REAL-WORLD FACTORS FAVORING A HIGH-DIVIDEND POLICY THE CLIENTELE EFFECT: A RESOLUTION OF REAL-WORLD FACTORS?

REAL-WORLD FACTORS FAVORING A HIGH-DIVIDEND POLICY AN INTRODUCTION Dividend: - Distribution of firm’s income to shareholders. Dividend Policy: - Determine the value of the firms as dividend increases or decreases. - Trade-off between retained earning and distributing cash to shareholders. Dividend Structure: - Communicate to market participants - Send signals about the prospect of the firm

REAL-WORLD FACTORS FAVORING A HIGH-DIVIDEND POLICY Firms pay high-dividend even in the presence of personal taxes on these dividends WHY? Consider 4 factors favoring a high-dividend policy

1st factor DESIRE FOR CURRENT INCOME Who: Retired people and individual living on fixed income. They would bid up the stock price if dividend increase and bid down the stock price should dividends decline. This argument does not hold in M & M theoretical model that dividend irrelevancy rest on the following assumption. No Tax No Transaction Cost No Issuance Cost Existence on Fixed Investment Policy Real-world: Current income argument is relevant and stock sales involve Brokerage fees Other transaction cost Time consuming

2nd factor BEHAVIORAL FINANCE Behaviorism in psychology theory – human behavior is learnt by adapting outside condition “The self is not something ready-made but something in continuous formation through choices of action” – John Dewey. Basic idea is ‘Self-Control’ – Investor must deal with it and decide on. Better return Or other investment instruments Always set personal rules like, never “dipping into principle” Behaviorists do not think that everyone has the same concept or idea This explain why firm pay dividend even in the presence of taxes.

3rd factor AGENCY COST Involves 3 parties: Bondholders Stockholders Management They form mutually beneficial reason and gain at the other’s expense. Potential conflict – bondholders and stockholders Bondholders want higher cash retained so it could be available to pay them during financial distress Make loan agreement to protect themselves on dividend payout DeAngelo and DeAngelo – firms in financial distress are reluctant to cut dividends. Potential conflict – Managers and stockholders Managers with selfish goal at the expense of stockholders Take on projects with negative NPVs or not work hard

3rd factor (continued) Several Scholars: Dividend to reduce agency cost Dividend payout equal to the amount of ‘surplus’ cash flow can reduce management ability to squander firm’s resources This factor is not an argument to for dividends over repurchases . Agency cost imply firms may increase dividend or share repurchases over hoarding large sum of cash.

4rd factor INFORMATION CONTENT AND DIVIDEND SIGNALING Information Content Effects Stock price rise when dividend increase The rise of stock prices following dividend increase is called ‘Information Content Effects Stockholders increases their expectation on future earning and cash flow Genting Malaysia Berhad (GENM) – Stock price rise 16% after dividend announcement with total dividend of 7% as compare to 6.48% in previous year. Stock price rises gradually from RM2.50 to RM2.90. Tradewinds (M) Bhd (TWS) – Stock price fall 4.6% when the total dividend decline from 23% in previous year to 20% this year. The stock price fall gradually from RM3.02 to RM2.88.

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING Dividend increases send good news and vice versa Signal about the financial state of the firms Management could increase dividend to show high cash flow even they know that the cash flow remain the same. This would hurt the stock prices if the market participant knew about it. Equation: Cash Flow = Capital Expenditure + Dividends

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING Suppose firm announces current dividend will be 30 million and market believes that capital expenditures are 70 million, the market would then determine cash flow to be 100 million. Cash Flow = Capital Expenditure + Dividends 100 70 30

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING 100 Assume the firm makes changes where dividend will be 40 million and the cash flow remain the same thus implying capital expenditures of 60 million. Cash Flow = Capital Expenditure + Dividends 100 70 30 Cash Flow = Capital Expenditure + Dividends 100 60 40

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING 100 Assume the firm makes changes where dividend will be 40 million and the cash flow remain the same thus implying capital expenditures of 60 million. As a result, the increase of dividend would hurt stock price because the increase of dividend is obtained by a reduction in capital expenditures. Cash Flow = Capital Expenditure + Dividends 100 70 30 Cash Flow = Capital Expenditure + Dividends 100 60 40

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING 100 On the other hand, assume that the capital expenditures remain at 70 million as well as dividend at 40 million thus implying cash flow to be 110 million. As a result, market will learn that cash flow has increase and the stock price would likely rise. Stock prices usually increase with cash flow. Cash Flow = Capital Expenditure + Dividends 100 60 40 Cash Flow = Capital Expenditure + Dividends 110 70 40

4rd factor (Continued) INFORMATION CONTENT AND DIVIDEND SIGNALING Most academic model implies that dividend and share repurchases are perfect substitutes. In these models, managers will consider to reduce capital expenditure to increase either dividend or share repurchases. In conclusion, firms pay higher dividends would send good signal about good financial prospect in the future and so vice versa. This indicates that investors prefer dividends to capital gains.

THE CLIENTELE EFFECT: A RESOLUTION OF REAL-WORLD FACTOR Personal taxes favors a low-dividend policy whereas other factors favor high-dividend HOW? Consider group of tax brackets favoring low and high-dividend policy

THE CLIENTELE EFFECT: A RESOLUTION OF REAL-WORLD FACTOR Different group of people prefer different dividend payout policies There are two categories of tax bracket individuals apart from tax-free institution and corporation Low Tax Bracket High Tax Bracket Retired person, pension funds and university lecturers generally prefers cash income – much better-off if they receive higher payout from earning Individual who do not need current income or individual in high tax bracket may prefer for capital gain for tax reason. Individual who need current income might sell some or all shares to obtain cash and thus selling pressure may result drop of stock prices.

THE CLIENTELE EFFECT: A RESOLUTION OF REAL-WORLD FACTOR (continued) A study made by John Graham and Alok Kumar disclose that Relative to low-income investor, high-income investor put a greater percentage of their asset into low-dividend securities Relative to low-income investor, high-income investor put a smaller percentage of their assets into high-dividend securities. In conclusion Clienteles are likely follow from the fact that tax bracket vary across investors. Suggest that there is also clienteles effect on stock prices. Further, clienteles effect on desire for current income.

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