Payout Policy

1. Payout Policy • Prepared by P. Asimakopoulos, Ph.D. candidate • Department of Banking and Financial Management, University of Piraeus, 2009

2. Payout Policy Does the payout policy(dividend policy) affect the firm value? How much cash should firms give back to shareholders? What payout policy should a firm follow? Why do corporations pay dividends?

3. DIVIDEND POLICY • By dividend policy, we mean the practice that management as well as the board of directors follow in making dividend payout decisions or, in other words, the size and pattern of cash distributions over time to shareholder. • Should corporations pay their shareholders through dividends or by repurchasing their shares, which is the least costly form of payout from a tax perspective?

4. Six empirical observations play an important role in discussions of payout policies: • Large, established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. • Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid-1980s, but since then have become an important form of payment. • Among firms traded on organized exchanges in the USA, the proportion of dividend-paying firms has been steadily declining. Since the beginning of the 1980s, most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends.

5. Six empirical observations play an important role in discussions of payout policies cont.: • Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. • Corporations smooth dividends relative to earnings. Repurchases are more volatile than dividends. • The market on average reacts positively to announcements of repurchase and dividend increases, and negatively toannouncements of dividend decreases.

6. DIVIDEND SMOOTHING • In his classic study, Lintner (1956 AER) interviewed managers of 28 US firms and found: • Firms have long-run target dividend payout ratios. • Changes in long-run, sustainable earnings are the most important determinant of changes in dividends. • Managers avoid making changes in their dividend payout rates that might have to be reversed. Dividends adjust gradually to achieve the target ratio (dividend smoothing). Managers are very reluctantto cut dividends • Management set dividend policy first • Fama and Babiak (1968 JASA) tested Lintner's model using annual data on 392 major industrial firms for the 19-year period 1946 - 1964. Their estimates were similar to those reported by Lintner.

7. DIVIDEND SMOOTHING cont. • Brav A.,Graham J., Harvey C., Michaely R. 2005 JFE, survey 384 financial executives in 2002 and they report that: • Dividend policy is still conservative But : • Firms target the dividend payout ratio less than they used to • Share repurchases are important form of payout • More flexible • Therefore, firms seem to increase dividends only if they are reasonably sure that they will be able to maintain them permanently at the new level.

8. MM proposition (1961): • For a given investment schedule, the market value of the firm is independent of its dividend (payout ) policy. • Prior to their paper, most economists believed that the more dividends a firm paid, the more valuable the firm would be. Where: Dt = the dividends paid by the firm at the end of period t, and rt = the investors’ opportunity cost of capital for period t.

9. MM proposition (1961) cont.: • Gordon (1959 RES)  more dividends more value (“bird in the hand fallacy”) • He argued that investors’ required rate of return rt would increase with retention of earnings and increased investment • Although, the future dividend stream would presumably be higher due to the investment of retained earnings (+NPV), he argued that the higher rt overshadows the larger future dividend stream due to uncertainty associated with the increased investment relative to the safety of the dividend According to him : retained earnings rather than current dividends made the cash flow stream for the shareholder riskier. • increase the cost of capital.(higher rt)

10. MM proposition (1961) cont.: • Miller and Modigliani (1961) pointed out that this view of dividend policy is incomplete and they developed a rigorous framework for analyzing payout policy. • What really counts is the firm's investment policy. • As long as investment policy does not change, altering the mix of retained earnings and payout will not affect firm's value. • For a given investment schedule, the market value of the firm is independent of its dividend (payout ) policy.

11. MM proposition (1961) cont.: • Assumptions: • Capital markets are frictionless (no transaction cost) • Firms and Individual have the same information(no asymmetric information) • All agents are price takers (competitive markets). • No taxes • Individuals know with certainty the future investment schedule and profits of the firms • For simplicity, all firms issue only common stock

12. MM proposition (1961) notation: Pt : Share price at the beginning of period t dt+1 : Dividend paid at the end of period t nt : Number of shares outstanding at the beginning of period t mt+1 : Number of new shares issued at the end of period t nt+1 = nt + mt+1 : Number of shares outstanding at the end of period t Vt = ntPt : Firm value at the beginning of period t Dt+1 = ntdt+1 : Total value of dividend paid at the end of period t Xt : Earnings (net cash flow) at the beginning of period t It : Investment outlay at the beginning of period t

13. (1) (2) MM proposition (1961) proof: • For simplicity, we assume that the rate of return, r, is constant over time. The rate of return is defined as: • Multiplying the numerator and denominator of (1) by nt and rearranging terms, we obtain:

14. MM proposition (1961) proof: • Using then the fact that nt+1 = nt + mt+1 and the definitions given above, we can rewrite (2) as: • That is, the current firm value is affected positively by the dividends paid out and the firm value next period and negatively by the new capital raised. (3)

15. (6) MM proposition (1961) proof: • Sources of funds: Xt+1 + mt+1Pt+1 • Uses of funds: Dt+1 + It+1 • By definition, the uses of funds must equal the sources of funds: Xt+1 + mt+1Pt+1 = Dt+1 + It+1 (4) Xt+1 - It+1 = Dt+1 - mt+1Pt+1 (5) • Substituting (5) into (3), we have:  Since D does not appear in (6), the firm value is independent of its dividend (payout) policy.

16. Insights of MM proposition (1961) • Firm value is maximized by making an appropriate choice of investment policy • Dividend policy does not affect firm value at all if investment policy is chosen to maximize firm’s value (Xt+1 - It+1 = Dt+1 - mt+1Pt+1 ) • They identify the siuations in which dividend policy can affect firm value. Dividend policy could matter because one of the assumptions underlying the result is violated: • Perfect and complete capital markets • absence of taxes, • symmetric information • no transaction costs • complete markets

17. Intuition of MM proposition (1961) • In the absence • of taxes, • transaction costs • and information asymmetries, • any increase (decrease) in dividends has no effect on the firm's investment plan because it is exactly offset by the issue of new equity (share repurchase). Therefore, the firm value is independent of its dividend (payout) policy.

18. (7) Interpretation of ΜΜ proposition (1961): • Therefore, if two firms have identical cash flows and investment schedules, absence of arbitrage opportunities requires that these two firms have identical values.To see it more clearly, we can solve (6) recursively to get: • Note: To get (7), we impose the no-bubble condition:

19. Asymmetric InformationDividends as a Signal of Firm Quality Key Points: • Insiders have better information about the firm’s future cash flow and dividends convey information about the firm’s prospect • Good firms cannot credibly signal their quality without incurring a cost. If the signal is costless, the bad firms will always mimic the good ones. • Dividend payments are costly both for good and bad firms but more for bad firms. • By increasing the dividend they promise to pay, good firms can reveal their quality because it is prohibitively costly for bad firms to mimic. • Good firms are willing to pay high dividends to separate themselves because the benefit of separation (higher share price) exceeds the cost (costly outside financing or not undertaking positive NPV projects).

20. Miller and Rock (1985 JF) “Dividend policy under Asymmetric Information” • Asymmetric information • Two period model with times t=1,2 • One decision • No-tax • Rational expectations • Uncertainty about firm’s dividend/investment/financing decision

21. Miller and Rock (1985) cont. The analysis of information effects to this point has assumed the market to expect that the firm will follow an optimal investment policy. But what if the firm were to cheat by cutting investment below the optimal level and paying out the proceeds in higher dividend? • Were the market now to add the higher dividend to the assumed optimal level of investment,  the market would overestimate the firm's current earnings and hence place a higher than warranted value of the firm's shares. A firm might fool the market at least temporarily by such tactics but the price rise would presumably be "reversed when the unfolding of events had made clear the true nature of the situation." (ΜΜ)

22. Miller and Rock (1985)Summary • Dividends are costly (and so credible) signals because an increase in dividend paid implies that the firm has to forgo profitable investment opportunities • A bad firm has lower earnings and so a given increase in dividend implies that a bad firm has to forgo more profitable opportunities • Therefore good firms can use dividends to credibly signal their quality and achieve an increase in their stock price • Criticism: dividends and share repurchases are perfect substitutes for one another

23. John and Williams 1985 JF“Dividend , dilution and taxes: a signaling equilibrium” Extremely adverse environment for signaling with dividends. A representative firm which is financed exclusively with equity. The representative firm pays no taxes and incurs no transaction costs when either distributing dividends, or issuing or retiring shares Investors, by contrast, pay taxes on dividends at a single, constant marginal rate, but no transaction costs when trading securities. In this model, taxes are critical, because without taxes or other costs of paying dividends, there is no signaling equilibrium. All sources and uses of firms' funds are fully observed by outsiders through costless public audits. Complete production technology is not observed by outsiders . Instead, insiders try to provide it to outsiders only through dividends There exists a signaling equilibrium with dividends, with corporate insiders distribute taxable dividends if and only if the demand for cash by both their firm and its current stockholders exceeds the supply of internal funds

24. John and Williams 1985 cont.The intuition of this signaling equilibrium When raising funds for investment, a firm must either issue new shares or retire fewer outstanding shares. Similarly, to raise cash on personal account, current stockholders must sell existing shares. In either case, current stockholders suffer some dilution in their fractional ownership of the firm. Reducing this dilution on either corporate or personal account is clearly more valuable to current stockholders when inside information is more favorable. Consequently, insiders, acting in the interests of their current stockholders, may distribute a taxable dividend if outsiders recognize this relationship, bid up the stock price, and thereby reduce current stockholders' dilution. In the resulting signaling equilibrium, insiders control dividends optimally, while outsiders pay the correct price for the firm's stock.

25. John and Williams 1985 cont.The intuition of this signaling equilibrium This signaling equilibrium exists because the marginal benefit to insiders of distributing dividends differs across firms. For firms with more valuable inside information, the premium paid in the market for stocks with marginally larger dividends, and thereby the reduction in dilution for current shareholders, just compensates stockholders for the incremental personal taxes on dividends. By contrast, for firms with less favorable inside information, the dissipative costs of the same dividend exceed at the margin the gains from reducing dilution. Consequently, there exists in the market a pricing function for stock which separates firms with more favorable inside information from those with less. In the resulting signaling equilibrium, firms with more favorable inside information optimally pay higher dividends, other things equal, and receive appropriately higher prices for their stock.

26. John and Williams (1985) summary • If C<L+I and current shareholders retain some fraction of the firm, then there exists from Riley ,a signaling equilibrium conditional on C, I, as well as L. • If C<L+I then stock must be sold to new investors, either by the corporation for investment or by initial stockholders for personal liquidity. In either case, initial shareholders suffer some dilution. • By signaling with dividends, insiders can then increase their firm's market price and thereby reduce this dilution. For stockholders retaining some fraction of their firm, the marginal benefit of reducing dilution is greater with truly more valuable firms: Upx > 0 • Thus, there exists a pricing function for the firm's stock, P, which compensates sufficiently only stockholders of truly more valuable firms to induce their insiders to signal with larger dividends. • For less valuable firms, the equilibrium pricing function, P, compensates stockholders for the taxes assessed on dividends only at smaller dividends. • Consequently, only insiders in firms with larger present values, X, signal with larger dividends, other things equal.

27. Dividends and market liquidity • Banerjeeet αl. (2006 JFQA) provides evidence of a negative link between firm dividend policy and stock market liquidity ίn the United States. Ιn a cross-section covering New York Stock Exchange and American Stock and Options Exchange firms for the years 1963 to 2003, they found that owners of less (more) liquid common stock are more (less) like1y tο receive cash dividends. • Ιn a similar study, Garay & Gonzalez (2005 WP) found after studying 19 emerging economies from 1989 to 2000, a negative empirical relation between the level of market liquidity (measured as stock turnover) and the dividend policy of the firms in the sample (using as a proxy the firms' dividend yield).

28. John and Williams (1985) summary • Dividends and repurchases are not at all related, and firms do not repurchase shares to avoid taxes, because it is precisely the cost of taxes that makes dividends desirable. • Shareholders in a firm have liquidity needs and they sell some of their shares. • If the firm is undervalued, then the shareholders would be selling theirs shares at a price below the true value. • However, suppose the firm pay a dividend, which is taxed • If outside investors take this as a good signal, then the share price will rise and shareholders will have to sell less equity to meet their liquidity needs maintaining a higher proportionate in the firm • Criticism: they take as given that shareholders must meet their liquidity needs by selling their shares.

29. Bhattacharya, S. (1979) “Imperfect information,dividend policy, and “the bird in the hand fallacy” • Asymmetry information because outside investors have imperfect information about firms’ profitability • Develops a model in which cash dividend function as a signal of expected cash flows of firms in an imperfect-information setting • There are sufficient investment opportunities, so that all of the cash flows from existing assets can be rationally reinvested • The payoffs from the project are not sufficient to cover the dividend • Outside financing will be needed to pay the dividend • Due to imperfection outside financing is costly • A firm with high quality projects has lower transaction cost to meet the same level of pre-commited dividend than a firm with a low quality projects

30. Bhattacharya (1979):Construction of The Model • There are three dates (t = 0, 1, 2) • Αll agents are risk neutral and there is no discounting. • There are two types of firms good (G) and bad (Β) with respective proportions λ and 1- λ. • At t = 1, 2, a firm of type i, (i = B,G) generates a cash flow of either Χ with probability pi or 0 with probability 1- pi where pG> pB . • At t = 0, only the firm’s manager knows pi • The manager's objective is to maximize γ0V0 + γ1 EoV1 where γ0, γ1 > 0 and Vt is the firm value at t. • At t = 0, the manager commits to paying a dividend d at t=1. • At t = 1, with probability 1-pi, outside financing will be needed to pay the dividend (it is assumed that the investment plan does not change). • Due to market imperfections, outside financing is costly. Raising an amount F costs (1+c)F, c>0.

31. Separating Equilibrium • The objective is to construct a separating equilibrium where dGdB=0 • Truthful information revelation requires that the following revelation constraints be satisfied: Note: At t=1 all information is revealed (IC)B

32. Separating Equilibrium • Solving (IC)G , we obtain : • Solving (IC)B , we obtain : • Since Hence, by committing to a dividend dG  d*, the good firm can reveal its type.

33. Separating Equilibrium • Some Remarks • The existence of the separating equilibrium requires that the manager is interested in the market value of the firm at t = 0 (that is, γ0> 0 ). • γ0can be interpreted as the intensity of the takeover threat. • The greater the takeover pressure, the stronger the incentive for a manager to announce a higher dividend, increase the stock price and avoid takeover.

34. Intuition of Bhattacharya Model • By committing to pay higher dividends in future, firms increase the probability of outside financing • This probability is high for firms with bad projects • The expected cost of committing higher dividend is higher for these firms  Firm with really good projects can use dividends to credibly signal private information about future cash flow

35. Criticism of Bhattacharya Model • It does not explain why firms use cash dividends to signal their prospects • Dividends and share repurchases are perfect substitutes for one another • Why managers care so much about the stock price of the next period?

36. Allen, Bernado and Welch (2000) • As in the previous models, dividends are a signal of good news • Firms pay dividends because they are interested in attracting a better-informed clientele (untaxed institutions, such as pension funds and mutual funds), who have a relative advantage in detecting high firm quality.A higher dividend increase the chance that institutions will detect their quality • Taxable dividends exist to attract informed institutions whose presence ensures that the firm will remain well run. If management underperforms, then the institutions will, for example, facilitate takeovers by selling large blocks of stock - or they may even become directly involved in the corporate governance process. • Their model accommodate dividend smoothing, because firms are reluctant to cut dividends knowing that their clientele (institutions) will punish them. A dividend reductions would indicate a desire to reduce institutional ownership and the implicit oversight of the firm's affairs • Low-quality firms do not have the incentive to mimic because their true value will be revealed

37. Criticism of Allen, Bernado and Welch (2000) • It can not explain why firms/manager have not found cheaper ways to signal their inside information • Why firms do not enact in better control on management to avoid monitoring by institutions • When a firm pays higher dividend, it attracts disproportionately larger ownership by institutions and these in turn are more likely to play a larger role in overseeing management, contrary to retail investors

38. Grullon, Michaely and Swaminathan(JB 2002) • Increases in dividends convey information about changes in risk rather than about growth in future cash flows • “maturity hypothesis” firms increase dividends when growth opportunities decline, which leads to a decrease in the firm’s systematic risk and profitability. • How, then, should the market react to dividend increase? • Dividend increase contains two pieces of news: • Good news: risk has decreases • Bad news : profitability declines return on assets declines profit growth declines

39. Implication of Signaling Models • Announcements of changes in dividends should lead to changes in the stock price in the same direction • Changes in dividends should be followed by changes in earnings (net cash flow) in the same directions • All the above implications are necessary, but not sufficient, conditions for dividend signaling