Chapter 19 -- Dividend Policy and Investment Decisions


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


 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 decrease the agency cost of equity

 Dividends 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


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