7.4 Dividend Policy Theories
Are dividends really relevant to the value of a firm? Why pay dividends at all? For example, Warren Buffet, long-time, renowned chairman of Berkshire Hathaway has said, more or less, that he will only pay dividends when his company is unable to identify internal investment opportunities that exceed the potential return that smaller investors’ respective opportunity sets present (after their paying taxes on those same dividends received). In the over five decades that he has run the firm, there has never been any dividend paid!
In terms more familiar to us, he is saying that he will pay a dividend only when internal projects’ projected Internal Rates for Return (IRRs) – or some other reasonable measure – are less than what an investor may earn on his own after receiving a dividend and paying taxes on it. Remember that the opportunity set available to a large corporation, with large sums of money, is much more attractive than the set available to the typical, small investor. In other words, a firm will pay a cash dividend if it can identify no internal capital budgeting project whose return, however defined, exceeds the firm’s hurdle rate.
The Clientele Theory of Dividends asserts that the firm will pay dividends if its investors are demanding it. In general, investors who want dividends, it is argued, will invest in companies that have a good dividend-paying track record.
Let’s review some well-known, academic dividend policy theories. First, we are already somewhat familiar with Modigliani & Miller’s (1961) “Dividend Irrelevance” theory.[1] As already discussed above, M&M argue that the firm’s basic earnings power, that is, the operating earnings (i.e., Earnings Before Interest and Taxes or EBIT) generated from its basic lines of business, are what drive the company’s valuation. The more elaborate, formal theory, which has been presented above, is quite complex, and utilizes a series of very restrictive assumptions and building blocks.
In short, M&M say that return on assets (ROA = EBIT / TA) – where TA = Total Assets – is more important than Payout Ratio (PR = D / NI), or hence Dividend (D) Growth (g). Put differently, the distribution of net income to the shareholder as between dividends and retained earnings has no effect on the firm’s overall capital costs (i.e., the total Firm β is unchanged), and thus on its overall valuation. Capital structure has no bearing on a firm’s value. Moreover, the capital budgeting process and investment policies are independent of its dividend policy.
Dividend policy, being irrelevant, once again, devolves necessarily from the position that capital structure does not matter; this is rationalized as investors can create homemade leverage (i.e., by ignoring, at first, the impact of – differential – tax rates, assuming equal borrowing rates as between corporations and individuals, and other restrictive assumptions.)
Gordon & Lintner (1962) espoused the “Bird-in-the-Hand” theory. (Myron Gordon, is the father of the “Gordon Model,” which we know better as the “Dividend Discount Model.”) They contend that investors prefer a dollar of dividends in the here and now over an unsure future dollar of capital gains. In a sense, g is riskier than D/P0 in the DDM formula. They challenged one of M&M’s assumptions, claiming that investors prefer less risky dividends, and are uncomfortable with capital gains’ prospects. In contrast, M&M claimed that R Firm is independent of PR and dividend policy.
A fourth theory may be referred to as “Tax Preference” theory. Here, an investor’s choice as between a dividend versus a capital gain depends on the investor’s marginal tax bracket, and the relative dividend versus capital gains taxation consequence.
In summary, we covered four academic theories: Modigliani & Miller’s (1961) “Dividend Irrelevance” theory; Gordon & Lintner (1962) espoused the “Bird-in-the-Hand” theory; and “Tax Preference” theory. Some of these notions may appear old or “exotic,” but they bear consideration.
- Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business, October 1961, pp. 411-433. ↵