Why Does It Dividend Policy?

In recent years, U.S. corporations have paid out about 50 percent of their net income ascash dividends. However, a significant number of corporations pay no cash dividendsand many pay more dividends than their net income.

Corporations view the dividend decision as quite important because it determines whatfunds flow to investors and what funds are retained by the firm for reinvestment. Dividendpolicy can also provide information to the stockholder concerning the firm’s performance.The bulk of this chapter considers the rationale both for a policy of high dividend payoutand for a policy of low dividend payout.

In part, all discussions of dividends are plagued by the “two-handed lawyer” problem.President Truman, while discussing the legal implications of a possible presidential deci-sion, asked his staff to set up a meeting with a lawyer. Supposedly Mr. Truman said, “ButI don’t want one of those two-handed lawyers.”When asked what a two-handed lawyer was,he replied, “You know, a lawyer who says, ‘On the one hand I recommend you do so-and-so because of the following reasons, but on the other hand I recommend that you don’t doit because of these other reasons.’ ” Unfortunately, any sensible treatment of dividend pol-icy will appear to be written by a two-handed lawyer. On the one hand there are many goodreasons for corporations to pay high dividends, but on the other hand there are many goodreasons to pay low dividends.

We begin this chapter with a discussion of some practical aspects of dividend pay-ments. Next we treat dividend policy. Before delineating the pros and cons of different div-idend levels, we examine a benchmark case in which the choice of the level of dividends isnot important. Surprisingly, we will see that this conceptual setup is not merely an academiccuriosity but, instead, quite applicable to the real world. Next we consider personal taxes,an imperfection generally inducing a low level of dividends. This is followed by reasonsjustifying a high dividend level. Finally, we study the history of dividends of the AppleComputer Company. The case provides some clues as to why firms pay dividends.


The term dividend usually refers to a cash distribution of earnings. If a distribution is madefrom sources other than current or accumulated retained earnings, the term distribution ratherthan dividend is used. However, it is acceptable to refer to a distribution from earnings as adividend and a distribution from capital as a liquidating dividend. More generally, any directpayment by the corporation to the shareholders may be considered part of dividend policy.
The most common type of dividend is in the form of cash. Public companies usuallypay regular cash dividends four times a year. Sometimes firms will pay a regular cash div-idend and an extra cash dividend. Paying a cash dividend reduces the corporate cash andretained earnings shown in the balance sheet—except in the case of a liquidating dividend(where paid-in capital may be reduced).

Another type of dividend is paid out in shares of stock. This dividend is referred to asa stock dividend. It is not a true dividend, because no cash leaves the firm. Rather, a stockdividend increases the number of shares outstanding, thereby reducing the value of eachshare. A stock dividend is commonly expressed as a ratio; for example, with a 2-percentstock dividend a shareholder receives one new share for every 50 currently owned.
When a firm declares a stock split, it increases the number of shares outstanding.Because each share is now entitled to a smaller percentage of the firm’s cash flow, the stockprice should fall. For example, if the managers of a firm whose stock is selling at $90 de-clare a 3:1 stock split, the price of a share of stock should fall to about $30. A stock splitstrongly resembles a stock dividend except it is usually much larger.


The decision whether or not to pay a dividend rests in the hands of the board of directors ofthe corporation. A dividend is distributable to shareholders of record on a specific date.When a dividend has been declared, it becomes a liability of the firm and cannot be easilyrescinded by the corporation. The amount of the dividend is expressed as dollars per share(dividend per share), as a percentage of the market price (dividend yield), or as a percent-age of earnings per share (dividend payout).

The mechanics of a dividend payment can be illustrated by the example in Figure 18.1and the following chronology.

1. Declaration date. On January 15 (the declaration date), the board of directorspasses a resolution to pay a dividend of $1 per share on February 16 to all holders of recordon January 30.
2. Date of record. The corporation prepares a list on January 30 of all individuals be-lieved to be stockholders as of this date. The word believed is important here, because thedividend will not be paid to those individuals whose notification of purchase is received bythe company after January 30.
3. Ex-dividend date. The procedure on the date of record would be unfair if efficientbrokerage houses could notify the corporation by January 30 of a trade occurring onJanuary 29, whereas the same trade might not reach the corporation until February 2 if ex-ecuted by a less efficient house. To eliminate this problem, all brokerage firms entitlestockholders to receive the dividend if they purchased the stock three business days before the date of record. The second day before the date of record, which is Wednesday, January28, in our example, is called the ex-dividend date. Before this date the stock is said to tradecum dividend.
4. Date of payment. The dividend checks are mailed to the stockholders on February 16.

Obviously, the ex-dividend date is important, because an individual purchasing the se-curity before the ex-dividend date will receive the current dividend, whereas another indi-vidual purchasing the security on or after this date will not receive the dividend. The stockprice should fall on the ex-dividend date.1It is worthwhile to note that this drop is an indi-cation of efficiency, not inefficiency, because the market rationally attaches value to a cashdividend. In a world with neither taxes nor transaction costs, the stock price would be ex-pected to fall by the amount of the dividend:
Before ex-dividend date Price = $(P + 1)
On or after ex-dividend date Price = $P

This is illustrated in Figure 18.2.
The amount of the price drop is a matter for empirical investigation. Elton and Gruberhave argued that, due to personal taxes, the stock price should fall by less than the dividend.2For example, consider the case with no capital gains taxes. On the day before a stock goesex-dividend, shareholders must decide either (1) to buy the stock immediately and pay taxon the forthcoming dividend, or (2) to buy the stock tomorrow, thereby missing the dividend.If all investors are in the 28-percent bracket and the quarterly dividend is $1, the stock priceshould fall by $0.72 on the ex-dividend date. That is, if the stock price falls by this amounton the ex-dividend date, purchasers will receive the same return from either strategy.3

1、Empirically, the stock price appears to fall within the first few minutes of the ex-dividend day.
2、N. Elton and M. Gruber, “Marginal Stockholder Tax Rates and the Clientele Effect,” Review of Economics andStatistics 52 (February 1970). See also R. Bali and G. L. Hite, “Ex-Dividend Day Stock Price Behavior:Discreteness or Tax-Induced Clienteles?” Journal of Financial Economics (February 1998) and M. Frank and R.Jagannathan, “Why Do Stock Prices Drop by Less than the Value of the Dividend? Evidence from a Countrywithout Taxes,” Journal of Financial Economics (February 1998).
3、The situation is more complex when capital gains are considered. The individual pays capital gains taxes upon asubsequent sale. Because the price drops on the ex-dividend date, the original purchase price is higher if thepurchase is made before the ex-dividend date, and the individual will reap, and pay taxes on, lower capital gains.Elton and Gruber show that the price drop should be somewhat more than 72¢ when capital gains are considered.

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