Determinants of Dividend Policy - Financial Management

Dividend policy determines how the earnings of a company are distributed. Earnings are either retained and reinvested in the company or are paid out to shareholders. In recent years, the retention of earnings has been a major source of equity financing for private industry. In 2003, corporations retained more than $122 billion in earnings while paying dividends of about $409 billion. Retained earnings are the most important source of equity. Retained earnings can be used to stimulate growth in future earnings and as a result can influence future share values. On the other hand, dividends provide stockholders with tangible current returns.

Industry and Company Variations in Dividend Payout Ratios

Dividend payout policies vary among different industries. As shown in Table 15.1, there is a wide variation in dividend payout ratios among different industries, ranging from 0 to 70 percent. Likewise, within a given industry, while many firms may have similar dividend payout ratios, there can still be considerable variation. For example, as illustrated in Table within the tobacco industry, the dividend payout ratios are in the 32.8 to 85.2 percent range. Within the basic chemical industry, the variation in dividend payout ratios ranges from 0 to 133.3 percent. This section examines some of the more important factors that combine to determine the dividend policy of a firm.

Legal Constraints

Most states have laws that regulate the dividend payments a firm chartered in that state can make. These laws basically state the following:

  • A firm’s capital cannot be used to make dividend payments.
  • Dividends must be paid out of a firm’s present and past net earnings.
  • Dividends cannot be paid when the firm is insolvent.

The first restriction is termed the capital impairment restriction. In some states, capital is defined as including only the par value of common stock; in others, capital is more broadly defined to also include the contributed capital in excess of par account (sometimes called capital surplus). For example, consider the following capital accounts on the balance sheet of Johnson Tool and Die Company:


If the company is chartered in a state that defines capital as the par value of common stock, then it can pay out a total of $600,000 ($1,100,000 – $500,000 par value) in dividends. If, however, the company’s home state restricts dividend payments to retained earnings alone, then Johnson Tool and Die could only pay dividends up to $200,000. Regardless of the dividend laws, however, it should be realized that dividends are paid from a firm’s cash account with an offsetting entry to the retained earnings account.

The second restriction, called the net earnings restriction, requires that a firm have generated earnings before it is permitted to pay any cash dividends. This prevents the equity owners from withdrawing their initial investment in the firm and impairing the security position of any of the firm’s creditors. The third restriction, termed the insolvency restriction, states that an insolvent company may not pay cash dividends. When a company is insolvent, its liabilities exceed its assets.

Payment of dividends would interfere with the creditors’ prior claims on the firm’s assets and therefore is prohibited.

Dividend Payout Ratios for Selected Industries

These three restrictions affect different types of companies in different ways. New firms, or small firms with a minimum of accumulated retained earnings, are most likely to feel the weight of these legal constraints when determining their dividend policies, whereas well -established companies with histories of profitable performance and large retained earnings accounts are less likely to be influenced by them.

Dividend Payout Ratios for Firms in the Tobacco

Dividend Payout Ratios for Firms in the Tobacco

Restrictive Covenants

Restrictive covenants generally have more impact on dividend policy than the legal constraints just discussed. These covenants are contained in bond indentures, term loans, short-term borrowing agreements, lease contracts, and preferred stock agreements. These restrictions limit the total amount of dividends a firm can pay.

Sometimes they may state that dividends cannot be paid at all until a firm’s earnings have reached a specified level. For example, the 3.75 percent preferred stock issues (Series B) of Dayton Power & Light limits the amount of common stock dividends that can be paid if the company’s net income falls below a certain level. In a dividend policy study of 80 troubled firms that cut dividends, researchers found that more than half of the firms apparently faced binding debt covenants in the years managers reduced dividends.

In addition, sinking fund requirements, which state that a certain portion of a firm’s cash flow must be set aside for the retirement of debt, sometimes limit dividend payments. Also, dividends may be prohibited if a firm’s net working capital (current assets less current liabilities) or its current ratio does not exceed a certain predetermined level.

Tax Considerations

At various times, the top personal marginal tax rates on dividend income have been higher than the top marginal tax rates on long -term capital gains income. At other times, the two top marginal tax rates have been equal. For example, prior to the 1986 Tax Reform Act, the top marginal tax rate on dividend income was 50 percent compared with 20 percent on long-term capital gains income. The 1986 Tax Reform Act eliminated this differential by taxing both dividend and capital gains income at the same marginal rate.

The Revenue Reconciliation Act of 1993 created new top marginal tax rates of 39.6 percent for dividend income and 28 percent for capital gains income for individual taxpayers.More recently, the Taxpayer Relief Act of 1997 lowered the maximum long -term capital gains rate for individuals to 20 percent and the Economic Growth and Tax Relief Reconciliation Act of 2001 reduced the top marginal tax rate on dividend income to 38.6 percent for 2002–2003. The 2003 Tax Reduction Act cut the tax rate on dividend income to 15 percent, the same as the new tax rate on capital gains income.

In spite of this equalization of tax rates on dividend and capital gains income, a tax disadvantage of dividends versus capital gains exists in that dividend income is taxed immediately (in the year it is received), but capital gains income (and corresponding taxes) can be deferred into the future. If a corporation decides to retain its earnings in anticipation of providing growth and future capital appreciation for its investors, the investors are not taxed until their shares are sold. Consequently, for most investors, the present value of the taxes on future capital gains income is less than the taxes on an equivalent amount of current dividend income. The deferral of taxes on capital gains can be viewed as an interest-free loan to the investor from the government.

Whereas the factors just explained tend to encourage corporations to retain their earnings, the IRS Code —specifically Sections 531 through 537—has the opposite effect. In essence, the code prohibits corporations from retaining an excessive amount of earnings to protect stockholders from paying taxes on dividends received. If the IRS rules that a corporation has accumulated excess earnings to protect its stockholders from having to pay personal income taxes on dividends, the firm has to pay a heavy penalty tax on those earnings. It is the responsibility of the IRS to prove this allegation, however.

Some companies are more likely to raise the suspicions of the IRS than others. For example, small closely held corporations whose shareholders are in high marginal tax brackets, firms that pay consistently low dividends, and those that have large amounts of cash and marketable securities are good candidates for IRS review.

Liquidity and Cash Flow Considerations

Recall from the previous chapter that free cash flow represents the portion of a firm’s cash flows available to service new debt, make dividend payments to shareholders, and invest in other projects. Since dividend payments represent cash outflows, the more liquid a firm is, the more able it is to pay dividends. Even if a firm has a past record of high earnings that have been reinvested, resulting in a large retained earnings balance, it may not be able to pay dividends unless it has sufficient liquid assets, primarily cash. For example, Corning, which had paid cash dividends continuously since 1945, eliminated its $0.06 per share quarterly dividend during the economic downturn of 2001.

The company was faced with a shriveling market for fiber-optic components, massive ($5.1 billion) write-downs of inventory and goodwill, and reduced cash flows. Liquidity is likely to be a problem during a long business downturn, when both earnings and cash flows often decline. Rapidly growing firms with many profitable investment opportunities also often find it difficult to maintain adequate liquidity and pay dividends at the same time.

Borrowing Capacity and Access to the Capital Markets

Liquidity is desirable for a number of reasons. Specifically, it provides protection in the event of a financial crisis. It also provides the flexibility needed to take advantage of unusual financial and investment opportunities. There are other ways of achieving this flexibility and security, however.

For example, companies frequently establish lines of credit and revolving credit agreements with banks, allowing them to borrow on short notice.Large well -established firms are usually able to go directly to credit markets with either a bond issue or a sale of commercial paper. The more access a firm has to these external sources of funds, the better able it will be to make dividend payments.

A small firm whose stock is closely held and infrequently traded often finds it difficult (or undesirable) to sell new equity shares in the markets. As a result, retained earnings are the only source of new equity.When a firm of this type is faced with desirable investment opportunities, the payment of dividends is often inconsistent with the objective of maximizing the value of the firm.

Earnings Stability

Most large widely held firms are reluctant to lower their dividend payments, even in times of financial stress. Therefore, a firm with a history of stable earnings is usually more willing to pay a higher dividend than a firm with erratic earnings.

A firm whose cash flows have been more or less constant over the years can be fairly confident about its future and frequently reflects this confidence in higher dividend payments.

Growth Prospects

A rapidly growing firm usually has a substantial need for funds to finance the abundance of attractive investment opportunities. Instead of paying large dividends and then attempting to sell new shares to raise the equity investment capital it needs, this type of firm usually retains larger portions of its earnings and avoids the expense and inconvenience of public stock offerings. Table illustrates the relationship between earnings growth rates and dividend payout ratios for selected companies. Note that the companies with the highest dividend payout ratios tend to have the lowest growth rates and vice versa.


In an inflationary environment, funds generated by depreciation often are not sufficient to replace a firm’s assets as they become obsolete. Under these circumstances, a firm may be forced to retain a higher percentage of earnings to maintain the earning power of its asset base. Inflation also has an impact on a firm’s working capital needs. In an atmosphere of rising prices, actual dollars invested in inventories and accounts receivable tend to increase to support the same physical volume of business.

And, because the dollar amounts of accounts payable and other payables requiring cash outlays are higher with rising prices, transaction cash balances normally have to be increased. Thus, inflation can force a firm to retain more earnings as it attempts to maintain its same relative preinflation working capital position.

Recent Dividend Payout Ratios and Earnings Growth

Recent Dividend Payout Ratios and Earnings Growth

Shareholder Preferences

In a closely held corporation with relatively few stockholders, management may be able to set dividends according to the preferences of its stockholders. For example, assume that the majority of a firm’s stockholders are in high marginal tax brackets. They probably favor a policy of high earnings retention, resulting in eventual price appreciation, over a high payout dividend policy.

However, high earnings retention implies that the firm has enough acceptable capital investment opportunities to justify the low payout dividend policy. In addition, recall that the IRS does not permit corporations to retain excessive earnings if they have no legitimate investment opportunities. Also, a policy of high retention when investment opportunities are not available is inconsistent with the objective of maximizing shareholder wealth.

In a large corporation whose shares are widely held, it is nearly impossible for a financial manager to take individual shareholders’ preferences into account when setting dividend policy. Some wealthy stockholders who are in high marginal income tax brackets may prefer that a company reinvest its earnings (i.e., low payout ratio) to generate long -term capital gains. Other shareholders, such as retired individuals and those living on fixed incomes (sometimes referred to as “widows and orphans”), may prefer a high dividend rate.

These shareholders may be willing to pay a premium for common stock in a compan that provides a higher dividend yield. Large institutional investors that are in a zero income tax bracket, such as pension funds, university endowment funds, philanthropic organizations (e.g., Ford Foundation), and trust funds, may prefer a high dividend yield for reasons different from those of private individual stockholders. First, endowment and trust funds are sometimes prohibited from spending the principal and must limit expenditures to the dividend (and/or interest) income generated by their investments.

Second, pension and trust funds have a legal obligation to follow conservative investment strategies, which have been interpreted by the courts to mean investments in companies that have a record of regular dividend payments. It has been argued that firms tend to develop their own “clientele” of investors. This clientele effect, originally articulated by Merton Miller and Franco Modigliani, indicates that investors will tend to be attracted to companies that have dividend policies consistent with the investors’ objectives.

Some companies, such as public utilities, that pay out a large percentage (typically 70 percent or more) of their earnings as dividends have traditionally attracted investors who desire a high dividend yield. In contrast, growth-oriented companies, which pay no (or very low) dividends, have tended to attract investors who prefer earnings retention and greater price appreciation. Empirical studies generally support the existence of a dividend clientele effect.

Protection Against Dilution

If a firm adopts a policy of paying out a large percentage of its annual earnings as dividends, it may need to sell new shares of stock from time to time to raise the equity capital needed to invest in potentially profitable projects. If existing investors do not or cannot acquire a proportionate share of the new issue, their percentage ownership interest in the firm is diluted. Some firms choose to retain more of their earnings and pay out lower dividends rather than risk dilution.

One of the alternatives to high earnings retention, however, involves raising external capital in the form of debt. This increases the financial risk of the firm, ultimately raising the cost of equity capital and at some point lowering share prices.If the firm feels that it already has an optimal capital structure, a policy of obtaining all external capital in the form of debt is likely to be counterproductive, unless sufficient new equity capital is retained or acquired in the capital markets to offset the increased debt.

Dividend Policy and Firm Value

There are two major schools of thought among finance scholars regarding the effect dividend policy has on a firm’s value. Although Miller and Modigliani argue that dividend policy does not have a significant effect on a firm’s value,11 Myron Gordon, David Durand, and John Lintner have argued that it does. Each viewpoint is discussed in this section.

Arguments for the Irrelevance of Dividends

The group led by Miller and Modigliani (MM) contends that a firm’s value is determined solely by its investment decisions and that the dividend payout ratio is a mere detail. They maintain that the effect of any particular dividend policy can be exactly offset by other forms of financing, such as the sale of new common equity shares. This argument depends on a number of key assumptions, however, including the following:

  • No taxes. Under this assumption, investors are indifferent about whether they receive either dividend income or capital gains income.
  • No transaction costs. This assumption implies that investors in the securities of firms paying small or no dividends can sell at no cost any number of shares they wish in order to convert capital gains into current income.
  • No issuance costs. If firms did not have to pay issuance costs on the issue of new securities, they could acquire needed equity capital at the same cost, regardless of whether they retained their past earnings or paid them out as dividends. The payment of dividends sometimes results in the need for periodic sales of new stock.
  • Existence of a fixed investment policy. According to MM, the firm’s investment policy is not affected by its dividend policy. Furthermore, MM claim that it is investment policy, not dividend policy, that really determines a firm’s value.

Informational Content MM realize that there is considerable empirical evidence indicating that changes in dividend policy influence stock prices. As discussed later in this chapter, many firms favor a policy of reasonably stable dividends. An increase in dividends conveys a certain type of information to the shareholders, such as an expectation of higher future earnings. Similarly, a cut in dividends may be viewed as conveying unfavorable information about the firm’s earnings prospects. MM argue that this informational content of dividend policy influences share prices, not the pattern of dividend payments per se.

Signaling Effects In effect, changes in dividend payments represent a signal to investors concerning management’s assessment of the future earnings and cash flows of the company. Management, as an insider, is perceived as having access to more complete information about future profitability than is available to investors outside the company. Dividend changes are thought to provide unambiguous signals about the company’s future prospects —information that cannot be conveyed fully through other methods, such as annual reports and management presentations before security analysts. The signaling effect of changes in dividends is similar to the signaling effect of changes in capital structure discussed in Chapter .

Clientele Effect MM also claim that the existence of clienteles of investors favoring a particular firm’s dividend policy should have no effect on share value. They recognize that a firm that changes its dividend policy could lose some stockholders to other firms with a more appealing dividend policy. This, in turn, may cause a temporary reduction in the price of the firm’s stock.

Other investors, however, who prefer the newly adopted dividend policy will view the firm as being undervalued and will purchase more shares. In the MM world, these transactions occur instantaneously and at no cost to the investor, the net result being that a stock’s value remains unchanged.

Arguments for the Relevance of Dividends

Scholars belonging to the second school of thought argue that share values are indeed influenced by the division of earnings between dividends and retention. Basically, they contend that the MM propositions are reasonable —given MM’s restrictive assumptions —but that dividend policy becomes important once these assumptions are removed.

Risk Aversion Specifically, Gordon asserts that shareholders who are risk averse may prefer some dividends over the promise of future capital gains because dividends are regular, certain returns, whereas future capital gains are less certain. This is sometimes referred to as the “bird -in -the-hand” theory. According to Gordon, dividends reduce investors’ uncertainty, causing them to discount a firm’s future earnings at a lower rate, thereby increasing the firm’s value.

In contrast, failure to pay dividends increases investors’ uncertainty, which raises the discount rate and lowers share prices. Although there is some empirical evidence to support this argument, it is difficult to decide which is more valid—the MM informational content (or signaling effect) of dividends approach or the Gordon uncertainty resolution approach.

Transaction Costs If the assumption of no transaction costs for investors is removed, then investors care whether they are paid cash dividends or receive capital gains. In the MM world, investors who own stock paying low or no dividends could periodically sell a portion of their holdings to satisfy current income requirements. In actuality, however, brokerage charges and odd-lot differentials make such liquidations expensive and imperfect substitutes for regular dividend payments.

Taxes Removal of the no-tax assumption also makes a difference to shareholders. As discussed earlier, shareholders in high income tax brackets may prefer low (or no) dividends and reinvestment of earnings within the firm because of the ability to defer taxes into the future (when the stock is sold) on such income. In his study of dividend policy from 1920 to 1960, John A. Brittain found evidence in support of this proposition.In general, he found that rising tax rates tend to reduce dividend payout rates.

Issuance (Flotation) Costs The existence of issuance costs on new equity sales also tends to make earnings retention more desirable. Given a firm’s investment policy, the payout of earnings the firm needs for investments requires it to raise external equity. External equity is more expensive, however, because of issuance costs. Therefore, the use of external equity will raise the firm’s cost of capital and reduce the value of the firm. In addition, the cost of selling small issues of equity to meet investment needs is likely to be prohibitively high for most firms. Therefore, firms that have sufficient investment opportunities to profitably use their retained funds tend to favor retention.

Agency Costs It has also been argued that the payment of dividends can reduce agency costs between shareholders and management.The payment of dividends reduces the amount of retained earnings available for reinvestment and requires the use of more external equity funds to finance growth. Raising external equity funds in the capital markets subjects the company to the scrutiny of regulators (such as the SEC) and potential investors, thereby serving as a monitoring function of managerial performance.

Conclusions Regarding Dividend Relevance The empirical evidence as to whether dividend policy affects firm valuation is mixed. Some studies have found that, because of tax effects, investors require higher pretax returns on high-dividend payout stocks than on low-dividend payout stocks.Other studies have found that share prices are unaffected by dividend payout policy. Many practitioners believe that dividends are important, both for their informational content and because external equity capital is more expensive than retained equity.Thus, when establishing an optimal dividend policy, a firm should consider shareholder preferences along with investment equity.

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