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Dividends and Other Pay-outs (Pay-out Policy Theories (Clientele Effect…
Dividends and Other Pay-outs
What is a dividend?
Distribution of earnings to shareholders
Dividend Irrelevancy Theorem
Investors can create homemade dividends
Paying dividends does not create value
Dividend policy is irrelevant
Advantages of Paying Dividends
Stable cash flows for investors
Appeal to investors with limited self-control
Keep cash from bondholders
Signal optimism about future performance
Disadvantages of Paying Dividends
Tax inefficient
Reduce internal sources of finance
Difficult to reduce dividend with impacting share price
Share Repurchases
Buys back own shares, reducing number of shares outstanding
Flexible
Only paid to those selling
Doesn't set expectations like dividends
More tax efficient than dividends - dividends are taxed at a corporate and personal rate
Share repurchases are taxed as capital gains which is usually a lower rate
Real-world Factors Favouring High-dividend Policy
Desire for current income
Behavourial finance
People lack the self-control to only take as much as they need. Dividends provide a stable constrained income
Agency costs
Wealth transfer from bondholders to shareholders
Information content of dividends
Dividend increase signals the firm is expected to perform well
Pay-out Policy Theories
Signalling
Provide shareholders with information through financial decisions
Increase/decrease dividend = Optimism/pessimism about future performance
Share price will respond according to whether financial decisions indicate optimism or pessimism
Clientele Effect
Different dividend clientele make different investment decisions based on which companies' dividend policies are most beneficial to them
Firms whose policies are in short supply will see shares prices rise
Once the market is in equilibrium, there is no benefit to changing dividend policy
Catering Theory
Managers change dividend policy when their investors' demands change
Once the decision of which policy to use has been made, changing is unlikely to make investors happy, as the firm will have attracted a certain type of clientele
Agency Theory
Target pay-out ratio = when transaction costs and agency costs are minimised
Dividend decisions depend on the capital structure of the firm
Life-cycle Theory
Dividend policy depends on the stage of the business life-cycle
Young firm = High growth = Low dividend
Mature firm = Low growth = High dividend
Contrasts with signalling theory
Tax Preference Theory
Investors prefer long-term capital gains to current dividend yield due to tax bias for capital gains
Bird-in-the-hand Theory
Investors are more concerned with certain dividends than uncertain capital gains
Investor discount capital gains more than dividend yield
Dividend Smoothing
Target pay-out ratio
Firms use a speed of adjustment coefficient so that dividends don't increase rapidly due to abnormally high earnings and subsequently have to be lowered