Dividend policy refers to the decision regarding the magnitude of the dividend payout, the percentage of earnings paid to the stockholders in the form of dividends. The central, and as yet unresolved, issue concerning dividend policy is whether changes affect firm value.
THE DIVIDEND IRRELEVANCE ARGUMENT
Consider a firm that has been financed entirely through sale of
100,000 shares of stock, will have a two-year life, and has a
required rate of return of 10 percent. In order to consider only
the effect of dividends, assume that the investment plans of the
firm are fixed, and will provide profits of $100,000 in each of the
two years. Will changing the amount of the first dividend affect
the value of the firm? Consider first a dividend policy that pays
out all profits as dividends1.00 per share at the end of each
year. Since the value of a share is the present
value of the future dividends at the required 10 percent, under
this policy the time zero value of a share is $1.7355:
Now, suppose the first dividend is increased to $1.50, in the
hope that this will increase the stock price. After the dividend is
paid, the firm must acquire another $50,000 to keep operating.
Assume for simplicity that the firm sells $50,000 of new stock
(replacing the $50,000 by borrowing or issuing bonds would have the
same result). The $50,000 paid for the new stock is the present
value of the dividend to be received (at the end of the second
year) by the new shareholders at the required 10 percent:
Under this modified dividend policy, $55,000 in dividends must
be paid to the new shareholders at the end of the second year. This
leaves only $45,000 or $0.45 to be distributed to the original
The time zero value of a share under this modified dividend
policy is now the present value of the modified
The equivalence of share value under the two different dividend policies indicates that dividend policy may shift the timing of dividends, but does not alter the total value of the dividends, and stock value remains unchanged.
An alternative example is to note that the rate of return on a
share of stock has two components: return from dividends equal to
Dividend/Price, and return from growth in price g. But
k and g are interrelated. If a firm has a rate of
return on equity of K and retains all earnings, g =
k. If the firm pays a portion of dividends b, however,
g = k(l - b). For example, a firm with a rate of return of
10 percent but paying half of earnings as dividends will grow at a
rate of 5 percent. Now, consider a firm with a 10 percent rate of
return which this year will pay 50 percent of its $2.00 earnings
out as dividends of $1.00 per share. At a 50 percent payout, the
growth rate will be half the 10 percent rate of return. Using the
Dividend Discount Model, the price of the stock is:
If the firm changes to a dividend payout policy of 75 percent of
earnings, the dividend will increase to $1.50 but the rate of
growth will decrease to 2.5 percent. Under this new policy the new
price of the stock is:
Again, the sole effect of dividend policy has been to shift the timing and amount of dividends. Because of the interrelationship between timing and amount, these shifts do alter the present value of the dividends or the price of the stock.
A somewhat different argument for dividend irrelevance was presented by F. Modigliani and M. H. Miller in their article "Dividend Policy, Growth, and the Valuation of Shares," which was published in the Journal of Business in 1961. They argued that the investor need not passively accept the dividend policy of the firm. Instead, the stockholder can adjust the policy to the desired stream of payments. The stockholder can shift dividends to closer time periods by selling stock, producing a "homemade" immediate dividend increase at the expense of later payments. Conversely the stockholder can shift dividends to a later period by using dividends to purchase stock, increasing future payments. Again, this is a switch between dividend returns and capital gains returns.
The argument against dividend relevance is based on an idealized theoretical world of perfect markets. This approach ignores the possibility of a number of factors or "imperfections" that affect the conclusions.
FACTORS FAVORING A HIGHER DIVIDEND PAYOUT
Agency costs are differences between the interests of stockholders and the interests of management. Higher dividend payments are argued to require more acquisition of external capital and subject management to greater scrutiny by the market, reducing agency costs.
This argument holds that future earnings are less predictable and more uncertain than dividends, at least because they are further in the future. The greater uncertainty of future earnings should be reflected in a higher discount rate on capital gains than on dividends. This in turn would cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future earnings.
This argument suggests that investors have a different attitude toward capital gains than toward dividends. Capital gains become part of the investment base or permanent capital, which investors hesitate to reduce. Paid dividends, however, are considered as current income and are spendable. Because "homemade" dividends require reduction of capital, they have a different psychological impact than paid dividends and are an imperfect substitute.
FACTORS FAVORING A LOWER DIVIDEND PAYOUT
Although both capital gains and dividends are taxed, the tax on capital gains is lower and will not be paid until the stock is sold. Since payment of capital gains tax can be delayed, investors will be reluctant to create dividends by selling stock. Investors attempting to undo a dividend payment by buying stock with dividends must pay taxes on the dividends, and cannot totally reverse the dividend. The investor will be better off if the firm retains the earnings and reinvests them to produce capital gains, since tax payment is deferred.
In addition to taxes, investors reinvesting dividends will also face various transactions costs such a brokerage fees. Conversely, a firm that pays dividends and then must turn to external sources also faces transactions costs such as the "flotation costs" of issuing new securities. If the firm retains the funds and reinvests directly, both types of cost are avoided.
A number of arguments are considered with the relative, rather than the absolute, level of dividends.
DIVIDENDS AS A RESIDUAL.
The argument for dividend irrelevancy assumes that all investment takes place at the required rate of return for the firm. In actuality, it is likely that the firm faces a mix of risk and return possibilities. The firm should thus accept all projects with a positive net present value, and pay dividends only if it has more funds than are expected to be required for attractive projects. While attractive to academics, this approach is seldom used in practice because it results in uncertain dividends and a greater perception of risk by investors.
The clientele effect indicates that investors will tend to hold stocks whose dividend policy fits their needs. That is, investors preferring more certain dividends over uncertain future earnings, or having a preference for current income over capital gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a stock will have a clientele attracted by its dividend policy). Under these conditions, it is not the dividend policy itself that is relevant, but the stability of the policy.
Most theoretical models assume that information is freely available to all. It has been suggested that in reality access to information varies. Management may have access to inside information, causing an "information asymmetry" between management and stockholders. Signaling refers to the use of dividends and dividend changes to convey information to investors. Similar to the clientele effect, it is not the absolute but rather the relative level of dividends that is important. Under this argument management will avoid increasing dividends unless it is highly likely that the higher level of dividends can be maintained. This implies that a dividend increase is a signal that the firm has reached a new level of profitability, and is a positive signal. A dividend decrease, on the other hand, indicates that profitability has decreased and the former dividend level cannot be supported, a negative signal. Note that under the residual argument, however, a dividend increase (decrease) signals a lack (abundance) of attractive projects and decreased (increased) future firm growth. Because of the potential for false signals, more costly signaling is considered more reliable.
DIVIDEND POLICY IN PRACTICE
It is clear that many investors consider dividends as a promise, and that signaling is an important consideration. Because of the possible signaling effects and investor perception of uncertainty, it is believed that management will attempt to "smooth" dividends rather than pay a constant percentage of earnings. To avoid negative signals, dividends will not be increased until management is certain that the new level can be maintained. The residual approach, however, is also seen in the tendency of rapidly growing firms to have a lower payout than more mature firms. Retention and reinvestment of earnings to postpone taxes is especially apparent in smaller or closely held corporations. It appears that there is not a single universal explanation of dividend decisions, but that all of the above factors and arguments have an impact that varies with the situation.
[David E. Upton]
Black, F. "The Dividend Puzzle." Journal of Portfolio Management 2, no. 2 (winter 1976): 5-8.
Emery, Douglas R., John D. Finnerty, and John D. Stowe. Principles of Financial Management. Upper Saddle River, NJ: Prentice Hall, 1998.
Mann, S. V. "The Dividend Puzzle: A Progress Report." Quarterly Journal of Business and Economics 28, no. 3 (summer 1989): 3-35.
Miller, M. H., and F. Modigliani. "Dividend Policy, Growth, and the Valuation of Shares." Journal of Business 34 (October 1961): 411-33.
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