15: Payout Policyis to determine whether a given company has an optimal (value-maximising) payout policy and, if so,
how that policy should be set. As we proceed, you may notice a puzzling fact. Almost all the real-world
issues we incorporate – such as taxes, transactions costs for issuing new securities and uncertainty about
a company’s investment opportunities – argue against the payment of cash dividends. Yet the majority of
established companies make dividend payments in most years.
15- 4a PERSONAL INCOME TAXES
When the personal tax rate on dividends is higher than the tax rate on capital gains, the result is clear
cut: companies wishing to distribute cash to shareholders should not pay cash dividends, but instead
should repurchase shares. This offers investors the choice of either receiving cash in a tax-favoured form
(as a capital gain) or forgoing the cash altogether by not selling shares, and thus seeing their share values
increase as their fractional ownership increases.
Why don’t we see more companies substituting share repurchase programs for cash dividend
payments? There are a few answers to this question. First, as we have seen, many Australian companies
have been repurchasing their shares during the past 10 years. Second, the companies that initiate share
repurchase programs are the same companies that also make large cash dividend payments. In some
countries, legislation can be a key factor. For example, in the US, the Internal Revenue Service (IRS) has
the power to rule that a given company’s share repurchase program is merely an attempt to avoid taxes.
The IRS can impose the higher personal income tax rates on all income received by investors. The actual
importance of this rule in deterring repurchases is questionable, however, because the IRS almost never
invokes it.
In Australia, the dividend imputation system reduces the impact of taxation of dividend income in
comparison to countries where this is not available. (Investors only pay, or receive, the net difference
between the franking credits and their personal income tax attributable to a dividend payment).
Furthermore, although there are various exemptions in place, the tax rate applied to capital gains in
Australia is simply the marginal income tax rate applicable to the investor at the time the capital gain is
crystallised. Thus, although there may be timing differences and a few exemptions in place, in Australia,
the tax rates applicable to cash dividends or share repurchases are the same.
On balance, incorporating personal taxes into our model does not help us understand why companies
pay dividends. However, tax effects may account for some of the patterns we observe, such as the rise in
share repurchase programs in Australia, the US and other industrialised countries.
15- 4b TRADING AND OTHER TRANSACTIONS COSTS
If personal taxes cannot explain observed dividend payments, what about transaction costs of issuing and
trading shares? Trading costs affect expected dividend payouts in two potentially offsetting ways. First, if
investors find it costly to sell just a few shares to generate cash – to create homemade dividends – then
they may be willing to pay a premium for shares that regularly pay dividends. Regular cash dividend
payments are a costless way to receive a cash return on an investor’s share portfolio. This cash could be
used either for consumption or for rebalancing the investor’s portfolio. In spite of this, a transaction cost
argument cannot easily explain why aggregate dividend payouts have remained fairly high, even as share
markets have become vastly more efficient and the costs of trading have declined dramatically.
The second effect of transaction costs on dividend payments is completely negative. This relates
to a company’s need to replace cash paid out as dividends with cash obtained through new share sales.