134 payout policy,2009

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Payout Policy

Prepared by P. Asimakopoulos, Ph.D. candidate

Department of Banking and Financial Management,

University of Piraeus, !!"

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Payout Policy

Does the payout policy#dividend policy$

affect the firm value%

&o' much cash should firms give back to

shareholders%

(hat payout policy should a firm follo'%

(hy do corporations pay dividends%

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DIVIDEND POLICY

By dividend policy, 'e mean the practice that

management as 'ell as the board of directors

follo' in making dividend payout decisions or, inother 'ords, the si)e and pattern of cash

distributions over time to shareholder.

*hould corporations pay their shareholders throughdividends or by repurchasing their shares, 'hich is the

least costly form of payout from a ta+ perspective%

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Six empirical observations play an important

role in discussions of payout policies$ -arge, established corporations typically pay out a significant

percentage of their earnings in the form of dividends and

repurchases.

$ &istorically, dividends have been the predominant form of payout.

*hare repurchases 'ere relatively unimportant until the mid"/!s,

but since then have become an important form of payment.

0$ Among firms traded on organi)ed e+changes in the U*A, the

proportion of dividendpaying firms has been steadily declining.

*ince the beginning of the "/!s, most firms have initiated theircash payment to shareholders in the form of repurchases rather

than dividends.

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Six empirical observations play an important

role in discussions of payout policies cont!1$ 2ndividuals in high ta+ brackets receive large amounts in cash

dividends and pay substantial amounts of ta+es on these dividends.

3$ 4orporations smooth dividends relative to earnings. 5epurchases

are more volatile than dividends.

6$ 7he market on average reacts positively to announcements of

repurchase and dividend increases, and negatively toannouncements of dividend decreases.

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DIVIDEND S"OO#$IN%

2n his classic study, -intner #"36 A85$ intervie'ed managers of /U* firms and found9

Firms have longrun target dividend payout ratios.

4hanges in longrun, sustainable earnings are the most important

determinant of changes in dividends.

Managers avoid making changes in their dividend payout rates thatmight have to be reversed. Dividends ad:ust gradually to achieve

the target ratio #dividend smoothing$. Managers are very reluctant

to cut dividends

Management set dividend policy first

Fama and Babiak #"6/ ;A*A$ tested -intner

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DIVIDEND S"OO#$IN% cont!

Brav A.,=raham ;., &arvey 4., Michaely 5. !!3 ;F8, survey 0/1

financial e+ecutives in !! and they report that9 Dividend policy is still conservative

But 9

Firms target the dividend payout ratio less than they used to

*hare repurchases are important form of payout

More fle+ible

7herefore, firms seem to increase dividends only if they are

reasonably sure that they 'ill be able to maintain them permanently at

the ne' level.

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"" proposition &'()'*

For a given investment schedule, the market value of the firm is

independent of its dividend #payout $ policy.

Prior to their paper, most economists believed that the more dividendsa firm paid, the more valuable the firm 'ould be.

(here9 Dt> the dividends paid by the firm at the end of period t, and

rt> the investors? opportunity cost of capital for period t.

= +

=

!

$#tt

t

t

r

DV

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"" proposition &'()'* cont!

=ordon #"3" 58*$

more dividends more value #@bird in the handfallacy$

&e argued that investors? reuired rate of return rt'ould increase 'ith

retention of earnings and increased investment

Although, the future dividend stream 'ould presumably be higher due tothe investment of retained earnings #CPE$, he argued that the higher r

t

overshado's the larger future dividend stream due to uncertaintyassociated 'ith the increased investment relative to the safety of thedividend

According to him 9

retained earnings rather than current dividends made the cash flo' stream

for the shareholder riskier.

increase the cost of capital.#higher rt$

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Miller and Modigliani #"6$ pointed out that this vie' of dividend

policy is incomplete and they developed a rigorous frame'ork for

analy)ing payout policy.

(hat really counts is the firm

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Assumptions9 4apital markets are frictionless #no transaction cost$

Firms and 2ndividual have the same information#noasymmetric information$

All agents are price takers #competitive markets$.

o ta+es

2ndividuals kno' 'ith certainty the future investmentschedule and profits of the firms

For simplicity, all firms issue only common stock

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"" proposition &'()'* notation

Pt9 *hare price at the beginning of period t

dtC

9 Dividend paid at the end of period t

nt9umber of shares outstanding at the beginning of period t

mtC

9umber of ne' shares issued at the end of period t

ntC >

ntC m

tC9umber of shares outstanding at the end of period t

Et> n

tP

t9 Firm value at the beginning of period t

DtC> ntdtC 9 7otal value of dividend paid at the end of period t

t9 8arnings #net cash flo'$ at the beginning of period t

2t9 2nvestment outlay at the beginning of period t

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"" proposition &'()'* proof

For simplicity, 'e assume that the rate of return, r, is

constant over time. 7he rate of return is defined as9

Multiplying the numerator and denominator of #$ by nt

and rearranging terms, 'e obtain9

t

ttt

P$P#Pdr

+= ++ #$

r

PnDV tttt

+

+= ++

,

,, #$

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Using then the fact that ntC >

ntC m

tCand the definitions

given above, 'e can re'rite #$ as9

7hat is, the current firm value is affected positively by the

dividends paid out and the firm value ne+t period andnegatively by the ne' capital raised.

rPmVDV ttttt

++= ++++

#0$

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*ources of funds9 tC

C mtC

PtC

Uses of funds9 DtC

C 2tC

By definition, the uses of funds must eual the sources offunds9

tC

C mtC

PtC

> DtC

C 2tC

#1$

tC

2tC

> DtC

mtC

PtC

#3$

*ubstituting #3$ into #0$, 'e have9

*ince D does not appear in #6$, the firm value is

independent of its dividend #payout$ policy.

r

VIXV tttt

+

+= +++

#6$

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Insi+,ts of "" proposition &'()'*

Firm value is ma+imi)ed by making an appropriate choice ofinvestment policy

Dividend policy does not affect firm value at all if investment policy ischosen to ma+imi)e firm?s value

#tC

2tC

> DtC

mtC

PtC

$

7hey identify the siuations in 'hich dividend policy can affect firmvalue. Dividend policy could matter because one of the assumptionsunderlying the result is violated9

Perfect and complete capital markets absence of ta+es, symmetric information no transaction costs complete markets

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Intuition of "" proposition &'()'*

2n the absence of ta+es,

transaction costs

and information asymmetries,

any increase #decrease$ in dividends has no effect on the firm

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Interpretation of -- proposition &'()'*

7herefore, if t'o firms have identical cash flo's and investment

schedules, absence of arbitrage opportunities reuires that these t'o

firms have identical values.7o see it more clearly, 'e can solve #6$

recursively to get9

ote9 7o get #G$, 'e impose the nobubble condition9

$#$#

++

=

+

= ttt IXr

V #G$

!$#

lim =

+ +

tV

r

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.symmetric Information

Dividends as a Si+nal of /irm 0uality

Hey Points9

2nsiders have better information about the firm?s future cash flo' anddividends convey information about the firm?s prospect

=ood firms cannot credibly signal their uality 'ithout incurring acost. 2f the signal is costless, the bad firms 'ill al'ays mimic the goodones.

Dividend payments are costly both for good and bad firms but morefor bad firms.

By increasing the dividend they promise to pay, good firms can

reveal their uality because it is prohibitively costly for bad firmsto mimic.

=ood firms are 'illing to pay high dividends to separate themselvesbecause the benefit of separation #higher share price$ e+ceeds the cost#costly outside financing or not undertaking positive PE pro:ects$.

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"iller and 1oc2 &'(34 5/*

6Dividend policy under .symmetric Information7

Asymmetric information

7'o period model 'ith times t>,

Ine decision ota+

5ational e+pectations

Uncertainty about firm?s dividendJinvestmentJfinancing

decision

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"iller and 1oc2 &'(34* cont!

7he analysis of information effects to this point has assumed themarket to e+pect that the firm 'ill follo' an optimal investment

policy.

But 'hat if the firm 'ere to cheat by cutting investment belo' the

optimal level and paying out the proceeds in higher dividend% (ere the market no' to add the higher dividend to the assumed optimal

level of investment,

the market 'ould overestimate the firm

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"iller and 1oc2 &'(34*

Summary Dividends are costly #and so credible$ signals because an

increase in dividend paid implies that the firm has to forgo

profitable investment opportunities

A bad firm has lo'er earnings and so a given increase in

dividend implies that a bad firm has to forgo more

profitable opportunities

7herefore good firms can use dividends to credibly signal

their uality and achieve an increase in their stock price 4riticism9 dividends and share repurchases are perfect

substitutes for one another

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5o,n and 8illiams '(34 5/

6Dividend 9 dilution and taxes a si+nalin+ e:uilibrium7

8+tremely adverse environment for signaling 'ith dividends. A representative firm 'hich is financed e+clusively 'ith euity.

7he representative firm pays no ta+es and incurs no transaction costs 'hen

either distributing dividends, or issuing or retiring shares

2nvestors, by contrast, pay ta+es on dividends at a single, constant marginal

rate, but no transaction costs 'hen trading securities.

2n this model, ta+es are critical, because 'ithout ta+es or other costs of paying

dividends, there is no signaling euilibrium.

All sources and uses of firms< funds are fully observed by outsiders through

costless public audits.

4omplete production technology is not observed by outsiders . 2nstead,

insiders try to provide it to outsiders only through dividends 7here e+ists a signaling euilibrium 'ith dividends, 'ith corporate insiders

distribute ta+able dividends if and only if the demand for cash by both their

firm and its current stockholders e+ceeds the supply of internal funds

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5o,n and 8illiams '(34 cont!

#,e intuition of t,is si+nalin+ e:uilibrium

(hen raising funds for investment, a firm must either issue ne' shares or

retire fe'er outstanding shares.

*imilarly, to raise cash on personal account, current stockholders must sell

e+isting shares.

2n either case, current stockholders suffer some dilution in their fractional

o'nership of the firm. 5educing this dilution on either corporate or personal

account is clearly more valuable to current stockholders 'hen inside

information is more favorable.

4onseuently, insiders, acting in the interests of their current stockholders,

may distribute a ta+able dividend if outsiders recogni)e this relationship, bid

up the stock price, and thereby reduce current stockholders< dilution. 2n the resulting signaling euilibrium, insiders control dividends optimally,

'hile outsiders pay the correct price for the firm

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7his signaling euilibrium e+ists because the marginal benefit to insiders of

distributing dividends differs across firms.

For firms 'ith more valuable inside information, the premium paid in the

market for stocks 'ith marginally larger dividends, and thereby the reduction

in dilution for current shareholders, :ust compensates stockholders for the

incremental personal ta+es on dividends. By contrast, for firms 'ith less favorable inside information, the dissipative

costs of the same dividend e+ceed at the margin the gains from reducing

dilution.

4onseuently, there e+ists in the market a pricing function for stock 'hich

separates firms 'ith more favorable inside information from those 'ith less.

2n the resulting signaling euilibrium, firms 'ith more favorable inside

information optimally pay higher dividends, other things eual, and receive

appropriately higher prices for their stock.

5o,n and 8illiams '(34 cont!

#,e intuition of t,is si+nalin+ e:uilibrium

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5o,n and 8illiams &'(34*

summary

2f 4-C2 and current shareholders retain some fraction of the firm, then theree+ists from 5iley ,a signaling euilibrium conditional on 4, 2, as 'ell as -.

2f 4-C2 then stock must be sold to ne' investors, either by the corporationfor investment or by initial stockholders for personal liuidity. 2n either case,initial shareholders suffer some dilution.

By signaling 'ith dividends, insiders can then increase their firm

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Dividends and

mar2et li:uidity

Baner:ee et l. #!!6 ;FOA$ provides evidence of a negative link bet'een firm

dividend policy and stock market liuidity n the United *tates. Qn a crosssection

covering e' Rork *tock 8+change and American *tock and Iptions 8+change

firms for the years "60 to !!0, they found that o'ners of less #more$ liuidcommon stock are more #less$ likey tS receive cash dividends.

Qn a similar study, =aray T =on)ale) #!!3 (P$ found after studying " emerging

economies from "/" to !!!, a negative empirical relation bet'een the level of

market liuidity #measured as stock turnover$ and the dividend policy of the firms in

the sample #using as a pro+y the firms< dividend yield$.

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5o,n and 8illiams &'(34*

summary

Dividends and repurchases are not at all related, and firms do notrepurchase shares to avoid ta+es, because it is precisely the cost ofta+es that makes dividends desirable.

*hareholders in a firm have liuidity needs and they sell some of theirshares.

2f the firm is undervalued, then the shareholders 'ould be sellingtheirs shares at a price belo' the true value.

&o'ever, suppose the firm pay a dividend, 'hich is ta+ed 2f outside investors take this as a good signal, then the share price 'ill rise

and shareholders 'ill have to sell less euity to meet their liuidity needs

maintaining a higher proportionate in the firm 4riticism9 they take as given that shareholders must meet their

liuidity needs by selling their shares.

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;,attac,arya9 S! &'(

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;,attac,arya &'(

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Separatin+ E:uilibrium

7he ob:ective is to construct a separating euilibrium

'here d=d

B>!

7ruthful information revelation reuires that the follo'ing

revelation constraints be satisfied9

ote9 At t> all information is revealed

! = = = = = ! B =#Y CY $Zd Cp #F.d $.#.p $#Cc$d [ Y p FCY p F #24$G

[$,$#,#$#Z

[$,$#,#$#Z$#

!!

GBGBG

GGGGGB

dcpdXpd

dcpdXpdXp

+++

+++

#24$B

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*olving #24$=, 'e obtain 9

*olving #24$B, 'e obtain 9

*ince

&ence, by committing to a dividend d=d\, the good firm

can reveal its type.

dcp

Xppd

G

BGG

+

$$##

$#

!

!

\

!

!

$[#$#Z

$#d

cpp

Xppd

BG

BGG

+

\

= Bp Np , dNd

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*ome 5emarks

7he e+istence of the separating euilibrium reuires that the

manager is interested in the market value of the firm at t > !

#that is, Y!N ! $.

Y!can be interpreted as the intensity of the takeover threat.

7he greater the takeover pressure, the stronger the incentive for amanager to announce a higher dividend, increase the stock priceand avoid takeover.

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Intuition of ;,attac,arya "odel

By committing to pay higher dividends in future, firms

increase the probability of outside financing

7his probability is high for firms 'ith bad pro:ects

7he e+pected cost of committing higher dividend is higher

for these firms

Firm 'ith really good pro:ects can use dividends to

credibly signal private information about future cash flo'

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Criticism of ;,attac,arya "odel

2t does not e+plain 'hy firms use cash dividends to signal

their prospects

Dividends and share repurchases are perfect substitutes for

one another

(hy managers care so much about the stock price of the

ne+t period%

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.llen9 ;ernado and 8elc, &=>>>*

As in the previous models, dividends are a signal of good ne's Firms pay dividends because they are interested in attracting a better

informed clientele #unta+ed institutions, such as pension funds and mutualfunds$, 'ho have a relative advantage in detecting high firm uality.A higherdividend increase the chance that institutions 'ill detect their uality

7a+able dividends e+ist to attract informed institutions 'hose presence

ensures that the firm 'ill remain 'ell run. 2f management underperforms,then the institutions 'ill, for e+ample, facilitate takeovers by selling large

blocks of stock or they may even become directly involved in the corporategovernance process.

7heir model accommodate dividend smoothing, because firms are reluctantto cut dividends kno'ing that their clientele #institutions$ 'ill punish them.

A dividend reductions 'ould indicate a desire to reduce institutionalo'nership and the implicit oversight of the firm

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Criticism of .llen9 ;ernado and 8elc, &=>>>*

2t can not e+plain 'hy firmsJmanager have not found cheaper 'ays to

signal their inside information

(hy firms do not enact in better control on management to avoidmonitoring by institutions

(hen a firm pays higher dividend, it attracts disproportionately larger

o'nership by institutions and these in turn are more likely to play a

larger role in overseeing management, contrary to retail investors

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%rullon9 "ic,aely and S?aminat,an

&5; =>>=*

2ncreases in dividends convey information about changes

in risk rather than about gro'th in future cash flo's

@maturity hypothesis firms increase dividends 'hen

gro'th opportunities decline, 'hich leads to a decrease in

the firm?s systematic risk and profitability.

&o', then, should the market react to dividend increase% Dividend increase contains t'o pieces of ne's9

=ood ne's9 risk has decreasesBad ne's 9 profitability declines

return on assets declines

profit gro'th declines

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Announcements of changes in dividends shouldlead to changes in the stock price in the samedirection

4hanges in dividends should be follo'ed bychanges in earnings #net cash flo'$ in the samedirections

All the above implications are necessary, but notsufficient, conditions for dividend signaling

Implication of Si+nalin+ "odels

134 payout policy,2009

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