Chapter 19 -- Dividend Policy and Investment Decisions

Chapter 19 -- Dividend Policy
and Investment Decisions
 Miller
and Modigliani (M&M) Hypothesis
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
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
proceeds are taxed at
ordinary income or special dividend
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
 Taken together portfolio considerations are
probably not very influential on dividend
Information Signaling
 Paying
dividends may signal
expectations of increasing future cash
 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
 Institutional restrictions
 Legal requirements
Income rules
Improperly accumulation earnings tax
 Cash
 Management interest
Firm-specific Variables
Management attitudes toward
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
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
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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