Chapter 25 Dividend policy

This chapter discusses the dividend policy that is crucial for areas of financial economics. Five empirical observations have played an important role in discussions of dividend policy: (1) corporations typically pay out a significant percentage of their earnings as dividends. (2) Historically, dividends have been the predominant form of payout; share repurchases were relatively unimportant until the mid 1980s. (3) Individuals in high tax brackets receive large amounts in dividends and pay substantial amounts of taxes on these dividends. (4) Corporations smooth dividends. (5) The market reacts positively to announcements of dividend increases and negatively to announcements of dividend decreases. Miller and Modigliani have showed that with perfect and complete capital markets, a firm's dividend policy will not affect its value. The basic premise of their argument is that firm value is determined by choosing optimal investments. The net payout is the difference between earnings and investment, and is simply a residual. The chapter focuses on the importance of taxes, and on the reconciliation of the first three empirical observations. The basic aim of the tax-related literature on dividends has been to investigate whether the firms that pay out high dividends are less valuable than firms that pay out low dividends.