Other Dividend Policy Issues

Before we discuss how dividend policy is set in practice, we must examine two other theoretical issues that could affect our views toward dividend policy: (1) the information content or signaling hypothesis and (2) the clientele effect.

Information Content, or Signaling, Hypothesis

When MM set forth their dividend irrelevance theory, they assumed that every-one investors and managers alike has identical information regarding the firm’s future earnings and dividend. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments and managers have better information about future prospects than public stockholders.

It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock while a dividend cut generally leads to a stock price decline. This could indicate that investors, in the aggregate, prefer dividends to capital gains. However, MM argued differently. They noted the well-established fact that corporations are reluctant to cut dividends, hence do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher-than-expected dividend increase is a “signal” to investors that the firm’s management forecasts good future earnings.⁴ Conversely a dividend reduction or a smaller-than-expected increase, is a signal that management is forecasting poor earnings in the future. Thus MM argued that investor’s reactions to changes in dividend policy do not necessarily show that investors prefer dividends to retained earnings. Rather, they argue that price changes following dividend actions simply indicate that there is an important information or signaling content in dividend announcements.

Like mot other aspects of dividend policy, empirical studies of signaling have had mixed result. There is clearly some information content in dividend announcements. However, it is difficult to tell whether the stock price changes that follow increase or decreases in dividends reflect only signaling effects or both signaling and dividend preference. Still signaling effects should definitely be considered when a firm is contemplating a change in dividend policy.

Clientele Effect

As we indicated earlier, different groups, or clienteles of stockholders prefer different dividend payout policies. For example retired individuals and university endowment funds generally prefer cash income so they may want the firm to pay out a high percentage of its earnings. Such investors (and pension funds) are often in low or even zero tax brackets so taxes are of no concern. On the other hand, stockholders in their peak earning years might prefer reinvestment, because they have less need for current investment income and would simply reinvest dividends received, after first paying income taxes on those dividends.

If a firm retains and reinvests income rather than paying dividends those stockholders who need current income would be disadvantaged. The value of their stock might increase but they would be forced to go to the trouble and expense of selling off some of their shares to obtain cash. Also some institutional investors (or trustees for individuals) would be legally precluded from selling stock and then “spending capital”. On the other hand, stockholders who are saving rather then spending dividends might favor the low dividend policy for the less the firm pays out in dividends the less these stockholders will have to pay in current taxes, and the less trouble and expense they will have to go through to reinvest their after-tax dividends. Therefore, investors who want current investment income should own shares in high dividend payout firms, while investors with no need for current investment income should own shares in low dividend payout firms. For example investors seeking high cash income might invest in electric utilities, which averaged a 79 percent payout from 1991 through 1995, while those favoring growth could invest in the semiconductor industry, which paid out only 7 percent.

To the extent that stockholders can switch firms, a firm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However, frequent switching would be inefficient because of (1) brokerage costs, (2) the likelihood that stockholders who are selling will have to pay capital gains taxes, and (3) a possible shortage of investors who like the firms newly adopted dividend policy. Thus, management should be hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary, but it might also be permanent if few new investors are attracted by the new dividend policy, then the stock price would remain depressed. Of course, the new policy might attract an even larger clientele than the firm had before in which case the stock price would rise.

Evidence from several studies suggests that there is an fact a clientele effect.⁵ MM and others have argued that one clientele is as good as another, so the existence of a clientele effect does not necessarily imply that one dividend policy is better than any other. MM may be wrong, though and neither they nor anyone else can prove that the aggregate makeup of investors permits firms to disregard clientele effects. This issue, like most others in the dividend arena, is still up in the air.