Chapter 7 DIVIDEND POLICY Behavioral Corporate Finance by

Chapter 7 DIVIDEND POLICY Behavioral Corporate Finance by Hersh Shefrin 0

Traditional Approach to Payouts w MM Theory: Investors are immune to framing effects, so the value is based on cash flows no matter how these flows are framed. w MM suggest that when taxes and transaction costs are set aside, dividend policy is irrelevant. w According to this theory, if there are tax disadvantages to dividends, firms should choose low or zero payout rates. 1

Cont. . w MM points out that if investors desired dividends, and firms were not paying dividends, then investors could create homemade dividends by selling shares. w There are other reasons why firms might pay out dividends: n n n Managers often know more than investors. There is tax penalty attached to cash dividend. In the absence of transaction costs, a share repurchase offsets a new issue of the same magnitude. 2

Changes in tax policy w In May 2003 the individual tax rate for both dividends and capital gains was reduced to 15%. w Before that dividends had been taxed as ordinary income, at a top rate of 38. 6%, and capital gains had been taxed at 20%. w The previous tax differential had imposed a penalty on investors who favours cash dividends over capital gains. 3

Cont. . w The attitude of investors and analysts towards dividends were dramatically different in 2003 than they had been in 1990 s. w Therefore, both tax considerations and attitude toward risk provide reasons why managers might reconsider the manner in which their dividend policies are catering to investors. 4

catering w Choosing a dividend policy with the purpose of responding to investors psychological needs, be those needs associated with preferences or with investor sentiment. 5

Dividends and Individual Investors: Psychology w In the behavioral approach, mental accounting and hedonic editing feature framing effects that lead individual investors to find dividends especially attractive. w Older, retired investors find dividends attractive because they view dividends as a replacement for wage and salary income. w Young, employed investors find dividends attractive because regular dividends make it easier for them to tolerate risk. 6

Example: Microsoft and Con Ed Widows and Orphan Stock? w March 2003, Microsoft dividend initiation. n July 21, 2004 issue of The Wall Street Journal indicated that Microsoft was moving in the direction of the old AT&T model, that is a “widows and orphans” stock. w Con Ed omitted dividend in 1974 to much protest. n Shareholders were older, retired, and in many cases widowed, who viewed dividend income in the same way as Social Security income. 7

Self Control and Behavioral Life Cycle Behavioral life cycle hypothesis: Over the course of their lives, people use mental accounts to cope with potential self control problems that cause inadequate savings. Mental Accounting Mentally separating information into manageable pieces, by maintaining separate accounts. Self Control The act of exercising control over one’s impulses, usually to delay gratification. 8

Cont. . w Behavioral life cycle hypothesis involves self-control motivated spending rules based on mental accounts for wealth. 1. current income 2. liquid assets 3. home equity and 4. future income w Don't dip into capital. w Dividend income is spendable. 9

Dividends and Risk w Risk is more tolerable when decomposed into a certain prior gain and an uncertain outcome. w Total return on a stock decomposes into a dividend yield and a capital gain. w Cash dividends play the role of the certain prior gain (bird in the hand). 10

Cont. . Hedonic Editing People prefer to experience gains separately rather than together , but integrate small losses into larger gains. 11

Empirical Evidence w Investors over the age of 65 concentrate their stock holdings in firms that pay high dividends, especially if the investors are retired. w These investors hold over 80% of their stock portfolio in dividend paying stocks. w In contrast, investors under the age of 45 hold 65% of their portfolios in dividend paying stocks. 12

Contrast with Institutional Investors w w w Among institutional investors, pension funds and banks find dividends attractive mainly because of stricter “prudent-man” rules, rather than because of a sizeable payout. Evidence suggests that institutional investors favor repurchases over dividend payouts. When a firm increases its dividend payout, institutions tend to decrease their holdings. 13

How Managers Think About Dividends w Managers have developed heuristics to set dividend policies that cater to investors’ psychological needs. w John Lintner's classic 1956 survey found that managers establish long-run target payout ratios, yet smooth dividends in the short-run. w Lintner reports that managers are particularly concerned about having to rescind a dividend increase. 14

What Has Changed Since 1956? w Fewer firms currently target the dividend payout ratio. n Instead, they target consistency in either the current level of dividends or the dividend growth rate. w Executives are less reluctant to omit a dividend. w Executives repurchase shares much more frequently. Exhibit 7. 1 15

Asymmetry w Dividend increases occur much more frequently than dividend decreases. n n During 1999 there were 1, 703 dividend increases or initiations. In contrast, there were only 135 decreases or omissions during that period. w The market reacts positively to announcements of repurchases and dividend increases, but more negatively to announcements of dividend decreases. 16

Managers' Beliefs w Over 80% state that there are negative consequences to reducing dividends. w Over 75% believe that dividends convey information about their firm. w Over 60% would rather raise funds to finance new investment projects than cut dividends. w About a third believe that paying dividends, instead of plowing back earnings, makes a firm’s stock less risky. 17

Attracting Institutional Investors w Just under 50% indicate that they set their policy in order to attract institutional investors to hold their stock. w About 30% cite “attracting institutional investors because they monitor management decisions. ” n n Fewer than 15% cite "paying out dividends to reduce cash, thereby disciplining our firm. " Fewer than 10% indicate that they pay dividends to show they can afford to bear costs of external funding or pass up profitable investments. 18

Attracting Individual Investors w Just over 40% mention that they set policy in order to attract individual (retail) investors. w Fewer that 30% mention the tax penalty associated with dividends. 19

Dividend Initiation w w Items cited by over 40% of respondents in connection with dividend initiation: Earnings per share increasing The influence of our institutional shareholders Our company having extra cash/marketable securities Having fewer profitable investments available (e. g. , as our industry matures) 20

Catering to Investors’ Tastes For Dividends w Managers appear to cater to investors' preference for dividends. w Expect stocks of dividend paying firms to have lower book-to-market equity than those of nondividend paying firms. n Citizen Utilities w Expect that the difference in these ratios would change over time, with the differential being wider during bear markets than during bull markets. 21

Catering and Price Effects w One way to gauge whether or not the stocks of dividend-paying firms are priced differently from the stocks of non-dividend paying firms is to compare their book to market ratios. w If investors favor cash dividends, then we would expect the stocks of dividend-paying firms to have higher market values and there fore lower book to market equity than those of non dividend-paying firms. 22

The End 23