Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 CHAPTER SIXTEEN 432 THE DIVIDEND CONTROVERSY Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 IN THIS CHAPTER we explain how companies set their dividend payments and we discuss the contro- versial question of how dividend policy affects the market value of the firm. The first step toward understanding dividend policy is to recognize that the phrase means differ- ent things to different people. Therefore we must start by defining what we mean by it. A firm’s decisions about dividends are often mixed up with other financing and investment deci- sions. Some firms pay low dividends because management is optimistic about the firm’s future and wishes to retain earnings for expansion. In this case the dividend is a by-product of the firm’s capital budgeting decision. Suppose, however, that the future opportunities evaporate, that a dividend in- crease is announced, and that the stock price falls. How do we separate the impact of the dividend increase from the impact of investors’ disappointment at the lost growth opportunities? Another firm might finance capital expenditures largely by borrowing. This releases cash for divi- dends. In this case the firm’s dividend is a by-product of the borrowing decision. We must isolate dividend policy from other problems of financial management. The precise ques- tion we should ask is, What is the effect of a change in cash dividends paid, given the firm’s capital budgeting and borrowing decisions? Of course the cash used to finance a dividend increase has to come from somewhere. If we fix the firm’s investment outlays and borrowing, there is only one pos- sible source—an issue of stock. Thus we define dividend policy as the trade-off between retaining earnings on the one hand and paying out cash and issuing new shares on the other. This trade-off may seem artificial at first, for we do not observe firms scheduling a stock issue to offset every dividend payment. But there are many firms that pay dividends and also issue stock from time to time. They could avoid the stock issues by paying lower dividends. Many other firms restrict dividends so that they do not have to issue shares. They could issue stock occasionally and increase the dividend. Both groups of firms are facing the dividend policy trade-off. Companies can hand back cash to their shareholders either by paying a dividend or by buying back their stock. So we start the chapter with some basic institutional material on dividends and stock re- purchases. We then look at how companies decide on dividend payments and we show how both div- idends and stock repurchases provide information to investors about company prospects. We then come to the central question, How does dividend policy affect firm value? You will see why we call this chapter “The Dividend Controversy.” 433 16.1 HOW DIVIDENDS ARE PAID The dividend is set by the firm’s board of directors. The announcement of the div- idend states that the payment will be made to all those stockholders who are reg- istered on a particular record date. Then about two weeks later dividend checks are mailed to stockholders. Shares are normally bought and sold with dividend or cum dividend until a few days before the record date, at which point they trade ex dividend. Investors who buy with dividend need not worry if their shares are not registered in time. The dividend must be paid over to them by the seller. The company is not free to declare whatever dividend it chooses. Some re- strictions may be imposed by lenders, who are concerned that excessive divi- dend payments would not leave enough in the kitty to pay the company’s debts. State law also helps to protect the company’s creditors against excessive Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 dividend payments. For example, companies are not allowed to pay a dividend out of legal capital, which is generally defined as the par value of outstanding shares. 1 Dividends Come in Different Forms Most companies pay a regular cash dividend each quarter, 2 but occasionally this reg- ular dividend is supplemented by a one-off extra or special dividend. 3 Dividends are not always in the form of cash. Frequently companies also declare stock dividends. For example, Archer Daniels Midland has paid a yearly stock divi- dend of 5 percent for over 20 years. That means it sends each shareholder 5 extra shares for every 100 shares currently owned. You can see that a stock dividend is very much like a stock split. (For example, Archer Daniels Midland could have skipped one year’s stock dividend and split each 100 shares into 105.) Both stock dividends and splits increase the number of shares, but the company’s assets, prof- its, and total value are unaffected. So both reduce value per share. The distinction between the two is technical. A stock dividend is shown in the accounts as a trans- fer from retained earnings to equity capital, whereas a split is shown as a reduction in the par value of each share. Many companies have automatic dividend reinvestment plans (DRIPs). Often the new shares are issued at a 5 percent discount from the market price; the firm offers this sweetener because it saves the underwriting costs of a regular share is- sue. 4 Sometimes 10 percent or more of total dividends will be reinvested under such plans. Dividend Payers and Nonpayers Fama and French, who have studied dividend payments in the United States, found that only about a fifth of public companies pay a dividend. 5 Some of the remainder paid dividends in the past but then fell on hard times and were forced to conserve cash. The other non-dividend-payers are mostly growth companies. They include such household names as Microsoft, Cisco, and Sun Microsystems, as well as many small, rapidly growing firms that have not yet reached full profitability. Of course, investors hope that these firms will eventually become profitable and that, when their rate of new investment slows down, they will be able to pay a dividend. 434 PART V Dividend Policy and Capital Structure 1 Where there is no par value, legal capital is defined as part or all of the receipts from the issue of shares. Companies with wasting assets, such as mining companies, are sometimes permitted to pay out legal capital. 2 In 1999 Disney changed to paying dividends once a year rather than quarterly. Disney has an unusu- ally large number of investors with only a handful of shares. By making an annual payment, Disney re- duced the substantial cost of mailing dividend checks to these investors. 3 Special dividends are much less common than they used to be. The reasons are analyzed in H. DeAn- gelo, L. DeAngelo, and D. Skinner, “Special Dividends and the Evolution of Dividend Signaling,” Jour- nal of Financial Economies 57 (2000), pp. 309–354. 4 Sometimes companies not only allow shareholders to reinvest dividends but also allow them to buy additional shares at a discount. In some cases substantial amounts of money have been invested. For example, AT&T has raised over $400 million a year through DRIPs. For an amusing and true rags-to- riches story, see M. S. Scholes and M. A. Wolfson, “Decentralized Investment Banking: The Case of Dividend-Reinvestment and Stock-Purchase Plans,” Journal of Financial Economics 24 (September 1989), pp. 7–36. 5 E. F. Fama and K. R. French, “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Financial Economics 60 (2001), pp. 3–43. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 Fama and French also found that the proportion of dividend payers has de- clined sharply from a peak of 67 percent in 1978. One reason for this is that a large number of small growth companies have gone public in the last 20 years. Many of these newly listed companies were in high-tech industries, had no earnings, and did not pay dividends. But the influx of newly listed growth companies does not fully explain the declining popularity of dividends. It seems that even large and profitable firms are somewhat less likely to pay a dividend than was once the case. Share Repurchase When a firm wants to pay out cash to its shareholders, it usually declares a cash dividend. The alternative is to repurchase its own stock. The reacquired shares may be kept in the company’s treasury and resold if the company needs money. There is an important difference in the taxation of dividends and stock repur- chases. Dividends are taxed as ordinary income, but stockholders who sell shares back to the firm pay tax only on capital gains realized in the sale. However, the In- ternal Revenue Service is on the lookout for companies that disguise dividends as repurchases, and it may decide that regular or proportional repurchases should be taxed as dividend payments. There are three main ways to repurchase stock. The most common method is for the firm to announce that it plans to buy its stock in the open market, just like any other investor. 6 However, sometimes companies offer to buy back a stated number of shares at a fixed price, which is typically set at about 20 percent above the current market level. Shareholders can then choose whether to accept this of- fer. Finally, repurchase may take place by direct negotiation with a major share- holder. The most notorious instances are greenmail transactions, in which the tar- get of a takeover attempt buys off the hostile bidder by repurchasing any shares that it has acquired. “Greenmail” means that these shares are repurchased by the target at a price which makes the bidder happy to leave the target alone. This price does not always make the target’s shareholders happy, as we point out in Chapter 33. Stock repurchase plans were big news in October 1987. On Monday, October 19, stock prices in the United States nose-dived more than 20 percent. The next day the board of Citicorp approved a plan to repurchase $250 million of the company’s stock. Citicorp was soon joined by a number of other corporations whose man- agers were equally concerned about the market crash. Altogether, over a two-day period these firms announced plans to buy back $6.2 billion of stock. News of these huge buyback programs helped to stem the slide in stock prices. Figure 16.1 shows that since the 1980s stock repurchases have mushroomed and are now larger in value than dividend payments. As we write this chapter at the end of October 2001, large new repurchase programs have just been announced in the last two weeks by IBM ($3.5 billion), McDonald’s ($5 billion), and Citigroup ($5 billion). The biggest and most dramatic repurchases have been in the oil industry, where cash resources for a long time outran good capital investment opportunities. Exxon Mobil is in first place, having spent about $27 billion on repurchasing shares through year-end 2000. CHAPTER 16 The Dividend Controversy 435 6 An alternative procedure is to employ a Dutch auction. In this case the firm states a series of prices at which it is prepared to repurchase stock. Shareholders submit offers declaring how many shares they wish to sell at each price and the company then calculates the lowest price at which it can buy the de- sired number of shares. This is another example of the uniform-price auction described in Section 15.3. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 Repurchases are like bumper dividends; they cause large amounts of cash to be paid to investors. But they don’t substitute for dividends. Most companies that repurchase stock are mature, profitable companies that also pay dividends. So the growth in stock repurchases cannot explain the declining proportion of divi- dend payers. Suppose that a company has accumulated large amounts of unwanted cash or wishes to change its capital structure by replacing equity with debt. It will usually do so by repurchasing stock rather than by paying out large dividends. For exam- ple, consider the case of U.S. banks. In 1997 large bank holding companies paid out just under 40 percent of their earnings as dividends. There were few profitable in- vestment opportunities for the remaining income, but the banks did not want to commit themselves in the long run to any larger dividend payments. They there- fore returned the cash to shareholders not by upping the dividend rate, but by re- purchasing $16 billion of stock. 7 Given these differences in the way that dividends and repurchases are used, it is not surprising to find that repurchases are much more volatile than dividends. Repurchases mushroom during boom times as firms accumulate excess cash and wither in recessions. 8 In recent years a number of countries, such as Japan and Sweden, have al- lowed repurchases for the first time. Some countries, however, continue to ban them entirely, while in many other countries repurchases are taxed as dividends, often at very high rates. In these countries firms that have amassed large moun- tains of cash may prefer to invest it on very low rates of return rather than to hand it back to shareholders, who could reinvest it in other firms that are short of cash. 436 PART V Dividend Policy and Capital Structure 1982 1984 1986 1988 1990 Year 1992 1994 1996 1998 0 20 40 60 80 100 120 140 160 $ Billions Repurchases Dividends FIGURE 16.1 Stock repurchases and dividends in the United States, 1982–1999. (Figures in $ billions.) Source: J. B. Carlson, “Why Is the Dividend Yield So Low?” Federal Reserve Bank of Cleveland Economic Commentary, April 1, 2001. 7 B. Hirtle, “Bank Holding Company Capital Ratios and Shareholder Payouts,” Federal Reserve Bank of New York: Current Issues in Economics and Finance 4 (September 1998). 8 These differences between dividends and repurchases are described in M. Jagannathan, C. Stephens, and M. S. Weisbach, “Financial Flexibility and the Choice between Dividends and Stock Repurchases,” Journal of Financial Economics 57 (2000), pp. 355–384. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 Lintner’s Model In the mid-1950s John Lintner conducted a classic series of interviews with corpo- rate managers about their dividend policies. 9 His description of how dividends are determined can be summarized in four “stylized facts”: 10 1. Firms have long-run target dividend payout ratios. Mature companies with stable earnings generally pay out a high proportion of earnings; growth companies have low payouts (if they pay any dividends at all). 2. Managers focus more on dividend changes than on absolute levels. Thus, paying a $2.00 dividend is an important financial decision if last year’s dividend was $1.00, but no big deal if last year’s dividend was $2.00. 3. Dividend changes follow shifts in long-run, sustainable earnings. Managers “smooth” dividends. Transitory earnings changes are unlikely to affect dividend payouts. 4. Managers are reluctant to make dividend changes that might have to be reversed. They are particularly worried about having to rescind a dividend increase. Lintner developed a simple model which is consistent with these facts and ex- plains dividend payments well. Here it is: Suppose that a firm always stuck to its target payout ratio. Then the dividend payment in the coming year (DIV 1 ) would equal a constant proportion of earnings per share (EPS 1 ): DIV 1 ϭ target dividend ϭ target ratio ϫ EPS 1 The dividend change would equal DIV 1 Ϫ DIV 0 ϭ target change ϭ target ratio ϫ EPS 1 Ϫ DIV 0 A firm that always stuck to its target payout ratio would have to change its div- idend whenever earnings changed. But the managers in Lintner’s survey were re- luctant to do this. They believed that shareholders prefer a steady progression in dividends. Therefore, even if circumstances appeared to warrant a large increase in their company’s dividend, they would move only partway toward their target payment. Their dividend changes therefore seemed to conform to the following model: DIV 1 Ϫ DIV 0 ϭ adjustment rate ϫ target change ϭ adjustment rate ϫ (target ratio ϫ EPS 1 Ϫ DIV 0 ) The more conservative the company, the more slowly it would move toward its tar- get and, therefore, the lower would be its adjustment rate. CHAPTER 16 The Dividend Controversy 437 16.2 HOW DO COMPANIES DECIDE ON DIVIDEND PAYMENTS? 9 J. Lintner, “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes,” American Economic Review 46 (May 1956), pp. 97–113. 10 The stylized facts are given by Terry A. Marsh and Robert C. Merton, “Dividend Behavior for the Ag- gregate Stock Market,” Journal of Business 60 (January 1987), pp. 1–40. See pp. 5–6. We have paraphrased and embellished. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 Lintner’s simple model suggests that the dividend depends in part on the firm’s current earnings and in part on the dividend for the previous year, which in turn de- pends on that year’s earnings and the dividend in the year before. Therefore, if Lint- ner is correct, we should be able to describe dividends in terms of a weighted aver- age of current and past earnings. 11 The probability of an increase in the dividend rate should be greatest when current earnings have increased; it should be somewhat less when only the earnings from the previous year have increased; and so on. An exten- sive study by Fama and Babiak confirmed this hypothesis. 12 Their tests of Lintner’s model suggest that it provides a fairly good explanation of how companies decide on the dividend rate, but it is not the whole story. We would expect managers to take future prospects as well as past achievements into account when setting the pay- ment. As we shall see in the next section, that is indeed the case. 438 PART V Dividend Policy and Capital Structure 11 This can be demonstrated as follows: Dividends per share in time t are (1) DIV t ϭ aT(EPS t ) ϩ (1 Ϫ a)DIV tϪ1 where a is the adjustment rate and T is the target payout ratio. But the same relationship holds in t Ϫ 1: (2) DIV tϪ1 ϭ aT(EPS tϪ1 ) ϩ (1 Ϫ a)DIV tϪ2 Substitute for DIV tϪ1 in (1): DIV t ϭ aT(EPS t ) ϩ aT(1 Ϫ a)(EPS tϪ1 ) ϩ (1 Ϫ a) 2 DIV tϪ2 We can make similar substitutions for DIV tϪ2 , DIV tϪ3 , etc., thereby obtaining DIV t ϭ aT(EPS t ) ϩ aT(1 Ϫ a)(EPS tϪ1 ) ϩ aT(1 Ϫ a) 2 (EPS tϪ2 ) ϩ ϩ aT(1 Ϫ a) n (EPS tϪn ) 12 E. F. Fama and H. Babiak, “Dividend Policy: An Empirical Analysis,” Journal of the American Statistical Association 63 (December 1968), pp. 1132–1161. 16.3 THE INFORMATION IN DIVIDENDS AND STOCK REPURCHASES In some countries you cannot rely on the information that companies provide. Pas- sion for secrecy and a tendency to construct multilayered corporate organizations produce asset and earnings figures that are next to meaningless. Some people say that, thanks to creative accounting, the situation is little better for some companies in the United States. How does an investor in such a world separate marginally profitable firms from the real money makers? One clue is dividends. Investors can’t read managers’ minds, but they can learn from managers’ actions. They know that a firm which re- ports good earnings and pays a generous dividend is putting its money where its mouth is. We can understand, therefore, why investors would value the informa- tion content of dividends and would refuse to believe a firm’s reported earnings unless they were backed up by an appropriate dividend policy. Of course, firms can cheat in the short run by overstating earnings and scraping up cash to pay a generous dividend. But it is hard to cheat in the long run, for a firm that is not making enough money will not have enough cash to pay out. If a firm chooses a high dividend payout without the cash flow to back it up, that firm will ultimately have to reduce its investment plans or turn to investors for addi- tional debt or equity financing. All of these consequences are costly. Therefore, most managers don’t increase dividends until they are confident that sufficient cash will flow in to pay them. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 There is some evidence that managers do look to the future when they set the div- idend payment. For example, Benartzi, Michaely, and Thaler found that dividend in- creases generally followed a couple of years of unusual earnings growth. 13 Although this rapid growth did not persist beyond the year in which the dividend was changed, for the most part the higher level of earnings was maintained and declines in earnings were relatively uncommon. More striking evidence that dividends are set with an eye to the future is provided by Healy and Palepu, who focus on companies that pay a dividend for the first time. 14 On average earnings jumped 43 percent in the year that the dividend was paid. If managers thought that this was a temporary windfall, they might have been cautious about committing themselves to paying out cash. But it looks as if they had good reason to be confident about prospects, for over the next four years earnings grew on average by a further 164 percent. If dividends provide some reassurance that the new level of earnings is likely to be sustained, it is no surprise to find that announcements of dividend cuts are usu- ally taken by investors as bad news (stock price falls) and that dividend increases are good news (stock price rises). For example, in the case of the dividend initia- tions studied by Healy and Palepu, the announcement of the dividend resulted in an abnormal rise of 4 percent in the stock price. 15 Notice that investors do not get excited about the level of a company’s dividend; they worry about the change, which they view as an important indicator of the sus- tainability of earnings. In Finance in the News we illustrate how an unexpected change in dividends can cause the stock price to bounce back and forth as investors struggle to interpret the significance of the change. It seems that in some other countries investors are less preoccupied with divi- dend changes. For example, in Japan there is a much closer relationship between corporations and major stockholders, and therefore information may be more eas- ily shared with investors. Consequently, Japanese corporations are more prone to cut their dividends when there is a drop in earnings, but investors do not mark the stocks down as sharply as in the United States. 16 The Information Content of Share Repurchase Share repurchases, like dividends, are a way to hand cash back to shareholders. But unlike dividends, share repurchases are frequently a one-off event. So a company that announces a repurchase program is not making a long-term commitment to earn and distribute more cash. The information in the announcement of a share repurchase pro- gram is therefore likely to be different from the information in a dividend payment. Companies repurchase shares when they have accumulated more cash than they can invest profitably or when they wish to increase their debt levels. Neither CHAPTER 16 The Dividend Controversy 439 13 See L. Benartzi, R. Michaely, and R. H. Thaler, “Do Changes in Dividends Signal the Future or the Past,” Journal of Finance 52 (July 1997), pp. 1007–1034. Similar results are reported in H. DeAngelo, L. DeAngelo, and D. Skinner, “Reversal of Fortune: Dividend Signaling and the Disappearance of Sus- tained Earnings Growth,” Journal of Financial Economics 40 (1996), pp. 341–372. 14 See P. Healy and K. Palepu, “Earnings Information Conveyed by Dividend Initiations and Omis- sions,” Journal of Financial Economics 21 (1988), pp. 149–175. 15 Healy and Palepu also looked at companies that stopped paying a dividend. In this case the stock price on average declined by an abnormal 9.5 percent on the announcement and earnings fell over the next four quarters. 16 The dividend policies of Japanese keiretsus are analyzed in K. L. Dewenter and V. A. Warther, “Divi- dends, Asymmetric Information, and Agency Conflicts: Evidence from a Comparison of the Dividend Policies of Japanese and U.S. Firms,” Journal of Finance 53 (June 1998), pp. 879–904. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 On May 9, 1994, FPL Group, the parent company of Florida Power & Light Company, announced a 32 percent reduction in its quarterly dividend payout, from 62 cents per share to 42 cents. In its an- nouncement, FPL did its best to spell out to in- vestors why it had taken such an unusual step. It stressed that it had studied the situation carefully and that, given the prospect of increased competi- tion in the electric utility industry, the company’s high dividend payout ratio (which had averaged 90 percent in the past 4 years) was no longer in the shareholders’ best interests. The new policy re- sulted in a payout of about 60 percent of the pre- vious year’s earnings. Management also an- nounced that, starting in 1995, the dividend payout would be reviewed in February instead of May to reinforce the linkage between dividends and an- nual earnings. In doing so, the company wanted to minimize unintended “signaling effects” from any future changes in dividends. At the same time that it announced this change in dividend policy, FPL Group’s board authorized the repurchase of up to 10 million shares of com- mon stock over the next 3 years. In adopting this strategy, the company noted that changes in the U.S. tax code since 1990 had made capital gains more attractive than dividends to shareholders. Besides providing a more tax-efficient means of distributing excess cash to its stockholders, FPL’s substitution of stock repurchases for divi- dends was also designed to increase the com- pany’s financial flexibility in preparation for a new era of heightened competition among utilities. Al- though much of the cash savings from the divi- dend cut would be returned to shareholders in the form of stock repurchases, the rest would be used to retire debt and so reduce the company’s lever- age ratio. This deleveraging was intended to pre- pare the company for the likely increase in busi- ness risk and to provide some slack that would allow the company to take advantage of future business opportunities. All this sounded logical, but investors’ first reac- tion was dismay. On the day of the announcement, the stock price fell nearly 14 percent. But, as analy- sis digested the news and considered the reasons for the reduction, they concluded that the action was not a signal of financial distress but a well- considered strategic decision. This view spread throughout the financial community, and FPL’s stock price began to recover. By the middle of the following month at least 15 major brokerage houses had placed FPL’s common stock on their “buy” lists and the price had largely recovered from its earlier fall. Source: Modified from D. Soter, E. Brigham, and P. Evanson, “The Dividend Cut ‘Heard ‘Round the World’: The Case of FPL,” Journal of Applied Corporate Finance 9 (Spring 1996), pp. 4–15. circumstance is good news in itself, but shareholders are frequently relieved to see companies paying out the excess cash rather than frittering it away on unprofitable investments. Shareholders also know that firms with large quantities of debt to service are less likely to squander cash. A study by Comment and Jarrell, who looked at the announcements of open-market repurchase programs, found that on average they resulted in an abnormal price rise of 2 percent. 17 440 FINANCE IN THE NEWS THE DIVIDEND CUT HEARD ’ROUND THE WORLD 17 See R. Comment and G. Jarrell, “The Relative Signalling Power of Dutch-Auction and Fixed Price Self- Tender Offers and Open-Market Share Repurchases,” Journal of Finance 46 (September 1991), pp. 1243–1271. There is also evidence of continuing superior performance during the years following a repurchase announcement. See D. Ikenberry, J. Lakonishok, and T. Vermaelen, “Market Underreaction to Open Market Share Repurchases,” Journal of Financial Economics 39 (1995), pp. 181–208. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy © The McGraw−Hill Companies, 2003 Stock repurchases may also be used to signal a manager’s confidence in the fu- ture. Suppose that you, the manager, believe that your stock is substantially un- dervalued. You announce that the company is prepared to buy back a fifth of its stock at a price that is 20 percent above the current market price. But (you say) you are certainly not going to sell any of your own stock at that price. Investors jump to the obvious conclusion—you must believe that the stock is good value even at 20 percent above the current price. When companies offer to repurchase their stock at a premium, senior manage- ment and directors usually commit to hold onto their stock. 18 So it is not surpris- ing that researchers have found that announcements of offers to buy back shares above the market price have prompted a larger rise in the stock price, averaging about 11 percent. 19 CHAPTER 16 The Dividend Controversy 441 18 Not only do managers’ hold onto their stock; on average they also add to their holdings before the an- nouncement of a repurchase. See D. S. Lee, W. Mikkelson, and M. M. Partch, “Managers Trading around Stock Repurchases,” Journal of Finance 47 (1992), pp. 1947–1961. 19 See R. Comment and G. Jarrell, op. cit. 20 M. H. Miller and F. Modigliani: “Dividend Policy, Growth and the Valuation of Shares,” Journal of Busi- ness 34 (October 1961), pp. 411–433. 21 Not everybody believed dividends make shareholders better off. MM’s arguments were anticipated in 1938 in J. B. Williams, The Theory of Investment Value, Harvard University Press, Cambridge, MA, 1938. Also, a proof very similar to MM’s was developed by J. Lintner in “Dividends, Earnings, Leverage, Stock Prices and the Supply of Capital to Corporations,” Review of Economics and Statistics 44 (August 1962), pp. 243–269. 16.4 THE DIVIDEND CONTROVERSY We have seen that a dividend increase indicates management’s optimism about earnings and thus affects the stock price. But the jump in stock price that accom- panies an unexpected dividend increase would happen eventually anyway as in- formation about future earnings comes out through other channels. We now ask whether the dividend decision changes the value of the stock, rather than simply providing a signal of stock value. One endearing feature of economics is that it can always accommodate not just two but three opposing points of view. And so it is with the controversy about dividend policy. On the right there is a conservative group which believes that an increase in dividend payout increases firm value. On the left, there is a radi- cal group which believes that an increase in payout reduces value. And in the center there is a middle-of-the-road party which claims that dividend policy makes no difference. The middle-of-the-road party was founded in 1961 by Miller and Modigliani (al- ways referred to as “MM” or “M and M”), when they published a theoretical pa- per showing the irrelevance of dividend policy in a world without taxes, transac- tion costs, or other market imperfections. 20 By the standards of 1961 MM were leftist radicals, because at that time most people believed that even under idealized assumptions increased dividends made shareholders better off. 21 But now MM’s proof is generally accepted as correct, and the argument has shifted to whether taxes or other market imperfections alter the situation. In the process MM have been pushed toward the center by a new leftist party which argues for low divi- dends. The leftists’ position is based on MM’s argument modified to take account [...]... middle -of- the-road party has increased its share of the vote 16. 7 THE MIDDLE -OF- THE-ROADERS The middle -of- the-road party, principally represented by Miller, Black, and Scholes, maintains that a company’s value is not affected by its dividend policy.39 We have already seen that this would be the case if there were no impediments such as transaction costs or taxes The middle -of- the-roaders are aware of. .. buyers of dividends, because they pay tax only on 30 percent of dividends received from other corporations (We say more on the taxation of intercorporate dividends later in this section.) Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 16 The Dividend Controversy CHAPTER 16 The Dividend Controversy A number of researchers... after-tax basis Thus, if A and B have the same beta, they should offer the same after-tax rate of return The spread between pretax and post-tax returns is determined by a weighted average of investors’ tax rates See M J Brennan, “Taxes, Market Valuation and Corporate Financial Policy,” National Tax Journal 23 (December 1970), pp 417–427 449 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition. .. empire building See R La Porta, F Lopez-de-Silanes, A Shleifer, and R W Vishny, “Agency Problems and Dividend Policies around the World,” Journal of Finance 55 (February 2000), pp 1–34 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 16 The Dividend Controversy CHAPTER 16 The Dividend Controversy Firm A (No Dividend)... transfer is caused Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 16 The Dividend Controversy CHAPTER 16 The Dividend Controversy Before dividend 443 FIGURE 16. 2 After dividend New stockholders This firm pays out a third of its worth as a dividend and raises the money by selling new shares The transfer of value to... that all income after corporate taxes is paid out as cash dividends to an investor in the top income tax bracket (figures in dollars per share) This is the chink in the armor of the middle -of- the-roaders If high dividends bring high taxes, it’s difficult to believe that investors get what they want The response of the middle -of- the-roaders has been to argue that there are plenty of wrinkles in the tax... securities that are held for more than 12 months only half of the gain is taxed Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure 16 The Dividend Controversy © The McGraw−Hill Companies, 2003 CHAPTER 16 The Dividend Controversy 455 Look once again at Table 16. 3 and think what would happen if the corporate tax rate was zero The shareholder with a 15... 1.10 1.21 1 .16 47 54 1.45 1.84 3.28 3.86 2.60 1.80 0.58 1.17 1.73 4.50 1.04 Ϫ.20 60 48 32 6 6 6 6 61 64 77 84 84 84 84 84 92 1.00 1.00 1.00 1.00 1.00 Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure 16 The Dividend Controversy © The McGraw−Hill Companies, 2003 CHAPTER 16 The Dividend Controversy 463 The current price of the shares of Charles River... doesn’t matter which clientele a particular firm chooses to appeal to If the middle -of- the-road party is right, we should not expect to observe any general association between dividend policy and market values, and the value of any individual company would be independent of its choice of dividend policy The middle -of- the-roaders stress that companies would not have generous payout policies unless they... Behavior for the Aggregate Stock Market,” Journal of Business, 60:1–40 (January 1987) Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V Dividend Policy and Capital Structure © The McGraw−Hill Companies, 2003 16 The Dividend Controversy CHAPTER 16 The Dividend Controversy 457 The pioneering article on dividend policy in the context of a perfect capital market is: M H Miller and F Modigliani: . Dividend Policies of Japanese and U.S. Firms,” Journal of Finance 53 (June 1998), pp. 879–904. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. . assumption, but it simplifies the proof of MM’s theory. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy ©. Lower Propensity to Pay?” Journal of Financial Economics 60 (2001), pp. 3–43. Brealey−Meyers: Principles of Corporate Finance, Seventh Edition V. Dividend Policy and Capital Structure 16. The Dividend Controversy ©