SK531 Economics of the rm, Diderik Lund, 1 September 2000
Signaling by means of dividends?
Bernheim and Wantz, AER (1995)
Background
Under classical tax system: Dividends disfavored
Better: Retain prots in rm
Moreover: Buy back shares (if not taxed)
Nevertheless: Do actually observe dividends
Page 532, rst column: \rms derive an advantage from the payment of dividends : : : "
Interpretation: Tax system implies no dividends. Must exist some
other advantage which counteracts tax disadvantage.
Contrast to Norway: Tax system after 1992 does not discriminate
against dividends. No basis for doing the same kind of research.
Another, more specic point: Test in Bernheim and Wantz (1995)
is based on variation in personal tax rates for dividends, not present
in Norway.
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Why dividends in spite of double taxation?
Three hypotheses:
1. Signaling high value
2. Limits powers of management
3. (Unexplained) shareholders' preference for dividends (| are
they credit rationed?)
All hypotheses imply: Higher dividend gives higher value of rm
('s shares). Observing this is not sucient to distinguish between
hypotheses.
Sequence of events (one rm, one year):
Dividends are announced
Stock market reacts to announcement, share price usually an
increasing function of announced dividends
(Some weeks later:) Dividends are paid out (= \share goes
ex-dividend")
Vt+1 Vt , Dt (time measured in days)
t + 1 called \ex-dividend date"
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
New in Bernheim and Wantz:
Test based on variation in tax rates
No longer question whether announcement of higher dividend
leads to higher share value
But: Can we see systematic dierences in the rst derivative of
this relationship (\bang-for-the-bucks") when tax rates vary?
And: Can this tell which of the hypotheses is right?
Presumes variation in tax rates over time (or between rms, or
regionally, or : : : )
U.S.A., data 1962{1988: Changes in particular in 1981 and
1986
Signaling: The more dividends are discriminated against by the
tax system, the more \bang-for-the bucks"
Management preferences: The more dividends are discriminated against by the tax system, the less \bang-for-the-bucks"
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Signaling
(For simplicity:) Two types of rms
Want as high market values as possible
Good rms cannot verify that they are good
Without information problem: Tax implies no dividend
Utility of management, U (v; y), increasing in v (market value
of rm), decreasing in y (dividends)
Good rm can better aord to pay dividends, can use it as
signal that it is good, y = y; v = v
Separating equilibrium: Bad rm nds it too expensive to imitate good one, chooses instead y = 0; v = v .
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Signaling, contd.
Higher tax rate on dividends: Even more expensive for bad rm
to imitate the good
Indierence curves twisted counter-clockwise, around (0; v)
Good rm doesn't need to pay as much dividends, is not imitated anyhow
New equilibrium has y = y ; v = v for good rm
Increased slope, i.e., greater \bang-for-the-bucks," compared to
low-tax situation
Summing up: More expensive to pay dividends, good rm does
not need to pay so much to avoid imitation
Later (p. 540, rst column): Same mechanism if other variables
are changed so that dividend payments becomes more expensive
0
0
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Alternative hypothesis:
Model without signaling (p. 536{537)
(\First case" from second column, p. 536 to second column p. 537,
somewhat simplied)
Market value before dividend distribution is
V (Y; y; ) = v(Y , y) + (1 , )y
where Y is total resources of rm, y is dividends, is dividend tax
rate, and v is an increasing and concave function (slightly convex
will also be OK).
Utility of management is
U (Y; y; w; ) = v(Y , y) + (1 , )y + w(Y , y)
where is unobserved by the market, w is increasing and concave. is stochastic (but always positive), with a new outcome each period.
Management chooses y to maximize own utility:
dU = 0 implies , v + (1 , ) , w = 0
dy
Total dierentiation w.r.t. y and :
dy = 1 < 0
,d = (,v , w )dy implies d
v + w
0
00
0
00
00
6
00
SK531 Economics of the rm, Diderik Lund, 1 September 2000
Model without signaling, contd.
A large implies a choice of low y . Change in the market value
(\bang-for-the-buck"):
dV = ,v + 1 , = w > 0
dy
0
0
given that management in each period obtains its f.o.c. Exception
if = 0.
Interpretation: For that y which is chosen by the management, we
have dV=dy > 0, i.e., the market value could have been increased
by choosing a larger y .
The eect of a tax:
0
1
d dVdy d(w )
dy
=
= w @, A < 0
0
d
00
d
opposite the signaling model.
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d
SK531 Economics of the rm, Diderik Lund, 1 September 2000
Empirical: Dependent variable
(left hand side side variable)
How does a dividend announcement aect the share price change
between just before and just after the announcement?
Choose to consider change over three-day period
Compare with change in market portfolio in same period
Left-hand side variable is relative change (= return) in share
price over period, minus return for mkt. pf.
Could be dierent mechanisms when dividends are increased as
compared to decreased, non-symmetric
Choose to consider increases only
Complete dataset AMEX and NASDAQ 1962{1988
12961 observationes of corporation, traded at one of these, increasing dividend compared with previous
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Empirical: Independent variables
(explanatory variables, right hand side variables)
First suggestion:
Share return = 0 + (1 + 2 ) dividend increase + : : :
Dividend increase must also be transformed into relative,
0
D
it , Dit
DIV =
p0it
it
where Dit0 is previous dividend, p0it is share price (average over
ten days), i is index for corporation no. i
The parenthesis gives \bang-for-the-buck"
By letting be included in the parenthesis, we allow for the
eect of a dividend change to be dierent when changes
Instead of one uses (with opposite0 sign): 1
s
1 , mjt CA
X
THETAt = wjt B@
1 , zjt
j =1
Previously calculated by Poterba (1987)
Weighted average for shareholders with dierent tax rates
mjt is personal marginal tax on dividends
zjt is personal marginal tax on capital gains, present value
wjt is fraction owned by shareholders in tax bracket j
In principle weights could be dened for each corporation, but
only an average THETA for each year was available
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Empirical: Independent variables, contd.
Other observables making dividends more expensive?
Same eect as tax both in signaling model and alternative
model.
Two variables are included
HIRATEDit shows whether corporation i has high or low \rating" when borrowing in the market
Hypothesis: More expensive to pay dividends if expensive to
borrow
Dummy variable: = 1 if high rating (BB+ or better), = 0 if
lower
Varies (almost entirely) between corporations, while THETAt
only varies between years
CAPt measures capacity utilization in industry, seasonally adjusted, for the month of the dividend payment
Hypothesis: More expensive to pay dividends when this is high
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Empirical: Independent variables, contd.
Wish to include other observable, possible explanatory variables
\: : : control for other economic conditions : : : " (p. 541)
If not: These will end up in error term
Problem if they are correlated with those explanatory variables
included
GROit is relative change in share price since previous dividend
payment
INFLit is relative change in consumer price index since previous
dividend payment
Both may explain increased dividends, and thus also eect on
share price of a given increase in dividends
MONTHSit is number of months since corporation last changed
the dividend
May explain eect on share price of a given increase in dividends
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Summing up, table 1
Coecients of DIV THETA, DIV HIRATED and DIV CAP have the sign predicted by the signaling model.
The rst and last of these are signicantly dierent from zero, while
the coecient of DIV HIRATED is not, i.e., we cannot reject
that it is zero.
Since data for HIRATED before 1977 were not so good, there are
two new regressions using only after 1977 data, and in these (table
2), HIRATED comes out signicant.
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SK531 Economics of the rm, Diderik Lund, 1 September 2000
Further modications
Doubt whether THETA really measures tax eect accurately
Numbers for each corporation would be better than a weigted
average
Also: Those with very low or high tax rates may not be trading
in a share, i.e., the market price may be determined by shareholders with some particular tax rate(s) (\clientele eects")
Alternative regressions: Divide 1962{1988 into three periods,
three \tax regimes", 1962{1981, 1982{1986, 1987{1988
Two main changes in tax rates, 1982 and 1987
Signaling model still veried
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