was the most important of these.Most companies appeared to have a target payout ratio;if there was a sudden unexpected increase in earnings,firms adjusted their dividends slowly.Firms were very reluctant to cut dividends. Based on interviews of the 28 firms'management teams,Lintner reported a median target payout ratio of 50%.Despite the very small sample and the fact that the study was conducted nearly half a century ago,the target payout ratio is not far from what we present in table 1 for all U.S.industrial firms over a much longer time period. Lintner's third finding was that management set dividend policy first.Other policies were then adjusted,taking dividend policy as given.For example,if investment opportunities were abundant and the firm had insufficient internal funds,it would resort to outside funds. Lintner suggested that the following model captured the most important elements of firms'dividend policies.For firm i, D*it=aiEit (2) Dt-Dtl=ai+ci(D*it-Di(t))+uit, (3) where for firm i D*it desired dividend payment during period t Dit actual dividend payment during period t Qi target payout ratio Eit earnings of the firm during period t a a constant relating to dividend growth Ci partial adjustment factor uit =error term This model was able to explain 85%of the dividend changes in his sample of companies. 11
was the most important of these. Most companies appeared to have a target payout ratio; if there was a sudden unexpected increase in earnings, firms adjusted their dividends slowly. Firms were very reluctant to cut dividends. Based on interviews of the 28 firms’ management teams, Lintner reported a median target payout ratio of 50%. Despite the very small sample and the fact that the study was conducted nearly half a century ago, the target payout ratio is not far from what we present in table 1 for all U.S. industrial firms over a much longer time period. Lintner's third finding was that management set dividend policy first. Other policies were then adjusted, taking dividend policy as given. For example, if investment opportunities were abundant and the firm had insufficient internal funds, it would resort to outside funds. Lintner suggested that the following model captured the most important elements of firms' dividend policies. For firm i, D*it = αiEit, (2) Dt - Dt-1 = ai + ci(D*it - Di(t-1)) + uit, (3) where for firm i D*it = desired dividend payment during period t Dit = actual dividend payment during period t αi = target payout ratio Eit = earnings of the firm during period t ai = a constant relating to dividend growth ci = partial adjustment factor uit = error term This model was able to explain 85% of the dividend changes in his sample of companies. 11
Fama and Babiak (1968)undertook a comprehensive study of the Lintner model's performance,using data for 392 major industrial firms over the period 1946 through 1964.They also found the Lintner model performed well.Over the years,other studies have confirmed this. The sixth observation is that the market usually reacts positively to announcements of increases in payouts and negatively to announcements of dividend decreases.This phenomenon has been documented by many studies,such as Pettit (1972),Charest (1978),Aharony and Swary (1980),and Michaely,Thaler,and Womack (1995)for dividends,and by Ikenberry, Lakonishok,and Vermaelen (1995)for repurchases.This evidence is consistent with managers knowing more than outside shareholders,and dividends and repurchases changes provide some information on future cash flows(e.g.,Bhattacharya,1979,or Miller and Rock,1985),or about the cost of capital (Grullon,Michaely and Swaminathan,2002,Grullon and Michaely 2000). The evidence is also consistent with the notion that when contracts are incomplete,higher payouts can sometimes be used to align management's interest with that of shareholders',as suggested by Grossman and Hart(1982),Easterbrook(1984)and Jensen (1986). 3.The Miller-Modigliani Dividend Irrelevance Proposition Miller and Modigliani (1961)showed that in perfect and complete capital markets,a firm's dividend policy does not affect its value.The basic premise of their argument is that firm value is determined by choosing optimal investments.The net payout is the difference between earnings and investment,and is simply a residual.Because the net payout comprises dividends and share issues/repurchases,a firm can adjust its dividends to any level with an offsetting change in shares outstanding.From the perspective of investors,dividend policy is irrelevant, 12
Fama and Babiak (1968) undertook a comprehensive study of the Lintner model's performance, using data for 392 major industrial firms over the period 1946 through 1964. They also found the Lintner model performed well. Over the years, other studies have confirmed this. The sixth observation is that the market usually reacts positively to announcements of increases in payouts and negatively to announcements of dividend decreases. This phenomenon has been documented by many studies, such as Pettit (1972), Charest (1978), Aharony and Swary (1980), and Michaely, Thaler, and Womack (1995) for dividends, and by Ikenberry, Lakonishok, and Vermaelen (1995) for repurchases. This evidence is consistent with managers knowing more than outside shareholders, and dividends and repurchases changes provide some information on future cash flows (e.g., Bhattacharya, 1979, or Miller and Rock, 1985), or about the cost of capital (Grullon, Michaely and Swaminathan, 2002, Grullon and Michaely 2000). The evidence is also consistent with the notion that when contracts are incomplete, higher payouts can sometimes be used to align management’s interest with that of shareholders’, as suggested by Grossman and Hart (1982), Easterbrook (1984) and Jensen (1986). 3. The Miller-Modigliani Dividend Irrelevance Proposition Miller and Modigliani (1961) showed that in perfect and complete capital markets, a firm's dividend policy does not affect its value. The basic premise of their argument is that firm value is determined by choosing optimal investments. The net payout is the difference between earnings and investment, and is simply a residual. Because the net payout comprises dividends and share issues/repurchases, a firm can adjust its dividends to any level with an offsetting change in shares outstanding. From the perspective of investors, dividend policy is irrelevant, 12
because any desired stream of payments can be replicated by appropriate purchases and sales of equity.Thus,investors will not pay a premium for any particular dividend policy. To illustrate the argument behind the theorem,suppose there are perfect and complete capital markets(with no taxes).At date t,the value of the firm is Vi=present value of payouts where payouts include dividends and repurchases.For ease of exposition,we initially consider the case with two periods,t and t+1.At date t,a firm has earnings,Et,(earned previously)on hand. It must decide on the level of investment,It the level of dividends,D the amount of shares to be issued,ASt(or repurchased if ASt is negative) The level of earnings at t+1,denoted Ei(It,0+1),depends on the level of investment It and a random variable 0+.Since t+1 is the final date,all earnings are paid out at t +1.Given complete markets,let P)=time t price of consumption in state Then it follows that V,=D:-△St+∫p(6+i)E+1(I,0+i)d0+1 (4) The sources and uses of funds identity says that in the current period t: E+△St=I+D (5) Using this to substitute for current payouts,D-ASt,gives Vt=Et-It+Spt(0)E+(It,0+)de+ (6) 13
because any desired stream of payments can be replicated by appropriate purchases and sales of equity. Thus, investors will not pay a premium for any particular dividend policy. To illustrate the argument behind the theorem, suppose there are perfect and complete capital markets (with no taxes). At date t, the value of the firm is Vt = present value of payouts where payouts include dividends and repurchases. For ease of exposition, we initially consider the case with two periods, t and t + 1. At date t, a firm has - earnings, Et, (earned previously) on hand. It must decide on - the level of investment, It - the level of dividends, Dt - the amount of shares to be issued, ∆St (or repurchased if ∆St is negative) The level of earnings at t + 1, denoted Et+1(It, θt+1), depends on the level of investment It and a random variable θt+1. Since t + 1 is the final date, all earnings are paid out at t + 1. Given complete markets, let pt(θt+1) = time t price of consumption in state θt+1 Then it follows that Vt = Dt - ∆St + ∫pt(θt+1)Et+1(It, θt+1)dθt+1 (4) The sources and uses of funds identity says that in the current period t: Et + ∆St = It + Dt (5) Using this to substitute for current payouts, Dt - ∆St, gives Vt = Et - It + ∫pt(θt+1)Et+1(It, θt+1)dθt+1 (6) 13
From equation (6)we can immediately see the first insight from Miller and Modigliani's analysis..Since Et is given,the only determinant of the value of the firm is current investment This analysis can be extended to the case with more than two periods.Now Vi=E-It+Vl (7) where V+1=E+1(L,0+i)-I+1+Vt+2 (8) and so on,recursively.It follows from this extension that it is only the sequence of investments It,I1,...that is important in determining firm value.Firm value ismaximized by making an appropriate choice of investment policy. The second insight from the Miller-Modigliani analysis concerns the firm's dividend policy,which involves setting the value of D each period.Given that investment is chosen to maximize firm value,the firm's payout in period t,Dt-ASt,must be equal to the difference between earnings and investment,E-It.However,the level of dividends,D,can take any value,since the level of share issuance,ASt,can always be set to offset this.It follows that dividend policy does not affect firm value at all.It is only investment policy that matters. The analysis above implicitly assumes 100%equity financing.It can be extended to include debt financing.In this case management can finance dividends by using both debt and equity issues.This added degree of freedom does not affect the result.As with equity-financed dividends,no additional value is created by debt-financed dividends,since capital markets are perfect and complete so the amount of debt does not affect the total value of the firm. The third and perhaps most important insight of Miller and Modigliani's analysis is that it identifies the situations in which dividend policy can affect firm value.It could matter,not 14
From equation (6) we can immediately see the first insight from Miller and Modigliani's analysis. . Since Et is given, the only determinant of the value of the firm is current investment It. This analysis can be extended to the case with more than two periods. Now Vt = Et - It + Vt+1 (7) where Vt+1 = Et+1(It, θt+1) - It+1 + Vt+2 (8) and so on, recursively. It follows from this extension that it is only the sequence of investments It, It+1, ... that is important in determining firm value. Firm value ismaximized by making an appropriate choice of investment policy. The second insight from the Miller-Modigliani analysis concerns the firm's dividend policy, which involves setting the value of Dt each period. Given that investment is chosen to maximize firm value, the firm's payout in period t, Dt - ∆St, must be equal to the difference between earnings and investment, Et - It. However, the level of dividends, Dt, can take any value, since the level of share issuance, ∆St, can always be set to offset this. It follows that dividend policy does not affect firm value at all. It is only investment policy that matters. The analysis above implicitly assumes 100% equity financing. It can be extended to include debt financing. In this case management can finance dividends by using both debt and equity issues. This added degree of freedom does not affect the result. As with equity-financed dividends, no additional value is created by debt-financed dividends, since capital markets are perfect and complete so the amount of debt does not affect the total value of the firm. The third and perhaps most important insight of Miller and Modigliani's analysis is that it identifies the situations in which dividend policy can affect firm value. It could matter, not 14
because dividends are "safer"than capital gains,as was traditionally argued,but because one of the assumptions underlying the result is violated. Perfect and complete capital markets have the following elements: 1. No taxes 2. Symmetric information Complete contracting possibilities 4. No transaction costs 5. Complete markets It is easy to see the role played by each of the above assumptions.The reason for Assumption 1 is clear.In the no-taxes case,it is irrelevant whether a firm pays out dividends or repurchases shares;what is important is Dt-ASt.If dividends and share repurchases are taxed differently,this is no longer the case.Suppose,for example,dividends are taxed at a higher rate than capital gains from share repurchases.Then it is optimal not to pay dividends,but instead to pay out any residual funds by repurchasing shares.In section 5 we discuss the issues raised by relaxing Assumption 1. Assumption 2 is that all participants (including the firms)have exactly the same information set.In practice,this is rarely the case.Managers are insiders and are likely to know more about the current and future prospects of the firm than outsiders.Dividends can reveal some information to outsiders about the value of the corporation.Moreover,insiders might even use dividends to deliberately change the market's perception about the firm's value.Again, dividend policy can affect firm value.Sections 6.1 and 7.1 consider the effect of asymmetric information. 15
because dividends are "safer" than capital gains, as was traditionally argued, but because one of the assumptions underlying the result is violated. Perfect and complete capital markets have the following elements: 1. No taxes 2. Symmetric information 3. Complete contracting possibilities 4. No transaction costs 5. Complete markets It is easy to see the role played by each of the above assumptions. The reason for Assumption 1 is clear. In the no-taxes case, it is irrelevant whether a firm pays out dividends or repurchases shares; what is important is Dt - ∆St. If dividends and share repurchases are taxed differently, this is no longer the case. Suppose, for example, dividends are taxed at a higher rate than capital gains from share repurchases. Then it is optimal not to pay dividends, but instead to pay out any residual funds by repurchasing shares. In section 5 we discuss the issues raised by relaxing Assumption 1. Assumption 2 is that all participants (including the firms) have exactly the same information set. In practice, this is rarely the case. Managers are insiders and are likely to know more about the current and future prospects of the firm than outsiders. Dividends can reveal some information to outsiders about the value of the corporation. Moreover, insiders might even use dividends to deliberately change the market's perception about the firm's value. Again, dividend policy can affect firm value. Sections 6.1 and 7.1 consider the effect of asymmetric information. 15