Payout Policy Franklin Allen University of Pennsylvania (allenf@wharton.upenn.edu) and Roni Michaely Cornell University and IDC (rm34@Cornell.edu) April,2002 Prepared for North-Holland Handbook of Economics edited by George Constantinides,Milton Harris,and Rene Stulz.We are in debt to Gustavo Grullon for his insights and help on this project.We would like to thank Harry DeAngelo,Eric Lie,Rene Stulz and Jeff Wurgler for their comments and suggestions
Payout Policy Franklin Allen University of Pennsylvania (allenf@wharton.upenn.edu) and Roni Michaely Cornell University and IDC (rm34@Cornell.edu) April, 2002 _____________________ Prepared for North-Holland Handbook of Economics edited by George Constantinides, Milton Harris, and Rene Stulz. We are in debt to Gustavo Grullon for his insights and help on this project. We would like to thank Harry DeAngelo, Eric Lie, Rene Stulz and Jeff Wurgler for their comments and suggestions
Abstract This paper surveys the literature on payout policy.We start with a description of the Miller- Modigliani payout irrelevance proposition,and then consider the effect of relaxing the assumptions on which it is based.We consider the role of taxes,asymmetric information, incomplete contracting possibilities,and transaction costs.The accumulated evidence indicates that changes in payout policies are not motivated by firms'desire to signal their true worth to the market.Both dividends and repurchases seem to be paid to reduce potential overinvestment by management.We also review the issue of the form of payout and the increased tendency to use open market share repurchases.Evidence suggests that the rise in the popularity of repurchases increased overall payout and increased firms'financial flexibility
Abstract This paper surveys the literature on payout policy. We start with a description of the MillerModigliani payout irrelevance proposition, and then consider the effect of relaxing the assumptions on which it is based. We consider the role of taxes, asymmetric information, incomplete contracting possibilities, and transaction costs. The accumulated evidence indicates that changes in payout policies are not motivated by firms’ desire to signal their true worth to the market. Both dividends and repurchases seem to be paid to reduce potential overinvestment by management. We also review the issue of the form of payout and the increased tendency to use open market share repurchases. Evidence suggests that the rise in the popularity of repurchases increased overall payout and increased firms’ financial flexibility
1.Introduction How much cash should firms give back to their shareholders?And what form should payment take?Should corporations pay their shareholders through dividends or by repurchasing their shares,which is the least costly form of payout from a tax perspective?Firms must make these important decisions over and over again (some must be repeated and some need to be reevaluated each period),on a regular basis. Because these decisions are dynamic they are labeled as payout policy.The word "policy"implies some consistency over time,and that payouts,and dividends in particular,do not simply evolve in an arbitrary and random manner.Much of the literature in the past forty years has attempted to find and explain the pattern in payout policies of corporations. The money involved in these payout decisions is substantial.For example,in 1999 corporations spent more than $350b on dividends and repurchases and over $400b on liquidating dividends in the form of cash spent on mergers and acquisitions. Payout policy is important not only because of the amount of money involved and the repeated nature of the decision,but also because payout policy is closely related to,and interacts with,most of the financial and investment decisions firms make.Management and the board of directors must decide the level of dividends,what repurchases to make (and the mirror image decision of equity issuance),the amount of financial slack the firm carries(which may be a non- trivial amount;for example,at the end of 1999,Microsoft held over $17b in financial slack), investment in real assets,mergers and acquisitions,and debt issuance.Since capital markets are neither perfect nor complete,all of these decisions interact with one another. Understanding payout policy may also help us to better understand the other pieces in this I Data on dividend and repurchases are from CRSP and Compustat.Data on cash M&A activity (for U.S.firms as acquirers only)is from SDC. 3
1. Introduction How much cash should firms give back to their shareholders? And what form should payment take? Should corporations pay their shareholders through dividends or by repurchasing their shares, which is the least costly form of payout from a tax perspective? Firms must make these important decisions over and over again (some must be repeated and some need to be reevaluated each period), on a regular basis. Because these decisions are dynamic they are labeled as payout policy. The word “policy” implies some consistency over time, and that payouts, and dividends in particular, do not simply evolve in an arbitrary and random manner. Much of the literature in the past forty years has attempted to find and explain the pattern in payout policies of corporations. The money involved in these payout decisions is substantial. For example, in 1999 corporations spent more than $350b on dividends and repurchases and over $400b on liquidating dividends in the form of cash spent on mergers and acquisitions.1 Payout policy is important not only because of the amount of money involved and the repeated nature of the decision, but also because payout policy is closely related to, and interacts with, most of the financial and investment decisions firms make. Management and the board of directors must decide the level of dividends, what repurchases to make (and the mirror image decision of equity issuance), the amount of financial slack the firm carries (which may be a nontrivial amount; for example, at the end of 1999, Microsoft held over $17b in financial slack), investment in real assets, mergers and acquisitions, and debt issuance. Since capital markets are neither perfect nor complete, all of these decisions interact with one another. Understanding payout policy may also help us to better understand the other pieces in this 1 Data on dividend and repurchases are from CRSP and Compustat. Data on cash M&A activity (for U.S. firms as acquirers only) is from SDC. 3
puzzle.Theories of capital structure,mergers and acquisitions,asset pricing,and capital budgeting all rely on a view of how and why firms pay out cash. Six empirical observations play an important role in discussions of payout policies: 1. Large,established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. 2. Historically,dividends have been the predominant form of payout.Share repurchases were relatively unimportant until the mid-1980s,but since then have become an important form of payment. 3. Among firms traded on organized exchanges in the U.S.,the proportion of dividend-paying firms has been steadily declining.Since the beginning of the 1980s,most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends. 4. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. 5. Corporations smooth dividends relative to earnings.Repurchases are more volatile than dividends 6 The market reacts positively to announcements of repurchase and dividend increases,and negatively to announcements of dividend decreases. The challenge to financial economists has been to develop a payout policy framework where firms maximize shareholders'wealth and investors maximize utility.In such a framework payout policy would function in a way that is consistent with these observations and is not rejected by empirical tests
puzzle. Theories of capital structure, mergers and acquisitions, asset pricing, and capital budgeting all rely on a view of how and why firms pay out cash. Six empirical observations play an important role in discussions of payout policies: 1. Large, established corporations typically pay out a significant percentage of their earnings in the form of dividends and repurchases. 2. Historically, dividends have been the predominant form of payout. Share repurchases were relatively unimportant until the mid-1980s, but since then have become an important form of payment. 3. Among firms traded on organized exchanges in the U.S., the proportion of dividend-paying firms has been steadily declining. Since the beginning of the 1980s, most firms have initiated their cash payment to shareholders in the form of repurchases rather than dividends. 4. Individuals in high tax brackets receive large amounts in cash dividends and pay substantial amounts of taxes on these dividends. 5. Corporations smooth dividends relative to earnings. Repurchases are more volatile than dividends. 6. The market reacts positively to announcements of repurchase and dividend increases, and negatively to announcements of dividend decreases. The challenge to financial economists has been to develop a payout policy framework where firms maximize shareholders’ wealth and investors maximize utility. In such a framework payout policy would function in a way that is consistent with these observations and is not rejected by empirical tests. 4
The seminal contribution to research on dividend policy is that of Miller and Modigliani (1961).Prior to their paper,most economists believed hat 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 Vo of the firm at date 0,if the first dividends are paid one period from now at date 1,is given by the formula: Vo=D (1) 名(1+r) where D,=the dividends paid by the firm at the end of period t r=the investors'opportunity cost of capital for period t Gordon(1959)argued that investors'required rate of return rt would increase with retention 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 grow faster),Gordon felt that higher rt would overshadow this effect.The reason for the increase in r would be the greater uncertainty associated with the increased investment relative to the safety of the dividend. Miller and Modigliani(1961)pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy.They show that what really counts is the firm's investment policy.As long as investment policy doesn't change, altering the mix of retained earnings and payout will not affect firm's value.The Miller and Modigliani 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 of a firm's value is its investment policy. The payout literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the notion that both 5
The seminal contribution to research on dividend policy is that of Miller and Modigliani (1961). Prior to their paper, most economists believed hat 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: (1+ r ) D = t t t t=1 0 ∑ ∞ V (1) where Dt = the dividends paid by the firm at the end of period t rt = the investors' opportunity cost of capital for period t Gordon (1959) argued that investors’ required rate of return rt would increase with retention 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 grow 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 (1961) pointed out that this view of dividend policy incomplete and they developed a rigorous framework for analyzing payout policy. They show that what really counts is the firm’s investment policy. As long as investment policy doesn’t change, altering the mix of retained earnings and payout will not affect firm’s value. The Miller and Modigliani 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 of a firm’s value is its investment policy. The payout literature that followed the Miller and Modigliani article attempted to reconcile the indisputable logic of their dividend irrelevance theorem with the notion that both 5
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: (① Taxes 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. (i) Asymmetric Information If managers know more about the true worth of their firm,dividends can be used to convey that information to the market,despite the costs associated with paying those dividends.(However,we note that with asymmetric information,dividends can also be viewed as bad news.Firms that pay dividends are the ones that have no positive NPV projects in which to invest.) (iii) Incomplete Contracts If contracts are incomplete or are not fully enforceable, equityholders may,under some circumstances,use dividends to discipline managers or to expropriate wealth from debtholders. (iv) Institutional Constraints.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. (V) Transaction Costs.If dividend payments minimize transaction costs to equityholders (either direct transaction costs or the effort of self control),then positive dividend payout may be optimal
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: (i) Taxes 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. (ii) Asymmetric Information If managers know more about the true worth of their firm, dividends can be used to convey that information to the market, despite the costs associated with paying those dividends. (However, we note that with asymmetric information, dividends can also be viewed as bad news. Firms that pay dividends are the ones that have no positive NPV projects in which to invest.) (iii) Incomplete Contracts If contracts are incomplete or are not fully enforceable, equityholders may, under some circumstances, use dividends to discipline managers or to expropriate wealth from debtholders. (iv) Institutional Constraints. If various institutions avoid investing in non- or lowdividend-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. (v) Transaction Costs. If dividend payments minimize transaction costs to equityholders (either direct transaction costs or the effort of self control), then positive dividend payout may be optimal. 6
In section 2 we elaborate further on some of the empirical observations about corporate payout policies.Section 3 reviews the Miller and Modigliani analysis.Subsequent sections recount the literature that has relaxed their assumptions in various ways. 2.Some Empirical Observations on Payout Policies In the previous section we state six important empirical findings about corporate payout policies. Table 1 and Figure 1 illustrate the first observation that corporations pay out a substantial portion of their earnings.Table 1 shows that for U.S.industrial firms,dollar expenditures on both dividends and repurchases have increased over the years. The table also illustrates the second empirical observation above.It shows that dividends have been the dominant form of payout in the early period,but that repurchases have become more and more important through the years.For example,during the 1970s the average dividend payout was 38%and the average repurchase payout was 3%.By the 1990s the average dividend payout was 58%and the average repurchase payout was 27%.From these numbers it appears U.S.corporations paid out over 80%of their earnings to shareholders.2 Clearly,payments to shareholders through dividends and repurchases represent a significant portion of corporate earnings.However,we note that these numbers are tilted towards large firms since we calculate payout as:(>Div/Earnings).In addition,aggregate earnings (i.e.,the denominator)contain many negative earnings.This is especially true in the later period,when more and more small, not yet profitable,firms registered on Nasdaq.When we calculate payout for each firm and then average across firms (equal weighted)the overall payout relative to earnings is around 25%. (Grullon and Michaely,2002,Figure 1). 2 See also Dunsby (1993)and Allen and Michaely (1995). 7
In section 2 we elaborate further on some of the empirical observations about corporate payout policies. Section 3 reviews the Miller and Modigliani analysis. Subsequent sections recount the literature that has relaxed their assumptions in various ways. 2. Some Empirical Observations on Payout Policies In the previous section we state six important empirical findings about corporate payout policies. Table 1 and Figure 1 illustrate the first observation that corporations pay out a substantial portion of their earnings. Table 1 shows that for U.S. industrial firms, dollar expenditures on both dividends and repurchases have increased over the years. The table also illustrates the second empirical observation above. It shows that dividends have been the dominant form of payout in the early period, but that repurchases have become more and more important through the years. For example, during the 1970s the average dividend payout was 38% and the average repurchase payout was 3%. By the 1990s the average dividend payout was 58% and the average repurchase payout was 27%. From these numbers it appears U.S. corporations paid out over 80% of their earnings to shareholders.2 Clearly, payments to shareholders through dividends and repurchases represent a significant portion of corporate earnings. However, we note that these numbers are tilted towards large firms since we calculate payout as: (ΣDiv/ΣEarnings). In addition, aggregate earnings (i.e., the denominator) contain many negative earnings. This is especially true in the later period, when more and more small, not yet profitable, firms registered on Nasdaq. When we calculate payout for each firm and then average across firms (equal weighted) the overall payout relative to earnings is around 25%. (Grullon and Michaely, 2002, Figure 1). 2 See also Dunsby (1993) and Allen and Michaely (1995). 7
To further illustrate the second observation,Figure 1 shows the evolution of dividend yield (total dividends over market value of equity),repurchase yield (repurchases over market value of equity)and payout yield(dividends plus repurchases over market value of equity)since the early 1970s.Whether we examine repurchases relative to earnings or to the market value of the firm,it is clear that repurchases as a payout method were not a factor until the mid-1980s.It is interesting that in the 1990s,firms'average total yield remained more or less constant while the dividend yield declined and the repurchase yield increased. The third observation is that dividends are now being paid by fewer firms.As we can see in Figure 2,Fama and French (2001)show that the proportion of firms that pay dividends (among all CRSP listed firms)has fallen dramatically over the years,regardless of their earnings level.Prior to the 1980's firms that initiated a cash payment usually did so with dividends.But since the beginning of the 1980s,most firms have initiated cash payments with repurchases. Figure 3 documents this observation for U.S.industrial firms.We define a cash distribution initiation as the first time after 1972 that a firm pays dividends and/or repurchases shares.Figure 3 shows that the proportion of firms that initiated a cash distribution by using only share repurchases increased from less than 27%in 1974 to more than 81%in 1998.Share repurchase programs have now become the preferred method of payout among firms initiating cash distributions to their equityholders.(For earlier evidence on trend in repurchases see Bagwell and Shoven,1989) The fourth observation is that individuals pay substantial taxes on the large amounts of dividends that they receive.We collected information from the Federal Reserve's Flow of Funds Accounts for the United States,and from the IRS,SOI Bulletin about total dividends paid and the amounts received by individuals and corporations for the years 1973-1996.Table 2 presents 8
To further illustrate the second observation, Figure 1 shows the evolution of dividend yield (total dividends over market value of equity), repurchase yield (repurchases over market value of equity) and payout yield (dividends plus repurchases over market value of equity) since the early 1970s. Whether we examine repurchases relative to earnings or to the market value of the firm, it is clear that repurchases as a payout method were not a factor until the mid-1980s. It is interesting that in the 1990s, firms’ average total yield remained more or less constant while the dividend yield declined and the repurchase yield increased. The third observation is that dividends are now being paid by fewer firms. As we can see in Figure 2, Fama and French (2001) show that the proportion of firms that pay dividends (among all CRSP listed firms) has fallen dramatically over the years, regardless of their earnings level. Prior to the 1980’s firms that initiated a cash payment usually did so with dividends. But since the beginning of the 1980s, most firms have initiated cash payments with repurchases. Figure 3 documents this observation for U.S. industrial firms. We define a cash distribution initiation as the first time after 1972 that a firm pays dividends and/or repurchases shares. Figure 3 shows that the proportion of firms that initiated a cash distribution by using only share repurchases increased from less than 27% in 1974 to more than 81% in 1998. Share repurchase programs have now become the preferred method of payout among firms initiating cash distributions to their equityholders. (For earlier evidence on trend in repurchases see Bagwell and Shoven, 1989) The fourth observation is that individuals pay substantial taxes on the large amounts of dividends that they receive. We collected information from the Federal Reserve’s Flow of Funds Accounts for the United States, and from the IRS, SOI Bulletin about total dividends paid and the amounts received by individuals and corporations for the years 1973-1996. Table 2 presents 8
the results.In most of the years in our sample (1973-1996)individuals received more than 50% of the dividends paid out by corporations.Moreover,most of these dividends were received by individuals in high tax brackets (those with annual gross income over $50,000). Peterson,Peterson,and Ang (1985)conducted a study of the tax returns of individuals in 1979.More than $33b of dividends were included in individuals'gross income that year.The total of dividends paid out by corporations in 1979 was $57.7b,so individuals received over two- thirds of that total.The average marginal tax rate on these dividends received by individuals (weighted by dividends received)was 40%. The fact that individuals pay considerable taxes on dividends has been particularly important in the dividend debate,because there appears to be a substantial tax disadvantage to dividends compared to repurchases.Dividends are taxed as ordinary income.Share repurchases are taxed on a capital gains basis.Since the tax rate on capital gains has usually been lower than the tax rate on ordinary income,investors had an advantage if firms repurchased,rather than paid dividends.Even after the 1986 Tax Reform Act(TRA)when the tax rates on ordinary income and capital gains were equal for several years,there was a tax disadvantage to dividends because capital gains were only taxed on realization.In the 2001 tax code,long-term capital gains are lower than ordinary income for most individual investors.For example,an investor in the highest marginal tax bracket pays 39.6%taxes on dividends and only 20%tax on long-term capital gains.Black (1976)calls the fact that corporations pay such large amounts of dividends despite the existence of another,relatively untaxed,payout method,the "dividend puzzle." The fifth observation is that corporations smooth dividends.From Table 1,we can see that during the entire 1972-1998 period,aggregate dividends fell only twice (in 1992 and in 1998),and then only by very small amounts.On the other hand,aggregate earnings fell five 9
the results. In most of the years in our sample (1973-1996) individuals received more than 50% of the dividends paid out by corporations. Moreover, most of these dividends were received by individuals in high tax brackets (those with annual gross income over $50,000). Peterson, Peterson, and Ang (1985) conducted a study of the tax returns of individuals in 1979. More than $33b of dividends were included in individuals’ gross income that year. The total of dividends paid out by corporations in 1979 was $57.7b, so individuals received over twothirds of that total. The average marginal tax rate on these dividends received by individuals (weighted by dividends received) was 40%. The fact that individuals pay considerable taxes on dividends has been particularly important in the dividend debate, because there appears to be a substantial tax disadvantage to dividends compared to repurchases. Dividends are taxed as ordinary income. Share repurchases are taxed on a capital gains basis. Since the tax rate on capital gains has usually been lower than the tax rate on ordinary income, investors had an advantage if firms repurchased, rather than paid dividends. Even after the 1986 Tax Reform Act (TRA) when the tax rates on ordinary income and capital gains were equal for several years, there was a tax disadvantage to dividends because capital gains were only taxed on realization. In the 2001 tax code, long-term capital gains are lower than ordinary income for most individual investors. For example, an investor in the highest marginal tax bracket pays 39.6% taxes on dividends and only 20% tax on long-term capital gains. Black (1976) calls the fact that corporations pay such large amounts of dividends despite the existence of another, relatively untaxed, payout method, the "dividend puzzle." The fifth observation is that corporations smooth dividends. From Table 1, we can see that during the entire 1972-1998 period, aggregate dividends fell only twice (in 1992 and in 1998), and then only by very small amounts. On the other hand, aggregate earnings fell five 9
times during the same time period and the drop was larger.Unlike dividends,repurchases are more volatile and more sensitive to economic conditions.During the recession in the early 1970s,firms cut repurchases.They did this again during the recession of the early 1990s. Overall,between 1972 and-1998,aggregate repurchases fell seven times. Firms usually increase dividends gradually and rarely cut them.Table 3 shows the number of dividend increases and decreases for over 13,000 publicly held issues,for the years 1971 to 2001 (Moody's dividend records,1999 and S&P's dividend book,2001).In each year, the number of dividend cuts is much smaller than the number of dividend increases.For example,in 1999,there were 1,763 dividend increases or initiations,but only 121 cuts or omissions. In a classic study,Lintner (1956)showed that dividend-smoothing behavior was widespread.He started with over 600 listed companies and selected 28 to survey and interview. Linter did not select these companies as a statistically representative sample,but chose them to encompass a wide range of different situations. Lintner made a number of important observations concerning the dividend policies of these firms.The first is that firms are primarily concerned with the stability of dividends.Firms do not set dividends de novo each quarter.Instead,they first consider whether they need to make any changes from the existing rate.Only when they have decided a change is necessary do they consider how large it should be.Managers appear to believe strongly that the market puts a premium on firms with a stable dividend policy. Second,Lintner observed that earnings were the most important determinant of any change in dividends.Management needed to explain to shareholders the reasons for its actions, and needed to base its explanations on simple and observable indicators.The level of earnings 10
times during the same time period and the drop was larger. Unlike dividends, repurchases are more volatile and more sensitive to economic conditions. During the recession in the early 1970s, firms cut repurchases. They did this again during the recession of the early 1990s. Overall, between 1972 and –1998, aggregate repurchases fell seven times. Firms usually increase dividends gradually and rarely cut them. Table 3 shows the number of dividend increases and decreases for over 13,000 publicly held issues, for the years 1971 to 2001 (Moody’s dividend records, 1999 and S&P’s dividend book, 2001). In each year, the number of dividend cuts is much smaller than the number of dividend increases. For example, in 1999, there were 1,763 dividend increases or initiations, but only 121 cuts or omissions. In a classic study, Lintner (1956) showed that dividend-smoothing behavior was widespread. He started with over 600 listed companies and selected 28 to survey and interview. Linter did not select these companies as a statistically representative sample, but chose them to encompass a wide range of different situations. Lintner made a number of important observations concerning the dividend policies of these firms. The first is that firms are primarily concerned with the stability of dividends. Firms do not set dividends de novo each quarter. Instead, they first consider whether they need to make any changes from the existing rate. Only when they have decided a change is necessary do they consider how large it should be. Managers appear to believe strongly that the market puts a premium on firms with a stable dividend policy. Second, Lintner observed that earnings were the most important determinant of any change in dividends. Management needed to explain to shareholders the reasons for its actions, and needed to base its explanations on simple and observable indicators. The level of earnings 10
