Dividend Policy

More Properly:
Payout Policy
Historical View
Illustrated by the arguments of Gordon (1959)
- more dividends = more value
Follows from the discounted dividend
approach to valuing a firm:

Dt
V0
t 1 (1 rt )
t
Historical View
Gordon argued that retained earnings rather than
current dividends made the cash flow stream for the
shareholder riskier.
This would increase the cost of capital.
The future dividend stream would presumably be
higher due to the investment of retained earnings
(+NPV).
He argued the first effect would be the dominant one.
Now called the bird in the hand fallacy.
Along Came M&M
Basic Point: Firm value is determined by its
investment policy, net dividends are simply
the residual of earnings after investment.
Dividend Irrelevance
No Taxes or Transactions Costs
Symmetric Information
Complete Contracting Possibilities
Perfect Capital Markets
Dividend Irrelevance Example
Consider the case of Ralph Inc.
Currently (time 0) Ralph Inc. is expected to survive another
year in business (till time 1). At which time the firm will
liquidate and all value will be distributed to claimants.
The firm is presently all equity financed with 50,000 shares
outstanding. The cash flow of the firm is risk free and it is
common knowledge that Ralph Inc. will receive $1 million
immediately and another $1 million at time 1.
The current dividend policy is for Ralph Inc. to payout its
entire cash flow as dividends as it is received. So $20 per
share now and at time 1.
The risk free rate in the economy is 5%. And the firm has
no positive NPV projects available.
Dividend Irrelevance Example
Ralph, the CEO of Ralph Inc. is convinced that an
alternative dividend policy would increase the
current stock price.
The current value of the firm and the price per share
is: V0 = Div0 + Div1/(1.05)
= $1m + $1m/(1.05)
= $1,952,380.95 or P0 = $39.05 per share.
The share price will drop to $19.05 after the time 0
dividend is paid.
Ralph wants you to evaluate the impact on the
current stock price of an increase or a decrease of
the current dividend of $2 per share.
Dividend Irrelevance Example
$2 per share dividend increase:
A $2 per share dividend requires $1,100,000 in total so the
firm must raise $100,000 to accomplish this policy change.
The firm can issue risk free bonds to raise $100,000 today
they must promise to repay $105,000 (5% risk free rate) in
one year.
This will leave only $895,000 in total dividends, or $17.90
per share, for the existing shareholders at time 0.
The time zero stock price will then be:
P0 = $22 + $17.90/(1.05) = $39.05 (??). The price will drop
to $39.05 - $22 = $17.05 when the time 0 dividend is paid.
Dividend Irrelevance Example
$2 per share dividend decrease:
With an $18 per share dividend today this leaves
an extra $100,000 in cash within the firm.
Because the firm has no positive NPV projects it
does the next best thing and makes a zero NPV
investment, buying t-bills.
With a risk free rate of 5%, the t-bills will return
$105,000 at time 1. This implies a total dividend
of $1,105,000 or $22.10 per share at time 1.
The current stock price is:
P0 = $18 + $22.10/(1.05) = $39.05
Dividend Irrelevance Example
What made this example work?
Two things were critical:
1. We fixed the cash the firm will receive and assumed
they had no positive NPV projects. This is a version
of the assumption that the dividend policy will not
alter the investment policy of the firm.
2. We assumed no taxes or transactions costs.
Several were not:
The one year time frame.
The risk free cash flows.
The fact that the firm was all equity financed.
Dividend Irrelevance Example
The insight this example is supposed to bring to you
is that under the irrelevance assumptions a change
in dividend policy results in the company simply
moving money across time.
Using the capital markets (so the NPV is zero)
ensures that no value is created or destroyed by this
movement. Thus the current stock price is not
changed.
Moving money across time is also what the capital
markets allow individual investors to do. Therefore,
a change in dividend policy doesnt do anything for
the investors they couldnt do themselves. Again no
price change is the result.
Empirical Observation 1
Corporations typically payout a significant
percentage of their after-tax profits as dividends.
Examination of dividend payouts over time shows that on
average firms paid out between 40% and 50% of their
profits.
This percentage has been rising.
Recently, a smaller percentage of all firms are paying
dividends. Seems in part due to a lot of new firms (who
traditionally dont pay dividends) and in part to the fact that
fewer firms of all types are paying dividends. Some
evidence suggests that firms are beginning to substitute
repurchases for dividends.
The dividend decision is an important financing decision!
Empirical Observation 2
Historically, dividends have been the
predominant form of payout. Share
repurchases were relatively unimportant until
the mid 1980s.
Before 1984 repurchases amounted to between
2% and 11% of corporate earnings. Since 1984
they have accounted for between 30% and 40%
and have been on the rise.
It is interesting to note that in the mid 80s the other
major form of payout from the corporate sector, M&A
activity, also dramatically increased.
Empirical Observation 3
Individuals in high tax brackets receive large
amounts of dividends and pay large taxes on
these dividends.
That they choose to do so is referred to by Fisher
Black as the Dividend Puzzle.
Study by Peterson, Peterson, & Ang (1985)
showed that individuals received $33 B in
dividends in 1979 (2/3rds of total paid) and the
marginal tax rate paid on the dividends was 40%
(versus 20% on capital gains).
Empirical Observation 4
Corporations smooth dividends.
Lintner in a survey of companies noted that:
Firms are primarily concerned with the stability of their
dividends.
Changes in earnings are the most important
determinant of changes in dividends.
Dividend changes lag earnings changes.
Dividend policy is set first then the investment and
financing decisions are made, taking dividends as
given.
Firms with many valuable investment projects are likely to
set a low target payout ratio and those with few a higher
target.
Empirical Observation 5
There are positive stock price reactions to
unexpected dividend increases and big negative
reactions to unexpected dividend decreases.
Pettit(1972), Charest(1978), Aharony & Swary(1980).
Consistent with asymmetric information models (dividends
relay information) and with incomplete contracting models
(dividends solve agency problems).
Inconsistent with the existence of a large tax differential (or
at least the tax effects are swamped by other effects).
Lets look at some explanations for why dividend
policy will matter.
Taxes
A large part of the literature on dividends has
focused on the impact of taxes on dividend policy
and tried to reconcile the first three empirical
observations.
Firms payout a lot, payout is in form of dividends not
repurchases, and high tax bracket individuals receive most
of these dividends.
Basic aim of the tax literature is to determine if there
is a tax effect do firms with high dividends have
lower value than otherwise equivalent firms that pay
low dividends?
Taxes
Is there a tax effect?
Fundamental question but not an easy one.
Do tax clienteles exist?
Simplest representation says: pay no dividends.
More clever ideas say: firms target groups of investors.
Is there dividend capture?
Examine trading volume around dividend announcements.
Managerial prescription?
Asymmetric Information
Dividend signaling models.
High (or higher) dividends signal good news.
Good news about what?
What is the signal cost?
If the goal is to signal information to the market,
why use dividends?
Given the cost to the firm (transactions costs) and the
cost to investors (taxes) there should be cheaper ways
to credibly communicate information about
expectations.
Asymmetric Information: Evidence
The information content of dividends.
In a statistical sense, dividends have very little information
content beyond that contained in past and present
earnings.
Large dividend changes seem to have some explanatory
power for the firms next quarter earnings.
Unexpected dividend changes positively related to changes
in stock price.
Not clear why the stock price reaction if there is no
information conveyed. Unless it is not signaling that
causes the reaction.
Agency Models
Stockholder Bondholder conflicts.
Bondholder wealth expropriation.
Excessive dividends can expropriate wealth from
bondholders and transfer it to stockholders.
Stockholder Manager conflicts.
Payouts as a disciplinary device.
Control of free cash flow problems.
More frequent scrutiny from the capital market.
Agency Models: Evidence
Bondholder wealth expropriation:
Bond prices do not drop when dividends are
increased.
There are covenants restricting dividends.
Covenants define a reserve out of which dividends may be
paid. However, firms tend to keep excess reserves.
Payouts as a disciplinary device:
Evidence is inconsistent with the free cash flow story.
Overall there is little convincing evidence that dividend
payouts help control any of the commonly considered
agency problems.
Other Stories
Prudent Man rules.
A stable dividend policy requirement for the firms
in which a money manager may invest in may be
a rule of thumb that helps constrain the money
manager, controlling agency problems.
Transactions cost arguments.
If investors are looking for current income
dividends may be a low cost way of achieving that
end.
Other cont
Behavioral theories.
People like to get dividends more than they like to
participate in repurchase programs.
Thaler and Shefrin (1981), Shefrin and Statman (1984)
Irrational market stories.
If managers have superior information and so can
time equity issues and if the market doesnt fully
adjust for this, dividends are a good policy.
A Prudent Prescription
Once again we have to admit that we dont have a
good answer to the question of what is the best
dividend policy. We can offer some meaningful
advice:
Firms should avoid having to cut back on positive NPV
projects to pay a dividend.
When personal taxes are a consideration, firms should
avoid issuing stock to pay a dividend.
Stock repurchases should be considered as an alternative
way to get surplus cash out of the firm when there are few
positive NPV projects and the firm has a surplus of
unneeded cash.