In a recent edition of their celebrated textbook Principles of Corporate Finance , Richard Brealey and Stewart Myers offer the following conclusion:
In a recent edition of their celebrated textbook Principles of Corporate Finance , Richard Brealey and Stewart Myers offer the following conclusion:
We spent [considerable attention] on dividend policy without being able to resolve the dividend controversy. Many people believe dividends are good, others believe they are bad, and still others believe they are irrelevant. If pressed, we stand somewhere in the middle, but we can’t be dogmatic about it.
Indeed, there are few topics in financial economic research where theory meets practice so unsuccessfully as where efforts are made to explain how and why firms pay dividends to their stockholders. From the pioneering irrelevance propositions of Franco Modigliani and Merton Miller to the more recent work of Frank Easterbrook suggesting that dividends are paid in order to reduce agency costs, much has been written on the topic without producing anything close to a definitive conclusion. Perhaps Fisher Black, in his article “The Dividend Puzzle,” said it best: “What should corporations do about dividend policy? We don’t know.”
The essence of the dividend puzzle appears to be that there is no clear-cut formula that advises a corporation how to set its payout policy. Although certain stockholders might choose to receive most or all of the expected compensation from their investments packaged in the form of periodic cash payments, many others would prefer to have the company reinvest those funds if it can do so more profitably than the investors’ next best alternative. Further complicating this decision are such factors as the potentially unpredictable nature of the firm’s future capital needs and shifts in the personal and corporate tax rates borne by the shareholders. To say the least, we have a very incomplete picture of the intellectual underpinnings of this basic—and seemingly innocuous—corporate decision. The good news is that every additional piece of theoretical or empirical evidence pushes us a little closer to solving the puzzle.
In this monograph, Professors James Wansley, William Lane, and Phillip Daves provide us with just such a gentle shove. In particular, rather than tackling the entire dividend payout issue, they focus on the consequences of a company’s decision to initiate dividend payments. Their empirical evidence supports two possible reasons for this phenomenon: (1) Some companies begin paying dividends only if they think they can sustain them in the future, which implies that investors might be able to infer something positive about a company’s earnings prospects from the initiation. (2) Some companies initiate dividends because of a general decline in investment opportunities; this category would include those maturing firms returning excess free cash flow to their stockholders rather than misallocating it to substandard projects.
Although neither of these findings can be considered path breaking, they are consistent with what we know from the existing literature about all dividend programs. For instance, agency theory holds that by reducing free cash flow through dividend payments, managers increase the possibility that they will have to raise additional investment capital in public markets, which would force a periodic external monitoring of their activities. On the other hand, signaling theory holds that managers privy to “inside” knowledge about the firm’s earnings prospects can bridge the information gap with investors by committing to a stream of payments that, as tradition and previous research tell us, will be costly to reduce in the future. Thus, the authors’ initial findings provide corroboration for what we already know about why firms pay dividends.
Given this prior evidence, the more interesting question addressed in the monograph is: What can investors do with this new information about dividend initiations? It is in pursuing an answer to this question that the authors’ most important contributions emerge. Specifically, Wansley, Lane, and Daves chronicle how the market reacts when a company begins to pay dividends and how astute investors might profit from interfirm differences in these reactions. Their findings about this latter point are encouraging, although they must be interpreted with a fair degree of caution. The trick, it seems, is being able to identify which non-dividend-paying companies are likely to begin payments in the near future. The authors’ data offer considerable guidance in initiation identification (e.g., concentrate on firms with decreasing growth rates and investment opportunities), the process is hardly an exact science.
This research has several appealing qualities. Chief among them is that it is written with the manager in mind, a point evident in the patience with which the authors summarize the existing academic literature in order to establish a context for their findings. In addition, the authors help us understand nuances in the role that dividend initiations play within larger dividend policy. Finally, Wansley, Lane, and Daves also provide a strong link between investment research and practice and, in the process, give investors some hope that markets are not completely efficient—if the proper analysis can be produced. For all of these reasons, the Research Foundation is pleased to have supported this work, and we recommend it to your attention.