discuss the significance of varying cash dividend payments for large firms quoted on stock markets

Empirically companies payout dividends with high ratio, and they spend much time and energy on deciding how much to pay out as dividends to maximize firm’s value.According to Gordon(1959)’s dividend discount model, firm’s value goes positively with the change of dividend payout, because capital gains are more risky than dividends.(1)But in 1961, Modigliani and Miller argued that there is no relationship between dividend and firm’s value if only there are some assumptions.It’s the irrelevance of dividend policy proposition and it became the benchmark of all debate relating dividend theories.One fundamental assumption in MM model is that the firm’s investment policy is irrelevant and independent from dividend policy. The firm can issue new shares without transaction costs and the issuing new share is the only way to finance for dividends when there is not enough profits or free cash flow.If a firm which had planned to pay $10,000 as dividend changed dividend policy to pay $15,000 instead, the firm should issue new share to make cash of $5,000. Issuing new shares make the new share price down by the same amount of changed dividends. Eventually, the firm’s value which is presented as stock price is the same as the first dividend policy.To the investor, the change of dividend policy is irrelevant. That can be achieved by ‘homemade dividend’. By buying and selling the stocks, investor can replicate the change of dividend policy. When dividends increase, investor can buy the stockl. When dividends decrease, investor may sell the stock to increase cash flow.When the assumptions are violated, dividends matter.  Assumptions are as follows;First,  No taxesSecond,  Symmetric informationThird,  No agency costTaxes can make dividend policy matter. In many countries, including the United States before 1986, the investor receiving dividends is taxed at a higher rate than the investor who receive a capital gain by selling shares.Even if taxes on dividends and capital gains are the same, investors will prefer not to obtain dividends, because the investor can postpone tax by delaying the sale of the share.In U.S., after mid-1990s the number of stock repurchases started to exceed the number of dividends.Stock repurchase is accomplished by three methods.First, simply buy a firm’s stock in the market.Second, the firms notice all investors in the market that the company would buy their shares at specified price. This procedure is called as ‘tender offer’.Third, a firm buy it’s shares from specific individual stockholders.The reasons for firms to take stock repurchases are as follows;First, FlexibilityIncrease in cash flow is temporary, stock repurchase is easy to accept by firms. Because it’s easy to increase or decrease the amount of repurchase.Second, Executive CompensationWhen there are stock options for executives of a firm, stock repurchase is better than dividends when it comes to the price of stock after paying out. So, stock repurchase can be beneficial for executives.Third, Offset to dilutionThe execution of stock options increases the number of shares outstanding, it means lowering of the stock price. In this case, stock repurchase can help offset to dilution on the value of the stock.Fourth. UndervaluationStock repurchase may be done as the method of investment by the firm when the stock price of the firm is believed as undervalued.If firms don’t have sufficient cash flow to pay dividends, paying dividend is costly. Investor should pay tax on dividend, firms should cost transaction cost for issuing new shares.But, what about the firm with enough cash flow to pay a dividend. The firm with sufficient cash might consider the following alternatives to a dividend.First, Select additional capital budgeting project even though it’s NPV is negative. Because big company may give the manager the prestige, high pay, etc.Second, Acquire other company.If a corporation acquire other company to avoid paying a dividend, the acquisition is hard to succeed. Because proper M&A strategy also not a easy business.Third, Purchase financial assets.Whether investing in financial asset is better or not relating to paying out a dividend depends on tax rate of individual and institution. If the tax rate of institution is lower than the rate of individual, it is better to invest in financial asset within company. But Internal Revenue Code penalizes firms exhibiting improper accumulation of surplus, so few companies actually invest in financial asset without limit.Fourth. Repurchase shares.Under current tax law, stockholders generally prefer a repurchase to a dividend. In the past, SEC had accused some firms undergoing share repurchase programs of illegal price manipulation, but not now. The IRS can penalize firms repurchasing their own stocks to avoid the taxes that would be levied on dividends.In reality, tax rates are various among investors. Institutions only pay 30% of dividend, while pension fund pay no tax.We can cluster investors according to their preferences for dividend depending on taxes. Which is so called ‘the clientele effect’.Investors would prefer stocks with dividends depending not on the dividend policy but on their tax brackets.Clienteles are likely to form in the following way;Table 1.Group    StocksIndividuals in high tax brackets    Zero- to low-payout stocksIndividuals in low tax brackets    Low- to medium-payout stocksTax-free institutions    Medium-payout stocksCorporations    High-payout stocksThe main implications of the clientele effect are the following.First, Firms get investors they deserve.Second, Firms are sticky on dividend policy due to the fact that there are already formed clientele around this dividend policy.Third, With diverse investors, the value of the firm is independent of its payout policy and dividend policy is irrelevant. Because reshuffling of investors will not have an effect on the value of the firm.Second important assumption of irrelevance proposition by MM is asymmetric information between manager and investor.In real world, shareholders have imperfect information. Thus, managers can choose to use dividends as a signal to convey information about the company. This information might influence shareholder’s perception and valuation of the firm. So, dividend policy dose matter.There are opposite opinions. First, there are less costly and more effective way of signalling information to shareholders. Second, the signal is unclear. There may be different reason to increase or decrease dividend payout.It is important that the market is sensitive to negative signal, so if firms decrease dividends with reasonable explanations, market might react negatively about that signal.The argument of asymmetric information is not proved empirically yet. Allen and Michaely(1995) said that ‘The relationship between dividend changes and subsequent earnings changes is positive, but not significant. Given these, it is rather hard to interpret any of the evidence as supporting the information signalling hypothesis’A reasonable essay. The use of more literature would have improved upon the quality of the essay.