Payout Policy

Prepared by P. Asimakopoulos, Ph.D. candidate

Department of Banking and Financial Management,
University of Piraeus, 2009

Payout Policy
Does

the payout policy(dividend policy)

affect the firm value?
How much cash should firms give back to
shareholders?
What payout policy should a firm follow?
Why do corporations pay dividends?

DIVIDEND POLICY
By

dividend policy, we mean the practice that

management as well as the board of directors
follow in making dividend payout decisions or, in
other words, the size and pattern of cash
distributions over time to shareholder.
Should corporations pay their shareholders through

dividends or by repurchasing their shares, which is the

least costly form of payout from a tax perspective?

Six empirical observations play an important

role in discussions of payout policies:
1)

2)

3)

Large, established corporations typically pay out a significant

percentage of their earnings in the form of dividends and
repurchases.
Historically, dividends have been the predominant form of payout.
Share repurchases were relatively unimportant until the mid-1980s,
but since then have become an important form of payment.
Among firms traded on organized exchanges in the USA, the
proportion of dividend-paying firms has been steadily declining.
Since the beginning of the 1980s, most firms have initiated their
cash payment to shareholders in the form of repurchases rather
than dividends.

Six empirical observations play an important

role in discussions of payout policies cont.:
4)

Individuals in high tax brackets receive large amounts in cash

dividends and pay substantial amounts of taxes on these dividends.

5)

Corporations smooth dividends relative to earnings. Repurchases

are more volatile than dividends.

6)

The market on average reacts positively to announcements of

repurchase and dividend increases, and negatively to
announcements of dividend decreases.

DIVIDEND SMOOTHING

In his classic study, Lintner (1956 AER) interviewed managers of 28

US firms and found:
Firms have long-run target dividend payout ratios.
Changes in long-run, sustainable earnings are the most important
determinant of changes in dividends.
Managers avoid making changes in their dividend payout rates that
might have to be reversed. Dividends adjust gradually to achieve
the target ratio (dividend smoothing). Managers are very reluctant
to cut dividends
Management set dividend policy first

Fama and Babiak (1968 JASA) tested Lintner's model using annual
data on 392 major industrial firms for the 19-year period 1946 - 1964.
Their estimates were similar to those reported by Lintner.

DIVIDEND SMOOTHING cont.

Brav A.,Graham J., Harvey C., Michaely R. 2005 JFE, survey 384
financial executives in 2002 and they report that:
Dividend policy is still conservative
But :
Firms target the dividend payout ratio less than they used to
Share repurchases are important form of payout
More flexible

Therefore, firms seem to increase dividends only if they are

reasonably sure that they will be able to maintain them permanently at
the new level.

MM proposition (1961):

For a given investment schedule, the market value of the firm is

independent of its dividend (payout ) policy.

Prior to their paper, most economists believed that the more dividends
a firm paid, the more valuable the firm would be .
V0

t 1

Dt
(1 rt ) t

Where: Dt = the dividends paid by the firm at the end of period t, and
rt = the investors opportunity cost of capital for period t.

MM proposition (1961) cont.:

Gordon (1959 RES) more dividends more value (bird in the hand
fallacy)

He argued that investors required rate of return rt would increase with

retention of earnings and increased investment

Although, the future dividend stream would presumably be higher due to

the investment of retained earnings (+NPV), he argued that the higher r t
overshadows the larger future dividend stream due to uncertainty
associated with the increased investment relative to the safety of the
dividend

According to him :
retained earnings rather than current dividends made the cash flow stream
for the shareholder riskier.
increase the cost of capital.(higher rt)

MM proposition (1961) cont.:

Miller and Modigliani (1961) pointed out that this view of dividend
policy is incomplete and they developed a rigorous framework for
analyzing payout policy.

What really counts is the firm's investment policy.

As long as investment policy does not change, altering the mix of

retained earnings and payout will not affect firm's value.

For a given investment schedule, the market value of the firm is

independent of its dividend (payout ) policy.

MM proposition (1961) cont.:

Assumptions:
Capital markets are frictionless (no transaction cost)
Firms and Individual have the same information(no

asymmetric information)
All agents are price takers (competitive markets).
No taxes
Individuals know with certainty the future investment
schedule and profits of the firms
For simplicity, all firms issue only common stock

MM proposition (1961) notation:

Pt : Share price at the beginning of period t
dt+1 : Dividend paid at the end of period t
nt : Number of shares outstanding at the beginning of period t
mt+1 : Number of new shares issued at the end of period t
nt+1 = nt + mt+1 : Number of shares outstanding at the end of period t
Vt = ntPt : Firm value at the beginning of period t
Dt+1 = ntdt+1 : Total value of dividend paid at the end of period t
Xt : Earnings (net cash flow) at the beginning of period t
It : Investment outlay at the beginning of period t

MM proposition (1961) proof:

For simplicity, we assume that the rate of return, r, is

constant over time. The rate of return is defined as:
r

d t 1 (Pt 1 Pt )
Pt

(1)

Multiplying the numerator and denominator of (1) by nt

and rearranging terms, we obtain:
Vt

Dt 1 nt Pt 1
1 r

(2)

MM proposition (1961) proof:

Using then the fact that nt+1 = nt + mt+1 and the definitions
given above, we can rewrite (2) as:
Dt 1 Vt 1 mt 1Pt 1
Vt
1 r

(3)

That is, the current firm value is affected positively by the

dividends paid out and the firm value next period and
negatively by the new capital raised.

MM proposition (1961) proof:

Sources of funds: Xt+1 + mt+1Pt+1

Uses of funds: Dt+1 + It+1
By definition, the uses of funds must equal the sources of
funds:
Xt+1 + mt+1Pt+1 = Dt+1 + It+1 (4)
Xt+1 - It+1 = Dt+1 - mt+1Pt+1 (5)
Substituting (5) into (3), we have:
X t 1 I t 1 Vt 1
Vt
(6)
1 r

Since D does not appear in (6), the firm value is

independent of its dividend (payout) policy.

Insights of MM proposition (1961)

Firm value is maximized by making an appropriate choice of

investment policy

Dividend policy does not affect firm value at all if investment policy is
chosen to maximize firms value
(Xt+1 - It+1 = Dt+1 - mt+1Pt+1 )

They identify the siuations in which dividend policy can affect firm
value. Dividend policy could matter because one of the assumptions
underlying the result is violated:
Perfect and complete capital markets

absence of taxes,
symmetric information
no transaction costs
complete markets

Intuition of MM proposition (1961)

In

the absence

of taxes,
transaction costs
and information asymmetries,
any increase (decrease) in dividends has no effect on the firm's
investment plan because it is exactly offset by the issue of new
equity (share repurchase). Therefore, the firm value is
independent of its dividend (payout) policy.

Interpretation of proposition (1961):

Therefore, if two firms have identical cash flows and investment

schedules, absence of arbitrage opportunities requires that these two
firms have identical values.To see it more clearly, we can solve (6)
recursively to get:

1
( X t I t )

1 (1 r )

Vt

(7)

Note: To get (7), we impose the no-bubble condition:

lim

1
V 0
t
(1 r )

Asymmetric Information
Dividends as a Signal of Firm Quality
Key Points:

Insiders have better information about the firms future cash flow and
dividends convey information about the firms prospect
Good firms cannot credibly signal their quality without incurring a
cost. If the signal is costless, the bad firms will always mimic the good
ones.
Dividend payments are costly both for good and bad firms but more
for bad firms.
By increasing the dividend they promise to pay, good firms can
reveal their quality because it is prohibitively costly for bad firms
to mimic.
Good firms are willing to pay high dividends to separate themselves
because the benefit of separation (higher share price) exceeds the cost
(costly outside financing or not undertaking positive NPV projects).

Miller and Rock (1985 JF)

Dividend policy under Asymmetric Information

Asymmetric information
Two period model with times t=1,2
One decision
No-tax
Rational expectations
Uncertainty about firms dividend/investment/financing
decision

Miller and Rock (1985) cont.

The analysis of information effects to this point has assumed the

market to expect that the firm will follow an optimal investment
policy.

But what if the firm were to cheat by cutting investment below the
optimal level and paying out the proceeds in higher dividend?
Were the market now to add the higher dividend to the assumed optimal

level of investment,
the market would overestimate the firm's current earnings and hence
place a higher than warranted value of the firm's shares.

A firm might fool the market at least temporarily by such tactics but
the price rise would presumably be "reversed when the unfolding of
events had made clear the true nature of the situation." ()

Miller and Rock (1985)

Summary

Dividends are costly (and so credible) signals because an

increase in dividend paid implies that the firm has to forgo
profitable investment opportunities
A bad firm has lower earnings and so a given increase in
dividend implies that a bad firm has to forgo more
profitable opportunities
Therefore good firms can use dividends to credibly signal
their quality and achieve an increase in their stock price
Criticism: dividends and share repurchases are perfect
substitutes for one another

John and Williams 1985 JF

Dividend , dilution and taxes: a signaling equilibrium

Extremely adverse environment for signaling with dividends.

A representative firm which is financed exclusively with equity.
The representative firm pays no taxes and incurs no transaction costs when
either distributing dividends, or issuing or retiring shares
Investors, by contrast, pay taxes on dividends at a single, constant marginal
rate, but no transaction costs when trading securities.
In this model, taxes are critical, because without taxes or other costs of paying
dividends, there is no signaling equilibrium.
All sources and uses of firms' funds are fully observed by outsiders through
costless public audits.
Complete production technology is not observed by outsiders . Instead,
insiders try to provide it to outsiders only through dividends
There exists a signaling equilibrium with dividends, with corporate insiders
distribute taxable dividends if and only if the demand for cash by both their
firm and its current stockholders exceeds the supply of internal funds

John and Williams 1985 cont.

The intuition of this signaling equilibrium

When raising funds for investment, a firm must either issue new shares or
retire fewer outstanding shares.
Similarly, to raise cash on personal account, current stockholders must sell
existing shares.
In either case, current stockholders suffer some dilution in their fractional
ownership of the firm. Reducing this dilution on either corporate or personal
account is clearly more valuable to current stockholders when inside
information is more favorable.
Consequently, insiders, acting in the interests of their current stockholders,
may distribute a taxable dividend if outsiders recognize this relationship, bid
up the stock price, and thereby reduce current stockholders' dilution.
In the resulting signaling equilibrium, insiders control dividends optimally,
while outsiders pay the correct price for the firm's stock.

John and Williams 1985 cont.

The intuition of this signaling equilibrium

This signaling equilibrium exists because the marginal benefit to insiders of

distributing dividends differs across firms.
For firms with more valuable inside information, the premium paid in the
market for stocks with marginally larger dividends, and thereby the reduction
in dilution for current shareholders, just compensates stockholders for the
incremental personal taxes on dividends.
By contrast, for firms with less favorable inside information, the dissipative
costs of the same dividend exceed at the margin the gains from reducing
dilution.
Consequently, there exists in the market a pricing function for stock which
separates firms with more favorable inside information from those with less.
In the resulting signaling equilibrium, firms with more favorable inside
information optimally pay higher dividends, other things equal, and receive
appropriately higher prices for their stock.

John and Williams (1985)

summary

If C<L+I and current shareholders retain some fraction of the firm, then there
exists from Riley ,a signaling equilibrium conditional on C, I, as well as L.
If C<L+I then stock must be sold to new investors, either by the corporation
for investment or by initial stockholders for personal liquidity. In either case,
initial shareholders suffer some dilution.
By signaling with dividends, insiders can then increase their firm's market
price and thereby reduce this dilution. For stockholders retaining some
fraction of their firm, the marginal benefit of reducing dilution is greater with
truly more valuable firms: Upx > 0
Thus, there exists a pricing function for the firm's stock, P, which compensates
sufficiently only stockholders of truly more valuable firms to induce their
insiders to signal with larger dividends.
For less valuable firms, the equilibrium pricing function, P, compensates
stockholders for the taxes assessed on dividends only at smaller dividends.
Consequently, only insiders in firms with larger present values, X, signal with
larger dividends, other things equal.

Dividends and
market liquidity

Banerjee et l. (2006 JFQA) provides evidence of a negative link between firm

dividend policy and stock market liquidity n the United States. n a cross-section
covering New York Stock Exchange and American Stock and Options Exchange
firms for the years 1963 to 2003, they found that owners of less (more) liquid
common stock are more (less) like1y t receive cash dividends.

n a similar study, Garay & Gonzalez (2005 WP) found after studying 19 emerging
economies from 1989 to 2000, a negative empirical relation between the level of
market liquidity (measured as stock turnover) and the dividend policy of the firms in
the sample (using as a proxy the firms' dividend yield).

John and Williams (1985)

summary

Dividends and repurchases are not at all related, and firms do not
repurchase shares to avoid taxes, because it is precisely the cost of
taxes that makes dividends desirable.
Shareholders in a firm have liquidity needs and they sell some of their
shares.
If the firm is undervalued, then the shareholders would be selling
theirs shares at a price below the true value.
However, suppose the firm pay a dividend, which is taxed
If outside investors take this as a good signal, then the share price will rise

and shareholders will have to sell less equity to meet their liquidity needs
maintaining a higher proportionate in the firm

Criticism: they take as given that shareholders must meet their

liquidity needs by selling their shares.

Bhattacharya, S. (1979)
Imperfect information,dividend policy, and the
bird in the hand fallacy

Asymmetry information because outside investors have imperfect

information about firms profitability
Develops a model in which cash dividend function as a signal of
expected cash flows of firms in an imperfect-information setting
There are sufficient investment opportunities, so that all of the cash
flows from existing assets can be rationally reinvested
The payoffs from the project are not sufficient to cover the dividend
Outside financing will be needed to pay the dividend
Due to imperfection outside financing is costly
A firm with high quality projects has lower transaction cost to meet the
same level of pre-commited dividend than a firm with a low quality
projects

Bhattacharya (1979):
Construction of The Model

There are three dates (t = 0, 1, 2)

ll agents are risk neutral and there is no discounting.
There are two types of firms good (G) and bad () with respective
proportions and 1- .
At t = 1, 2, a firm of type i, (i = B,G) generates a cash flow of either
with probability pi or 0 with probability 1- pi where pG> pB .
At t = 0, only the firms manager knows pi
The manager's objective is to maximize 0V0 + 1 EoV1
where 0, 1 > 0 and Vt is the firm value at t.
At t = 0, the manager commits to paying a dividend d at t=1.
At t = 1, with probability 1-pi, outside financing will be needed to pay
the dividend (it is assumed that the investment plan does not change).
Due to market imperfections, outside financing is costly. Raising an
amount F costs (1+c)F, c>0.

Separating Equilibrium

The objective is to construct a separating equilibrium

where dGdB=0

Truthful information revelation requires that the following

revelation constraints be satisfied:

( 0 +1 )[d G +pG (X-d G )-(1-p G )(1+c)d G ] 0 p B X+1p G X (IC)G

( 0 1 ) p B X 0 [d G pG ( X d G ) (1 pG )(1 c)d G ]
1[d G p B ( X d G ) (1 p B )(1 c)d G ]

Note: At t=1 all information is revealed

(IC)B

Separating Equilibrium

Solving (IC)G , we obtain :

0 ( pG p B ) X
dG
d
( 0 1 )(1 pG )c

Solving (IC)B , we obtain :

dG

0 ( pG p B ) X
d*
[ 0 (1 pG ) 1 (1 p B )]c

*
p
>p
,
d>d
Since G B

Hence, by committing to a dividend dG d*, the good firm

can reveal its type.

Separating Equilibrium
Some Remarks
The existence of the separating equilibrium requires that the
manager is interested in the market value of the firm at t = 0
(that is, 0> 0 ).
0 can be interpreted as the intensity of the takeover threat.
The greater the takeover pressure, the stronger the incentive for a
manager to announce a higher dividend, increase the stock price
and avoid takeover.

Intuition of Bhattacharya Model

By committing to pay higher dividends in future, firms

increase the probability of outside financing
This probability is high for firms with bad projects
The expected cost of committing higher dividend is higher
for these firms

Firm with really good projects can use dividends to

credibly signal private information about future cash flow

Criticism of Bhattacharya Model

It does not explain why firms use cash dividends to signal

their prospects
Dividends and share repurchases are perfect substitutes for
one another
Why managers care so much about the stock price of the
next period?

Allen, Bernado and Welch (2000)

As in the previous models, dividends are a signal of good news

Firms pay dividends because they are interested in attracting a betterinformed clientele (untaxed institutions, such as pension funds and mutual
funds), who have a relative advantage in detecting high firm quality.A higher
dividend increase the chance that institutions will detect their quality
Taxable dividends exist to attract informed institutions whose presence
ensures that the firm will remain well run. If management underperforms,
then the institutions will, for example, facilitate takeovers by selling large
blocks of stock - or they may even become directly involved in the corporate
governance process.
Their model accommodate dividend smoothing, because firms are reluctant
to cut dividends knowing that their clientele (institutions) will punish them.
A dividend reductions would indicate a desire to reduce institutional
ownership and the implicit oversight of the firm's affairs
Low-quality firms do not have the incentive to mimic because their true
value will be revealed

Criticism of Allen, Bernado and Welch (2000)

It can not explain why firms/manager have not found cheaper ways to
signal their inside information

Why firms do not enact in better control on management to avoid

monitoring by institutions

When a firm pays higher dividend, it attracts disproportionately larger

ownership by institutions and these in turn are more likely to play a
larger role in overseeing management, contrary to retail investors

Grullon, Michaely and Swaminathan

(JB 2002)
Increases in dividends convey information about changes
in risk rather than about growth in future cash flows
maturity hypothesis firms increase dividends when
growth opportunities decline, which leads to a decrease in
the firms systematic risk and profitability.
How, then, should the market react to dividend increase?
Dividend increase contains two pieces of news:
Good news: risk has decreases
Bad news : profitability declines
return on assets declines
profit growth declines

Implication of Signaling Models

Announcements

of changes in dividends should

lead to changes in the stock price in the same
direction
Changes in dividends should be followed by
changes in earnings (net cash flow) in the same
directions

All the above implications are necessary, but not

sufficient, conditions for dividend signaling