Chapter 8 Dividend Policy

Learning Objectives
 Explain why framing effects lead some investors, finding cash dividends attractive, to
employ dividend-based heuristics.
 Identify conditions under which managers cater to investors’ preference for cash
dividends.
 Describe heuristics that managers use to set the dividend policies of their firms.
 Explain how managers use dividend policy to engage in behavioral signaling.
 Describe the manner in which managers view dividends differently from share
repurchases.
Traditional Treatment
 MM framework is that investors are immune to framing effects, so that value is based
on cash flows no matter how these flows are framed (for e.g. pay cash dividend or
repurchase shares from shareholders)
 MM suggests that when taxes and transaction costs are set aside, dividend policy is
irrelevant.
 According to this theory, if there are tax disadvantages to dividends, firms should
choose low or zero payout rates.
Signaling
 Managers often know more than investors. For example, think about what happens
when managers, as insiders, have good projects, with high NPV, but regular investors
lack the inside information to assess the value of these projects properly.
 In that case, managers with high-NPV projects might choose to pay a dividend, in
order to signal that they can afford the tax-related penalty (i.e., shareholders will pay
tax for the dividends as income).
Bird in the Hand
 Because of quasi-hedonic editing, people are more willing to accept risk when the
payoff is decomposed into a certain prior gain and an uncertain outcome than when
the payoff is not decomposed.
 In this respect, the total return on a stock can be decomposed into a dividend
yield and a capital gain (or loss).
 Young, employed investors find dividends attractive because regular dividends make
it easier for them to tolerate risk.
Behavioral Pitfalls Box
 What behavioral phenomena come to mind as you read its contents?
Widows and Orphans
 March 2003, Microsoft dividend initiation.
 July 21, 2004 issue of The Wall Street Journal indicated that Microsoft was
moving in the direction of the old AT&T model, that is a “widows and
orphans” stock.
 Con Ed omitted dividend in 1974 to much protest.
 Shareholders were older, retired, and in many cases widowed, who viewed
dividend income in the same way as Social Security income.
Behavioral Life Cycle
 Behavioral life cycle hypothesis involves self-control motivated spending rules based
on mental accounts for wealth.
 current income.
 liquid assets.
 Home equity
 Future income
 Don't dip into capital.
 Dividend income is spendable as it may fall under current income.
Institutional Investors
 Institutional investors’ ownership in dividend-paying stocks is about twice as large as
in non-dividend-paying stocks.
 Among institutional investors, pension funds and banks find dividends attractive
mainly because of stricter “prudent-man” rules, rather than because of a sizeable
payout.
 However, the evidence suggests that institutional investors favor repurchases over
dividend payouts.
Dividend Reinvestment
 Institutional investors refrain from reinvesting most dividends.
 For mutual funds, dividend reinvestment is only 2% as common as 0% reinvestment;
and for institutional investors, the comparable figure is 10%.
 Low reinvestment rates are consistent with investment professionals seeking to satisfy
prudent man constraints rather than targeting desired portfolio weights for dividend
paying stocks.
How Managers Think About Dividends
 Managers have developed heuristics to set dividend policies that cater to investors’
psychological needs.
 John Lintner's classic 1956 survey found that managers establish long-run target
payout ratios, yet smooth dividends in the short-run.
 Lintner reports that managers are particularly concerned about having to rescind a
dividend increase.
What Has Changed Since 1956?
 Fewer firms currently target the dividend payout ratio.
 Instead, they target consistency in either the current level of dividends or the
dividend growth rate.
 Executives are less reluctant to omit a dividend.
 Executives repurchase shares much more frequently.
Asymmetry
 Dividend increases occur much more frequently than dividend decreases.
 During 1999 there were 1,703 dividend increases or initiations.
 In contrast, there were only 135 decreases or omissions during that period.
 The market reacts positively to announcements of repurchases and dividend increases,
but more negatively to announcements of dividend decreases.
Managers' Beliefs
 Over 80% state that there are negative consequences to reducing dividends.
 Over 75% believe that dividends convey information about their firm.
 Over 60% would rather raise funds to finance new investment projects than cut
dividends.
 About a third believe that paying dividends, instead of plowing back earnings, makes
a firm’s stock less risky.
Dividend Policy Target Variable
 The most frequent target is dividends per share, a response that drew just under 50%.
 This was followed by the dividend payout ratio (about 25%), and growth in dividends
per share (also about 25%).
Information and Signaling
 Over 75% of respondents believe that dividends convey information about their firm
to investors, and over 80% state that there are negative consequences to reducing
dividends.
 About a third believe that paying dividends, instead of plowing back earnings, makes
a firm’s stock less risky.
New Investment Projects and Signaling
  Just over 60% would rather raise funds to finance new investment projects than
reduce dividends to finance those projects.
 Re signaling, fewer than 10% indicate that they pay dividends to show they can afford
to bear the costs of external funding or of passing up profitable investments, in order
to make their firms look better than competitors.
Attracting Institutional Investors
 Just under 50% indicate that they set their policy in order to attract institutional
investors to hold their stock.
 About 30% cite “attracting institutional investors because they monitor management
decisions.”
 Fewer than 15% cite "paying out dividends to reduce cash, thereby
disciplining our firm."
 Fewer than 10% indicate that they pay dividends to show they can afford to
bear costs of external funding or pass up profitable investments.
Attracting Individual Investors
 Just over 40% mention that they set policy in order to attract individual (retail)
investors.
 Fewer that 30% mention the tax penalty associated with dividends.
Dividend Initiation
 Items cited by over 40% of respondents in connection with dividend initiation:
 Earnings per share increasing.
 The influence of our institutional shareholders.
 Our company having extra cash/marketable securities.
 Having fewer profitable investments available (e.g., as our industry matures).
Dividend Policy and Investors’ Tastes
 Establish a stable dividend policy to attract investors focused on either the widows
and orphans motive or the bird in the hand motive.
 Expect stocks of dividend paying firms to have lower book-to-market equity than
those of non-dividend paying firms.
 Citizen Utilities, two classes of stock, one paying cash dividends and one
stock dividends, with first class paying a premium over the second class.
Catering
 Expect that the difference in these ratios would change over time, with the differential
being wider during bear markets than during bull markets.
 Many managers initiate dividend payments in an effort to cater to investors’ demand
for cash dividends.
 Initiations rise when the book-to-market equity differential widens.
 Dividend increases occur after past earnings have improved, and stock prices respond
positively to announcements about dividend increases.
Evidence
  Future earnings are at best weakly related to past dividend changes.
 The strongest link seems to be that firms that increase dividends are less likely to
suffer future earnings decreases than firms that maintain dividend payouts.
 Changes in dividends signal the past rather than the future.
 That is, managers engage in unwarranted trend extrapolation.
Increases and Cuts
 Share price reaction to dividend cuts is larger in magnitude than the reaction to
dividend increases, with the difference roughly being a factor of two.
 The relationship between share price reaction and the magnitude of the change in
dividend per share is highly nonlinear.
Zero
 Changes around zero are much more important than are larger movements.
 On average, the market reacts to small cuts in dividends of up to $0.025 by increasing
76 basis points for each $0.01 change.
 In contrast, the market reacts to small increases in dividends up to $0.025 with a
market reaction of 36 basis points.
 For the next increments, the pattern is similar but the reaction per $0.01 of dividend
change drops off quickly.
Dividend Omissions
 Most firms that omit dividends are prior losers.
 Following the announcement, prices drift for at least a year, suggesting underreaction.
 The reaction to dividend initiations, not surprisingly a price rise, also features drift.
 The strength of the effect is half as large as it is for dividend omissions.
 Remember that psychologically losses loom at least twice as large as gains.
Behavioral Signaling
 Managers seek to maximize BPV in markets where many of their investors employ
reference points associated with either consumption, as in the case of self-control, or
to measure gains and losses for quasi-hedonic editing purposes.
 Managers take into account that because of loss aversion, these investors react more
strongly to losses relative to their reference points more intensely than gains of
comparable magnitude.
 Therefore, managers will want investors to interpret dividend payout policy as a
signal, but primarily to increase stock price rather than to separate themselves
explicitly from competitors.
Reference Points
 Managers learn which variables investors tend to use as reference points, such as
dividends per share.
 Among individual investor dividend clienteles, older retired investors have a natural
reason to focus on dividends per share.
  They mostly consume their dividends, pay attention to their consumer budgets, and
dislike having to cut consumption.
 Those in other clienteles who reinvest their dividends might find dividends per share
to be a more salient reference point than dividend payout ratio and dividend yield,
both of which generally give rise to variable dividends per share.
BPV
 Managers can set payout policy in a way that makes reference points as salient to
investors as possible, and to manage their variation over time to maximize BPV.
 BPV-maximizing managers who think about catering behavior in which they raise the
level of the next dividend per share in order to increase VS (value in the short-term)
must take into account their ability to avoid having to reduce dividends per share
thereafter, which would decrease VL.
 Because of loss aversion, “better safe than sorry” is a maxim that applies.
Salience 显着性
 Many boards appear to think of setting and communicating dividend policy in easily
recalled dollar amounts.
 The most common threshold unit for defining dividend per share is 25 cents.
 This is followed by 10 cents, 15 cents, 5 cents, and 20 cents, with notable spikes at
multiples of 5 cents.
 Non-round values are rare.
Salient Changes
 For changes in dividends per share, the modal increase is exactly to the next
threshold.
 However, for the most part, changes in quarterly dividends cluster at zero exactly.
 Firms mostly maintain dividends per share, and most only consider changing
the level on an annual basis.
Streaks
 Long streaks generate stronger reference points, therefore suggesting that patterns in
announcement effects should be more pronounced in series with longer streaks.
 On average, the longer a streak has been, the longer it is likely to continue.
 After a streak has lasted for several years, the probability of its continuing from the
prior quarter is almost 90%.
Corporate Nudges
 For corporate managers, the choice of dividend policy should reflect the manner in
which shareholders treat dividends.
 Managers of firms whose shareholders rely on dividends to fund consumption
expenses need to understand behavioral signaling, and that as a result, they too might
need to treat money as if it is not fungible (sth that is easy to exchange or trade).
 For example, managers might need to rely on external financing to fund new projects
instead of reducing the dividend.
Summary
 Older, retired investors find dividends attractive because they view dividends as a
replacement for wage and salary income.
 Young, employed investors find dividends attractive because regular dividends make
it easier for them to tolerate stock market risk.
 Managers have developed heuristics to meet investors’ psychological needs.
 In following these heuristics, managers convey information to investors, and in this
sense dividend policy serves a signaling function.
 Prices are impacted by changes in dividend policy and share repurchases.
 Many of these impacts give rise to price inefficiencies, notably drift effects.
 Markets underreact to both dividend omissions and dividend initiations, and the
strength of the price impact is twice as large in the case of omissions.
 Markets also underreact to share repurchases.