Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

18. Dividends and Dividend
    Policy

© The McGraw−Hill^643

Companies, 2002

zero tax brackets. This group includes some of the largest investors in the economy,

such as pension funds, endowment funds, and trust funds.

There are some legal reasons for large institutions to favor high-dividend yields.

First, institutions such as pension funds and trust funds are often set up to manage

money for the benefit of others. The managers of such institutions have a fiduciary re-

sponsibilityto invest the money prudently. It has been considered imprudent in courts of

law to buy stock in companies with no established dividend record.

Second, institutions such as university endowment funds and trust funds are fre-

quently prohibited from spending any of the principal. Such institutions might therefore

prefer to hold high-dividend yield stocks so they have some ability to spend. Like wid-

ows and orphans, this group thus prefers current income. However, unlike widows and

orphans, this group is very large in terms of the amount of stock owned.

Conclusion

Overall, individual investors (for whatever reason) may have a desire for current income

and may thus be willing to pay the dividend tax. In addition, some very large investors

such as corporations and tax-free institutions may have a very strong preference for

high-dividend payouts.

A RESOLUTION OF REAL-WORLD FACTORS?

In the previous sections, we presented some factors that favor a low-dividend policy and

others that favor a high-dividend policy. In this section, we discuss two important con-

cepts related to dividends and dividend policy: the information content of dividends and

the clientele effect. The first topic illustrates both the importance of dividends in general

and the importance of distinguishing between dividends and dividend policy. The sec-

ond topic suggests that, despite the many real-world considerations we have discussed,

the dividend payout ratio may not be as important as we originally imagined.

Information Content of Dividends

To begin, we quickly review some of our earlier discussion. Previously, we examined

three different positions on dividends:

1. Based on the homemade dividend argument, dividend policy is irrelevant.


2. Because of tax effects for individual investors and new issues costs, a low-dividend
   policy is best.


3. Because of the desire for current income and related factors, a high-dividend policy
   is best.
   If you wanted to decide which of these positions is the right one, an obvious way to get
   started would be to look at what happens to stock prices when companies announce divi-
   dend changes. You would find with some consistency that stock prices rise when the cur-

CONCEPT QUESTIONS

18.4a Why might some individual investors favor a high-dividend payout?

18.4bWhy might some nonindividual investors prefer a high-dividend payout?

616 PART SIX Cost of Capital and Long-Term Financial Policy

18.5