Theories of Dividend Policy

Types of dividends include the following:

1. Regular cash dividends: Periodic dividend payments made in cash are known as regular cash dividends. Generally, companies strive for stability in their regular dividends, increasing them slowly and refraining from any reductions. Stable or increasing dividends paid regularly are perceived as a sign of consistent (and growing) profitability.

Frequency of dividend payments vary globally: U.S. and Canadian companies typically pay dividends quarterly, while European and Asian companies typically pay dividends semiannually and annually, respectively.

1. Extra or special (irregular) dividends: A cash dividend supplementing regular dividends, or a dividend of a company that normally does not pay dividends, is known as a special dividend. Special dividends are paid under unusual circumstances (e.g., when the company spins off a division) under the expectation that the dividend is not recurring. Extra dividends may be paid if the company had an especially profitable year but does not want to commit to a higher ongoing regular dividend payment.

2. Liquidating dividend: This is paid by a company when the whole firm or part of the firm is sold, or when dividends in excess of cumulative retained earnings are paid (resulting in a reduction of stated capital). A liquidating dividend is considered to be a return of capital as opposed to a return on capital.

3. Stock dividend: A non cash dividend paid in the form of additional shares is known as a stock dividend. After payment of a stock dividend, shareholders have more shares and the cost per share will be lower (while the total cost basis remains the same). Shareholders’ proportionate ownership of the company does not change, because every shareholder receives the same percentage stock dividend.

Shareholders are usually not taxed on stock dividends. Because the market value of the company is unchanged, the market price per share declines, leaving the shareholders with no net gain.

Imagine a company earning $100,000 annually that has 100,000 shares outstanding with a market price per share of $10. Current EPS and P/E are then $1.00 and 10, respectively. Suppose that this company then declares a 10% stock dividend; the company now has 110,000 shares outstanding and earnings per share (EPS) of $0.90909.

Applying the original P/E multiple of 10, the stock price should now be $9.091. Hence, a holder of 110 shares should have holdings valued at $1000, the same as before the stock dividend. Companies consider stock dividends desirable because they encourage long term investing and, hence, may reduce the cost of equity capital.

Stock dividends also help increase a stock’s float, and therefore, its liquidity. Stock dividends may also be used to decrease the market price of a stock to a desirable trading range that attracts more investors (high stock prices coupled with a minimum order size tend to limit ownership by small retail investors). Companies that continue to pay the same regular cash dividend per share following a stock dividend have effectively increased their cash dividend.

However, companies that pay out the same total amount of cash dividends as before (i.e., the same payout ratio) effectively decrease the dividend per share (though the dividend yield would be unchanged, because dividends and price decrease by same percentage following the stock dividend).

The popularity of stock dividends varies by market. For example, stock dividends are very popular in China (中国).

1. Stock splits: These are similar to stock dividends (non cash) but generally larger in size. A two for one stock split is the same as a 100% stock dividend. Reverse stock splits (much less common) reduce the number of shares outstanding and increase the price per share.

The intent of a reverse stock split is similar to that of a regular stock split, to bring the market price of the stock within a desirable range, but in this case the firm is trying to attract institutional investors and mutual funds that shun low priced stocks. Reverse stock splits are less common in Asia (e.g., reverse stock splits were illegal in Japan (日本) until 2001).

Accounting Issues

Cash dividend payments reduce cash as well as stockholders’ equity. This results in a lower quick ratio and current ratio, and higher leverage (e.g., debt to equity and debt to asset) ratios. Conversely, stock dividends (and stock splits or reverse stock splits) leave a company’s capital structure unchanged and do not affect any of these ratios.

In the case of a stock dividend, a decrease in retained earnings (corresponding to the value of the stock dividend) is offset by an increase in contributed capital, leaving the value of total equity unchanged. A stock split or reverse stock split does not affect the book value of the equity, nor does it affect the tax cost basis for the shareholders.

Dividend irrelevance. Merton Miller and Franco Modigliani (MM) maintain that dividend policy is irrelevant, as it has no effect on the price of a firm’s stock or its cost of capital. MM’s argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a stockholder and you don’t like the firm’s dividend policy.

If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received was too small, you can sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be the same.

You should note that the dividend irrelevance theory holds only in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares. You should also note that the MM discussion pertains to the firm’s total payout policy (rather than to the narrower dividend policy).

Bird in hand (dividend preference theory) argument for dividend policy. When MM conclude that dividends are irrelevant, they mean that investors don’t care about the firm’s dividend policy since they can create their own. If they don’t care, the firm’s dividend policy will not affect the firm’s stock price and, consequently, dividend policy will not affect the firm’s required rate of return on equity capital ( r s). Myron Gordon and John Lintner, however, argue that r s decreases as the dividend payout increases.

Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains.

They base this argument on the fact that, when measuring total return, the dividend yield component, D1 / P0 , has less risk than the growth component g.

Tax aversion. In many countries, dividends have historically been taxed at higher rates than capital gains. In the 1970s, U.S. tax rates on dividend income were as high as 70%, while the taxes on capital gains were 35%. In the late 1990s, the rates were much lower, but the same general relationship was still in place: dividends were taxed as ordinary income with rates as high as 39.1%, while long term capital gains were taxed at 20%.

Under such a situation, according to the tax aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax aversion theory implies that investors would want companies to have a zero dividend payout ratio so that they will not be burdened with higher tax rates.

In the real world, tax laws often prevent companies from accumulating excess earnings, making dividend payments necessary. Also note that in 2003, tax laws in the United States changed so that dividends and long term capital gains are both taxed at the same 15% rate.

Conclusions from the three theories. The results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy. Research suggests that higher tax rates do result in lower dividend payouts. In the United States, however, the change in tax law that put dividends and capital gains on common ground is likely to make the tax aversion theory irrelevant.

There is empirical support for the “bird in the hand” theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles are satisfied.

Information asymmetry refers to differences in information available to a company’s board and management (insiders) as compared to the investors (outsiders). Dividends convey more credible information to the investors as compared to plain statements. This is so because dividends entail actual cash flow and are expected to be “sticky” (i.e., continue in the future).

Companies refrain from increasing dividends unless they expect to continue to pay out the higher levels in the future. Similarly, companies loathe cutting dividends unless they expect that the lower levels of dividends reflect long run poorer prospects of the company in the future.

The information conveyed by dividend initiation is ambiguous. On one hand, a dividend initiation could mean that a company is optimistic about the future and is sharing its wealth with stockholders, a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities, a negative signal.

An unexpected dividend increase can signal to investors that a company’s future business prospects are strong and that managers will share the success with shareholders. Studies have found that companies with a long history of dividend increases are dominant in their industries and have high returns on assets and low debt ratios.

Unexpected dividend decreases or omissions are typically negative signals that the business is in trouble and that management does not believe that the current dividend payment can be maintained. In rare instances, however, a dividend decrease or omission could be a positive sign. Management may believe that profitable investment opportunities are available and that shareholders would ultimately receive a greater benefit by having earnings reinvested in the company rather than being paid out as dividends.

Agency Costs

Between shareholders and managers: Agency costs reflect the inefficiencies due to divergence of interests between managers and stockholders. One aspect of agency issue is that managers may have an incentive to overinvest (“empire building”). This may lead to investment in some negative NPV projects, which reduces stockholder wealth.

One way to reduce agency cost is to increase the payout of free cash flow as dividends. Generally, it makes sense for growing firms to retain a larger proportion of their earnings. However, mature firms in relatively non cyclical industries do not need to hoard cash.

In such cases, a higher dividend payout would be welcomed by the investors resulting in increases in stock value.

Between shareholders and bondholders: For firms financed by debt as well as equity, there may be an agency conflict between shareholders and bondholders. When there is risky debt outstanding, shareholders can pay themselves a large dividend, leaving the bondholders with a lower asset base as collateral. This way, there could be a transfer of wealth from bondholders to stockholders.

Typically, agency conflict between stockholders and bondholders is resolved via provisions in the bond indenture. These provisions may include restrictions on dividend payment, maintenance of certain balance sheet ratios, and so on.

A company’s dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders. Six primary factors affect a company’s dividend payout policy:

1. Investment opportunities. Availability of positive NPV investment opportunities and the speed with which the firm must react to the opportunities determines the amount of cash the firm must keep on hand. If a firm faces many profitable investment opportunities and has to react quickly to capitalize on the opportunities (i.e., it does not have time to raise external capital), the dividend payout may be low.

2. Expected volatility of future earnings. Firms tie their target payout ratio to long run sustainable earnings and are reluctant to increase dividends unless reversal is not expected in the near future. Hence, when earnings are volatile, firms are more cautious in changing dividend payout.

3. Financial flexibility. Firms with excess cash and a desire to maintain financial flexibility may resort to stock repurchases instead of dividends as a way to pay out excess cash.

Since stock repurchase plans are not considered sticky (i.e., there is no implicit expectation by the market of an ongoing repurchase program), they don’t entail reduction in financial flexibility going forward. Having cash on hand affords companies flexibility to meet unforeseen operating needs and investment opportunities. Financial flexibility is especially important during times of crisis when liquidity dries up and credit may be hard to obtain.

4. Tax considerations. Investors are concerned about after tax returns. Investment income is taxed by most countries; however, the ways that dividends are taxed vary widely from country to country. The method and amount of tax applied to a dividend payment can have a significant impact on a firm’s dividend policy.

Generally, in countries where capital gains are taxed at a favorable rate compared to dividends, high tax bracket investors (like some individuals) prefer low dividend payouts, and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. A lower tax rate for dividends compared to capital gains does not necessarily mean companies will raise their dividend payouts. Stockholders may not prefer a higher dividend payout, even if the tax rate on dividends is more favorable, for multiple reasons:

• Taxes on dividends are paid when the dividend is received, while capital gains taxes are paid only when shares are sold.
• The cost basis of shares may receive a step up in valuation at the shareholder’s death. This means that taxes on capital gains may not have to be paid at all. − Tax exempt institutions, such as pension funds and endowments, will be indifferent between

dividends or capital gains.

5. Flotation costs. When a company issues new shares of common stock, a flotation cost of 3% to 7% is taken from the amount of capital raised to pay for investment bankers and other costs associated with issuing the new stock. Since retained earnings have no such fee, the cost of new equity capital is always higher than the cost of retained earnings. Larger companies typically have lower flotation costs as compared to smaller companies.

Generally, the higher the flotation costs, the lower the dividend payout, given the need for equity capital in positive NPV projects.

6. Contractual and legal restrictions. Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business. Common legal and contractual restrictions on dividend payments include:

• The impairment of capital rule. A legal requirement in some countries mandates that dividends paid cannot be in excess of retained earnings.
• Debt covenants. These are designed to protect bondholders and dictate things a company must or must not do. Many covenants require a firm to meet or exceed a certain target for liquidity ratios (e.g., current ratio) and coverage ratios (e.g., interest coverage ratio) before they can pay a dividend.

Dividends paid in the United States are taxed according to what is called a double taxation system. Earnings are taxed at the corporate level regardless of whether they are distributed as dividends, and dividends are taxed again at the shareholder level. In 2003, new tax legislation was passed in the United States that reduced the maximum tax rate on dividends at the individual shareholder level from 39.6% to 15%.

Since a dollar of earnings distributed as dividends is first taxed at the corporate level, with the after corporate tax amount taxed at the individual level, we can calculate the total effective tax rate as:

Worked example: Effective tax rate under a double taxation system

A U.S. company’s annual earnings are $300, and the corporate tax rate is 35%. Assume that the company pays out 100% of its earnings as dividends. Calculate the effective tax rate on a dollar of corporate earnings paid out as dividends assuming a 15% tax rate on dividend income.

Solution

$$\text{Effective (double) tax rate}=\frac{300-165.75}{300}=44.75\%$$

or

$$0.35+(1-0.35)(0.15)=0.4475\text{ or }44.75\%$$

A split rate corporate tax system taxes earnings distributed as dividends at a lower rate than earnings that are retained. The effect is to offset the higher (double) tax rate applied to dividends at the individual level. Germany had a split rate system until 2009.

The calculation of the effective tax rate under a split rate system is similar to the computation of the effective tax rate under double taxation except that the corporate tax rate applicable would be the corporate tax rate for distributed income.

Worked example: Effective tax rate under an imputation system

Phil Cornelius and Ian Todd both own 100 shares of stock in a British corporation that makes £1.00 per share in pretax income. The corporation pays out all of its income as dividends. Cornelius is in the 20% individual tax bracket, while Todd is in the 40% individual tax bracket.

The tax rate applicable to the corporation is 30%. Calculate the effective tax rate on the dividend for each shareholder.

Solution

Effective Tax Rate Under an Imputation System

Under an imputation system, the effective tax rate on the dividend is simply the shareholder’s marginal tax rate.