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Payout Policy in the 21 st Century

July 9, 2004 Tuck Conference on Corporate Finance. Payout Policy in the 21 st Century. Alon Brav Duke University, Durham, NC USA John R. Graham Duke University, Durham, NC USA Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge, MA USA

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Payout Policy in the 21 st Century

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  1. July 9, 2004 Tuck Conference on Corporate Finance Payout Policy in the 21st Century Alon Brav Duke University, Durham, NC USA John R. Graham Duke University, Durham, NC USA Campbell R. Harvey Duke University, Durham, NC USA National Bureau of Economic Research, Cambridge, MA USA Roni Michaely Cornell University, Ithaca, NY USA IDC, Israel

  2. Brav/Graham/Harvey/Michaely: Payout PolicyIntroduction • In 1956, John Lintner laid the foundation for the modern understanding of dividend policy • He conducted detailed interviews with 28 companies • His research helped set the agenda for theoretical and empirical research on dividend policy • Much has changed in the last 50 years. • Possibly different payout policy goals • Repurchases • More insights from theory that may help direct the spotlight in the right direction • We revisit this path-breaking study at the beginning of the 21st century

  3. Brav/Graham/Harvey/Michaely: Payout PolicyIntroduction • We survey 384 financial executives with an instrument that focuses on both dividends and repurchases • 256 public, 128 private • Most presented results are based on the public firms • We conduct one-on-one interviews with 23 CFOs or Treasurers of prominent corporations • Interviews last between 40 minutes and two hours

  4. Brav/Graham/Harvey/Michaely: Payout PolicyMethodology

  5. Brav/Graham/Harvey/Michaely: Payout PolicyMethodology Survey and Interview Design • Draft survey instrument “refereed” by both finance researchers and experts in survey design • Interviewed structured to adhere to best scientific practices of interviews, e.g. Sudman and Bradburn (1983)

  6. Brav/Graham/Harvey/Michaely: Payout PolicyMethodology Survey Delivery • Survey CFOs, Treasurers, Finance VPs • Primarily members of Financial Executives International • Two $500 random winners • Three surveys • FEI CFO Forum (April 23, 2002, Co. Springs CO) • Dave Ikenberry NFCF (May 1, 2002, Houston TX) • Mass emailing to 2200 FEI members • Overall ~16% response rate

  7. Brav/Graham/Harvey/Michaely: Payout PolicyHow are payout decisions made? Goals of Treasury department: • Fund investment • M&M • Liquidity and possible contingencies • Payout decisions are second-order Except... • DO NOT CUT DIVIDENDS ranks equal to or above all of these items

  8. Brav/Graham/Harvey/Michaely: Payout PolicyPayout vs. Investment Decisions Repurchases Dividends

  9. Brav/Graham/Harvey/Michaely: Payout PolicyDividends vs. Repurchases (Fig. 2)

  10. Brav/Graham/Harvey/Michaely: Payout PolicyComplements or Substitutes? • Level of dividend fixed • Substitute repurchases for change in dividends • One way substitution • Would use even more repurchases if they were free of constraint of dividend history

  11. Brav/Graham/Harvey/Michaely: Payout PolicyLintner (1956) Three main points • Target payout ratio (dividend/earnings) • Dividend policy set conservatively • “partial adjustment” to target payout • smooth through time • sticky (history important) • Level given, focus on changes • tied to long-run sustainable earnings • do not increase now if you might have to cut later • No repurchases

  12. Brav/Graham/Harvey/Michaely: Payout PolicyCompare to Lintner (1956) Dividend policy still “conservative”? • Yes • Perceived big penalty for cut, small reward for increase • So, smooth, to avoid future cuts • Path dependence of dividend policy • BUT • stealth dividend cut if possible • holding dividend constant OK

  13. Brav/Graham/Harvey/Michaely: Payout PolicyPayout Decisions Still Made Conservatively? vs. Lintner (1956) Repurchases: No, flexible Dividends: Yes, still conservative

  14. Brav/Graham/Harvey/Michaely: Payout PolicyConservatively increase payout? Similar to Lintner (1956)? Repurchases Dividends

  15. Brav/Graham/Harvey/Michaely: Payout PolicyPayout ratio still target? vs. Lintner (1956)

  16. Brav/Graham/Harvey/Michaely: Payout PolicyPayout ratio still target? vs. Lintner (1956)

  17. Brav/Graham/Harvey/Michaely: Payout PolicyPayout ratio still target? vs. Lintner (1956) Extension of Fama-Babiak (1968), Choe (1990) • The SOA= and TP= . • Both SOA and TP have declined through time using both matching sample to our survey and broader Compustat sample

  18. Brav/Graham/Harvey/Michaely: Payout PolicySummary vs. Lintner (1956) • Dividend policy still very conservative • Modern cash cows live in (close to) Lintner world • Repurchase policy is not (i.e., it is more flexible) • Payout ratio no longer target • Targets very flexible • Repurchases now very important

  19. Brav/Graham/Harvey/Michaely: Payout Policy Miller and Modigliani (1961) • Payout Policy irrelevant if capital markets perfect • Imperfections that could explain payout policy • Taxes • Managerial agency conflict • Information/signaling • Other factors (EPS, float, credit ratings, etc) • Clienteles could result from imperfections

  20. Brav/Graham/Harvey/Michaely: Payout Policy A. Taxes • Theory: At least for individual investors, dividends are taxed move heavily than capital gains. • Therefore: • Firms should consider investors’ taxation when deciding about payout policy • Relative taxation should affect the amount of dividends they pay

  21. Brav/Graham/Harvey/Michaely: Payout Policy A. Taxes • Interviews: repurchases are “efficient way to return capital” • taxes (2nd order) important • Surveys: modest support Repurchases Dividends

  22. Brav/Graham/Harvey/Michaely: Payout Policy B. Clienteles • Investors that pay (relatively) more taxes on dividends should hold stocks that pay out through repurchases. • Translation: Individual investors should have an aversion to dividend paying stocks. By implications, institutions should be more attracted to such stocks. • Prudent man • Institutions as monitors

  23. Brav/Graham/Harvey/Michaely: Payout Policy B. Clienteles • Retail investors • Prefer dividends, in spite of tax disadvantage • Firms like because loyal • Institutions • If anything, prefer repurchases • Some can not invest in zero dividend stocks • 42% say pay dividends because of prudent man rules • Tax advantage not an issue to institutions • Firms like because they “have the money”

  24. Brav/Graham/Harvey/Michaely: Payout Policy B. Clienteles • Companies do not think that dividends attract institutions more so than do repurchases • Companies do not use dividends or repurchases attract institutions to monitor • Inconsistent with Allen, Bernardo, and Welch (2000) idea that firms use dividends to attract institutional investors Repurchases Dividends

  25. Brav/Graham/Harvey/Michaely: Payout Policy C. Agency Stories • Firms pay dividends to impose discipline on managers

  26. Brav/Graham/Harvey/Michaely: Payout Policy C: Free Cash Flow • Interviews: some say: “money can burn hole in pocket” • But payout not the way to fix the problem • Surveys: (1) no support in general, (2) repurchases work as well as dividends but (3) Cash cows are much more likely to pay; more reluctant to cut; more likely to keep dividend growth as earnings growth Repurchases Dividends

  27. Brav/Graham/Harvey/Michaely: Payout Policy D. Asymmetric Information • Conveying information • Costly self-imposed action—Signaling • Adverse selection • Do informed investors benefit from repurchase programs, at expense of uninformed? • Stock undervaluation

  28. Brav/Graham/Harvey/Michaely: Payout Policy D: Do payout decisions convey information? • Interviews: Yes, punctuation mark at end of sentence • Need to be consistent with other forms of communication • Repurchases convey as much as dividends • Surveys: Yes, convey info in general Repurchases Dividends

  29. Brav/Graham/Harvey/Michaely: Payout PolicyInformation: Signaling Repurchases Dividends

  30. Brav/Graham/Harvey/Michaely: Payout Policy D. Information: Signaling • Surveys • No supporting evidence • Scores are even lower for growth/risky firms • 39% (16%) say keep div (repurchase) policy of peers • Interviews • Spent hours on this issue • Generally try to group selves with peers (not separate) • No evidence of • increasing dividend to show market that firm is strong • viewing dividend as self-imposed cost • Avoiding dividend cut • Possibly a signal (costly for bad firms, separate from bad) • Cuts are rare – can’t explain dividend policy for most firms • Does not explain why firms pay dividends in the first place

  31. Brav/Graham/Harvey/Michaely: Payout Policy D. Information: Stock Price • Interviews: Would like to buy when price low, but • often want to maintain liquidity at this time • do not want credit rating downgrade • So, it’s a conditional objective • Surveys: repurchases, stock good investment Repurchases Dividends

  32. Brav/Graham/Harvey/Michaely: Payout Policy E. Other factors: EPS • Interviews: managers are concerned about EPS • Some think it’s automatic that repurchases increase EPS • Other believe that it depends on alternative use of funds • Surveys: EPS important Repurchase questions

  33. Brav/Graham/Harvey/Michaely: Payout Policy E. Other factors: Float and credit ratings • Interviews: Float very important • Execs think they need to have a large number of shareholders • Interviews: credit rating important • Hoard cash to improve rating • Especially for financial firms or firms with financial divisions Repurchases Dividends

  34. Brav/Graham/Harvey/Michaely: Payout PolicyInitiate with repurchases or dividends?

  35. Brav/Graham/Harvey/Michaely: Payout PolicyWhy initiate payout? Repurchases Dividends

  36. Brav/Graham/Harvey/Michaely: Payout PolicyConclusions • Payout policy is not first-order important* (M&M) • Repurchases: decided de novo • Dividends: level very important • Managers prefer repurchases over dividends because they are more flexible. • Not because of taxes.

  37. Brav/Graham/Harvey/Michaely: Payout PolicyConclusions • According to managers, payout • convey information • NOT being used as a costly signal • NOT being used to attract institutions • Managers do not use dividends over repurchases to attract institutions • Institutions do not push for more dividends

  38. Brav/Graham/Harvey/Michaely: Payout PolicyConclusions • Managers of cash cows believe more strongly that • Dividends should be stable • Keeping dividend growth rate with earnings growth • But all managers reject the notion that they need dividends so that they will not spend cash unwisely.

  39. Brav/Graham/Harvey/Michaely: Payout PolicyRules of the Game: How payout policies are determined • Make investment plans first* • Take care of cash/liquidity needs • *BUT, remember, level of dividends fixed • Only reduce dividends in extraordinary circumstances • Severe penalty for cutting dividend because the market believes that “cuts precede bad news” • So, don’t ever cut dividends • unless you have an amazing investment opportunity • smaller penalty if competitors cut • Think very carefully before initiating dividends

  40. Brav/Graham/Harvey/Michaely: Payout PolicyRules of the Game • Desire to maintain the level of dividend “at any cost” consistent with findings in Graham, Harvey and Rajgopal, 2004, “The Economic Implications of Corporate Financial Reporting” • Here managers desire to hit consensus EPS “at any cost” • 55% would knowingly sacrifice value (not pursue a very positive NPV project) if it would cause the firm to miss next quarter’s target! • 78% would knowingly sacrifice value to smooth earnings

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