Dividends: To Pay or Not to Pay There is no general agreement whether dividends should or should not

Dividends: To Pay or Not to Pay There is no general agreement whether dividends should or should not

be paid. Here are several views: ■ The Dividend Irrelevance Theory: The payment of dividends does not

affect the value of the firm since the investment decision is independent of the financing decision.

■ The “Bird in the Hand” Theory: Investors prefer a certain dividend stream to an uncertain price appreciation. ■ The Tax-Preference Explanation: Due to the way in which dividends are taxed, investors should prefer the retention of funds to the payment of dividends.

■ The Signalling Explanation: Dividends provide a way for the manage- ment to inform investors about the firm’s future prospects. ■ The Agency Explanation: The payment of dividends forces the firm to seek more external financing, which subjects the firm to the scrutiny of investors.

Let’s take a further look at each view. The Dividend Irrelevance Theory The dividend irrelevance argument was

developed by Merton Miller and Franco Modigliani. 15 Basically, the argu- ment is that if there is a perfect market—no taxes, no transactions costs, no costs related to issuing new securities, and no costs of sending or receiving information—the value of the firm is unaffected by payment of dividends.

How can this be? Suppose investment decisions are fixed—that is, the firm will invest in certain projects regardless how they are financed. The value of the firm is the present value of all future cash flows of the firm— which depend on the investment decisions that management makes, not on how these investments are financed. If the investment decision is fixed, whether a firm pays a dividend or not does not affect the value of the firm.

A firm raises additional funds either through earnings or by selling securities—sufficient to meet its investment decisions and its dividend deci- sion. The dividend decision therefore affects only the financing decision— how much capital the firm has to raise to fulfill its investment decisions.

The Miller and Modigliani argument implies that the dividend decision is a residual decision. If the firm has no profitable investments to under- take, the firm can pay out funds that would have gone to investments to shareholders. And whether or not the firm pays dividends is of no conse- quence to the value of the firm. In other words, dividends are irrelevant.

15 Merton Miller and Franco Modigliani. “Dividend Policy, Growth and the Valua- tion of Shares,” Journal of Business (October 1961), pp. 411–433.

FINANCING DECISIONS

But we don’t live in a perfect world with a perfect market. Are the imperfections (taxes, transactions costs, etc.) enough to alter the conclu- sions of Miller and Modigliani? It isn’t clear.

The “Bird in the Hand” Theory

A popular view is that dividends represent a sure thing relative to share price appreciation. The return to sharehold- ers is comprised of two parts: the return from dividends—the dividend

yield—and the return from the change in the share price—the capital

yield. Firms generate earnings and can either pay them out in cash divi- dends or reinvest earnings in profitable investments, increasing the value of the stock and, hence, share price. Once a dividend is paid, it is a cer- tain cash flow. Shareholders can cash their quarterly dividend checks and reinvest the funds. But an increase in share price is not a sure thing. It only becomes a sure thing when the share’s price increases over the price the shareholder paid and he or she sells the shares.

We can see that prices of dividend-paying stocks are less volatile than nondividend-paying stocks. But are dividend-paying stocks less risky because they pay dividends? Or are less risky firms more likely to pay dividends? Most of the evidence supports the latter. Firms that have greater risk—business risk, financial risk, or both—tend to pay little or no dividends. Firms whose cash flows are more variable tend to avoid large dividend commitments that they could not satisfy during periods of poorer financial performance.

The Tax-Preference Explanation The dividend income shareholders receive is taxed as any other income, such as wages or salaries. If shareholders sell their stock, any gain they make (called capital gains) is given preferential tax treatment—taxed effectively at a lower rate than dividend income. Capital gains are taxed at lower rates due to two aspects of the tax law.

First, capital gains are only taxed when realized—when you sell the stock. If you receive $20 of dividends in 2001, you pay taxes on that income in 2001. If you bought stock in 1990 and sell it in 2007, you do not pay tax on any gain until 2007! So, while the price of the stock may go up $20 in 2001, you don’t pay any tax on that $20 until you sell the stock in 2007. And since the taxes you pay on this gain are in the future, you effectively pay lower taxes on the capital gain as compared to an equivalent amount of dividends.

Second, capital gains are taxed at relatively lower rates. Whether through a special capital gain exclusion—that means part of the gain does not get figured into your taxable income—or through a special tax rate, capital gains have been taxed at lower rates than dividend income throughout most of U.S. tax history.

Common Stock

But the tax impact is different for different types of shareholders. An individual taxpayer includes dividend income along with other income such as wages to determine taxable income. But a corporation receiving a dividend from another corporation may take a dividends received deduction—a deduction of a large portion of the dividend

income. 16 Therefore, corporations pay taxes on a small portion of their dividend income. Still other shareholders may not even be taxed on div- idend income. For example, a pension fund beneficiary does not pay taxes on the dividend income it gets from its investments (these earnings are eventually taxed when the pension is paid out to the employee after retirement).

Dividends are taxed at rates higher than capital gains, though there are two things that could affect this difference for some investors. First, investors that have high marginal tax rates may gravitate towards stocks that pay little or no dividends. This means the shareholders of dividend paying stocks have lower marginal tax rates. This is referred to as a tax clientele—investors who choose stocks on the basis of the taxes they have to pay.

Second, investors with high marginal tax rates can use legitimate investment strategies—such as borrowing to buy stock and using the deduction from the interest payments on the loan to offset the dividend income in order to reduce the tax impact of dividends. 17

The Signalling Explanation Firms that pay dividends seem to maintain a rela- tively stable dividend, either in terms of a constant or growing dividend payout or in terms of a constant or growing dividend per share. And when firms change their dividend—either increasing or reducing (“cut- ting”) the dividend—the price of the firm’s shares seems to be affected: When a dividend is increased, the price of its shares goes up; when a dividend is cut, the price goes down. This reaction is attributed to inves- tors’ perception of the meaning of the dividend change: Increases are good news, decreases are bad news.

16 As we saw in Chapter 5, the dividends received deduction ranges from 70% to 100%, depending on the ownership relation between the two corporations.

17 Several strategies that can be used to reduce the taxes on dividend income are dis- cussed by Merton Miller and Myron Scholes in “Dividend and Taxes,” Journal of

Financial Economics (1979), pp. 333–364. However, Pamela Peterson, David Peter- son, and James Ang, in their article entitled “Direct Evidence on the Marginal Rate of Taxation on Dividend Income,” Journal of Financial Economics (1985), pp. 267– 282, document that investors do not appear to take advantage of these strategies and end up paying substantial taxes on dividend income.

FINANCING DECISIONS

Managers likely have some information that investors do not have.

A change in dividend may be a way for managers to signal this private information. Since we observe that when dividends are lowered, the price of a share falls, we expect managers not to increase a dividend unless they thought they could maintain it into the future. Realizing this, investors may view a dividend increase as management’s increased confidence in the future operating performance of the firm.

The Agency Explanation The relation between the owners and the managers of a firm is an agency relationship: The owners are the principals and the managers are the agents. The managers are charged with acting in the best interests of the owners. Nevertheless, there are possibilities for conflicts between the interests of the two. If the firm pays a dividend, managers may be forced to raise new capital outside of the firm—that is, issue new securities instead of using internally generated capital—sub- jecting them to the scrutiny of equity research analysts and other inves- tors. This extra scrutiny helps reduce the possibility that managers will not work in the best interests of the shareholders. But issuing new secu- rities is not costless. There are costs of issuing new securities—flotation

costs. In “agency theory speak,” these costs are part of monitoring

costs—incurred to help monitor the managers’ behavior and insure behavior is consistent with shareholder wealth maximization.

The payment of dividends also reduces the amount of free cash flow under control of management. Free cash flow is the cash in excess of the cash needed to finance profitable investment opportunities. A profitable investment opportunity is any investment that provides the firm with a return greater than what shareholders could get elsewhere on their money—that is, a return greater than the shareholders’ opportunity cost.

Because free cash flow is the cash flow left over after all profitable projects are undertaken, the only projects left are the unprofitable ones. Should free cash be reinvested in the unprofitable investments or paid out to shareholders? Of course if managers make decisions consistent with shareholder wealth maximization, any free cash flow should be paid out to shareholders since—by the definition of a profitable invest- ment opportunity—the shareholders could get a better return investing the funds they receive.

If the firm pays a dividend, funds are paid out to shareholders. If the firm needs funds, they could be raised by issuing new securities. If the shareholders wish to reinvest the funds received as dividends in the firm, they could buy these new securities. The payment of dividends therefore reduces the cash flow in the hands of management, reducing the possi- bility that managers will invest funds in unprofitable investment oppor- tunities.

Common Stock

Summing Up: To Pay Dividends or Not We can figure out reasons why a firm should or should not pay dividends, but not why they actually do or do

not—this is the “dividend puzzle”. 18 But we do know from looking at dividends and the market’s reaction to them that:

■ If a firm increases its dividends or pays a dividend for the first time, this is viewed as good news—its share price increases. ■ If a firm decreases its dividend or omits it completely, this is viewed as bad news—its share price declines.

That’s why financial managers must be aware of the relation between dividends and the value of the common stock in establishing or chang- ing dividend policy.