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 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

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