CHAPTER 7

1. CHAPTER 7 DIVIDEND POLICY Oleh : EKO NUGROHO PUTRANTIYO 1208 2008 0105

2. Traditional Approach • M-M is a framework whose basic premise is that investors are immune from framing effects. • Value is based on cash flows no matter how these flows are framed.

3. Dividend Irrelevance • M-M 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. • If investors desired dividends, and firms were not paying dividends, then investors could create homemade dividend by selling shares.

4. No Single Traditional View • Some follow M-M and advocate minimizing dividend payouts. • Others advocate dividend payouts because of issues that M-M do not into account, such as agency conflicts. • Zero dividend payouts might make sense if investors could trust managers to avoid adopting projects that benefit themselves (the managers), but carry negative NPV from the perspective of shareholders.

5. Asymmetric Information: Signaling • Managers often know more than investors. • 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.

6. Taxes • There is a tax penalty attached to cash dividends. • Dividends are taxed immediately as ordinary income; however, capital gains can be deferred until they are realized. • If firms plows back all of their earnings instead of paying dividends, then investors receive their wealth in the form of a capital gains instead of dividends. • They only pay tax when they sell the stock.

7. Share Repurchase • In the absence of taxes, share repurchases have identical cash flow implications as dividends. • The two can be considered as substitute means for distributing cash to shareholders. • Repurchases avoid double taxation. • Repurchases need to be intermittent. • Otherwise they will be treated as dividends and subject to tax.

8. Changes in Tax Policy • In May 2003 the individual tax rate for both dividends and capital gains was reduced to 15%. • Before that, dividends had been taxed as ordinary income, at a top rate of 38.6%, and capital gains had been taxed at 20%. • The previous tax differential had imposed a penalty on investors who favor cash dividends over capital gains.

9. With the differential eliminated, firms increased their payouts, thereby indicating that dividend policy is important and responsive to economic conditions. • In May 2004, The Wall Street Journal reported that firms in the S&P 500 paid out record-level dividends.

10. Changing Attitudes and Perceptions About Risk • The attitudes of investors and analysts towards dividends were dramatically different in 2003 than they had been in the 1990s. • Both tax considerations and attitude towards risk provide reasons why managers might reconsider the manner in which their dividend policies cater to investors. • An article that appeared in Barron’s Online on July 17, 2003 pointed out that investors no longer viewed dividends as negative and passé, as they did during the 1990s dot-com bubble.

11. Microsoft • In January 2003, Microsoft Corporation announced that after a 2-for-1 stock split it would pay an annual dividend of 8 cents per share, beginning in March. • The March dividend was the first in Microsoft’s history, and amounted to a total payout of $870.6 million at a time when Microsoft held $43.4 billion in cash and cash equivalents. • Eight months later, it announced that it would double its dividend payout.

12. Widows and Orphan Stock? • In a front page story, the July 21 issue of The Wall Street Journal stated that Microsoft was seeking to broaden its investor base, • Moving in the direction of the old AT&T model, that is a “widows and orphans” stock in respect to regular dividend income and low risk.

13. Individual Investor Psychology • Do individual investors realize that dividend policy would be irrelevant in a world with zero taxes and transaction costs? • Do they find the cash flow framing effects described by M-M to be transparent? • These questions lie at the heart of the behavioral approach to dividend policy.

14. Concept Preview Question 7.1 Imagine that you are retired and use three sources to fund your monthly expenses: • Social Security to fund 20% of your expenses • a defined benefit pension plan funds that funds 45% of your expenses • dividends from the one stock you own, a utility stock, to fund the remaining 35%.

15. Choice • Because of new investment opportunities, the managers of the firm have decided to omit the next quarterly dividend. • You have a choice. • Either you can let your consumption expenditures decline by 35% over the next 3 months, or • You can sell some of your stock, and spend the proceeds on consumption. • If you had to choose between these two courses of action, what would you do?

16. Typical Responses • For people immune to framing effects who regard wealth as fungible, there is no reason to think that consumption should drop by the same amount as the omitted dividend. • Investors can use their equity wealth to fund consumption by selling some of their shares. • It is typical for 90% answering concept preview question 7.1 to say that they would cut consumption by the amount of the omitted dividend.

17. Con Ed • In 1974, the shareholders of utility firm Consolidated Edison actually faced the dilemma described in concept preview question 7.1. • The precipitating circumstance was the sudden quadrupling of oil prices in1974. • The higher costs led Con Ed to omit a dividend for the first time in eighty-nine years.

18. Investor Reaction • Shareholders were older, retired, and in many cases widowed, who viewed dividend income in the same way as Social Security income. • They relied on both their dividends and their Social Security checks to fund consumer expenses. • She simply means now she will get only one check a month, and that will be her Social Security, and she’s not going to make it, because you have denied her that dividend.

19. Behavioral Life Cycle • People who behave in accordance with the behavioral life cycle hypothesis establish mental accounts for their wealth, and adopt spending rules that are tied to their associated account balances. • Broadly speaking, the mental accounts correspond to • current income, • liquid assets, • home equity and • future income

20. Jane and Her Bonus • Has learned that she will receive a special bonus over and above her regular compensation. • This special bonus will be paid out of the ordinary cycle, it will be paid monthly over the course of a year, and it will increase her (after tax) take home pay by $500 a month for the next 12 months.

21. Monthly Consumption • By how much would Jane plan to increase her household monthly consumption during the next year? • The typical answer is $250.

22. Inheritance • Suppose that instead of receiving a $6000 bonus at work, Jane learned that one of her distant relatives died and left her a small inheritance with an after tax value of $6,000. • However, she was told that she would not receive the money for five years. • During that time the money would be held in a unit investment trust where it will be invested in conservative interest bearing securities.

23. Consumption • At the end of five years, she will definitely receive the $6,000 plus the interest that accrued. • By how much would you expect that Jane’s household's consumption to increase over the next 12 months as a result of this gift? • The typical response is $0.

24. Bottom Line • The bottom line is that people appear to organize their wealth into different mental accounts. • The $500 monthly bonus amount went into the current income mental account. • The $6,000 inheritance plus accumulated interest went into the future income mental account.

25. Rules • People appear to follow rules whereby money in the current income account is used to fund current expenses. • Money in the future income account is off-limits when it comes to funding current expenses.

26. Dividends and BLC • If dividend income is allocated to current income, then people tend to treat that income as “spendable.” • In this respect, retired individual investors use dividends to mimic pension income, Social Security checks, and the paychecks of yesteryear. • That is why dividends are labeled as “income.”

27. Don't Dip Into Capital • However, equity is typically held in an asset account. • Retired investors who adopt the rule “don’t dip into capital” essentially prohibit themselves from spending out of their asset accounts. • Many older, retired stockholders will not “dip into capital” in order to exert self-control.

28. Concept Preview Question 7.2 • Imagine that you face the following choice. You can accept a guaranteed $1,500 or take a risk. • If you take the risk, the outcome will be determined by the toss of a fair coin. • If heads comes up, you win $1,950. • If tails comes up, you win $1,050. Would you accept the guaranteed $1,500 or take the risk?

29. Imagine that you took a risky decision that resulted in a gain of $1,500 for you, and you pocket the money. • Now you have the opportunity to take a second risk, involving a fair coin. • If heads comes up, you win $450. • If tails comes up, you lose $450. Would you accept the second risk?

30. Hedonic Editing • Typically more people say they are willing to accept the second risk in part 2 of concept preview question 7.2 than to accept the risk in part 1. • Yet, in terms of incremental cash flows, the two risks are identical. • Apparently, people prefer to experience gains separately rather than together, and is part of a general phenomenon known as “hedonic editing.”

31. Decomposition • The main point is that 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. • The total return on a stock can be decomposed into a dividend yield and a capital gain (or loss). • In the case of dividend paying stocks, cash dividends play the role of the certain prior gain.

32. Bird in the Hand • Some people are more willing to accept risk when their payoffs are framed as packages of a safe component, such as a dividend, and a risky component, such as an uncertain capital gain. • That is why, a dividend is sometimes described as “a bird in the hand,” as contrasted with “two in the bush.”

33. Insights From Financial Columnists • Thousands of income-starved investors--largely retirees, if not actually widows and orphans--still pine for low-risk stocks with high and predictable dividends. • A classic example is the old AT&T, which paid its shareholders exactly $1.50 per share each year from 1922 to 1958, and then raised its payout consistently until 1983, after which the company was forced to break up.

34. Empirical Evidence • Accounts of almost 78,000 investors trading at a large discount brokerage firm between 1991 and 1996. • Investors over the age of 65 concentrate their stock holdings in firms that pay high dividends, especially if the investors are retired. • These investors hold over 80% of their stock portfolio in dividend paying stocks. • In contrast, investors under the age of 45 hold 65% of their portfolios in dividend paying stocks.

35. Older Investors • On average, older investors held a portfolio consisting of 6 stocks with a value of $55,685. • In contrast, younger investors held a portfolio consisting of 4 stocks with a value of $24,402. • Older investors also traded less frequently than younger investors.

36. CEX • Consumer Expenditure Survey (CEX) from the Bureau of Labor Statistics. • 1988 to 2001, and involves 3,272 household-year observations. • Total expenditure including durables, is about $50,000 (measured in December 2001 dollars).

37. Broad Statistics • Total income, which includes dividends, but not capital gains, has a mean of $56,789. • For the mean household, interest income is $1,207 and dividend income is $891. • On average, interest and dividends account for 4% and 2% of total income, respectively. • The distribution is skewed, with the median household reporting zero dividend income.

38. Marginal Propensityto Consume • The marginal propensity to consume from dividend income is 0.49, the same as the marginal propensity to consume out of total income. • The marginal propensity to consume from total current-year returns is close to 0.

39. Marginal Propensity to Withdraw • The marginal propensity to withdraw ordinary dividends is 0.9. • In contrast, the marginal propensity to withdraw capital gains is 0.02.

40. Contrast with Institutional Investors • 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. • When a firm increases its dividend payouts, institutions tend to decrease their holdings.

41. Cisco Systems • In November 2002 the shareholders of Cisco Systems voted on a proposal that Cisco initiate a cash dividend, and rejected the proposal by a margin of 10-to-1. • At the time, Cisco held $21 billion in cash, and it had been generating cash flow from operations at the rate of $4 billion per year. • Opposing the proposal were Cisco’s board and managers, and its institutional investors.

42. How Managers Think About Dividends • In the early 1970s, dividends dominated repurchases as a form of payout. Corporations paid out more than $10 in dividends for every $1 spent repurchasing shares. • During the 1980s this situation began to change, as corporations increased the frequency with which they repurchased shares.

43. Smoothing • Corporations smooth dividends relative to earnings. • Between 1972 and 1998, aggregate earnings fell 5 times. • However, aggregate dividends fell only twice, once in 1992 and again in 1998, and the decline was much smaller than for earnings.

44. 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 the same period.

45. Market Reaction • The market reacts positively to announcements of repurchases and dividend increases and negatively to announcements of dividend decreases. • The effect is asymmetric: the price impact associated with a decrease in dividends is considerably stronger than the impact associated with an increase in dividends.

46. Dividend Omissions • At the same time, it appears that corporations might have become less reluctant to omit dividends. • Between 1989 and 1992, the average number of omissions was 302. • Between 1993 and 1998, the average had grown to 1,087.

47. John Lintner: 1956 • 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.

48. Recent Survey Evidence • The factor most frequently underlying decisions about dividend policy is maintaining consistency with the firm’s historic dividend policy. • Mentioned by over 80% of respondents. • This was closely followed by stability of future earnings, and a sustainable change in earnings.

49. Dividend Targets? • What do you target when you make your dividend decisions? • 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%).

50. Dividends as a Conveyor of Information • Over 75% of respondents believe that dividends convey information about their firm to investors. • 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. • Over 60% would rather raise funds to finance new investment projects than reduce dividends.