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THE DIVIDEND DECISION
F A C T S A B O U T P A Y O U T T H E P A Y O U T C O N T R O V E RSY G O O D-B A D S C H O O L
I will be talking from finance perspective only, and let me assure I am not biased. Primarily I will be discussing the
above three mentioned topics. Let me introduce you on my topic of interest. Initially see the big picture.
The Big Picture Detailed
FACTS ABOUT PAYOUT: Generally, dividends are paid annually in India while the same are paid quarterly in
United States. Dividend decision is the decision relating whether to return cash to its stockholders and, if so,
then how much. Even the owner of a private company/ firm has to visualize the same (ie, decision about how
much cash he or she plans to withdraw from the business and how much to reinvest.)
Payout policy presents 2 specific questions -how much cash should the corporation pay out to its shareholders? and the
next is mode of distribution –either by dividends or by buy back.
Some companies used to pay dividends, but then fell on hard times and ceased to do so. Most non–dividend payers are
young growth companies that have never paid a dividend and will not pay one in the foreseeable future (say Berkshire
Hathaway, Amazon, and Google & smaller growth firms too)
Types of Dividends Some of them are:
(i) Cash Dividends (ii) Stock Dividends [ Here, No. of shares increases & generally per share price decreases] (iii)
regular dividend [annually/semi –annually/quarterly] (iv) special dividend [paid in addition to regular dividends-
but are paid irregularly](v) Liquidating dividends [nature-return on capital rather than ordinary income]
As clarified from the data companies instead of paying a dividend use the cash to repurchase stock and such shares
are kept in the company’s treasury and may be resold if the company needs money. As discussed on the stability
of dividends in comparison to Buy Back, announcement of a share repurchase is not a commitment to continue
repurchases in later years. So the information content of a repurchase announcement is less strongly positive than
the announcement of a dividend increase. We do have number of methods for buy back, however, buy back may
take place via direct negotiation with a major shareholder.
Interestingly, many countries have banned this method at times, consequently, firms started accumulating large
amount of cash and started investing at lower rates had the same cash be in the hands of the investor. At present
many countries have relaxed this mechanism. I inform you some economies allowing repurchase. But many of
these limitations have now been removed. Japan allowed repurchases in the year 1995, Sweden in 2000 &
Germany in 1998. Many multinational giants now repurchase huge amounts of stock. In 2007 the Spanish bank
BBVA, BP, Royal Dutch Shell, and Glaxo Smith Kline all spent huge sums on buying back their stock.
Study shows that on average repurchase resulted in an abnormal price rise of 2%. What investors may think
on buy back decision? Do they appreciate?
Investors may applaud repurchases if they worry that managers would otherwise fritter away the money on
perks or unprofitable empire building.
Repurchases can also reflect management optimism, perhaps their view that their company’s shares are
underpriced by investors.
Stock repurchases may also be used to signal a manager’s confidence in the future.
The graph shows the % of companies in European Union
paying dividends or repurchasing, it is clear that
dividend payouts are declining while repurchasing are
increasing from 1997. Research shows that dividends
are more stable than repurchases. I don’t think
talking about “How Firms Pay Dividends” would be a
value addition as we all are aware on this. The
announcement of the dividend states that the payment
will be made to all stockholders who are registered on a
particular record date.
A survey in 2004 talks:
i) Managers focus more on dividend changes than on absolute dividend levels. Hence, paying a dividend of $2.00
per share is an important financial decision if last year’s dividend was $1.50, but no big deal if last year’s
dividend was also $2.00.
ii) Managers “smooth” dividends. Dividend changes follow shifts in long-run, sustainable earnings. Transitory
earnings changes are unlikely to affect dividends.
iii) Managers do particularly worry about having to rescind a dividend increase and, if necessary, would issue
shares or borrow to maintain the dividend.
I, being an investor have the mentality that announcement of dividend increase is a good news, even more
managers do not increase the dividends unless they are confident that the payment can be maintained. Now I am
confident that my company is confident in generation future profits.
The information content of dividends implies that dividend increases predict future profitability, but evidences
are rarely found.
What this news create is that it results in share price rise as the market expects growth in the companies while the
news relating to dividend cut off results in reduction of share price. This means market is efficient as it forecasts the
future with the news.
What should corporations do- DIVIDENDS OR REPURCHASE [CONTROVERSY]
Announcements of dividends and repurchases can convey information about management’s confidence and so
affect the stock price. But eventually the stock price change would happen anyway as information seeps out
through other channels. Does payout policy affect value in the long run?
On the right are conservatives who argue that investors pay more for firms with generous, stable dividends. On
the left, another group argues that repurchases are better because repurchases mean higher stock prices, and
capital gains have been taxed at lower effective rates than dividends. And in the center, a middle-of-the-road party
claims that the choice between
dividends and repurchases has no effect on value. [I will be discussing 2 schools of thoughts on dividends on
DIVIDENDS ARE IRRELEVANT
This school of thought is propounded by Miller and Modigliani and says that dividends do not really matter
because they do not affect firm value [ie, stockholders are indifferent between receiving dividends and
earning capital gains (price appreciation)] which is based on two assumptions. The first is that there is no tax
disadvantage to an investor to receiving dividends relative to capital gains, and the second is that firms can raise
funds in capital markets for new investments without bearing significant issuance costs.
The thought is simple since they say that in totality investors get the same. In case a higher dividend is paid it
results in low capital appreciation and vice versa, provided tax on dividends and tax on capital gains are same. In
India dividends are exempt in the hands of investors. If these assumptions do not hold true, then investors
who need cash urgently might prefer to receive dividends.
Now if the company wants to up the dividend without changing their investment policy or capital structure, then
there is the need of extra cash which must come from somewhere. If the firm fixes its borrowing; the only way, it
can finance the extra dividend is to sell more shares.
Alternatively, rather than increasing dividends and selling new shares, the firm can pay lower dividends. With
investment policy and borrowing fixed, the cash that is saved can only be used to buy back some of the firm’s
existing shares. Thus any change in dividend payout must be offset by the sale or repurchase of shares.
Proof of Irrelevance
Let us consider a Balance sheet of a firm pre and post payout based on market values.
Assumptions for simplicity:
-Consider there is no debt.
-Net Working capital is enough to meet the business operations.
-All of its fixed assets are paid for.
-Surplus cash is left over cash.
-Market is perfect [ stocks are fairly priced]
We do have choices- you may go for dividend payments or repurchase the stock
Now let us say the company goes for paying dividend to its shareholders. $1 per share can be paid as dividend out
of surplus cash. The stock price will be $ 10 per share. Finally, a shareholder has $1 (dividend) plus $10 (value of
stock) =$11 in his hand.
Say, it goes for buy back. Maximum buy back shall be = [1 million/ $11 per share] = 90,909 shares. Post
repurchase no. of shares outstanding shall be 909,091. Now share price becomes 11 [ie 10 million divided by
909091 shares]. Again share holder has $11 in his hand.
Hence, at the end the shareholder’s wealth is the same with dividends as with repurchases. This is what
MM proved in their article in 1961.
It’s all rumor to say that “Repurchases do guarantee a higher stock price” which we proved in the above example.
Repurchases also reduce the number of shares outstanding, so future earnings per share are higher than
if the same amount were paid out as dividends.
WHAT WE LEARNT
If MM are correct and payout policy does not affect value, then the choice between dividends and repurchases is
merely tactical. A company will decide to repurchase if it wants to retain the flexibility to cut back payout if valuable
investment opportunities arise. Another company may decide to pay dividends to assure stockholders that it will run
a tight ship, paying out free cash flow to limit the temptation for careless spending. Firms should never give up a
positive NPV project to increase a dividend (or to pay a
dividend for the first time). This situation exists in a perfect market. I don’t like to create a debatable situation in
this short write up on the topic whether market is rational or irrational. Robert Shiller & Eugene Fama both
being Nobel Prize Winners have contradictory views on the market. You may refer their research papers &
books on the said topic.
What We Know And Do Not Know About Dividend Policy -Some Survey Evidence About Dividends
Policy Statements % who
1 We try to avoid reducing dividends per share 93.8%
2 We try to maintain a smooth dividend from year to year 89.6%
3 We consider the level of dividends per share that we have paid in recent
4 We are reluctant to make dividend changes that might have to be reversed in
5 We consider the change or growth in dividends per share. 66.7 66.7%
6 We consider the cost of raising external capital to be smaller than the cost of
7 We pay dividends to attract investors subject to “prudent man” investment
Adapted from Table 4 of A. Brav, J. R. Graham, C. R. Harvey, and R. Michaely,
“Payout Policy in the 21st Century,” Journal of Financial Economics (2005).
SCHOOLS OF THOUGHT very brief
Interestingly we have 2 schools of thoughts - DIVIDENDS ARE BAD SCHOOL & DIVIDENDS ARE GOOD SCHOOL
Dividends have historically been taxed at much higher rates than capital gains in the United States. Based on this tax
disadvantage, dividend payments reduce the returns to stockholders after personal taxes. Stockholders, they posited, would
respond by reducing the stock prices of the firms making these payments, relative to firms that do not pay dividends.
Consequently, firms would be better off either retaining the money they would have paid out as dividends or repurchasing
stock. In 2003, the basis for this argument was largely eliminated when the tax rate on dividends was reduced to match the
tax rate on capital gains. If this is the case dividends are good in India as dividends are exempt in the hands of shareholders.
If a company does not have excess cash, and/or has several good investment opportunities (NPV>0), returning money
to stockholders (dividends or stock repurchases) is bad.
Notwithstanding the tax disadvantages associated with dividends for most of the last hundred years in the United
States, firms continued to pay dividends and many investors viewed such payments positively. This gave rise to a
thought that argues dividends are good and can increase firm value. Some of the arguments used are questionable,
but some have a reasonable basis in fact.
If a company has excess cash, and few good investment opportunities (NPV>0), returning money to
stockholders (dividends or stock repurchases) is good.
Even you have these thoughts if you are playing with the live data. See here:
There are much more to express on the topic – I request the readers to consider this be an introductory topic. I
am thankful to my teachers, authors, writers, their books and various publications from whom I remain updated
in this segment. I must acknowledge my finance guru CA Rajiv Singh, Prof. Aswath Damodaran, RWJ, Brealey-
Myers-Allen for this write up. The data and references are facts & based on authentic sources research papers.
Thank you for reading!!!