Analysis of Dividend Policy

If the debt-to-equity ratio is in favor of the former the manager would have greater dispersion in determining the dividend policy. More debt means less tax liability and less dividend payout. When debt holders power increases vis–vis equity holders dividend policy becomes an instrument in the hands of the manager to play each group against the other (Pike, &amp. Neale, 2003).
The dividend policy and the capital market structure of the firm can be examined with reference to a number of theories. The Modigliani-Miller Theorem is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm (Ross, Westerfield, &amp. Jaffe, 2002). In recent times these theoretical constructs have been developed in line with an ever increasing tendency to consider the leverage issue of the company. Leveraging by managers to achieve exclusive personal goals is nothing new. In fact, it’s the conflict of interests between the principals or owners (or shareholders) and the agents (or managers) that have thrust the issue of leverage to the fore. In other words, the complex issues revolving around the capital structure of the firm are basically influenced by this conflict in which managers tend to have more information about the probable outcomes of future investments than shareholders. Thus this information asymmetry leads to a series of other problems.
Disagreement between managers’ behavior on the one hand and the shareholders’ behavior on the other gives rise to a series of other related problems, e.g. information asymmetry, agency costs, taxation and bankruptcy costs. Information asymmetry refers to the manager’s ability to control the flow of information in his favor so that the principal or the owner would have less access to information (Jonathan, &amp. DeMarzo, 2007). Agency costs are related to the principal-agent relationship. For example, when a principal hires an agent he does so with the intention that the latter would act in conformance with certain rules to bring about what the former wishes.
However, the motivating factor behind such performance is monetary compensation such a good salary to the manager. Therefore such behavior on the part of the manager would not be in his best interest. His tendency to deviate from what is expected of him is common among all managers. In order to reduce such negative behavior, the manager must be adequately compensated. However, the principal does not know what the agent would do to ensure that his own interest prevails. Costs that are associated with this behavior are known as principal-agent costs or the principal-agent problem.
(a). Asset substitution effect
Assuming that projects are riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and shareholders to condone such risky investment decisions on the part of managers. However, in the long run with new projects rising, the value of the firm is bound to decrease while a net transfer of wealth from debt-holders to shareholders is more likely.