Dividends Versus Capital Gains : What Do Investors Prefer?

When deciding how much cash to distribute to stockholders, financial managers must keep in mind that the firm’s objective is to maximize shareholder value. Consequently, the target payout ratio-defined as the percentage of net income to be paid out as cash dividends –should be based in large part on investors, preferences for dividends versus capital gains: do investors prefer (1) to have the firm distribute income as cash dividends or (2) to have it either repurchase stock or else plow the earnings back into the business, both of which should result in capital gains? This preference can be considered in terms of the constant growth stock valuation model:

D₁

P₀ = -------------

    K_s - g

If the company increases the payout ratio, it raises D₁. This increase in the numerator, taken alone, would cause the stock price to rise. However, if D₁ is raised, then less money will be available for reinvestment, that will cause the expected growth rate to decline, and that would tend to lower the stock’s price. Thus any change in payout policy will have two opposing effects. Therefore, the firm’s optimal dividend policy must strike a balance between current dividends and future growth so as to maximize the stock price.

In this section we examine three theories of investor preference: (1) the dividend irrelevance theory, (2) the “bird-in-the-hand” theory and (3) the tax preference theory.

Dividend Irrelevance Theory

It has been argued that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. If dividend policy has no significant effects, then it would be irrelevant. The principal proponents of the dividend irrelevance theory are Merton Miller and Franco Modigliani (MM)¹. They argued that the firm’s value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the firm depends only on the income produced by its assets not on how this income is split between dividends and retained earnings.

To understand MM’s argument that dividend policy is irrelevant, recognize that any shareholder can construct his or her own dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a 5 percent dividend can “create” it by selling 5 percent of his or her stock. Conversely, if a company pays a higher dividend than an investor desires, the investor can use the unwanted dividends to buy additional shares of the company’s stock. If investors could buy and sell shares and thus create their own dividend policy without incurring costs, then the firm’s dividend policy would truly be irrelevant. Note, though that investors who want additional dividends must incur brokerage costs to sell shares, and investors who do not want dividends must first pay taxes on the unwanted dividends and then incur brokerage costs to purchase shares with the after-tax dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be relevant.

In developing their dividend theory. MM made a number of assumptions, especially the absence of taxes and brokerage costs. Obviously, taxes and brokerage costs do exist, so the MM irrelevance theory may not be true. However, MM argued (correctly) that all economic theories are based on simplifying assumptions, and that the validity of a theory must be judged by empirical tests, not by the realism of its assumptions. We will discuss empirical tests of MM’s dividend irrelevance theory shortly.

Bird-in-the-Hand Theory

The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not affect the required rate of return on equity K_s. This conclusion has been hotly debated in academic circles. In particular, Myron Gordon and John Lintner argued that K_s decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which are supposed to result from retaining earnings than they are of receiving dividend payments.² Gordon and Lintner said, in effect that investors value a dollar of expected dividends more highly than a dollar of expected capital gains because the dividend yield component, D₁/P₀, is less risky than the g component in the total expected return equation, K_s=D₁/P₀ + g.

MM disagreed. They argued that K_s is independent of dividend policy, which implies that investors are indifferent between D₁/P₀ and g and, hence, between dividends and capital gains. MM called the Gordon-Lintner argument the bird-in-the-hand fallacy because, in MM’s view, most investors plan to reinvest their dividends in the stock of the same or similar firms, and in any event the riskiness of the firm’s cash flows to investors in the long run is determined by the riskiness of operating cash flows not by dividend payout policy.

Tax Preference Theory

There are three tax-related reasons for thinking that investors might prefer a low dividend payout to a high payout: (1) Long-term capital gains are taxed at a maximum rate of 28 percent, whereas dividend income is taxed at effective rates which go up to 39.6 percent. Therefore, wealthy investors (who own most of the stock and receive most of the dividends) might prefer to have companies retain and plow earnings back into the business. Earnings growth would presumably lead to stock price increases, and lower-taxed capital gains would be substituted fro higher-taxed dividends. (2) Taxes are not paid on the gain until a stock is sold. Due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. (3) If a stock is held by someone until he or she dies, no capital gains tax is due at all-the beneficiaries who receive the stock can use the stocks’ value on the death day as their cost basis and thus completely escape the capital gains tax.

Because of these tax advantages, investors may prefer to have companies retain most of their earnings. If so investors would be willing to pay more for low-payout companies than for otherwise similar high-payout companies.