Dividend Policy - To Pay or Not to PayA dividend policy is a corporation’s decision about the payment of cash dividends to shareholders. There are several basic ways of describing a corporation’s dividend policy: no dividends, constant growth in dividends per share, constant payout ratio, and low regular dividends with periodic extra dividends. The corporations that typically do not pay dividends are those that are generally viewed as younger, faster growing companies. For example, Microsoft Corporation was founded in 1975 and went public in 1986, but it did not pay a cash dividend until January 2003. A common pattern of cash dividends tends to be the constant growth of dividends per share. Another pattern is the constant payout ratio. Many companies in the food processing industry, such as Kellogg and tootsie roll industries, pay dividends that are a relatively constant percentage of earnings. Some companies display both a constant dividend payout and a constant growth in dividends. This type of dividend pattern is characteristic of large, mature companies that have predictable earnings growth—the dividends growth tends to mimic the earnings growth, resulting in a constant payout.


What considerations behind those variety dividend policies? There are certain theories and explanations that relevant and worth overviewing as I will discuss in this post. Read on…


U.S. corporations that pay dividends tend to pay either constant or increasing dividends per share. Dividends tend to be lower in industries that have many profitable opportunities to invest their earnings. But as a company matures and finds fewer and fewer profitable investment opportunities, a greater portion of its earnings are paid out in dividends.

Many corporations are reluctant to cut dividends because the corporation’s share price usually falls when a dividend reduction is announced. For example, the U.S. auto manufacturers cut dividends during the recession in the early 1990s. As earnings per share declined the auto makers did not cut dividends until EPS were negative—and in the case of General motors, not until it had experienced two consecutive loss years. But as earnings recovered in the mid-1990s, dividends were increased [13 General motors increased dividends until cutting them once again in 2006 as it incurred substantial losses].

Corporations tend to raise their regular quarterly dividend only when they are sure they can keep it up in the future. By giving a special or extra dividend, the corporation is able to provide more cash to the shareholders without committing itself to paying an increased dividend each period into the future.


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 Signaling Explanation – Dividends provide a way for the management 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 overview each of the above theory and explanation. Read on…


The Dividend Irrelevance Theory

The dividend irrelevance argument was developed by Merton Miller and Franco Modigliani [Note: Merton miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of shares,” Journal of Business (October 1961), pp. 411–433]. Basically, the argument 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 corporation is unaffected by payment of dividends. How can this be?

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

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


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

But businesses don’t live in a perfect world with a perfect market. Are the imperfections (taxes, transactions costs, etc.) enough to alter the conclusions 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 shareholders 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.

Corporations generate earnings and can either pay them out in cash dividends or reinvest earnings in profitable investments, increasing the value of the stock and, hence, share price. Once a dividend is paid, it is a certain 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 becomes a sure thing only when the share’s price increases over the price the shareholder paid and he or she sells the shares.

We can observe that prices of dividend-paying stocks are less volatile than non-dividend-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. Companies that have greater risk—business risk, financial risk, or both—tend to pay little or no dividends. Companies 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

If dividend income is taxed at the same rates as capital gain income, investors may prefer capital gains because of the time value of money. The fact is; capital gains are taxed only when realized—that is, when the investor sells the stock—whereas dividend income is taxed when received. If, however, dividend income is taxed at rates higher than that applied to capital gain income, investors should prefer stock price appreciation to dividend income because of both the time value of money and the lower rates.

Historically, capital gain income has been taxed in the United States at rates lower than that applied to dividend income for individual investors. However, the current situation for individuals is that dividend income and capital gain income are taxed at the same rates [Note: The Jobs & Growth tax relief reconciliation act of 2003 lowered the tax rate individuals pay on dividends to 15% or 5%, depending on the individual’s other income, at the same time lowering the tax rate on capital gains to the same 15% or 5% rates. though these tax rate cuts were intended to expire in 2008, they were extended by the tax relief and health Care act of 2006].

Even with the same rates applied to income, capital gain income is still preferred because the tax on any stock appreciation is deferred until the stock is sold. But the tax impact is different for different types of shareholders. A corporation receiving a dividend from another corporation may take a dividends received deduction—a deduction of a large portion of the dividend income. Therefore, corporations pay taxes on a small portion of their dividend income. Still other shareholders may not even be taxed on dividend 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].

Even if dividend income were taxed at rates higher than that of capital gains, investors could take investment actions that affect this difference.

  • First, investors that have high marginal tax rates may gravitate toward stocks that pay little or no dividends. This means the shareholders of dividendpaying 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.


Several strategies that can be used to reduce the taxes on dividend income are discussed by Merton Miller and Myron Scholes in “Dividend and taxes” Journal of Financial Economics (1979), pp. 333–364. However, Pamela Peterson, David Peterson, 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.


The Signaling Explanation

Companies that pay dividends seem to maintain a relatively 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 companies change their dividend—either increasing or reducing (cutting) the dividend—the price of the company’s shares seems to be affected: When a dividend is increased, the price of the company’s shares typically goes up; when a dividend is cut, the price usually goes down. This reaction is attributed to investor’s perception of the meaning of the dividend change: increases are good news, decreases are bad news.

The board of directors is likely to have some information that investors do not have; a change in dividend may be a way for the board to signal this private information. Because most boards of directors are aware that when dividends are lowered, the price of a share usually falls, most investors do not expect boards to increase a dividend unless they thought the company could maintain it into the future. Realizing this, investors may view a dividend increase as the board’s increased confidence in the future operating performance of the firm.


The Agency Explanation

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. Management is 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, the CFO may be forced to raise new capital outside of the firm—that is, issue new securities instead of using internally generated capital—subjecting them to the scrutiny of equity research analysts and other investors. This extra scrutiny helps reduce the possibility that managers will not work in the best interests of the shareholders. But issuing new securities 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 manager’s 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 company with a return greater than what shareholders could get elsewhere on their money—that is, a return greater than the shareholder’s 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 boards make decisions consistent with shareholder wealth maximization, any free cash flow should be paid out to shareholders since—by the definition of a profitable investment opportunity—the shareholders could get a better return investing the funds they receive.


If the company pays a dividend, funds are paid out to shareholders. If the company needs additional funds, they could be raised by issuing new securities, and if the shareholders wish to reinvest the funds received as dividends in the firm, they could buy these new securities. One view of the role of dividends is that the payment of dividends therefore reduces the cash flow in the hands of management, reducing the possibility that managers will invest funds in unprofitable investment opportunities.


Summing Up [To Pay Dividends or Not]

We can figure out reasons why a company should or should not pay dividends, but not why they actually do or do not—this is the “dividend puzzle” [Note: The phrase “dividend puzzle” originates from Fischer black, “the Dividend Puzzle”, Journal of Portfolio Management (Winter 1976), pp. 5–8].  But we do know from looking at dividends and the market’s reaction to them that:

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


That’s why CFOs would need to be aware of the relation between dividends and the value of the common stock in establishing or changing dividend policy.