1. Dividend Policy More Properly: Payout Policy

2. Historical View  Illustrated by the arguments of Gordon (1959) - more dividends more value.  Follows from the discounted dividend approach to valuing a firm:

3. 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  Complete Markets

4. Dividend Irrelevance  Assume an all equity firm for simplicity.  Firm value is the discounted value of the payouts to the equity holders.

5. Empirical Observations – 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.  Recently, a smaller percentage of all firms are paying dividends. Seems in part due to a lot of new firms and in part to the fact that fewer firms of all types are paying dividends. Some evidence suggests that firms are substituting repurchases for dividends.

6. Empirical Observations – 2  Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid 1980’s.  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 80’s the other major form of payout from the corporate sector, M&A activity, also dramatically increased.

7. Empirical Observations – 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 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).

8. Empirical Observations – 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 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.

9. Lintner Model  Two equations can be used to explain changes in dividends:  This is still one of the most useful ways to model dividend payouts by firms.

10. Empirical Observations – 5  There are positive stock price reactions to dividend increases and big negative reactions to 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 a large tax differential (or at least the tax effects are swamped by other effects).

11. 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.  Basic aim of the tax literature is to determine if there is a tax effect – do firms with high dividends have lower value than equivalent firms that pay low dividends?

12. 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?

13. 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 communicate information about expectations credibly.

14. Asymmetric Information: Predictions  The information content of dividends.  Signal of future cash flow.  Signal of current earnings via sources and uses of funds identity.  The predicted reactions.  Dividend changes should be followed by changes in earnings in the same direction.  Unexpected dividend changes should be followed by revised market expectations and/or stock prices.

15. Asymmetric Information: Evidence  The information content of dividends.  In a statistical sense, dividends have relatively little information content beyond that contained in past and present earnings.  “Large” changes seem to have some explanatory power for the firm’s next quarter earnings.  Specially designated dividends and repurchases.  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.

16. Agency Models  Stockholder – Bondholder conflicts.  Bondholder wealth expropriation.  Excessive dividends can expropriate wealth from bondholders and transfer it to stockholders.  Bond prices do not drop when dividends are increased.  Bond covenants restricting dividends.  Covenants define a reserve out of which dividends may be paid.  Firms tend to keep excess reserves.

17. Agency Models cont…  Stockholder – Manager conflicts.  Payouts as a disciplinary device.  Control of free cash flow problems.  More frequent scrutiny from the capital market.  The empirical evidence.  Evidence is inconsistent with the free cash flow story.  Overall there is little convincing evidence that dividend payouts help control agency problems.

18. “Other” Stories  “Prudent Man” rules.  A stable dividend policy for firms that are invested in by a money manager may be a rule of thumb that helps constrain the agent.  Transactions cost arguments.  If investors are looking for current income dividends may be a low cost way of achieving that end.

19. “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 so can time equity issues and the market doesn’t fully adjust for this, dividends are a good policy.

20. The Prudent Prescription  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.

21. Summary  We have identified many of the things that should be important in establishing a firm’s payout policy.  We have some evidence that some of them are important in shaping actual policies.  We still don’t know how they all fit together to establish an “optimal” policy nor do we know if there even is such a thing.