and Modigliani (1961) concluded that dividend policy is irrelevant to firm value. However, capital markets are less than perfect in the real business world. Consequently, in the presence of realistic capital market imperfections such as information asymmetry, agency costs, taxes, and irrational investor behaviour, dividend policy creates a means to enhance shareholder value. This paper seeks to discuss the main theories that explain why firms pay dividends and the impact of such distributions on the value of the firm.

Keywords – Dividends, market imperfections, dividend payments, firm value.

I. INTRODUCTION

The question of why firms pay dividends and the impact of dividend distributions on the value of a firm has been the subject of considerable debate for several decades. Based on either a behavioural or empirical approach, studies have provided rationales to address the issue of why firms pay dividends and the impact of such disbursement on the value of a firm. However, as of today, corporate dividend policy still remains a puzzle as a mix of opinion continues to exist about the impact of dividend policy on firm value (Black, 1976; Brealey et al., 2008).
The theoretical framework of the impact of dividend distributions on firm value revolves around two schools of thought, which have divergent views. The first school of thought is the dividend irrelevance hypothesis put forward by Miller and Modigliani (1961).The authors argued that in a perfect capital market with investor rationality, the dividend policy has no impact on shareholders’ wealth and, is, therefore, irrelevant. Under a perfect capital market, information is costless and available to everyone, no distorting taxes exist, floatation and transaction costs are non-existent, and no contracting or agency cost exist (Lease et al., 2000). An alternative school of thought is the dividend relevance theory, which suggests that a properly managed dividend policy is critical to the value of the firm (Graham & Dodd, 1934; Lintner, 1962; Gordon, 1963). In other words, dividend policy is relevant to firm value in that firms that pay a higher dividend enjoys a lower discount rate for future cash flows and thus have a higher value.

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