Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

part because they know they’ll be reluctant to reduce them in the future. In one of the earliest research

studies on dividends, John Lintner^4 documented several patterns with respect to companies’ dividend

policies, patterns that are roughly consistent with this conservative view of dividends. In particular:

1 Companies have long-run target dividend payout ratios.

2 Dividend changes follow shifts in long-run, sustainable earnings (not short-run changes in earnings).

3 Managers are reluctant to increase dividends if they might have to be cut later.

4 Managers focus on dividend changes rather than on dividend levels.

Lintner developed a simple model that captured these patterns and estimated companies’ target payout

ratios as well as the speed with which companies adjusted to those ratios. A slower adjustment speed

simply means that companies smooth dividends more as earnings change. You might guess – because

companies are placing more importance in recent years on share repurchases, and because managers

view them as a more flexible tool than dividends for paying cash to shareholders – that companies’ target

dividend payouts are now lower (and that adjustments to the target now occur more slowly) than when

Lintner published his findings. Indeed, more recent research by Leary and Michaely^5 finds that, for the

period 1950–83, companies that paid dividends had a target of distributing a little more than one-third

of their earnings as dividends; moreover, when their dividend payouts deviated from the desired target,

companies made adjustments to close about one-third of that gap each year. But from 1984–2002, the

target payout ratio appears to have fallen to just 20% of earnings, and likewise the speed of adjustment to

that target is much slower. In other words, dividend smoothing increased in recent years.

4 See John Lintner, ‘The Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes’, American Economic Review

46 (May 1956), pp. 97–113.

5 See Mark T Leary and Roni Michaely, ‘Why Firms Smooth Dividends: Empirical Evidence’, working paper (17 February 2009), Johnson

Graduate School of Management, Cornell University, Ithaca, NY.

FIGURE 15.4 CFOS’ VIEWS ON WHY COMPANIES REPURCHASE SHARES

0% 10% 20% 30%

% of CFOs identifying factor as important

or very important

40% 50% 60% 70% 80% 90%

Common stock

float adequate

Demand by

institutional investors

Extra cash on

balance sheet

Offset stock

option dilution

Try to increase EPS

Better than

other investments

Stock price low

Source: Reprinted from Brav, Graham, Harvey and Michaely, ‘Payout Policy in the 21st Century,’ Journal of Financial Economics, 77,

pp. 483–527, Copyright © 2005, with permission from Elsevier.