Dividends’ Impact on Investment Decisions

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Table of Contents

Introduction
Analysis
Dividend policy
Dividend irrelevance and relevance theory
The signaling explanation
Conclusion
References

Introduction

Wealth creation can be achieved through different strategies. Developing an investment portfolio is one of the most effective wealth creation strategies. According to Khan and Jain (2007), the investment decision entails the selection of different assets in which investors decide to commit their funds. The investment decision can either entail investing in long-term or short-term assets. Uwajeh (2011) supports this view in his assertion that the “majority of investors seek to invest their money in an investment vehicle to generate a higher value” (p. 23).

Individuals and organizations must define clearly their goals and expectations concerning their finances. Uwajeh (2011) contends that some investors are motivated to invest to derive periodic income flows either quarterly or annually from the initial investment. Thus, investors should formulate reasonable investment goals. According to Doroghazi (2012), it is imperative for investors to determine the minimum investment goal, for example, a 10% return on their total investment. However, investors must appreciate the fact that the annual returns are likely to fluctuate due to market changes.

Earning dividends constitutes one of the core drivers that motivate individuals to invest in different stocks or shares. Baker and Powell (2005) assert that investing in-stock products that pay dividends on an increasing basis should be a key consideration amongst investors to maximize the return from their portfolio. In their investment decision, an investor must develop an optimal understanding of the interplay between dividend payout and the level of investment. Sebabole (2014) corroborates that an organization’s cash flows have a significant impact on the dividend payout capacity. This essay entails an evaluation of the impact of dividends on investment decisions.

Analysis

In the course of their operations, organizations have the discretion to issue dividends to investors. Khan and Jain (2007) assert that organizational managers may consider two main sources of dividends. These sources include the organization’s earnings and its capital. However, paying shareholders’ dividends out of capital might be limited by legal constraints. In addition to the above aspects, the dividends might be paid in two main forms, which include cash or capitalization into shares, which are commonly referred to as bonus shares.

Individuals have an opportunity to invest for income by selecting stocks that earn dividend yields. In the course of making investment decisions, it is essential for investors to develop an adequate understanding of the target organization’s dividend policy decision. Khan and Jain (2007) affirm that the analysis of an organization’s dividend policy should be undertaken by assessing the financing decision.

Organizational managers are faced with two main alternatives in dealing with the profits earned. The profit can be retained in order to foster the organization’s long-term growth. Khan and Jain (2007) posit that alternatively, “the profit can be distributed to stockholders as dividends” (p. 19). The dividends are obtained by dividing the profits amongst the shareholders. The dividend payout ratio is determined by internal and external factors. One of the internal factors entails the organization’s cash flow streams. Conversely, the external factors are related to the legal constraints. Khan and Jain (2007) assert that the “final decision as to which course should be followed depends largely on a significant element in the dividend decision, the dividend-payout ratio” (p. 19). However, the final decision on how to treat the earnings largely depends on the available investment opportunities and the shareholders’ preferences. According to Gaspar, Massa, Matos, Patgiri, and Rehman (2012), organizational managers assess the trade-off between the stockholders’ investment prospect and the payout choice. The amount received by an individual investor as dividends depends on the number of shares held. Thus, as the number of stocks held increases, “the income flow received by investors in the form of dividend increases” (Gaspar et al., 2012, 9. 270).

In an effort to attract investors, most organizations have integrated the concept of dividends. Uwajeh (2011) asserts that investors must undertake extensive research to determine the most effective stock to invest in. Furthermore, Uwajeh (2011) is of the view that as long as “you hold a portfolio of performing stocks you should receive a dividend yield on a regular basis” (p. 43). Thus, it is possible for investors to generate a stream of income by targeting dividend-yielding stocks. One of the unique characteristics of investing in dividend-yielding stocks is that despite the decline in the value of the initial investment, the investor continues to earn the dividend return. Subsequently, the dividend is not affected by the fluctuation in his or her stock value. This aspect means that investors can avoid the risk associated with investing in the stock market by focusing on dividends (Uwajeh, 2011).

Most investors who invest for speculative purposes such as share price appreciation in the stock market ignore the fact that it is possible to generate a stream of returns from dividends. Dividends are a key component of an organization’s total investment returns. Investors who intend to generate income from dividends must select the stocks wisely. Some of the organizations that investors must consider entail the mature organizations that do not largely depend on retained earnings to cater for organizational growth such as staffing and purchase of additional plants and equipment (Gaspar et al., 2012).

Dividend policy

The above analysis cites dividends as an effective strategy that individuals can adopt in order to generate a stream of income. Gaspar et al. (2012) assert that it is myopic for individual investors to assume that the organization’s board of directors in collaboration with the managers will distribute all the earnings made as dividends. On the contrary, organizations appreciate the likelihood of encountering deficit financing. If an organization distributes all its earnings as dividends, it is likely to resort to financing its operations using extraordinary debt capital or by issuing additional equity shares in the stock market.

To avoid such situations, it is imperative for organizational managers to formulate effective dividend policies. Consequently, the formulation of a dividend policy should consider organizations’ cash flows. Moreover, one can assert that assessing an organization’s dividend-paying capacity is a critical aspect that investors intending to generate a stream of income should consider.

Dividend irrelevance and relevance theory

The concept of dividends has been a puzzle to individual and organizational investors. Doroghazi (2012) cites the existence of varied opinions on the significance of the dividend policy. The variation is well illustrated by the dividend irrelevance and irrelevance theory. The dividend irrelevance theory postulates that the dividend paid by an organization is irrelevant. Additionally, shareholders are indifferent with reference to receiving dividends. Whether an organization pays high or low dividends does not matter to investors. Moreover, the theory argues that the dividend policy is only a packaging adopted by an organization by its cash flows. Thus, the theory recognizes that an organization’s dividend payout capacity depends on its assets. Baker and Powell (2005) further opine that the dividend paid out to investors makes investors richer while the organization becomes poorer with an equivalent margin. The theory further assumes that there is ‘no optimal’ dividend policy.

The second theory that explains the concept of dividends entails the dividend relevance theory. The theory argues that an organization’s dividend policy matters in attracting investors. The dividend relevance theory accentuates the dividend policy matters in improving an organization’s attractiveness to investors. According to the theory, significant imperfection or frictions characterize markets. The imperfections arise from three main sources, which include agency costs, asymmetric information, and taxes.

The signaling explanation

In addition to the above explanation, the relevance of dividends in investment decision-making is further illustrated by the need to gather adequate information. Ramalingegowda, Wang, and Yu (2013) assert that perfect markets are characterized by information asymmetry. Only a few individuals such as the corporate managers may be privileged to have information that might contribute to effective investment decision-making. The stock price information might not present the true earning capacity of an organization due to information asymmetry. The existence of information asymmetry might limit the potential investors’ ability to make effective decisions. According to the signaling theory, some investors rely on the dividend information in evaluating an organization’s stock price. Subsequently, dividends convey relevant information regarding the quality of an organization, hence providing potential insight into their investment decision-making process. Baker and Powell (2005) contend that shareholders consider dividends as tangible evidence of an organization’s future prospects. Thus, dividends are a source of relevant information content. If an organization announces its decision to offer investors high dividends, it may perceive such information as relevant in determining the organization’s future dividend-payment prospects. Thus, information on dividends increases the investors’ level of confidence in the possibility of generating a positive stream of income in the form of dividends. Alternatively, the omission or decline in the level of dividend issued to investors might signal prospects of weak future cash flows and earnings. Under such circumstances, the likelihood of developing positive confidence amongst investors regarding an organization’s dividend payment might be significantly limited.

Investors have specific expectations in their investment processes. First, some investors are motivated to purchase securities by the need to generate income. Subsequently, they are likely to target organizations that offer stable and relatively large dividends. Thus, the omission or reduction in the level of investment might lead to significant challenges amongst such investors (Baker & Powell, 2005).

Apart from the income stream associated with dividends, the significance of the dividend information is also relevant to investors who invest for speculative purposes in the stock market. Baker and Powell (2005) opine that an increase “in stock prices often accompanies larger than expected dividend increases” (p. 416). Similarly, a decline in the level of dividends might lead to a remarkable decline in stock prices. This aspect underscores the fact that dividends are a source of relevant information amongst investors seeking a stream of income and those investing for speculative purposes. Changes in the dividend policy are immediately reflected in an organization’s stock prices. Baker and Powell (2005) affirm that dividends are “important because the timing and size of a firm’s expected dividend payments ultimately determine the value of a firm’s stock” (p. 405).

The investors consider the dividend policy in making investment decisions in order to assess the extent to which it is aligned with their risk preferences. Past studies show that the stockholders’ risk perception influences their dividend policy preferences. For example, if an organization has integrated a dividend policy that requires $1 retention for every share, the investors might expect to generate a higher return in the future by reselling their stocks at a price higher than $1. However, risk-averse investors might not be attracted to invest in such an organization. On the contrary, the investors might demand to receive cash dividends rather than wait to resell their stocks at a higher price. This argument is supported by the ‘bird-in-the-hand’ argument (Baker & Powell, 2005).

Additionally, the risk-averse investors might also evaluate the dividend payout policy in making investment decisions in order to determine the degree to which the dividend policy is aligned with their risk preferences. Schwartz (2013) argues that investing in dividend-paying stocks enables “investors to get cash out of the market without reselling stock and incurring nettlesome trading costs” (par. 7).

The significance of dividends in the investment decision-making process is further explained by the investors’ tax liability. Some investors are attracted to invest in stocks to generate a sufficient stream of income to cover their taxes and other consumption needs. Baker and Powell (2005) assert that investors have different tax statuses. Investors within the high-income tax bracket are mainly attracted to stocks that are characterized by no or low dividends. Investors who receive dividends are required to declare it as a source of income in their tax payment processes. Consequently, such investors decide to invest in such stocks in order to reduce the tax liability associated with high dividend-paying stocks. By retaining, their earnings organizations enable the investors in the high tax bracket to postpone their payment on capital gains such as the dividends. Thus, such a dividend policy enables investors to “reduce the present value of their future tax payments” (Baker & Powell, 2005, p. 418).

The dividend disbursement influences the level of investment in dividend-yielding stocks. Carey and Essayyad (2001) support this view by noting that since “it appears that cash flow is important in the investment decision, the dividend payout decision may affect the level of investment” (p. 302). Moreover, Carey and Essayyad (2001) are of the perception that an organization might not pay dividends if it is legally insolvent or characterized by overdue liabilities. Carey and Essayyad (2001) further corroborate that an organization might not advance cash dividends to stockholders if it is experiencing liquidity challenges.

The above analysis cites dividends as a fundamental element that investors should take into account in making investment decisions. Investors are motivated to invest in stocks for different purposes. The first category entails investors who intend to generate a stream of income. Dividends constitute a critical source of income amongst investors seeking a stream of income. Alternatively, some investors are motivated to purchase stocks by the need to generate high returns through speculation. In the course of making investment decisions, it is essential for organizations to consider the target organizations’ dividend policy.

Conclusion

This analysis recognizes the existence of different theories concerning dividends, such as the dividend irrelevance and relevance theory. However, this paper refutes the dividend irrelevance theory, which asserts that investors are indifferent regarding dividends. Thus, it supports the dividend relevance theory, which affirms that investors are concerned about dividends in their investment decision-making process. The significance of dividends in the investors’ decision-making process cannot be overlooked in the process. Dividends are a source of relevant information that investors can rely on. The unique nature of dividends as a source of investment information arises from the view that the information is not asymmetry as opposed to information on the stock price. Furthermore, the dividend has a significant impact on the investors’ decision-making process as it enables investors to make decisions that align with their investment needs and risk preferences. Thus, the consideration of dividends enables investors to construct their most preferred investment portfolio. Therefore, investors are in a position to make effective investment decisions on the level of investments with reference to the dividend-earning stocks to invest in.

Considering the relevance of dividends in the investment decision-making process, investors must develop a comprehensive understanding of the factors that influence an organization’s dividend-paying capacity. By analyzing the dividend-paying capacity, the organization will be in a position to identify organizations that use dividends as a way of attracting investors. Thus, the probability of avoiding the risk associated with poor investment decisions is improved considerably.

References

Baker, K., & Powell, G. (2005). Understanding financial management; a practical guide. Oxford, UK: Blackwell Publishers.

Carey, O., & Essayyad, M. (2001). The essential of financial management. New Jersey, NJ: Research & Education Association.

Doroghazi, R. (2012). The physician’s guide to investing; a practical approach to building wealth. New York, NY: Springer Science & Business Media.

Gaspar, J., Massa, M., Matos, P., Patgiri, R., & Rehman, Z. (2012). Payout policy choices and shareholder investment horizons. Review of Finance, 17(2), 261-320.

Khan, M., & Jain, P. (2007). Financial management. New Delhi, India: Tata McGraw-Hill.

Schwartz, T. (2013). Dividends; take the money and run. Web.

Sebabole, M. (2014). Asset returns predictability and portfolio selection; hedge funds versus Equities. Global Conference on Business and Finance Proceedings, 9(2), 102-111.

Ramalingegowda, S., Wang, C., & Yu, Y. (2013). The role of financial reporting quality in mitigating the constraining effects of dividend policy on investment decisions. The Accounting Review, 88(3), 1007-1039.

Uwajeh, A. (2011). Building wealth with dividend stocks in the Nigerian stock market. Chicago, IL: Tata McGraw-Hill.

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