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Chapter 19 -- Dividend Policy and Investment Decisions. Miller and Modigliani (M&M) Hypothesis Assumptions no taxes, transaction costs, or brokerage fees no flotation cost information is free and available to all Conclusion: in a perfect capital market dividend policy does not matter.
Chapter 19 -- Dividend Policy and Investment Decisions • Miller and Modigliani (M&M) Hypothesis • Assumptions • no taxes, transaction costs, or brokerage fees • no flotation cost • information is free and available to all • Conclusion: in a perfect capital market dividend policy does not matter
Transaction costs • Brokerage fees must be paid by the shareholders to reinvest dividends • There could be an information cost to reinvesting dividends • Some companies use dividend reinvestment plans to eliminate brokerage fees • The presence of transaction costs decreases the desire for the company to pay dividends
Flotation costs • Floatation cost is the cost of issuing new debt or equity to replace money paid out in the form of dividends • The presence of flotation cost would decrease the desire to pay dividends
Taxes • Dividends proceeds are taxed at ordinary income or special dividend rates • Share repurchases are taxed at capital gains rates • Clientele effects may mitigate some taxes for a small clientele
Portfolio Considerations • High tax paying individuals may not hold stock in dividend-paying companies • Some pension plans have dividend requirements for the stock to be held in their portfolios • Taken together portfolio considerations are probably not very influential on dividend policy
Information Signaling • Paying dividends may signal expectations of increasing future cash flows • Actions speak louder than words • False signals are too costly • Information signaling has a significant influence on dividend policy
Agency Costs • An increase in dividends increases the agency cost of debt • Dividends take money out of the company that would otherwise serve as a safety margin for creditors • Dividends decrease the agency cost of equity • Dividends take money out of the company that might otherwise serve as a safety margin for managers or be consumed frivolously by managers
Firm-specific Variables • Investment opportunities • Institutional restrictions • Legal requirements • Restrictive covenants • Income rules • Improperly accumulation earnings tax • Cash flow • Management interest
Firm-specific Variables • Management interest • Control • Takeover defense • Management attitudes toward risk • Management growth preference
Common Policies • Constant dollar policy • Constant pay-out ratio policy • Constant dollar plus extras • Residual policy • Constant dollar with increases each year • For those companies paying dividend this appears to be the most popular -- easier for the analyst to project
Stock Dividends • You receive, for example, 5 additional shares for each hundred shares you held • If you owned 1% of the company before, you own 1% after the stock dividend • Stock dividends simply divide ownership into smaller pieces • May signal future dividend plans
Stock Repurchases • Alternative to dividends for distributing money to shareholders • Taxed at capital gains rate • Voluntary, not mandatory • Positive signal • May not create expectation