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:

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 In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price.

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: V 0 = Div 0 + Div 1 /(1.05) = $1m + $1m/(1.05) = $1,952, or P 0 = $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: P 0 = $22 + $17.90/(1.05) = $39.05 (??). The price will drop to $ $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: P 0 = $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 just an extreme 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 to begin with.

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 such action. Thus the current stock price is not changed. Viewed another way, moving money across time is exactly what the capital markets allow individual investors to do. Therefore, a change in dividend policy doesn’t do anything for the investors they couldn’t 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.  Recently, a smaller percentage of all firms are paying dividends. Seems in part due to a lot of new firms (who traditionally don’t 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.  This finding confirms that the dividend decision is indeed an important financing decision!

Empirical Observation 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.

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).  More recently, 1996, individual investors held 54% of all stocks by market value yet received only 35% of all dividends paid indicating that individuals tend to hold low dividend paying stocks but still receive significant amounts of dividends.

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.

GM’s Earnings and Dividends per Share, 1985–2006

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). Let’s 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 this with 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. It is true that there is a tax disadvantage to a firm retaining unneeded cash but why is the payout in the form of dividends.

The Declining Use of Dividends

The Changing Composition of Payouts

Asymmetric Information Dividend signaling models.  High (or higher) dividends signal good news. Good news about what? What is the signal cost?  Is an increase in dividends necessarily good news? May be reflecting a lack of good investments.  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 firm’s 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 of course 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 doesn’t fully adjust for this, dividends are a good policy.

A Prudent Prescription Once again we have to admit that we don’t 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 (see example 17.2 in text).  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.