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( 7 .)


Association, 1968, v63(324), 1132-1161.


the firm™s concern about its capability to maintain higher dividends in future periods.
Another is the negative market view of dividend decreases, and the consequent drop in
the stock price. Figure 10.6 provides a summary of the percentages of all firms that
increased, decreased, or left unchanged their annual dividends per share from 1989 to

Estimated using Compustat annual database.
As you can see, in most years the number of firms that do not change their dollar
dividends far exceeds the number that do. Among the firms that change dividends, a
much higher percentage, on average, increase dividends than decrease them.

Dividends Follow a Smoother Path than Earnings
As a result of the reluctance of firms to raise dividends until they feel able to
maintain them, and to cut dividends unless they absolutely have to, dividends follow a
much smoother path than earnings. This view that dividends are not as volatile as
earnings on a year-to-year basis is supported by a couple of empirical facts. First, the
variability in historical dividends is significantly lower than the variability in historical
earnings. Using annual data on aggregate earnings and dividends from 1960 to 2003, for


instance, the standard deviation of dividends is 5% while the standard deviation in
earnings is about 14%. Second, the standard deviation in earnings yields across
companies is significantly higher than the standard deviation in dividend yields. In other
words, the variation in earnings yields across firms is much greater than the variation in
dividend yields.

A Firm™s Dividend Policy Tends To Follow The Life Cycle Of The Firm
In chapter 7, we introduced the link between a firm™s place in the life cycle and its
financing mix and choices. In particular, we noted five stages in the growth life cycle “
start up, rapid expansion, high growth, mature growth and decline. In this section, we will
examine the link between a firm™s place in the life cycle and its dividend policy. Not
surprisingly, firms generally adopt dividend policies that best fit where they are currently
in their life cycles. For instance, high-growth firms with great investment opportunities
do not usually pay dividends, whereas stable firms with larger cash flows and fewer
projects tend to pay more of their earnings out as dividends. Figure 10.7 looks at the
typical path that dividend payout follows over a firm™s life cycle.

Figure 10.7: Life Cycle Analysis of Dividend Policy

$ Revenues/



External funding High, but High, relative Moderates, relative Low, as projects dry
Low, as projects dry
needs constrained by to firm value. to firm value. up.

Negative or
Internal financing Negative or Low, relative to High, relative to More than funding needs
low funding needs funding needs

Capacity to pay None None Very low Increasing High

Stage 1 Stage 2 Stage 4 Stage 5
Growth stage Stage 3 Years
Start-up Rapid Expansion Mature Growth Decline
High Growth

This intuitive relationship between dividend policy and growth is emphasized when we
look at the relationship between a firm™s payout ratio and its expected growth rate. For
instance, we classified firms on the New York Stock Exchange in January 2004 into six
classes, based upon analyst estimates of expected growth rates in earnings per share for
the next 5 years, and estimated the dividend payout ratios and dividend yields for each
class; these are reported in Figure 10.8.


Source: Value Line Database
The firms with the highest expected growth rates pay the lowest dividends, both as a
percent of earnings (payout ratio) and as a percent of price (dividend yield).3

10.3. ˜: Dividend Policy at Growth Firms
Assume that you are following a growth firm, whose growth rate has begun easing.
Which of the following would you most likely observe in terms of dividend policy at the
a. An immediate increase of dividends to reflect the lower reinvestment needs.
b. No change in dividend policy, and an increase in the cash balance.
c. No change in dividend policy, and an increase in acquisitions of other firms

3 These are growth rates projected by Value Line for firms in April 1999.


Differences in Dividend Policy across Countries
Figures 10.5 to 10.8 showed several trends and patterns in dividend policies at
U.S. companies.4 They share some common features with firms in other countries, and
there are some differences. As in the United States, dividends in other countries are sticky
and follow earnings. However, there are differences in the magnitude of dividend payout
ratios across countries. Figure 10.9 shows the proportion of earnings paid out in
dividends in the G-7 countries in 1982-84 and again in 1989-91.

Source: Rajan and Zingales
These differences can be attributed to:
1. Differences in Stage of Growth: Just as higher growth companies tend to pay out less
of their earnings in dividends (see Figure 10.8), countries with higher growth pay out less
in dividends. For instance, Japan had much higher expected growth in 1982-84 than the
other G-7 countries and paid out a much smaller percentage of its earnings as dividends.
2. Differences in Tax Treatment: Unlike the United States, where dividends are double
taxed, some countries provide at least partial protection against the double taxation of

4Rajan, R. and L. Zingales, What do we know about capital structure? Some Evidence from International
Data, Journal of Finance, 1995, v50, 1421-1460.


dividends. For instance, Germany taxes corporate retained earnings at a higher rate than
corporate dividends.
3. Differences in Corporate Control: When there is a separation between ownership and
management, as there is in many large publicly traded firms, and where stockholders
have little control over managers, the dividends paid by firms will be lower. Managers,
left to their own devices, have a much greater incentive to accumulate cash than do
Not surprisingly, the dividend payout ratios of companies in emerging markets are
much lower than the dividend payout ratios in the G-7 countries. The higher growth and
relative power of incumbent management in these countries contribute to keeping these
payout ratios low.

10.4. ˜: Dividend policies and Stock Buyback Restrictions
Some countries do not allow firms to buy back stock from their stockholders. Which of
the following would you expect of dividend policies in these countries (relative to
countries that don™t restrict stock buybacks)?
a. Higher portion of earnings will be paid out in dividends; More volatile dividends;
b. Lower portion of earnings will be paid out in dividends; More volatile dividends
c. Higher portion of earnings will be paid out in dividends; Less volatile dividends;
d. Lower portion of earnings will be paid out in dividends; Less volatile dividends;

Illustration 10.1: Dividends, Dividend Yields and Payout Ratios
In the illustration that follows, we will examine the dollar dividends paid at
Disney, Aracruz and Deutsche Bank between 2001 and 2003. Each year, we will also
compute the dividend yield and dividend payout ratio for each firm.
Deutsche Bank Disney Aracruz
2001 2002 2003 2001 2002 2003 2001 2002 2003
DPS ‚¬ 1.30 ‚¬ 1.30 ‚¬ 1.30 $0.21 $0.21 $0.21 R$ 0.14 R$ 0.18 R$ 0.32
EPS ‚¬ 2.44 ‚¬ 0.64 ‚¬ 0.27 $0.11 $0.60 $0.65 R$ 0.20 R$ 0.01 R$ 0.85
Stock Price ‚¬ 79.40 ‚¬ 43.90 ‚¬ 65.70 $20.72 $16.31 $23.33 R$ 3.91 R$ 6.76 R$ 10.60
Dividend Yield 1.64% 2.96% 1.98% 1.01% 1.29% 0.90% 3.53% 2.69% 3.00%
Dividend Payout 53.28% 203.13% 481.48% 190.91% 35.00% 32.31% 69.01% 1818.44% 37.41%


Of the three companies, Aracruz had the highest dividend yield across the three years.
Disney and Deutsche paid the same dividends per share each year, but the volatility in
their stock prices and earnings made the payout ratios and dividend yields volatile. In
fact, Deutsche maintained its dividends at 1.30 Euros per share in the face of declining
earnings per share in 2002 and 2003, a testimonial to the stickiness of dividends.
As noted earlier in the book, Aracruz, like most Brazilian companies, maintains
two classes of shares “ voting share (called common and held by insiders) and non-voting
shares (called preferred shares and held by outside investors). The dividend policies are
different for the two classes, with preferred shares getting higher dividends. In fact, the
failure to pay a mandated dividend to preferred stockholders (usually set at a payout ratio
of 35%) can result in preferred stockholders getting some voting control of the firm.
Effectively, this puts a floor on the dividend payout ratio.

When Are Dividends Irrelevant?
There is a school of thought that argues that what a firm pays in dividends is
irrelevant and that stockholders are indifferent about receiving dividends. Like the capital
structure irrelevance proposition, the dividend irrelevance argument has its roots in a
paper crafted by Miller and Modigliani.5

The Underlying Assumptions
The underlying intuition for the dividend irrelevance proposition is simple. Firms
that pay more dividends offer less price appreciation but must provide the same total
return to stockholders, given their risk characteristics and the cash flows from their
investment decisions. Thus, there are no taxes, or if dividends and capital gains are taxed
at the same rate, investors should be indifferent to receiving their returns in dividends or
price appreciation.
For this argument to work, in addition to assuming that there is no tax advantage
or disadvantage associated with dividends, we also have to assume the following:

5Miller, M. and F. Modigliani, 1961, Dividend Policy, Growth and the Valuation of Shares, Journal of
Business, 411-433.


There are no transactions costs associated with converting price appreciation into

cash, by selling stock. If this were not true, investors who need cash urgently might
prefer to receive dividends.
Firms that pay too much in dividends can issue stock, again with no flotation or

transactions costs, to take on good projects. There is also an implicit assumption that
this stock is fairly priced.
The investment decisions of the firm are unaffected by its dividend decisions, and the

firm™s operating cash flows are the same no matter which dividend policy is adopted.
Managers of firms that pay too little in dividends do not waste the cash pursuing their

own interests (i.e., managers with large free cash flows do not use them to take on
bad projects).
Under these assumptions, neither the firms paying the dividends nor the stockholders
receiving them will be adversely affected by firms paying either too little or too much in

10.5. ˜: Dividend Irrelevance
Based upon the Miller Modigliani assumptions, dividends are least likely to affect value


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