One area (of many) in which the realities of the financial markets differ with traditional economic theory is dividends. Under a theory espoused by Merton Miller and Franco Modigliani in 1961 (“Dividend Policy, Growth, and the Valuation of Shares”), corporations should be indifferent to investor preferences for dividends. Rather, Miller and Modigliani considered investors with a certain preference for a particular payout ratio as being “entirely as good” as investors with different preferences. The two also believe companies should seek out the best use of cash as opposed to having a set dividend policy. However, a new analysis of global dividend policies by Laurence Booth and Jun Zhou (“Dividend Policy: A Selective Review of Results From Around the World,” Global Finance Journal accepted manuscript) finds the decisions made by companies to pay and raise their dividends are affected by many factors beyond the optimal use of capital espoused by Miller and Modigliani. The following discussion of those factors will shed light on why some companies take the dividend actions that they do.
A company can use a dividend as way to convey, or “signal,” information about its financial strength and prospects. For instance, a common perception is to view dividend-paying companies as having more financial stability or otherwise being less risky. Such a perception has validity: Dividends are a cost to the companies distributing them because they require the outflow of cash to shareholders. Reaction to changes in the dividend is long-standing evidence of signaling. Stocks of companies that raise or initiate dividends outperform over time, in aggregate. Conversely, stocks of companies that cut or suspend their dividends underperform. Such actions are viewed by investors as conveying strength (weakness) and optimism (pessimism). The response by investors to such actions is even stronger among American depositary receipts (ADRs), which foreign firms use to have a listing on U.S. markets. Since there is less information about such companies in the U.S. than there is about domestic companies, the signal given by the dividend change has more importance.
This pattern is not replicated in all foreign markets, however. The dividend signal is weaker among Japanese companies due to higher rates of cross-ownership. Booth and Zhou cite research discussing the ease with which information flows between key cross-owners. Companies listed on the London Stock Exchange release dividend and earnings news simultaneously. This causes the dividend signal to be weaker during periods of growing or stable earnings, but higher during periods of economic uncertainty.
Ownership and the Payment of Dividends
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In common law countries, such as the United States, shareholders have no legal right to dividend payments. Rather, dividends are paid solely at the discretion of the board of directors. The board of directors may be pressured to make certain decisions by a company’s executives, however.
This structure creates an “arms-length” separation between shareholders and corporate executives. It also creates what is known as an “agency cost,” by forcing a company to choose between holding onto its free cash and distributing it out to investors as an incentive to invest in the company. From the standpoint of shareholders, dividends reduce the agency cost by making the executives think more carefully about how they utilize free cash flow. Executives who know they have to make regular dividend payments should be more careful with their spending decisions.
Summarizing the findings of several studies, Booth and Zhou wrote, “Generally firms with weak governance, weak shareholder protection, or dispersed share ownership are more likely to use dividends, or a combination of dividends and debt, as pre-commitment devices to alleviate the fears of external investors; that is, they prefer using regular dividend payments to using special dividends or share repurchase as a pre-commitment device … For smaller firms with limited numbers of shareholders and informed investors, there are fewer agency problems, and little reason to use the dividend to signal when a telephone call works just as well. As firms get larger—with a more dispersed shareholder clientele, increasing institutional ownership, and public market debt—the importance of dividends increases, both as a pre-commitment device and as a signal.”
The Influence of Taxes on Dividends
The Miller and Modigliani theory treats the taxation of dividends as being unimportant. However, the evidence supports the sentiment of taxpayers. Following the 2003 tax cut, which lowered the dividend tax rate to a then top rate of 15% (the top tax rate is now 20% plus a 3.8% surtax), a large number of companies either initiated dividends or increased their dividends. A study referenced by Booth and Zhou also linked the changes in dividend increases to companies with higher executive ownership.
A Company’s Maturation Matters Too
Finally, dividend policy is dependent on where a company is in terms of its “life cycle.” Newer companies experiencing strong growth and lower (or even no) retained earnings are unlikely to pay dividends. Established firms with greater retained earnings will be more likely to pay dividends. This is due, in part, to demands by investors for more cash to be returned to them as retained earnings grow in size.