Finance 7311

1
Finance 7311

• Dividend Policy

2
Stylized Facts

• Dividends are seldom reduced
• Payout ratios are less than 1
• Market reactions
• Negative to dividend decrease
• Positive to dividend increase
• Corporate payout ratios have decreased, as have
  dividend yields

3
Dividend Theories

• Irrelevance
• Bird-in-the-hand transactions costs
• Taxes
• Signaling
• Agency Theory

4
Irrelevance

• Miller and Modigliani again
• Holding investment fixed, dividend policy is
  irrelevant
• Dividend is financed by issuing debt or equity
• No effect on circle and hence the value of the
  firm

5
Bird-in-the-hand

• Dividends are less risky than capital gains
• Investors prefer dividends to capital gains
• The TOTAL return doesnt change just how it is
  packaged between dividends and capital gains.
• Too costly to sell fractions of shares to create
  income
• Clientele effect

6
Clientele Taxes

• Dividends are taxed more highly than capital
  gains
• Investors would prefer a lower payout policy
• Better yet, investors would prefer a stock buyback

7
Signaling

• Information asymmetry
• Management assumed to know more about firms
  future prospects than outsiders
• Market reacts negatively to dividend cuts
• Firms can use changes in dividends to signal
  future prospects

8
Signaling

• Firms with higher future prospects can signal
  such by increasing dividends
• Must be more costly for the low attribute firm to
  replicate the signal
• Once increased, the firm will not want to
  decrease for reason cited above
• May explain the change in dividends, but not the
  level
• Same idea as issuing debt rather equity

9
Agency Theory

• Firms are reluctant to cut dividends for reasons
  previously cited
• Committing to a higher dividend policy commits
  the payout of the companys future cash flows
• Takes cash out of managements hands reduces
  overinvestment problem
• Same as argument for using more debt

10
What should dividend policy be?

• Should primarily be a function of investment
  needs.
• Excessive FCF could be paid out in the form of
  dividends
• Better yet, because of tax reasons and financial
  flexibility, stock repurchases are more efficient
  way to get excess FCF back to S/H