AAII, the American Association of Individual Investors

The Factors Driving Dividend Policy

An analysis of global dividend policies attributed the rationale for companies to pay and raise their dividends to many factors, including communicating information, so-called “agency costs,” tax policy and a company’s maturation.

Companies can use dividends to convey, or “signal,” information about their 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.

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).

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. 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.

The taxation of dividends should be unimportant to a company’s payout policy. Tax policies do matter to investors, however, and this in turn has an influence on a company’s dividend policy. Following the 2003 tax cut in the U.S., 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.

Finally, dividend policy is dependent on where a company is in terms of its “life cycle.” Established firms with greater retained earnings are more likely to pay dividends, in part because of demand by investors for more cash to be returned to them as retained earnings grow in size.

Source: “Dividend Policy: A Selective Review of Results From Around the World,” Laurence Booth and Jun Zhou, Global Finance Journal accepted manuscript.