Chapter 19 -- Dividend Policy and Investment Decisions

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Chapter 19 -- Dividend Policy
and Investment Decisions
 Miller
and Modigliani (M&M) Hypothesis
Assumptions
no
taxes, transaction costs, or brokerage fees
no flotation cost
information is free and available to all
 Conclusion:
in a perfect capital market
dividend policy does not matter
Transaction costs
 Brokerage
fees must be paid by the
shareholders to reinvest dividends
 There could be an information cost to
reinvesting dividends
 Some companies use dividend reinvestment
plans to eliminate brokerage fees
 The presence of transaction costs decreases
the desire for the company to pay dividends
Flotation costs
Floatation
cost is the cost of issuing
new debt or equity to replace money
paid out in the form of dividends
The presence of flotation cost would
decrease the desire to pay dividends
Taxes
Dividends
proceeds are taxed at
ordinary income or special dividend
rates
Share repurchases are taxed at
capital gains rates
Clientele effects may mitigate some
taxes for a small clientele
Portfolio Considerations
 High
tax paying individuals may not hold
stock in dividend-paying companies
 Some pension plans have dividend
requirements for the stock to be held in their
portfolios
 Taken together portfolio considerations are
probably not very influential on dividend
policy
Information Signaling
 Paying
dividends may signal
expectations of increasing future cash
flows
 Actions speak louder than words
 False signals are too costly
 Information signaling has a significant
influence on dividend policy
Agency Costs
 An
increase in dividends increases the agency
cost of debt
 Dividends
take money out of the company that would
otherwise serve as a safety margin for creditors
 Dividends
 Dividends
decrease the agency cost of equity
take money out of the company that might
otherwise serve as a safety margin for managers or be
consumed frivolously by managers
Firm-specific Variables
 Investment
opportunities
 Institutional restrictions
 Legal requirements
Restrictive
covenants
Income rules
Improperly accumulation earnings tax
 Cash
flow
 Management interest
Firm-specific Variables
Management
interest
Control
Takeover
defense
Management attitudes toward
risk
Management growth preference
Common Policies
 Constant
dollar policy
 Constant pay-out ratio policy
 Constant dollar plus extras
 Residual policy
 Constant dollar with increases each year
For
those companies paying dividend this
appears to be the most popular -- easier for
the analyst to project
Stock Dividends
 You
receive, for example, 5 additional shares
for each hundred shares you held
 If you owned 1% of the company before, you
own 1% after the stock dividend
 Stock dividends simply divide ownership into
smaller pieces
 May signal future dividend plans
Stock Repurchases
Alternative
to dividends for
distributing money to shareholders
Taxed at capital gains rate
Voluntary, not mandatory
Positive signal
May not create expectation
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