in Glasgow

M.Sc. FINANCE

FINANCE III

UNIT 3

DIVIDENDS

J R Davies
CONTENTS
Page
PREVIEW 1
Aims 1
Objectives 1
INTRODUCTION 1
MECHANICS OF DIVIDENDS PAYMENTS 4
DETERMINEING DIVIDENDS PAYMENTS 7
DIVIDEND IRRELEVANCY PROPOSITION 10
Sources and Uses of Funds 12
UNCERTAINTY RESOLUTION 17
RELAXING ASSUMPTIONS 18
Transactions Costs 18
TAXES AND DIVIDEND POLICY 19
Clientele Effect 19
AGENCY COSTS AND DIVIDENDS 24
THE INFORMATION CONTENT OF DIVIDENDS: THE SIGNALLING 26
HYPOTHESIS
EMPIRICAL EVIDENCE ON DIVIDEND POLICY 28
AN ALTERNATIVE TO DIVIDEND PAYMENTS – THE REPURCHASE 32
OF SHARES
CONCLUSION 33
ANSWERS TO SELF ASSESSMENT QUESTIONS 34
PREVIEW

Aims
The aims of this unit are to provide an introduction to the dividend behaviour of
companies, to consider the relationship between the dividend policy of a company and
the value of its shares, and identify the primary factors that a company should take
into account in developing its dividend policy.

Objectives
After completing this unit you should be able to

 understand the primary characteristics of the dividend policies adopted by

companies in the UK;
 analyse the market’s reaction to dividend announcements;
 explain the nature of the dividend irrelevancy theory;
 appreciate the role of transactions costs, taxes, and costly and imperfect
information in influencing dividend decisions;
 explain the nature and role of the clientele effect;
 evaluate the empirical evidence relating to dividend decisions; and
 differentiate between relevant and irrelevant considerations in taking
dividend decisions.

INTRODUCTION
Expected dividends are generally perceived to be critical determinant of the price of a
share. Investors are assumed to buy shares for the dividends they are expected to
produce. This allows share prices to be modelled as the present value of the expected
value of the stream of future dividends. But even if it is accepted that expected
dividends are a key determinant of share prices it does not necessarily mean that a
company can influence its share price by changing its dividend policy – the proportion
of its earnings or profits paid out as dividends to shareholders.

It is not feasible for a company to change its dividend policy without this affecting
either its investment policy or the level of its external funding. A company that
decides to pay out more of its earnings in the form of dividends will have less
earnings available for use within the company. This implies it will either have to cut
back on its investments in new assets, or if its investment plans are to be maintained it
will have to issue more shares or increase its borrowing.

Consider a company with promising investments to exploit. It can fund its investment
programme by retaining earnings or by seeking funds externally. If it chooses to
retain earnings the dividends paid to shareholders in the short term will be lower than
they would be if external funding was arranged. The shareholders of a company
funding its investments by retentions at the expense of immediate dividends can
expected to be compensated for their short term sacrifice by higher dividends in the
future. Whilst they will have to wait for these future cash dividends it does not mean
that their investment return will be any lower in the short term. In principle the value
of their shares should increase in line with retentions, producing capital gains to

1
compensate for the loss of dividends. The shareholders of firms using external
funding cannot look forward to such high future dividends. They receive higher
dividends in the short term at the expense of the company creating more claims on
future earnings. If more share are issued and the level of future earnings is given,
there must be lower future dividends per share for the initial set of shareholders.

Dividend decisions appear to be taken very seriously by both corporate financial

managers and investors. Their concern may seem to be well founded by the
observation that dividend announcements out of line with the market’s expectations
appear to produce significant share price reactions. Recognising that the
announcement of a dividend increase is often associated with a positive market
response finance directors might be tempted to propose increases in dividends as a
way of pushing up the price of their company’s shares. As we shall see a rational and
efficient market will see through such ploy, and the share price will only respond to
dividend increases that signal increases in the expected earnings of the company.

The traditional view that dividend policy does matter, and can influences share prices,
is well represented in the writings of Graham and Dodd. Their textbook on security
analysis, first published more than fifty years ago, continues to be very influential
among practitioners:

“… the verdict of the stock market is overwhelming in favour of liberal

dividends as against niggardly ones. The common stock investor must
take this judgement into account in the valuation of stock for purchase.
It is now becoming standard practise to evaluate common stock by
applying one multiplier to that portion of the earnings paid out as
dividends and a much smaller multiplier to the undistributed balance.”

“two companies with the same general earning power and general
position in an industry, the one paying the larger dividend will almost
always sell at a higher price.”

B Graham & D L Dodd, “Security Analysis: Principles & Techniques”,

3rd Ed., McGraw Hill, 1951.

The alternative view that dividend policy is relevant in the content of perfectly
competitive capital markets was developed by Miller and Modigliani in 1961, in a
follow up article to their analysis of the capital structure policies of companies
published in 1958. The methodological approach adopted is the same, as is the
conclusion of their analysis that a company’s financing decisions are irrelevant for the
determination of its share price. Given competitive markets, financing decisions, and
the dividend decision is essentially a financing decision, are unimportant: value is
determined by the ability of the business to generate cash flows:

“Like many other propositions in economics, the irrelevancy of

dividend policy given investment policy, is ‘obvious once you think of
it’. It is, after all, merely one more instance of the general principle
that there are no ‘financial illusions’ in a rational economic
environment. Values are determined solely by real considerations –
in this case the earning power of the firm’s assets and its investment

2
 policy – and not on how the fruits of the earnings power are
‘packaged’ for distribution.”
Miller and Modigliani (1961)

The debate on dividend policy is to a large extent concerned with the question of
whether or not the composition of the expected return on a share, in the form of the
expected dividend yield and the expected capital gain yield,

E  D jt 1  E  Pt 1   Pt
E  R jt   
Pt Pt

influences the overall expected rate of return. If the view that the market favours high
payouts is correct the higher the expected dividend payment in relation to retentions
the higher the share price. The higher the share price associated with high payout
implies a lower overall expected rate of return. Of course if this line of reasoning is
correct a company increasing its payout ratio would see its share price increase,
producing on a temporary basis a high rate of return. The alternative view put
forward by Miller and Modigliani is that its share price is independent of the payout
policy and the breakdown of its expected return into the dividend yield and capital
gains yield.

Before embarking on a more detailed discussion of dividend policy we should

establish some realistic expectations about the possibility of resolving the issues
surrounding dividend policy. Fisher Black of the Black and Scholes model, one of the
outstanding figures in the development of modern financial theory, has written

“What should the individual investor do about dividends in his

portfolio? We don’t know.

What should the corporation do about the dividend policy? We don’t

know.”
The Dividend Puzzle (Black 1976)

Black refers to the large amount of tax paid on dividends which could be avoided by
investors taking their returns in the form of more lightly taxed capital gains, as the
dividend puzzle.

These negative conclusions were reached by Black after considering the latest
theoretical and empirical studies, available in 1976, but I suspect that there has been
nothing published since he write his article twenty or so years ago that would have led
him to change his position. Of course this is not to say that we know nothing about
dividend policy! We can eliminate many misunderstandings and identify the key
issues even though a fully comprehensive and satisfactory theory still eludes us.
Having established realistic expectations let us proceed!

Any satisfactory theory of dividends must be able to explain some generally observed
features of the dividend policies adopted by companies (see for example Allen and
Michaely (1995)]:

3
  companies typically pay out a relatively high proportion of their earnings
in the form of dividends;
 dividends constitute the most important form of payout of cash by firms to
shareholders, but this can also be done at the individual firm level through
the repurchase of shares and at the aggregate level by takeovers paid for in
cash;
 many shareholders in the USA, and to a lesser extent in the UK, receive
large dividend payments on which substantial amounts of tax are paid,
despite their appearing to be more tax efficient ways of securing the
returns from their investment;
 companies tend to be very cautious about increasing dividends and are
very reluctant to cut dividends, and appear to engage in dividend
smoothing exercises; and
 the stock market appears to react positively to the announcement of
dividends increases and negatively to dividend decreases.

MECHANICS OF DIVIDENDS PAYMENTS

Prior to the announcement of a dividend payment the market will have formed a view
of the prospects of the company and this will be embodied in the share price. If the
proposed dividend differs from that expected by the market there is likely to be a
reappraisal by the market of the firm’s investment value, and a change in the share
price will possibly follow. In theoretical terms this is interpreted as an information
effect: the price of the share changes in response to the new information contained in
the difference between the proposed dividend payment and the payment anticipated
by the market. But this is not simply a response to the payment of a smaller or larger
dividend than expected. The price reaction is likely in part at least to be the result of a
change in expectations with respect to subsequent dividend payments. As we shall
see later, significant share price changes are usually attributed to a re-assessment of
the longer term ability of the company to generate earnings.

When a company pays dividends it is disbursing some of its assets to its shareholders
so we would expected the market value of its equity to fall in the absence of taxes and
transactions costs. The share price can be expected to fall in line with the dividend
payment. The value of shareholders’ stake in the company falls whilst their holdings
of cash increase.

Dividends will be paid to the shareholders of record on a date which is specified when
the proposed dividend is announced. Following the announcement the share is trade
in what is referred to as a cum-dividend basis: the entitlement to the expected dividend
is bought and sold along with the share. This will continue up to the ex-dividend date
– the day on which the share ceases to be traded with an entitlement to the dividend.
When a share goes ex-dividend a fall in the share price can be anticipated. It seems
reasonable to assume that the price investors will be prepared to pay immediately
before the share goes ex-dividend will exceed the price immediately afterwards by the
amount of the dividend:

P  Cum  dividend   P  Ex  dividend   Dividend Per Share

4
But we shall see below that factors such as tax considerations can disturb this
relationship.

The likely price reactions around the dividend payment date are outline in figure
3.1(1) and (b) below. Two dates are of particular interest – the date on which the
proposed dividend is announced and the date on which the share goes ex-dividend. In
figure (a) it is assumed that the performance of the company is completely in line with
investor expectations and the announcement of the dividend produces no price
reaction. It is also being assumed that the profit generating activities of the company
add steadily to the assets of the company over time, producing a constant rate of
growth in price of the share over time – representing a normal rate of return. In figure
(b) the possibility of factors other than the dividend announcement influencing the
share price of the company are taken into account, and it is assumed that the dividend
announcement is associated with a significant positive revision of the firm’s future
prospects by the market. In both cases it is assumed that the share falls on the ex-
dividend day. No systematic share price reaction is anticipated on the day that the
payment is actually made.

Figure 3.1(a) Dividend Announcements And Ex-Dividend Price Reactions

No Change In Expectations

Share Price Pt

time
announcement ex-dividend payment
date day day

5
Figure 3.1(b) Dividend Announcements And Ex-Dividend Price Reactions

Continuing Market Adjustments And Change In Expectations

Share Price Pt

time
announcement ex-dividend payment
date day day

Firms are not under any contractual obligation to pay a dividend. Whether a dividend
will be paid, and how much is paid, are decisions taken by a company’s board of
directors. The decisions are constrained to the extent that dividends must be paid
from realised profits. Companies may pay out more in the form of dividends than
their current profits in any one year, but only if the company has built up retained
earnings in previous years. Dividends cannot be paid if this implies that the
company’s capital will be reduced. (Dividends are paid from cash rather than current
profits or retentions – but the payment of a dividend runs down the company’s assets,
and this must have corresponding impact on the other side of the balance sheet. The
concern with maintaining a company’s capital is more to do with maintaining its net
assets to protect its creditors.)

Dividends in the UK tend to be paid in two instalments: an interim dividend during

the course of the accounting year and a final dividend after the end of the accounting
year. The interim dividend is based on the level of expected profits, whereas the final
dividend is based on harder information about the year’s profit performance.

In the UK the city pages tend to refer to dividend cover rather than the payout ration,
the reciprocal of the payout ratio

Earnings Per Share 1

Dividend Cover  
Dividend Per Share 1  b

where b stand for the retention ratio.

[The number of times that the dividend could be paid from the company’s earnings
conveys the same information as the payout ratio 1  b  , but it places the emphasis
on the sustainability of dividends rather than proportion of earnings paid out!]

A higher proportion of profits tends to be paid out in the form of dividends in the UK than in
comparable industrial countries. As figure 3.2 indicates that after falling in the 1960’s and for much of
the 1970’s there has been a significant increase in payout ratio over the last ten years or so.

6
Figure 3.2 Dividend Payout Ratio: UK Industrial And
Commercial Companies, 1963-93

Per Cent
40

30

20

10

0
1965 1970 1975 1980 1985 1990

Source: Economic Trends Annual Supplement 1994, Bond et al (1995)

The higher payout ratio for the UK is reflected in a higher than average dividend yield
as indicated in table 3.1. (In principle a lower than average price-earnings could
produce a higher dividend yield even though the payout ratio was no higher than
average – but the price-earnings ratio in the UK is no lower than that of other
countries.)

Table 3.1 Dividend Yields in the G7 Countries, 1992 and 1993

1992 1993
Canada 2.5 2.6
France 2.9 2.9
Germany 1.7 2.1
Italy 1.6 2.2
Japan 0.8 0.8
UK 3.9 3.9
US 2.7 2.8

Source: Bond et al (1995)

DETERMINING DIVIDENDS PAYMENTS

One of the most important studies of how companies determine their dividend policies
was undertaken some forty years ago by Lintner (1956). The study does not attempt
to relate the dividend policy of a company to its share price or return to shareholders
so cannot throw any direct light on the relationship between a company’s value and its
dividend policy, but it has been very influential in developing our understanding of

7
how managers take dividends decisions. Following interviews with the management
of 28 companies, carefully selected to cover a range of different circumstances,
Lintner suggested that the that the dividend decision of companies can be explained
by a simple model. The interviews suggested that

 managers considered each year’s dividend in relation to last year’s

payment rather than determining the dividend afresh each year on the basis
of the company’s current earnings and investment requirements;
 management seem to have in mind a long term target payout ratio; and
 dividends increased with earnings over time, but only to the extent that the
dividend increases appeared to be sustainable.

Lintner suggested that in taking decisions the board of directors tend to evaluate
proposed dividend payments in relation to the dividend paid out in the last period.
Even if earnings have fallen there is a great reluctance to cut the dividend. When
earnings increase in the longer term in line with some loosely defined target payout
ratio. It is unlikely that the dividend will be immediately increased to this level. A
more limited increase is likely to be approved. The dividend will tend to be increased
by a proportion of the difference between the last dividend payment and the long run
target. This implies that the adjustment to the higher level of earnings will be spread
out over time. As a result should the level of earnings fall back the dividends may not
have to be reduced. As a result should the level of earnings fall back the dividend
may not have to be reduced. The critical elements in modelling dividend changes are
clearly the target payout ration and the adjustment to changes in earnings. Taking
these factors into account Lintner proposed that the changes in dividend for a
company can be approximated by the following equation:

Dt  s z EPS t  Dt 1 

where EPS is the earnings per share in period t ;

Dt 1 is the dividend in the previous period;
z is the long run target payout ratio; and
s is the adjustment factor.

the dividend in period t being simply the last dividend plus the change in dividend:

Dt  Dt 1  Dt

For example, a company might have a target payout ratio of 0.6 and an adjustment
factor of 0.75. In the long term it aims at paying out 60 per cent of its earnings. But
if in the short term earnings increases and a dividend based on the long term payout
ration would exceed the previous dividend the firm will only increase its dividend by
75 per cent of the difference between the two. Assume a company with a dividend of
£1.20 in the last period records earnings per share in the current period of £3.00. A
payout ratio of 60 per cent suggests a dividend of £1.80. If the dividends is increased
to this level and earnings fall in subsequent time periods such a dividends payment
may not be sustainable. So recognising this, the dividends is only increased by 0.75
of the difference between the long term target of £1.80 and the last dividend paid of
£1.20. This gives an increase of 0.95 times 60p or 45p and a dividend of £1.65 for the

8
current period. [see the example below on how dividends would evolve for a
company over time.]

Based on this analysis, Lintner used the following statistical model to explain
dividend changes of companies over time:

Dit  a i  s i [ z e EPS it  Di ,t 1 ]  U it

where i refers to firm i

ai a constant terms; and
U it an error term

It was found to be possible on this basis to explain 85 per cent of the changes in the
dividend for the companies in Lintner’s sample (the average value of z and s were
found to be 50 per cent and 30 per cent respectively). Fama and Babiak (1968) report
more comprehensive tests and further provide support for Lintner’s model. (The
found that adding a term for the lagged earnings and suppressing the constant term
only produced marginal improvements over the basic Lintner model). The following
example illustrates the mechanical operation for the Lintner model.

Lintner Model: Example

Dt  Dt 1  s z  EPS t   Dt 

Year EPS t z  EPS t   z  EPS t   Dt 1  D Dt

s x (4)
(1) (2) (3) (4) (5) (6)
1 50
2 145 72.50 22.50 6.75 57
3 155 77.50 20.50 6.15 63
4 140 70.00 7.00 2.10 65
5 160 80.00 15.00 4.50 70
6 170 85.00 15.00 4.50 75
7 175 87.50 12.50 3.75 79
8 180 90.00 11.00 3.33 82
9 168 84.00 2.00 0.60 83
10 172 86.00 3.00 0.90 84

Assumed values
Adjusted factor s = .3
Target payout ratio z= .5
Initial dividend D1 = 50p

Changes in = Adjustment Target Dividend - Last Dividend

Factor
Dividends

9
 Dt = s Dt* - Dt 1

Target Dividend = Target Ratio x EPS

Dt* = z  EPS t 

Proposed Dividend = Dt 1 + Dt

= Dt 1  s z  EPS t   Dt 1 

SAQ 3.1
A company’s expected earnings per share for the next three years are 140p, 180p and
170p. The company’s target payout ratio is 0.5 and its adjustment factor is 0.6. If the
last dividend paid was 60p evaluate the expected dividends for each of the next three
years.

DIVIDEND IRRELEVANCY PROPOSITION

Dividend payments involve the transfer of resources, in the form of cash, from a
company to its shareholders. Before the dividend is paid the shareholder has an
indirect claim on the cash as part of the assets of the company in which he or she has a
stake. It does not seem to be plausible to argue that transferring money from a
company to its owners can create value in the content of perfectly competitive
markets.

A company can only increase is dividend, while keeping its planned level of
investment expenditure, if it raises funds externally in some way. It can issue
additional shares or it can borrow. Given that we have already established that capital
structure decisions will not affect value in the context of perfectly competitive
markets, we can develop the analysis of the consequences of increasing the dividend
payment equally well whether we assume it is funded by the issuing debt or equity. It
is, however, simpler to assume that any increase in dividends is financed by an issue
of new shares as this implies the replacements of retained earnings by capital of the
same risk character.

As long as new shares are issued on the basis of fair prices, reflecting the present value of the case
flows that those subscribing to the shares can expect to receive, the company of increasing the dividend
and issuing shares will be neutral. The initial shareholders will receive a higher dividend now, a higher
immediate cash flow, and will forego future dividends of an equal present value. The new investors
will subscribe the cash to fund the additional dividend payment to be received by the initial
shareholders. They do so in return for a claim on the firm’s later cashflows which will be received at
the expense of the firm’s initial shareholders (see figure 3.3).
Figure 3.3 Dividend Payment Funded By An Issue Of Shares

Total Net assets Prior to Value of Initial Total Net Assets

Dividend Payment Shareholders’ Claims Following New

10
 (Initial Shareholders’ Following Payment of Issue and Dividend
Interest) Dividend Payment

Initial Shareholders’ Initial Shareholders’

Initial Shareholders’ Residual Claim on Net Claims
Claims on Net Assets = Assets =
Dividend New Shareholders’
Claims

Miller and Modigliani (1961) set out the analysis more formally by demonstrating that
the expected dividend does not enter into the value equation for shares. It is assumed
that capital markets are perfectly competitive and that the firm will maximise the
wealth of its existing shareholders by planning to undertake all profitable investment.
In the following analysis investment is assumed to be at the optimal level in each time
period, ie. all positive NPV investments are undertaken.

The notion of perfectly competitive capital markets implies

 full and costless information – so the consequences of all decisions and

policies are transparent, and rational investors take these consequences
into account in their decision taking;
 zero transactions costs – so that companies can make payments and issue
new shares without incurring any administrative or investment banking
costs, and investors can liquidate some of their shareholders without
incurring any brokerage costs of dividend payments fall short of their cash
requirements, or alternatively buy additional shares if dividends payments
exceeds their immediate expenditure requirements;
 no taxes – there is no tax advantage or disadvantage from receiving
income in the form of either dividends or capital gains; and
 all investors and companies are small in relation to the market as a whole,
and are consequently unable to exercise any market power (this implies
that they are price takes in a market where prices are determined by supply
and demand).

Miller and Modigliani develop their analysis from a simple source and use of funds
statement. The sources of funds are equal to the earnings generated by the firm plus
the proceeds from the sale of additional shares, and the uses of funds are given by the
sum of investment and dividend expenditure. As earnings and investment are
assumed to be given any increase in dividends must result in a corresponding increase
in funds raised from the sale of shares.

Before proceeding to the analysis we need to introduce some notation:

Nt = number of shares outstanding at the end of time period t

N t = number of shares issued at the end of time period t (such
shares do not qualify for dividends at time t )
P0 = share price at the start of the first year

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 Pt = share price at the end of year t (ex dividend)
Et = aggregate earnings at the end of period t
It = investment at the end of period t
Dt = aggregate dividends at the end of period t
Vt = value of equity at the end of period t
r = discount rate ie. shareholders’ required rate of return

Sources and Uses of Funds

E t  NPt  I t  Dt

The equation can be rearranged to focus on the value of the dividend at the end of
period t :

Dt  E t  NPt  I t

The dividends payment is seen to be equal to the sum of earnings and the proceeds
from any new issue, less the investment expenditure to be undertaken.

The aggregate value of the value of the equity outstanding today is given by the
number of shares outstanding  N 0  time the price of the share price  P0  . Its value
can be determined, by using a one period dividend valuation model, as the present
value of the expected dividend plus the anticipated market value of the shares at the
end of the period:

1
V0  N 0 P0   N 0 P1  D1 
(1  r )

where N 0 P1 is the expected value of the initial investors’ stake at the end of period
one.

Substituting the expression derived from the flow of funds identity for the dividend
payment gives

1
V0   N 0 P1   E1  NP1  I t  
(1  r )

Rearranging the equation

1
V0    E1  I 1    N 0  N  P1 
(1  r )

The total number of shares outstanding at the end of period one is equal to the initial
number of shares  N 0  plus the additional number of shares issued  N  , and this is
equivalent to the aggregate number of shares outstanding at the end of period  N 1  .
Substituting N 1 for  N 0  N  :

12
 1
V0    E1  I 1   N 1 P1 
1  r 
1
   E1  I 1   V1 
1  r 

This equation tells us that the value of the company’s equity today depends in part on
the value of the equity at one year ahead. Using the one period model to determine
the value of the equity at the end of period in terms of claims at the end of the second
year gives

1
V1    E 2  I 2   V2 
1  r 

Substituting this value into the equation for the value of equity today gives

1 1 1
V0   E1  I 1    E2  I 2   V2
1  r  1  r  2
1  r  2

This analysis can be extended indefinitely into the future, resulting in the following
valuation equation

n
1 1
V0    Et  I t   Vn
t 1 1  r  t
1  r  n
And when n   the value of the second term goes to zero, leaving

1
V0    Et  I t 
t 1 1  r  t

This suggests that the value of the shares of a company today depends simply on the
sum of the discounted value of the difference between expected earnings and planned
investments for each year into the future. Dividends do not appear in the equation.
Value depends simply on real factors – earnings and investment.

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Miller and Modigliani (1961) demonstrate that all of the following three models
produce the same value for a company’s equity given perfectly competitive markets

1
V0    E t  I t 
t 1 1  r  t
1
V0  E1  PVGO
r

1
V0   Dt*
t 1 1  r  t

where PVGO constitutes the present value of growth opportunities

Dt* stands for dividends accruing to today’s shareholders’ in period t

The equivalence of the second and third of these models was developed in Finance I
Unit 4. If it is assumed that all investments are financed from retentions and there are
no new issues of equity or increase in borrowing then

Dt*   Et  I t 

and the first and third of the models are obviously identical.

To back up this formal analysis Miller and Modigliani point out that investors will not
be concerned about the dividend policy adopted by any company in which they hold
shares in a perfectly competitive market. In the absence of transactions costs
investors can make their own dividends by selling shares if companies do not payout
enough to satisfy their expenditure requirements, or can buy more shares from their
dividend income if this exceeds their expenditure requirements. As Edwards (1984)
observed

“Shareholders can … declare their own dividends by appropriate sales

of their shares, and hence dividends policy in the current period is of
no consequence.”

And it is just as easy for shareholders to undo a dividend payment by immediately

purchasing some additional shares. The possibilities are summarised is figure 3.4.

Figure 3.4 Homemade Dividends And Retentions

Shareholder Preference Company Dividend Policy
High Payout Low Payout
Income (high expenditure) No Action Required Sell Shares
Investment (low expenditure) Use Dividends To Buy Shares No Action Required

Whilst Miller and Modigliani develop their analysis in the context of perfectly
competitive markets they recognise the possible implications of relaxing their
assumptions. Indeed their comments on the consequences of recognising the
implications of tax, transactions costs, imperfect information etc. set the agenda for

14
research on dividend policy for the next thirty years. Nevertheless they do not appear
to think that these imperfections are critically important. Miller, in particular, has
taken the view that the dividend irrelevancy proposition is of far more practical
importance than might be anticipated, given that it is derived on the basis of stringent
and what might appear to be questionable assumptions. Writing twenty years later he
contended that

“there is now substantial agreement within the academic community,

based in turn on many careful, scientific, statistical studies, that there
is no systematic, exploitable relation between a firm’s dividend policy
and the value of its shares. That value is governed by its earnings, or
more precisely, by its earning power.”
Merton Miller (1981)

Or, put more succinctly – dividend policy is of no relevance! Miller clearly has not
listened to what Fisher Black had to say about our lack of understanding! Not only
has Miller (in partnership with Modigliani) made the primary theoretical contribution
to the debate on dividend policy but he clearly believes that the theory has strong
policy relevance in a world characterised by some, but in his eyes, relatively
unimportant market imperfections. We will now consider some of the primary
objections to the irrelevancy proposition of Miller and Modigliani. To begin we will
examine the argument that as dividends are more certain than retentions increasing the
payout ratio will lead to an increase in the market value of shares. We will then
proceed to relax some of the assumptions of the perfectly competitive model, and ask
whether or not particular market imperfections can result in the dividends policy of a
company exerting some influence on its share price. Following this we will
reconsider the methodological approach adopted by Miller and Modigliani in
assuming that the expected level of profits and the investment policy of the firm are
independent of the dividend policy.

Dividend Payments and Value

The wealth of a shareholder just before a dividend payment is made consists of:
 the dividend payment anticipated; plus
 the present value of expected dividends in future time period.

If an increase is proposed in immediate dividends, funded by issue of shares

 the value of the dividend payment anticipated will go up; and
 the shareholders claims on the present value of expected future dividends
will go down.

New shareholders (buying the additional shares being issued)

 subscribe cash; and
 receive claims on future dividends of an equivalent present value.

15
Illustration of Dividend Irrelevancy:

Ydrych Plc: Dividend Increases and Shareholder Values

Ydrych plc is expected to generate earnings per share of 40p at the end of next year,
and to continue with its established policy of paying out 60 per cent of earnings in the
form of dividend indefinitely into the future. This will produce a dividend of 24p next
year. The company’s dividend payments are expected to grow at a rate of 8 per cent
on the basis of investments financed by retentions. It employs no external funding and
shareholders require a 20 per cent rate of return. The shares of the company can be
valued using the Gordon dividend valuation model:

1 1
P0  D1  E1 1  b 
rg rg
1
 401  .10   200p
.20  .08

This is the ex-dividend price of the share at time period zero. The cum-dividend price
of the share would have been 222.22p. (This is based on a dividend payment having
just been made which is consistent with a dividend series growing at 8 per cent, where
the next dividend payment is 24p. The value of the dividend payment just made is
derived as 24/(1 + .08), and is equal to 22.22p. The earnings per share necessary to
produce a dividend of 22.22p given the firm’s payout policy is 37.04p.)

Consider the position of shareholders if the company had decided to pay out 37.04p
per share instead of retaining 14.82p, and had financed this by selling shares at the
new lower ex-dividend price of 185.18 (this price is derived by taking the 14.82p away
from 200p). To raise 14.82p at the share price of 185.18p would required the issue of
14.82p/185.18p shares for every share currently outstanding, ie. an increase in .08
shares for every one outstanding. This implies that the initial shareholders will now
only own one share for every 1.08 shares that the company has issued, ie. 1/1.08 or
92.596 per cent of the shares. The issue of additional shares implies that future
dividends will have to be distributed amongst a larger number of shareholders, and
each share will no receive approximately 92 per cent of the amount anticipated prior to
the increase in the dividend. The price of the share will be given by

1
P0*   .92536 401  .40  185.1852
.20  .08

This is consistent with the ex-dividend price of a share, and implies that the wealth of
the shareholders will be unaffected by the change. Under the original policy for every
share they received a dividend payment of 22.22p and held a share worth 200p:

D0  P0  222.22p  200.00p  222.22p

Under the new dividend policy they receive a dividend of 37.04p and have a share
worth 185.18p: = 37.04p + 185.18p = 222.22p.
UNCERTAINTY RESOLUTION

16
It has been argued that dividends in the form of cash payments are not exposed to any
uncertainty whereas the value of retained earnings used to fund new investment is
inevitably uncertain. Retentions leading to increases in a company’s net assets should
produce increases in expected earnings and dividends and a higher share price. It is
however contended that the capital gains produced by retentions will depend on the
stock market’s evaluation of the earnings that the additional assets are expected to
produce. The notion that dividends produce a certain return in the form of a cash
payment whereas dividend produce uncertain capital gains has been used to argue in
favour of companies increasing their payout ratios. For example, Woods (1975)
contended that

“dividends, by putting certain cash into the shareholder’s hands,

confer a benefit on him which is certain and tangible in a sense in
which retained earnings, however lucratively invested do not.”

The argument that a pound of retentions is less certain than a pound of dividends,
justifying the application of a higher multiplies to dividends than to retentions, as
suggested by Graham and Dodds, has a certain plausibility. But on closer
examination it can be seen to be mistaken.

Admittedly retentions will be invested in risky assets. But differences in the risk
exposure of assets does not necessarily affect their values: fairly obviously £100 in
cash is no more valuable than £100 of shares, assuming the shares can be immediately
sold to yield £100 without incurring any transactions costs. Retentions constitute an
equity investment, and this is risky in relation to cash. This will also be the case for
any shares issued to allow higher dividend payments to be paid. The failure to
appreciate that assets of different risk can be equally valuable is known as the “bird in
the hand” fallacy.

Myron Gordon (1961), whose name is closely linked to the dividends growth model,
has also taken the view that restricting dividends to fund uncertain investment may
not be in the interest of shareholders. Gordon views retentions as leading to the
substitution of future dividends for present dividends. He goes on to suggest that
more distant dividends are more uncertain, and as a result higher discount rates should
be employed in deriving their present value. This view is quite plausible even thought
we find it convenient to simplify and assume that the discount rate is constant over
time. However, even if it is accepted that the discount rate should increase with time,
it does not imply that a firms dividend policy will be relevant in determining its share
price. If the cash flows from an investment it becomes more uncertain with the
passage of time this should be taken into account when the investment is evaluated.
But if the investment is worthwhile it should be undertaken in the interests of
shareholders despite the uncertainty. Similarly shareholders will be prepared to
forego dividends today for larger and uncertain future dividends as long as the present
value of these future dividends, evaluated, if appropriate, with a discount rate
increasing over time, is at least equal to the dividend foregone today. In suggesting
that dividends may be preferable to retentions Gordon is either suggesting that
retentions are used to fund investments that are not sufficiently profitable, in which
case the problem arises with the company’s investment rather than its dividend policy,
or he is committing a version of the bird in the hand fallacy.

17
The mistaken view that firms can increase their value by paying out more of earnings
in the form of certain dividends at the expanse of retentions of uncertain value may
stem in part from the observation that high payment companies tend to be considered
to low risk investments. But the low risk character of the investment does not stem
from the high payouts. On the contrary it is the low risk that leads to the high payout.
As companies are reluctant to cut dividends the payout of earnings may be restricted
to the level that management believes to be sustainable. The lower the volatility of
earnings the higher the level at which the payout ratio can be set without this
subsequently embarrassing management. There may be some confusion over the case
and effect in the observed negative correlation of risk and payout ratios.

RELAXING ASSUMPTIONS
Transactions Costs
In the real world investors buying and selling shares incur transactions costs as do
companies having the make new issues to fund dividend payments. Those investors
requiring income from their shareholdings to fund expenditure will prefer to receive
their investment returns in the form of dividends, thereby avoiding the transactions
costs they would incur if they were forced to sell shares to generate cash. However, if
it is necessary for companies to fund additional dividend payments by making new
issues the company will incur transactions costs. It is the company’s shareholders that
will ultimately bear the costs of these new issues. This suggests that these costs to be
incurred by the company must be traded off against the investors’ transactions costs to
obtain a cost minimising outcome in the interests of shareholders.

Even if the potential transactions costs for investors forced to liquidate some of their
shares exceed those of companies forced to make new issues, it does not follow that
high payment policies will necessarily lead to higher share prices. If there is a
shortage of aggregate dividends in relation to aggregate investor demand the shares of
a firm with a high payout ration will sell at premium. In these circumstances a firm
will be able to push up its share price by increasing its payout for the receipt of cash
income. However, once the overall level of dividends is in line with aggregate
investor requirements there will be no scope for any firm to influence its share price
by changing its dividend policy. Companies with high payouts will attract
shareholders requiring immediate income and the low payout companies’ shares will
tend to be held by investors saving their income from their shareholdings and
ploughing it back into investments. This matching of the needs of investors with the
policies in adopted by companies is referred to as the clientele effect, and it will be
considered further in relation to tax below. So we can conclude that even in the
presence of transaction costs unsatisfied clienteles must exist before firms can
influence their share prices by adjusting their dividend policies.

An observations that is consistent with a clientele effect at work in minimising the

impact of transactions costs is the emphasis placed on stability of dividends by
management. Manager are conservative and do not appear to be prepared to increase
dividends in line with earnings but instead allow dividend increases to lag increases in
earnings. By providing investors with a stream of dividends which is far more stable
than earnings and far easier to forecast, companies can help investors structure their
portfolios so as to generate the cash inflows they require. This will reduce the need
for homemade dividends and minimise transactions costs.

18
For the clientele effect to work effectively to minimise transactions costs we would
expect to find companies with low payouts not only attracting investors with a
preference for capital gains as opposed to dividends, but also these companies would
avoid the expenses associated with new issues, unless funding requirements for
investment outstripped earnings. However, in the UK companies making new issues
tend not only to pay dividends but are frequently observed to increase their dividends
in the same year as they make a new issue. The simple story to account for this is the
use of the dividend increase to make the shares attractive and the market ready to
absorb the additional shares. But this story does not fit well with the irrelevancy view
of dividends even when this is modified to incorporate transactions costs. Clearly
introducing transactions costs into the analysis cannot account for all features of
observed dividend behaviour.

TAXES AND DIVIDENDS POLICY

Shareholders are interested in after tax returns and if dividends are taxed at a different
rate to capital gains the form in which shareholders received their returns will
determine their net tax return. In these circumstances a shareholder will no longer
consider the dividend policy of a company to be irrelevant (we shall see later that this
does not necessarily imply that dividend policy becomes relevant for companies!).
Shareholders paying a higher rate of tax on dividends income will prefer to receive
their return in the form of capital gains, and will favour companies that tend to plough
back a high proportion of their earnings – assuming the companies have profitable
investment available to exploit.

If capital gains tax is lower than the income tax paid on dividends it seems reasonable
to suppose that the before tax rate of return on companies paying out a higher
proportion of the earnings as dividends must be higher than the before tax rate of
return on companies retaining most of their earnings. It is only on this basis that the
after tax rates of return can be equal.

Clientele Effect
Taxpayers with high marginal rates of tax are likely to prefer low payout shares and
prefer their returns in the form of capital gains whilst tax payers with low or zero
marginal rates of tax will tend to prefer high payout shares. Building on a suggestion
to be found in the Miller-Modigliani (1961) paper a highly plausible case has been
developed to suggest that dividend policy remains irrelevant despite differences in the
tax treatment of capital gains and dividends. Miller and Modigliani observed that

“Each corporation would tend to attract to itself a ‘clientele’

consisting of those preferring its particular payout ratio, but one
clientele would be entirely as good as another in terms of the valuation
it would imply for the firm.”

It was appreciated that this would lead to dividend irrelevancy.

“If for example the frequency distribution of corporate payout ratios

happened to correspond exactly with the distribution of investor

19
 preferences for payout ratios, then the existence of these preferences
would clearly lead ultimately to a situation whose implications were
difference, in no fundamental respect from the perfect market case.”

Black and Scholes (1974) point out that although income tax rates may be higher than
capital gains rates in the USA some investors may still prefer high dividends rather
than capital gains.

 companies tend to pay higher taxes on capital gains on their holdings of

shares (there is a provision which allows 87 per cent of dividend income to
be free of tax);
 in some trust funds the income is divided among beneficiaries on the basis
of capital gains and dividends, and shares paying some dividends would be
demanded to allow income to be paid to those only entitled to dividend
income despite the tax disadvantage; and
 in some endowment funds only dividend income can be spent so the
trustees wishing to undertake expenditure have no option other than to
hold some dividend paying shares.

Other individual and institutional investors may not be subject to tax at all and may be
indifferent to the form in which they receive their income.

Black and Scholes on the Clientele Effect

“If corporations are generally aware of the demands of some investors for high
dividend yields, and the demands of other investors for low dividends yields, then they
will adjust their dividends policies to supply the level of yield that are most on demand
at any particular time. As a result, the supply of shares at each level of yield will
come to match the demand or yield and investors as a group will be happy with the
available range of yields. After equilibrium is reached no corporation will be able to
affect the share price by changing its dividend policy.

Fisher Black and Myron Scholes, “The Effects of Dividend Yields and Dividend Policy on
Common Stock Prices and Returns”, Journal of Financial Economics, May 1974.

For the clientele effect to function effectively there must be a sufficient number of
companies within each risk group offering investors a range of dividend policies. If
this is not the case investors will be required to trade off the advantages of reducing
transaction costs against the loss of benefits from diversification. This is the result of
having to limit the choice of securities for a diversified portfolio to companies with
suitable payout policies. This becomes a particularly series problem if high payout
companies tend to be low risk companies and low payout companies tend to be higher
risk companies.

Evidence in support of these clientele effect is provided by Elton and Gruber (1970).
The fall in share prices experienced when shares go ex-dividend was examined to see
if the price reactions were consistent with the existence of clienteles. If tax clienteles
exist it would be found that investors paying high marginal rates of tax would tend to
hold shares characterised by relatively low payouts and on low dividend yield. In
general tax clienteles can be expected to result in a negative relationship between the

20
marginal tax rate of investors and the dividend yield of their portfolios. It was also
hypthesised that the higher the tax bracket of the typical investor the smaller the price
reaction to be expected when a share goes ex-dividend.

Elton and Gruber assumed that the observed decline in the price of a share would
make the typical investor indifferent between the alternative possibilities of i)
receiving a dividends and the associated fall in the share price, and ii) selling the share
just before the share goes ex-dividend.

 PB  P0  1  t g    PA  P0  1  t g   D1  t p 

where Po = purchase price of share

PB = price before dividend payment
PA = price after dividend payment
tg = capital gains tax
tp = personal tax on dividends

The left hand side of the equation gives the capital gain, the difference between the
purchase price of the share and its price immediately before the payment of the
dividend, net of the capital gains tax. The right hand side of the equation gives the
capital gain after tax, assuming the share is sold after the dividend payment, and the
next of tax dividend payment. Adding P0 1  t g  to both sides eliminates the P0
term, and gives

PB 1  t g   PA 1  t g   D1  t p 

This makes it clear that the original purchase price is irrelevant – it is only the price
change around the dividend payment that needs to be considered. Rearranging the
previous equation gives

 PB  PA  1  t g   D1  t p 

The term on the left hand side represents the fall in price when the share goes ex-
dividend, adjusted for the change in capital gains tax liability implied by the fall in
share price, and the term on the right hand side is the after tax dividend payment.
When these two terms are equal an investor will be indifferent between selling the
share immediately prior to the ex-dividend date and receiving the dividend.
Rearranging the equation gives

PB  PA 1  t p 

D 1  t g 
This specified the price change as a proportion of the dividend that is necessary to
make investors indifferent selling their shares just before goes ex-dividend and
continuing to hold the share and getting the dividend. It was found by Elton and
Gruber that the average price decline was 77.7 per cent of the dividend payment.
Assuming that the typical investor’s capital gains tax rate was half of the personal tax

21
on dividends (the case in the USA at the time of the study) it was possible to
determine the value of t g and t p :

PB  PA 1  t p 

D 1  0.5 t g 
Letting the left hand side equal 0.777 and solving for t p .

1  t 
p
0.777 
1  0.5t  p

0.7771  0.5t p   1  t 
p

t p  0.365

It was found that the average tax rate implied by the average fall in share price 77 per
cent was 36.4 per cent.

Elton and Gruber next ranked all shares according to their dividend yields, and then
sorted them into portfolios on this basis. The average fall in price on the ex-dividend
day was then determined for each portfolio and expressed as a proportion of the
portfolio dividend. It was found that if the portfolio with the lowest dividend was
omitted from the analysis the ranking of portfolios by dividend yield was almost
identical to the ranking in terms of the change in price expressed as a proportion of
the dividend. This was interpreted as strong evidence in favour of the working of a
tax clientele effect. The implied tax bracket for each portfolio was determined by
again assuming that the capital gains tax rate was half the tax rate on dividend
income. In line with the nature of the ranking reported above it was found that there
was a strong tendency for the implied tax rate to fall as the dividend yield increased.
This is what would be expected if investors in high tax brackets were tending to
choose shares with low payouts, and relatively low dividend yields, and investors in
low tax brackets were tending to choose portfolio with high dividend yield (see table
3.2).

Table 3.2 Portfolios Ranked According To Dividend Yield (10 portfolios)

Portfolio Dividend Yield P Implied Tax Bracket
D
1 0.0124 0.6690 0.4974
2 0.0216 0.4873 0.6146
3 0.0276 0.5447 0.5915
4 0.0328 0.6246 0.5315
5 0.0376 0.7953 0.3398
6 0.0416 0.8679 0.2334
7 0.0452 0.9209 0.1465
8 0.0496 0.9054 0.1747
9 0.0552 1.0123 -
10 0.0708 1.1755 -

22
Kalay (1977) questioned the analysis presented by Elton and Gruber, drawing
attention to the possibility of arbitrage profits for short term traders of the share price
of a companies just about to go ex-dividend is expected to fall by less than the
dividend. Such traders pay capital gains tax at the same rates as they pay tax on
dividend income, and are therefore indifference to the form in which income is
received. By purchasing shares just before the ex-dividend day and selling them
immediately afterwards they would pay income tax on dividends they received, and
obtain a tax credit on the capital loss incurred on the fall in share price. The expected
profit would be given by

Profit   PB  D1  t p   PA   PB  PA  t p
  D 1  t p    PB  PA  1  t p 
   D   PB  PA   1  t p 

Clearly a profit would be expected if D   PB  PA  and to eliminate arbitrage profits

the following condition must hold

D  PB  PA

The same result would follow as a result of trading by investors who are not subject to
tax. The analysis is suggestive but not complete as it does not take into account either
transactions costs or the risk associated with the expected price adjustment.
Nevertheless it poses problems for the interpretation of Elton and Gruber results, and
leaves the tax clientele discussion in the air!

Other forms of evidence on the operation of a clientele effect is equally mixed. Pettit
(1977) examined the composition of 900 individual portfolios and found that the
average dividend yield on securities included in portfolio tended to be

 positively related to investor age;

 negatively related to investor income; and
 negatively related to the difference between the investor’s marginal tax
rates on dividends and capital gains.

Pettit contended that a preference for dividends to finance current consumption could
be expected to be positively related to investor age and negatively related to income.
As the study inferred the tax rates of investors from the level of their income and
factors such as family size, the tax variable employed was far from precise.
Nevertheless it was still found to be the most important variable in explaining the
dividends yields of investors’ portfolios. On this basis Pettit’s study is supportive of
the existence of a clientele effect.

In another US study, Llewelen, Stanley, Lease and Schlarbaum (1978) conducted a

survey of the clients of a large broker and then attempted to use multiple discriminant
analysis to see if any characteristics of investors could be related to the dividends
yield of the shares held in their portfolio. It was concluded that

23
 “a substantially sharper profile of differences would be necessary to
raise much concern about specialisation along tax lines or to suggest a
tax tailored dividend policy … we are unable to find in the data much
evidence to support the notion that an important dividends tax-
clientele effect is in fact present.”

Clearly results at odds with those of Pettit and Elton and Gruber. It is a failure to
resolve issues of this nature that explains the conclusion reached by Fisher Black.

Transaction Costs, Taxes and Clientele Effects

Investors will buy shares in those companies with dividends policies that are
consistent with their preferences.

If high payout companies are in limited supply in relation to investor demand the share
prices of such companies will tend to be high in relation to their expected earnings –
this will encourage additional firms to adopt high payout policies.

In equilibrium the supply and demand for dividend policies will balance as a result of
companies adjusting to meet investor requirements.

No particular dividend policy is able to command a premium and for any one company
its dividend policy has no impact on its share price.

SAQ 3.2
An investor acquired some shares eighteen months ago at a price of 150p, and the
current price is 270p. The company has announced the intention of paying a dividend
of 40p. If the shares are sold immediately the investor will be liable for capital gains
tax on the increase in share price of 120p at a rate of 25 per cent. Past experience
suggests that the share price will fall by 80 per cent of the dividend when it goes ex-
dividend. Dividend will be taxed at a rate of 40 per cent. The investor has decidied to
sell the shares but does not know whether she should do so before or after the dividend
payment. Determine at what point she should sell the shares.

AGENCY COSTS AND DIVIDENDS

The assumption of the Miller-Modigliani model, that full information is available to
all parties does not allow for any conflict between the interests of managers and
shareholders. Relaxing the assumptions it is necessary to recognise that managers are
likely to be interests in maximising their utility which is not necessarily consistent
with the objective of maximising the value of the company’s shares. As we have seen
potential conflict of interest between managers and shareholders gives rise to agency
costs (see unit two). One possible explanation for the payment of dividends despite
the tax disadvantage of such payments is their role in reducing agency costs.

Easterbrook (1984) identified two forms of agency costs that might be reduced by the
payment of dividends:

24
  the costs of monitoring managers; and
 the costs of risk avoidance by managers.
The payment of higher dividends, given the level of investment and earnings of a
company, increases the likelihood that it will have to issue additional securities.
Easterbrook suggests that

“Both the monitoring problem and the risk aversion problem are less
serious if the firm is constantly in the market for new capital.”

Not only is the monitoring of managers by shareholders likely to be expensive but the
amount of monitoring is likely to fall short of the optimum. Shareholders will tend to
leave it to other shareholders and potential investors to check on the performance of
management – endeavouring to obtain the benefits of monitoring without incurring
any costs (this is the free rider problem, producing less than the socially optimal level
of monitoring).

If by paying dividends firms have to issue additional securities more frequently some
monitoring will be undertaken by capital market institutions:

“When it issues new securities, the firm’s affairs will be reviewed by

an investment banker or some similar intermediary acting as a
monitor for the collective interest of shareholders, and the purchasers
of new instruments … Managers who need to raise money consistently
are more likely to act in investors’ interest than managers who are
immune from this type of scrutiny.”

Eaterbrook’s second agency costs argument is based on the view that risk adverse
managers have and incentive to retain earnings rather than payout dividends.
Retentions increase a firm’s equity capital, and reduce its debt-equity ratio, and
thereby reduce its bankruptcy risk. Managers generally have far more to lose from the
bankruptcy of the firm that employs than its shareholders holding diversified
portfolios. The retentions of earnings rather than the payment of dividends is also
perceived to be in the interest of the firm’s debt holders. If the debt has been issued
on terms reflecting a particular debt-equity ration retaining earnings will reduce the
risk exposure of the debt holders.

“If managers first issue debt and ten finance new projects out of
retained earnings the debt-equity ratio will fall. The lower its falls, the
lower the managers’ risk and the greater the boom bestowed on the
debt holders, who received their contracted for interest but escape the
contracted for risk. Financing projects out of retrained earnings – if
unanticipated by bond holders – transfers wealth from shareholders to
debt holders.”

Assume that the value of a firm is given by the sum of the debt and equity. An
increase in the market value of the debt can only occur at the expense of the value of
the equity if the overall value of the firm is fixed. The market value of the debt will
increase if its interest rate was fixed on the basis of a given debt-equity ration. With a
reduction in the debt-equity ratio and the risk exposure of the debt, the yield required
by the debtholders will fall, and the value of the debt will increase.

25
This argument is interesting but has two major weaknesses. The first of these is
recognised by Easterbrook. A decrease in the debt-equity ratio as a result of
retentions will only transfer wealth from equity holders to debt holders if the
reducation in gearing is unanticipated. Secondly if the alternative to using retentions
is the issue of additional shares, the security of the debt holders will also increase.
Any increase in equity capital will reduce the debt-equity ration and the risk of the
debtholder. Dividend policy maybe interpreted as affecting value as a result of its
implications for a company’s capital structure, but it is not the ultimate cause of the
change in value. Dividend policy would not be relevant to value if additional funding
is raised in the form of debt and equity whether the was in the form of retentions or
new issues, so as to keep the capital structure of the company constant over time.

THE INFORMATION CONTENT OF DIVIDENDS:

THE SIGNALLING HYTPOHESIS
The announcement of a dividend increase by a company is often associated with an
increase in its share price, generating abnormal returns for its shareholders. This
appears to be evident against the Miller-Modigliani irrelevancy hypothesis. But there
is the possibility that the price reaction is not a response to the dividend
announcement but a change in investors’ perception of the future earning power of the
company. This will be the case if the dividend increase is interpreted as a signal by
investors of management’s belief that future earnings are expected to be higher.

Pettit (1972) is one of the first studies of the information effect of dividends reported
evidence of abnormal price changes on the announcement of dividend changes, with
the largest changes in price being associated with the largest dividend changes. The
price adjustments were found to be concentrated on the day of the announcement or
the day following, a finding consistent with the market efficiency in terms of the
speed of reaction. A major difficulty with Pettit’s study was the possibility that the
observed price adjustments were in response to earnings changes announced
simultaneously with the dividend changes, though Pettit took the view that dividend
announcements dominated the earnings announcements. As the study did not attempt
to separate out the dividend and earnings changes its conclusion must be treated with
caution. Aharony and Surary (1980) in a subsequent study focusing on quarterly
dividend announcements, which were not contaminated by the simultaneous release of
earnings information, concluded that dividend announcements do not tend to provide
any information. Taking a different approach Watts (1973) considered the possibility
that dividends convey information about the future earnings of the company. To
identify the information content of dividend announcements Watts differentiated
between actual and expected dividends as it is only the surprise element that produces
new information. The unexpected component of dividends was found to be positively
related to future earnings changes. However, the size of the earnings change
identified on the basis of the dividend change was very small. It did not provide the
basis for the development of a profitable trading strategy once transactions costs were
taken into account. On this basis Watts concluded that the hypothesis that dividend
announcement contained information should be rejected. A study by Asquith and
Mullins (1983), however, supported the conclusions of the earlier studies, reporting a
more significant information effect. They contended that to look at dividends

26
changes, reporting a more significant information effect. They contended that to look
at dividend changes, when many such changes were already anticipated by the
market, will lead to a relatively weak relationship being observed. To try to identify
unexpected dividend increase they examined the relationship being observed. To try
to identify unexpected dividend increase they examined the market’s reaction to the
announcements of a dividend by companies that had not paid any dividends for at
least 10 years. Their study found significant abnormal returns, and this was
interpreted to support the conclusion that dividend announcements can convey
important information to the market. It is not however, very plausible to contend that
the outcome for these rather removed circumstances to be relevant for dividends
announcements in general.

The possibility that dividend announcements convey information about the value of
the company stems from a recognition that managers may be more fully informed
than investors. As we have seen the Miller-Modigliani model was based on the
assumption of full information, but they recognised the possibility that dividend
announcements might convey information. Dealing with the observation that share
prices sometimes change when dividend announcements occur, it was pointed out that
this is not necessarily in conflict with the dividend irrelevancy proposition:

“… we might take note of a common confusion about the meanings of

the irrelevance proposition occasioned by the fact that in the real
worlds a change in the dividend rate is often followed by a change in
the market prices (sometimes spectacularly so). Such a phenomenon
would not be incompatible with irrelevance to the extent that it was
merely a reflection of what might be called “informational content” of
dividends, an attribute of particular dividend payments hitherto
excluded by assumption from the discussion and proofs. That is,
where a firm has adopted a policy of dividend stabilization with a
long-established and generally appreciated “target payout ratio”
investors are likely to (an have good reason to) interpret a change in
the dividend rate as a change in managements’ views of future profit
prospects for the firm. The dividend change, in other words, provide
the occasion for the price change though not its value, the price still
being solely a refection of future earnings and growth opportunities.

Dividend Policy, Growth and the Valuation of Shares, (1961)

It has been subsequently suggested that dividend policy may be deliberately employed
by managers as a means of conveying information about the company’s prospects to
the market. Why is it necessary to use such an indirect method of communicating
with investors when the information can be made public through a press release?
Firstly, there is the question of credibility. Favourable statements by management
about the company’s prospects might not be believed without providing hard evidence
to back up the statement. It may not always be possible to produce convincing
evidence or the provision of such evidence might be helpful to the company’s
competitors. Increasing dividends might in some circumstances be a credible signal
of improved earnings expectations, thereby making the provision of detailed
information to investors unnecessary. For example, a company might have developed
a reputations for being very reluctant to cut dividends and being prepared to increased

27
dividends only when the earnings outlook suggests that such increases are sustainable.
When a company with this sort of reputation increases its dividends payout the market
is likely to reassess its view of its earnings prospects. Dividend increases may in
some circumstances be viewed by the market as a more reliable indicator of a
company’s prospects than the announcement of higher earnings. Dividends require
cash payments whereas the earnings figure is an accounting number and this depends
in part at least on the judgement of the accountant. For companies perceived to have
been in some difficulty the ability to increases dividends payments might send a
stronger message to the markets than an announcement of higher earnings.

However the message carried by an increase in dividends is not that simple to

interpret. It is not impossible for a firm in difficulties to mislead the market by
increasing its dividend. Of course a firm that is on the verge of insolvency my not
have the cash available to fund the deception, and what is available may be necessary
to hold creditors at bay. However, it is conceivable that a firm could be in serious
long term difficulties while still having access to cash in the short term. Moreover
even when management is not attempting to deceive the market an increase in
dividends can be a rational response for firms in difficulties when the outlook for the
firm becomes less promising. Declining markets and a failure to find attractive
investment possibilities should prompt management acting in the interests of the
company’s shareholders, to increase the payout of earnings.

More formal models of the role of dividend changes as information signals have been
developed by Bhattacharya (1979), John and Williams (1985) and Miller and Rock
91985). These models are based on the assumption that managers are better informed
than the market, and wish to convey this information to investors. It is also assumed
that for signals to be credible they have to impose costs on the sender if they turn out
to be false. This is the mechanism that prevents companies misleading the market, eg.
a firm with poor prospects increasing its dividend so as to produce a higher share
price.

EMPIRICAL EVIDENCE ON DIVIDEND POLICY

We have already considered some empirical studies on dividend policy and in this
section we will look briefly at some of the other important studies relating to the
dividend irrelevancy proposition. Survey evidence strongly supports the view that
companies do not behave as if dividend policy is irrelevant. Companies are found to
follow well defined and stable policies. There is certainly no evidence to suggest that
they considered the dividend decision to be irrelevant in the sense of allowing
dividends to change randomly over time.

As we have seen Lintner (1956) found that it is possible to explain changes in US

companies’ dividends payments over time using a relatively simple model: companies
seem to employ a target payout ratio and adjust dividends as earnings increases over
time to the extent that a dividend increase appears to be sustainable. Lintner’s model
is consistent with a company following quite well defined dividend policy rather
allowing short term earnings in conjunction with its funding requirements to
determine the level of its dividend payment.

28
 In another frequently quoted study Rozeff (1982) found significant cross-sectional
regularities in corporate payout ratios in the USA. Such regularities are also difficult
to reconcile with the notion that dividend policy is irrelevant. Indeed Rozeff’s results
are not inconsistent with a company having an optimal dividend policy. Rozeff
argues along similar lines to Easterbrook (1983) that dividend payments can reduce
agency costs by forcing companies to raise capital externally. But the advantages of
being exposed to critical evaluation by the capital market are offset in part at least by
the costs of new issues. The optimal dividend policy for a company is seen to emerge
from a trade off of lower agency costs against the flotation costs of new issues. But
even though Rozeff’s study identifies a number of factors that appear to influence the
dividend decision the empirical results cannot be used to identify an optimal dividend
policy for a particular firm.

To test his hypothesis Rozeff identifies variables to act as proxies for external
financing costs and agency costs. It is assumed that the dividend policy of a
company, measured as the average payout ratio, attempts to minimise the sum of these
two costs. It is those companies that grow rapidly that will incur above average costs
of raising external funding if the payout ratio was allowed to vary randomly over
time. (If dividend policy is irrelevant there is reason to chose one policy as opposed
to another, or to maintain stability over time!). To minimise costs faster growing
companies will tend to adopt lower payouts all else being equal. Companies with
riskier earnings will also minimise their costs adopting low payout ratios. Companies
with a high proportion of shares held by insiders (members of the board) will be
exposed to relatively low agency costs. On this basis they will minimise their costs
by paying out a lower proportion of profits – they do not have to rely on the external
monitoring resulting from new issues to keep management focused on shareholders’
interests. Companies with insiders accounting for a small proportion of ownership,
and this is likely to be the case for companies with a large number of shareholders, are
likely to be vulnerable to high agency costs and will try to minimise these by paying
high dividends and making use of external capital despite the costs this implies.

Rozeff attempted to explain the average payout ratios of 1,000 companies over the
period 1974-80 using the following variables:

Grow 1: the growth rate of revenues from 1974 to 1979

Grow 2: the value line forecast of the growth of revenues 1979-84
Ins: the proportion of shares owned by insiders
Stock: the number of shareholders
Beta: a measure of the riskiness of firms

The result of the regression using these variables is

Payout = 47.81 - 0.90 INS - 0.321 GROW1 - 0.526 GROW2 - 26.543 BETA + 2.584 STOCK
Ratio
(12.83) (-4.10) (-6.38) (-6.43) (-17.05) (7.73)

Adjusted R 2 = 0.48.

29
All of the variables have the expected sign, are statistically significant at the 5 per
cent level, and the regression explains 48 per cent of the cross sectional variability. It
certainly appears to be the case that dividend policies are subject to systematic
influences and that agency considerations are of some importance.

The primary focus of much of the empirical work on dividend policies has been to
determine whether or not returns are systematically related to the payout policies of
companies. The early studies tended to conclude that price-earnings ratios were
positively correlated with payout ratios, supporting the view put forward by Graham
and Dodds that the multiplies applied to dividends is larger than the multiplier for
retentions. But these studies failed to allow for risk, and risk tends to be negatively
correlated with payout ratios. Unfortunately the results of later studies, controlling for
risk and employing the latest econometric techniques. Have not produced conclusive
results [see for example Black and Scholes (1974) and Litzenberger and Ramaswamy
(1979)]. The later studies focus on the differences in effective tax rates on capital
gains and dividends.

Practitioners tend to believe, along with graham and Dodds, that dividends are more
highly valued than retentions. They observe that the returns on the share of firms with
high payout ratios tended to be lower, suggesting that the share price are higher.
Some early empirical studies provided support for these beliefs. The studies
employed regression equations of the following nature to explain the cross section of
share prices

Pj  a  b j D j  b2 ( E j  D j )  u j

where Pj = price of the shares of company j

Dj = dividend per share of company j
Ej = earnings per share of company j
Ej  Dj = retentions per share of company j
uj = error term
b1 = dividends coefficient
b2 = retentions coefficient

The evidence indicated that b1  b2 : a higher multipliers seems to be applied to

dividends than to retentions in the valuation of shares. However, the weaknesses of
such studies were identified more than thorty years ago by Friend and Puckett 91964).
Friend and Puckett’s primary criticism related to the omission of crucial variable - the
risk of the firm. The greater the uncertainty relating to earnings the more likely it is
that firms will favour low payout policies. There is consequently likely to be a
negative correlation between payout ratios and risk, and this would lead to a lower
multiplier being applied to the earnings of a low payout firm. The regression results
may indicate little about the relevance of dividends policy and simply indicate that
share prices are negatively related to risk all else being equal. When Friend and
Puckett added a risk variable to the model it was no longer possible to conclude that
dividends are preferred to retentions. It appeared that the relative importance of
dividends and retentions depended on growth prospects of the industries of the firms
under consideration.

30
There are a number of difficulties in constructing tests of the relationship between
expected return and a company’s dividend policy. First of all we cannot observe
expected returns, and have to deal with actual returns. However, whilst we can expect
to find that there are differences, possibly quite significant differences, between
expected and actual returns it is quite acceptable to use actual returns as a proxy for
expected returns as along as the differences that arise are of a non-systematic nature.
Given random errors we can reasonably assume that the historical average is a
reasonable guide to the expected outcome.

Secondly, we cannot observe the expected dividend yield. Once again we have to
make use of historical evidence to develop the non-observable expected value of the
dividend yield. Generally last years’ yield is used as a proxy.

Thirdly, the definition of the dividend yield poses problems. In one sense it is only on
the ex-dividend day that a share has a meaningful dividend yield. On all other days
expected returns on investments occur in the form of capital appreciation. Without
transactions costs an investor in a higher tax bracket for dividend income could hold a
high dividend yield share for all days in the year apart from the ex-dividend date.
Shares would be sold prior to the ex-dividend date to avoid the receipt of dividend
income, and bought back immediately a share goes ex-dividend.

Black and Scholes determine for all the shares traded in the NYSE over the period
1931 and 1966 on an annual basis their dividend yield and betas. The shares were
then classified into portfolios in two stages. Firstly, all shares were allocated to five
different portfolio on the basis of their dividend yields and secondly each of these
portfolios was sub-divided into five portfolios on the basis of their betas. This
produced twentyfive portfolios offering a range of yield and risks. Black and Scholes
were attempting to provide a framework which would allow them to hold risk
constant while allowing dividends yields to vary. The coefficient of the dividends
yield was found to be so small, for the period 1935 to 1966, only one per cent of the
average returns can be attributed to dividend yield, as to be indistinguishable from
zero.

The Black and Scholes conclusions were subsequently challenged by Litzenberger

and Ramaswamy (1979, 1982) who found a statistically significant relationship
between before tax excess returns (the difference between actual returns and the
predicted returns using the capital asset pricing model), and excess dividend yields
(differences from the typical dividend yield). In their critique of the Black and
Scholes study Litzenberger and Ramaswamy argue that the dividend yield measure
they employed was not sufficiently sensitive. As we have seen Black and Scholes
used last year’s dividend as a proportion of the previous year’s closing price.
Litzenberger and Ramaswamy measure dividend yields on a monthly basis,
contending that if a dividend tax effect exists it will be most obvious in the months
when shares go ex-dividend yield. But their results have in turn been criticised by
Miller and Scholes (1981). It was contended that Litzenberger and Ramaswamy
failed to differentiate sufficiently carefully between dividend announcement and
dividend tax effects.

The dividend controversy is still to be resolved. To the extent that we cannot draw
any conclusions for policy and can perhaps agree with Hess (1986).

31
 “The failure of academic researchers to establish a systematic or
casual connection between dividend yields and stock retruns means
that corporate treasurers can relegate dividend policy to its rightful
position in the hierarchy of corporate decisions. And this is far below
the corporate investment decision.”

But what does he mean by rightful. Perhaps we should return to the conclusion drawn
by Fisher Black and accept that empirical studies have failed to resolve the issues.
We are still to develop a full understanding of dividend policy.

AN ALTERNATIVE TO DIVIDEND PAYMENTS –

THE REPURCHASE OF SHARES
Dividends are the conventional way of transferring cash from a company to its
shareholders, but given perfectly competitive capital markets companies can achieve
the same objective by the repurchase of shares. The payment of a dividend reduces
the net assets of a company and the purchase of shares has the same effect.

If shares are purchases from investors in proportion to their overall holdings of shares
the transaction is the same in real terms as a payment of dividends. Each shareholder
will obtain the same immediate cash inflow, and following the transaction will own
fewer shares but the value of these shares will be higher. (There are fewer shares
outstanding but the value of the company’s net assets is the same as it would have
been if a dividend payment had been made). The increase in the value of shares
compensates for the reduction in the number of shares being held. But more usually
the repurchase will be made in the open market. This will result in the net assets of
the company falling but the proportionate ownership of the remaining shareholders
will increase. The value of their holdings will be the same as it would have been prior
to the declaration of a dividend.

Share Repurchase: Value Implications

Consider a company with 100 shares outstanding that are worth £11 each and net
assets of £1,100. Of the company declares a dividend of £1 per share the share price
will fall from £11 to £10, and the net assets of the company will fall to £1,000. If the
company instead of using £100 to pay a dividend buys shares in proportion to the
holdings of each shareholder it can buy £100/£1 shares, or 9.09 shares. Each
shareholder’s holdings will go down by 9.09/100 or 9.09 per cent. The value of each
share outstanding will be £1,000/90.91 or £11.00. An investor who owned one share
will now own 0.91 shares worth £10. Alternatively the company could purchase £100
of shares on the open market. This will also reduce the number of shares outstanding
by £100/£11 = 9.091 shares. There will be again 90.9 shares outstanding, and net
assets of the company will be worth £1,000. Each shares will be worth £1,000/90.909
= £11.00. Instead of owning a share of £10 plus a dividend of £1 an investors will
hold shares worth £11.

A study by Vermaelen (1981) of share repurchase in the USA made through cash
tender offers found that on average shareholders wealth increased by 15.7 per cent

32
around the time of the announcement. This is considerably more than any tax saving
produce by substituting the purchasing of shares for the payment of dividend
payments. The increases in wealth, reflecting a greater proportion increase in the
price of shares than would be justified by the proportionate reduction in the number of
shares outstanding, was interpreted as evidence that share repurchase tend on average
to convey favourable information to the market about the position of a company.

CONCLUSION
This unit has considered dividend policy from a theoretical perspective that assumes a
firm’s earnings and investment possibilities are the critical determinants of the value
of a firm. Financial considerations are perceived to be unimportant when places
alongside the real activities of a company. The payment of higher dividends implies
the use of additional external funding if a company’s investment policy is to be kept
unchanged, and the dividend policy is therefore an important determinant of the firm’s
financing arrangements. When all investors are fully informed and there are not
transactions costs or taxes, it is fairly clear that a firm’s dividend policy is irrelevant.
Retentions and new issues are perfect substitutes, as are dividends and the sale of
shares as ways of generating cash for shareholders. The notion that dividends are
valued more highly than retentions because dividends constitute a certain cash flow
whereas retentions constitute an investment in assets that can be expected to produce
uncertain earnings, was found to be based on misunderstanding. However, in a world
of imperfect information, transactions costs and taxes it is quite possible that the value
of a firm will depend in part at least on its dividend policy. Of course the functioning
of clientele effects ,may well depend in such a way as to minimise the effects of
transactions costs and taxes in promoting the relevance of dividend policy. The
evidence of Lintner and others suggest dividend policy is considered to be important
by managers, taking a view as to what investors consider to be relevant. However this
does not imply that dividend policy is necessarily and important determinant of the
value. It may be important to meet the needs of a firm’s clienteles in a predictable
and reliable fashion.

We found that even though the empirical testing of dividend policy propositions has
been extensive the evidence accumulated has been inconclusive. In these
circumstances it is difference to draw any policy conclusions for companies. Those
that are based more on common sense than sophisticated theorising. Companies
should probably decide on a payout policy reflecting on their investment needs.
Growth companies should have relatively low payout, and keep the transactions costs
of raising external funds low. However, they should maintain sufficient liquidity to
allow them to maintain a stable dividend policy to keep the transactions costs of their
shareholders to a minimum. And management should recognise that any change in
dividend policy is likely to be interpreted by the market as indicative of the future
prospects of the company.

33
ANSWERS TO SELF ASSESSMENT QUESTIONS
3.1 Time Et Et E t  Dt 1 Dt

0 60.00

1 66.00 140 70 6.00

2 80.40 180 90 14.40

3 83.16 170 85 2.76

3.2 Option A: Sell immediately

Net receipts = ( PB  P0 )(1  t g ) = (270 – 150)(1 - .25)

= 90

Option B: Sell following payment of dividend

PA = PB  0.8 D

= 270 – 0.8 x 40

= 238

Net receipts = PA ( PA  P0 )t g  D(1  t p )

= 270(238 – 150) 0.25 + 40 (1 - .4)

= 272

34