15: Payout Policy15- 4c THE RESIDUAL THEORY OF DIVIDENDS
The previous discussion suggests another possible explanation of observed dividend payments. Might
dividends simply be a residual, the cash left over after companies have funded all their positive-NPV
projects? If that’s the case, it would help explain why companies in rapidly growing industries retain
almost all their profits, whereas companies in mature, slow-growing industries tend to have very high
dividend payouts. It would also explain the ‘life-cycle’ pattern of dividend payments for individual
companies, where young, fast-growing companies rarely pay any dividends. But those same companies
typically transition to a high-payout strategy as they mature and their growth rate slows.
This residual theory of dividends probably has some merit, but it suffers from one problem. Actual
dividend payments are not as variable as they would be if companies treated them strictly as residual
cash flows. In fact, over time, dividend payments exhibit very stable patterns of cash flow. As noted
earlier, evidence suggests that company managers smooth dividends, and that they are very cautious
about changing established dividend payout levels. Clearly, the residual theory does not fully explain how
companies make their dividend policy decisions.
15- 4d PAYING DIVIDENDS AS A MEANS OF COMMUNICATING
INFORMATION
Sooner or later, most people who study the dividend puzzle recognise that companies may pay dividends
to convey information to investors. Managers, who have a better understanding of the company’s true
financial condition than do shareholders, can convey this information to shareholders through the
dividend policy they select. Dividend payments have what accountants call ‘cash validity’, meaning that
dividend payments are believable and are hard for weaker companies to duplicate. Phrased in economic
terms, in a world characterised by asymmetric information between managers and investors, cash
dividend payments serve as credible information sent from corporate insiders (officers and directors)
to the company’s shareholders. Viewed in this way, every aspect of a company’s dividend policy conveys
significant new information.
15- 4e WHAT TYPE OF INFORMATION IS BEING COMMUNICATED?
When a company begins paying dividends (a dividend initiation), it is conveying management’s
confidence that the company is now profitable enough to both fund its investment projects and pay
out cash. Investors and managers know that reducing or eliminating dividend payments after they have
begun results in negative market reaction. Therefore, dividend initiations send a strong signal to the
market about management’s assessment of the company’s long-term ability to generate cash.
The same logic applies to dividend increases. Because everyone understands that dividend decreases
should be avoided, management’s willingness to increase dividend payments clearly implies confidence
that its profits will remain high enough to support the new payment level. Dividend increases suggest a
permanent increase in a company’s normal level of profitability. In other words, dividends change only
when the level of permanent earnings changes. Unfortunately, this logic applies even more strongly to
dividend decreases. Dividend cuts are viewed as very bad news. Managers reduce dividend payments
only when they have no choice, such as when there is a cash flow crisis or when the financial health of
the company is declining and no turnaround is in sight. Therefore, it is no surprise that when managers
decrease dividends, the market reaction is often severe.
residual theory of
dividends
Observed dividend payments
are simply a residual, the cash
left over after companies have
funded all their positive-NPV
investmentsFrank Popoff, Chairman of
the Board (retired), Dow
Chemical
‘The decision specific
to dividends is one that
boards wrestle with on a
regular basis.’
See the entire interview on
the CourseMate website.Source: Cengage LearningCOURSEMATE
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