Lecture 10: Corporate Equity,
Earnings and Dividends
The Corporation
• [1611] A body corporate legally authorized to act
as a single individual, an artificial person created
by royal charter, prescription, or act of legislature,
and having authority to preserve certain rights in
perpetual succession. (OED)
• Compare publicani of ancient Rome, essentially
corporations (though the most prominent were
private collecting agencies for taxes)
For-Profit vs. Non-Profit
• For-profit corporation is owned by
shareholders, equal claim after debts paid,
subject to corporate profits tax.
• Non-profit is not owned, self-perpetuating
directors. Not subject to corporate profits
tax.
Common vs. Preferred Stock
• Common stock: dividend is at discretion of firm,
subject to legal restrictions
• Preferred stock: Specified dividend does not have
to be paid, but firm cannot pay dividend on
common stock unless all past preferred stock
dividends are paid.
• Corporate bonds: Firm is contractually obligated
to pay coupons and there is a maturity date when
principal must be paid.
Limited Liability
• Even publicani had some form of limited
liability sometimes
• New York State legislature made limited
liability standard for all corporations, 1811
• Standard copied by other states, finally
California, 1931.
Other Corporate Obligations
• Convertible bonds: bondholder has option
to convert the bond to stock
• Employee incentive options
• Tracking stock
• Junk bonds
• Warrants
• Partnership contracts
Voting of Common Shares
• Usually one share one vote, in person or by
proxy, for board of directors and some other
essential matters
• Shareholders meetings usually annual event,
and required by law for big events such as
merging corporation
• Shareholder meeting circuses
Berle and Means
• Adolf A. Berle Jr., and Gardiner C. Means, The
Modern Corporation and Private Property, 1933
• Separation of ownership and control
• “ownership is so widely scattered that working
control can be maintained with but a minority
interest.”
• The “quasi-public corporation” is constrained by
law to serve other interests.
Payment of Dividends
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Purely discretionary
Young firms typically pay none
NASDAQ dividend yield virtually zero
Corporate culture influences dividends.
Microsoft
• Liquidity constraints on dividends
Modigliani-Miller Dividend
Irrelevance Theory
• Journal of Business, 1961.
• Assume no taxes or transactions costs
• Consider purely financial transaction:
selling shares to pay dividends
• M&M Conclusion: Dividend policy has no
effect on the value of the firm.
• Purely nominal difference between dividend
checks and repurchase checks.
Adding Taxes to M&M World
• Dividends are taxable as personal income,
share repurchases are capital gains, lower
rate.
• Announcing payment of new dividends
should lower value of firm by present value
of taxes.
Why Do Firms Pay Dividends?
• Hersch Shefrin and Meir Statman: Selfcontrol theory of dividends. (analogy to
Christmas clubs, overwithholding) Rule of
thumb spending rule.
• Prospect theory interpretation: framing
matters. Dividends framed as income.
• University endowments once required highyield investments to provide income
Dividend Signalling
• By raising dividends, firm shows it can
court bankruptcy.
• Battacharya, Hakansson, Ross
• Problem: alternative signalling methods are
cheaper tax-wise
Lintner Model of Dividends
• DIVt-DIVt-1= ( × EPSt-DIVt-1)
• =adjustment rate, 0< <1
• =target ratio, 0< <1

DIVt    (1   ) k EPSt  k
k 0
Kahneman & Tversky Framing
Example
• “US is preparing for a rare Asian disease
which is expected to kill 600 people.”
• “If Program A is adopted, 200 people will
be saved. If program B is adopted, there is a
1/3 probability that 600 people will be
saved and a 2/3 probability that no people
will be saved.” (Majority: A)
K&T Framing Continued
• Other respondents given a different choice:
• If program C is adopted, 400 people will die
If Program D is adopted, there is a 1/3
probability that no one will die, and a 2/3
probability tha 600 people will die.”
(Majority: D) Scientific American 1981
General Public Utilities Corp
• President Kuhn proposed to substitute
stock dividends for cash dividends, and
offered to sell the stock dividend for any
stockholder for minimal transaction cost.
(ca. 1968)
• Direct saving to shareholder: $4 million a
year.
• Intense negative shareholder reaction
S&P D/E & D/P 1871-2004
Share Repurchase
• Once rare, now S&P 500 firms repurchase
approx. 2% of shares per year. They issue
about 1% of shares per year in employee
option exercise, so net repurchase is about
1% per year.
• Repurchase now almost as high as
dividends paid, but firms still pay
dividends. A puzzle.
Reasons for Share Repurchase
• Tax break for investors
• Firms’ unwillingness to cut dividends, uncertainty
that current earnings will continue
• Price pop after a repurchase. Buybacks taken as a
signal. But price pops are fading.
• Now investors sometimes view repurchase as a
sign that firm is “old economy.” NASDAQ firms
less likely to repurchase shares, as if they think
value is too high.
Employee Options and Share
Repurchase
• The “overhang,” percent of stock market promised
to employees via options, stood at 6.2% in 144 of
largest S&P 500 firms in 1998.
• Option holders have an interest in repurchasing
shares rather than paying dividends.
• Lambert Lanen & Larker JFQA 1985: dividend
payouts reduced after option plans introduced.
Reasons for Declining Dividend,
Earnings Yield in New
Millennium
• Perception of great growth opportunities
with new technology
• First-mover advantage prized
• Dividends, Earnings are for losers
• Problem in valuing firms