There have been many theoretical studies on dividend policy. Miller and Modigliani (1961) had a seminal contribution to research on dividend policy. Prior to this, most researchers believed that the more dividends a firm paid, the more valuable the firm would be. This view was derived from an extension of the discounted dividends approach to firm valuation, which says that the value V0 of the firm at date 0, if the first dividends are paid one period from now at date 1, is given by the formula V0=
1 (1 )
t
t t t
r
D , where Dt is the divided paid by the firm at the end of
period t, and rtistheinvestors’opportunity costofcapitalforperiod t. Gordon (1959) argued that investors’ required rate of return rt would increase with retaining of earnings and increased investment. Although the future dividend stream would presumably be larger as a result of the increase in investment (i.e., Dt would grows faster), Gordon felt that higher rt would overshadow this effect. The reason for the increase in rt would be the greater uncertainty associated with the increased investment relative to the safety of the dividend.
Miller and Modigliani pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy. They showed thatwhatreally countsisthefirm’sinvestmentpolicy. Aslong asinvestmentpolicy doesn’tchange,altering themix ofretained earningsand payoutwillnotaffectthe firm’s value. The framework has formed the foundation of subsequent work on dividends and payout policy in general. It is important to note that their framework is rich enough to encompass both dividends and repurchases, as the only determinant ofafirm’svalueisitsinvestmentpolicy.
The dividend literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the
notion that both managers and markets care about payouts, and dividends in particular.
The theoretical work on this issue suggests five possible imperfections that management should consider when it determines dividend policy. They are taxes, asymmetric information, an incomplete contract, institutional constraints and transaction costs.
First, if dividends are taxed more heavily than capital gains, and investors cannot use dynamic trading strategies to avoid this higher taxation, then minimizing dividends is optimal. Second, if managers know more about the true worth of their firm, dividends can be used to convey the information to the market, despite the costs associated with paying those dividends. Third, if contracts are incomplete or are not fully enforceable, equityholders may use dividends to discipline managers or to expropriate wealth from debtholders. Fourth, if various institutions avoid investing in non-or-low-dividend-paying stocks because of legal restrictions, management may find that it is optimal to pay dividends despite the tax burden it imposes on individual investors. Fifth, if dividends payments minimize transaction costs to shareholders, then positive dividend payout may be optimal.
The best known literature of asymmetric information are those of Bhattacharya (1979), Miller and Rock (1985), and John and Williams (1985). The basic idea in all these models is that the firms adjust dividends to signal their prospects. A rise in dividend typically signals that the firm will do better, and a decrease suggests that it will do worse. These theories may explain why firms pay out so much of their earnings as dividends. Bhattacharya has the feature that dividends and repurchase are perfect substitutes for one another. It does not matter whether the good firm signals its value through repurchasing shares or paying dividends, because the end result will be the same. Therefore, one of the implications of these models is that dividends and repurchases are perfect substitutes.
Miller and Rock (1985) also constructed a two-period model. In their model, at time zero firms invest in a project, the profitability of which cannot be observed by investors. At time 1, the project produces earnings and the firm uses these to finance
its dividend payment and its new investment. Investors cannot observe either earnings or the new investment. An important assumption in their model is that some shareholders want to sell their holdings in the firm at time 1, and that this factor entermanager’sinvestmentand payoutdecisions. Attime2,thefirm’sinvestment again produces earnings. A critical assumption of the model is that the firm’s earnings are correlated through time. This setting implies that the firm has an incentive to make shareholders believe that the earnings at time 1 are high so that the shareholders who sell will receive a high price. Since both earnings and investment are unobservable, a bad firm can pretend to have high earnings by cutting its investment and paying out high dividends. A good firm must pay a level of dividends that is sufficiently high to make it unattractive for bad firms to reduce their investment enough to achieve the same level. The Miller and Rock theory has a number of attractive features. The basic story that firms shave investment to make dividends higher and signal high earnings is entirely plausible. Unlike the Bhattacharya model, the Miller and Rock theory does not rely on assumptions that are difficult to interpret, such as firms being able to commit to a dividend level.
John and William’sstarting pointistheassumption thatshareholdersin afirm have liquidity needs thatthey mustmeetby selling someoftheirshares. Thefirm’s managers act in the interest of the original shareholders and know the true value of the firm. Outside investors do not. If the firm is undervalued when the shareholders must meet their liquidity needs, then these shareholders would be selling at a price below the true value. However, suppose the firm pays a dividend, which is taxed.
If outside investors take this as a good signal, then the share price will rise.
Shareholders will have to sell less equity to meet their liquidity needs and will maintain ahigherproportionatesharein thefirm. John and William’smodelavoid the objection to most signaling theories of dividends. Firms do not repurchase shares to avoid taxes, because it is precisely the cost of the taxes that makes dividends desirable. This is clearly an important innovation.
After the Miller and Rock (1985) and John and Williams (1985) papers, a number of other theories with multiple signals were developed. Ambarish, John, and
Williams (1987) constructed a single-period model with dividends, investment, and stock repurchases. Williams (1988) developed a multi-period model with these elements and showed that in the efficient signaling equilibrium, firm typically pay dividends, choose their investments in risky assets to maximize net present value, and issue new stock. Constantinides and Grundy (1989) focused on the interaction between investment decisions and shares repurchase and financing decisions in a signaling equilibrium.
Brenheim (1991) also provided a theory of dividend in which signaling occurs because dividends are taxed more heavily than repurchases. In this model, the firm controls the amount paid by varying the proportion of the total payout that is in the form of dividends, rather than repurchases. A good firm can choose the optimal amount of taxes to provide the signal. As with the John and Williams model, Brenheim’smodeldoesnotprovideagood explanation ofdividend smoothing.
Allen, Bernardo, and Welch (2000) took a different approach to dividend signaling.
As in the previous models, dividends are a signal of good news. However, in their model firms pay dividends because they are interested in attracting a better-informed clientele. Untaxed institutions are the primary holders of dividend-paying stocks because they are a tax-disadvantaged payout method for other potential stockholders.
Another reason why good firms like institutions to hold their stock is that these stockholders are better informed and have a relative advantage in detecting high quality firm. Low-quality firms do not have the incentive to mimic, since they do not wish their true worth to be revealed. Paying dividends increases the chance that institutions will detect the firm’squality.
Kumar (1988) provided a theory of dividend smoothing. In his model, the managers who make the investment decision know the true productivity type of the firm but the outside investors do not. Managers will try to achieve lower investment by underreporting the firm’s productivity type. Grullon et al. (2002) proposed maturity hypothesis to say about the relation between dividend changes and risk changes. They proposed that there are several elements that contribute to firms becoming mature. Thus, a dividend increase indicates that a firm has matured.