Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

model, the signalling model predicts that share prices should rise in response to dividend increases (and

fall in response to dividend decreases). However, the signalling model also predicts that companies with

high-growth opportunities will pay higher dividends, contrary to the empirical evidence.

There is some evidence supporting the agency and signalling theories; however, the views of

corporate managers don’t line up too closely with these theories. Recall that the agency cost theory says

that dividends solve the agency problems that arise between shareholders and managers because of the

separation of ownership and control. In a 2005 survey of CFOs by Brav and colleagues,^6 fewer than 15%

of the CFOs responding agreed that these agency-related issues influence dividend policy. Of course, the

crux of agency theory is that managers do not always behave in shareholders’ best interests, so it may not

be surprising that CFOs do not acknowledge the importance of the agency theory in surveys. Our view is

that signalling probably does play a role in explaining some payout decisions (such as, perhaps, Starbucks’

first-ever dividend in 2010), but is less relevant in many cases, so, averaged across all companies, the

survey support for signalling is modest.

15-4 REAL-WORLD INFLUENCES ON

PAYOUT POLICY

Few of us have ever traded in perfect and frictionless capital markets, so our next task is to examine

whether dividend policy continues to be irrelevant when we account for real-world factors such as taxes,

trading costs and information differences between managers and investors. Our final goal for this section

6 See Alon Brav, John R. Graham, Campbell R. Harvey and Roni Michaely, ‘Payout Policy in the 21st Century’, Journal of Financial Economics 77,

pp. 483–527.

LO 15.5

7 Imagine a company that has an intermediate dividend policy compared to Payout and Retention.

This company pays out half its earnings to shareholders and finances new investment partially

through new share issues and partially through retained profits. Describe how dissatisfied

shareholders in this company could unwind the dividend policy if they preferred either higher or

lower dividends.

8 Managers of slow-growing but profitable companies (such as tobacco companies) may pay out

earnings as dividends. What can they choose to do instead?

9 How do Miller and Modigliani arrive at their conclusion that dividend policy is irrelevant in a world

of perfect and frictionless capital markets?

10 What effect would it have on a company’s decision with regard to paying out cash to its

shareholders if for the recipient, dividends were taxed at higher rates than gains made on share

sales?

11 Why are both the agency model and the signalling model consistent with the observation that

share prices fall for companies that decrease dividends?

CONCEPT REVIEW QUESTIONS 15-3