Dividend Policy

This chapter introduces dividend policy as both financial and business decisions. First, it presents the history of dividend payment, definition of dividend, and typical types of dividend. Dividends originate from liquidating payments of sailing vessels in the early 16th century and become popular with the development of corporations. In this book, a dividend is defined as a cash payment to shareholders. By payment time, there are three typical types of dividend including final dividend, interim dividend, and special dividend. Second, it presents definition, important dates, measures, and patterns of dividend policy. Dividend policy includes two decisions: the first is to pay or not to pay dividends, and the second is the dividend magnitude. Investors have to follow important dates of dividend payments in order to make their investment decisions. Important dates include declaration date, record date, ex-dividend date, and payment date. Dividend payout ratio and dividend yield are two common measures of dividend policy. Common patterns of dividend policy are no dividend policy, residual dividend policy, stable dividend policy, and irregular dividend policy. Finally, dividend policy is both financial and business-related decisions. Therefore, dividend decisions are affected by various levels of business environment such as internal, micro (industry), and macro-environment. Dividend theories are the behind mechanisms to explain the effect of each factor in the business environment on corporate dividend policy. Dividend policy, in turn, determines shareholders' wealth through its impact on stock price.

This chapter analyzes how firms conduct their dividend policy around the world. In principles, firms are free to pay or not to pay dividends and choose dividend levels. However, in some countries, the government requires firms to pay dividends annually in order to protect minority shareholders. Brazil, Chile, Colombia, Greece, and Venezuela are five countries of mandatory dividend payments. In addition, using the Compustat database, we investigate how nonfinancial firms pay dividends over the period 2001–2020. The percentage of payers tends to decrease across four time periods including 2001–2005, 2006–2010, 2011–2015, and 2016–2020. Newly listed firms are less likely to distribute dividends than old firms. “Payers,” “Always payers,” and “Former payers” have positive earnings while “Nonpayers” and “Never payers” experience negative earnings. “Never payers” have the highest level of cash while “Always payers” and “Former payers” have the smallest cash reserves. Moreover, Asia-Pacific has the largest proportion of payers but it tends to decrease. America has the lowest proportion of dividend payers, but it tends to increase. Firms in developing countries are more likely to pay dividends. Both the proportion of payers and the average payout ratio of civil law countries are much higher than those of common law countries. The United States has the lowest percentage of paying firms and dividend payouts. Furthermore, construction and wholesale trade industries have the highest proportions of payers and payout ratios. Mineral and services industries are less likely to pay dividends. Tax rates for dividends and capital gains are diverse across countries.

This chapter presents both main arguments of dividend policy theories and their empirical evidence. According to Miller and Modigliani (1961), dividend decisions are not relevant to firm value in a perfect capital market. Nevertheless, there are several market frictions in the real world (e.g., information asymmetry, agency problems, transaction costs, firm maturity, catering incentives and taxes). Therefore, academics use them to develop theories which help them explain corporate dividend decisions. Particularly, signaling theory considers dividend payments as a signal about firms' future prospects since outside investors face information disadvantage. “Bird-in-hand” theory argues that investors prefer dividends to capital gains since the former have lower risk than the latter. Agency theory is developed from the conflict of interest between corporate managers and shareholders. Corporate managers have high incentives to restrict dividend payments. Furthermore, transaction cost theory and pecking order theory posit that firms prefer internal to external funds. This drives firms to hold more cash and pay less dividends. Life cycle theory explains dividend policy by firm maturity. Mature firms have fewer investment opportunities, and thus, they tend to pay more dividends. Catering theory states that dividend decisions are based on investors' demand. Firms pay more dividends since investors prefer dividends and assign higher value to dividend payers. Tax clientele theory argues that firms that have corporate dividend policy rely on the comparative income tax rates for dividends and capital gains. Under the tax discriminations against dividends, firms tend to restrict their dividends in order to increase their stock prices.

This chapter analyzes how the internal environment determines corporate dividend decisions. First, dividend policy is influenced by strategic and financial issues. Corporate strategies are developed by top managers to achieve firms' missions, visions, and long-term goals while business strategies are designed by middle managers to maintain firms' competitive advantages. These strategies affect corporate dividend decisions through corporate performance and business operations. In addition, many financial characteristics are important determinants of dividend policy. Financial characteristics are classified into three groups, namely performance-related issues (e.g., firm profitability, free cash flow, and stock liquidity), leverage-related issues (e.g., debt ratio, asset tangibility, business risk, and firm size), and investment-related issues (e.g., investment opportunities and firm maturity). Firms with high profitability, free cash flow tends to pay more dividends. Stock liquidity may have a positive effect on dividend payments through lowering costs of equity; however, it may also have a negative effect through weakening the signaling motive. Moreover, firms with high debt ratio, low asset tangibility, high business risk, and small size face higher costs of external financing. Therefore, they have low incentives to pay dividends. When firms have more investment opportunities, they are more likely to restrict dividends and save cash for their investment projects and vice versa. Second, internal stakeholders may influence corporate dividend policy since their benefits are closely related to dividend decisions. Shareholders, directors, the chief executive officer, and employees have different characteristics, positions, and hold various proportions of shares. Therefore, they create pressures on dividend decisions to protect their wealth.

This chapter analyzes how the industry environment determines corporate dividend decisions. First, common participants in the product market are competitors, suppliers, and customers. These micro-stakeholders create competitive pressures on firms and thus affect their current and future performance. Competitors influence dividend decisions through three mechanisms, namely predation threat, corporate governance, and imitation. Predation threat reduces firms' incentives to pay dividends when facing high rivalry. Competition helps firms improve corporate governance. However, strong corporate governance may increase or decrease dividend payments since dividend policy may be the outcome of strong corporate governance or the substitute for weak corporate governance, respectively. Besides, firms tend to imitate their industry peers in dividend policy. Second, as a financial policy, dividend policy is also affected by participants in the financial market like investors, creditors, and auditors. These financial stakeholders' behaviors are important to stock prices. Due to the agency problem, creditors have high incentives to restrict firm's dividend payments in order to protect their benefits. On the other hand, creditors are effective external monitors who help firms improve their corporate governance. Outside investors affect corporate dividend policy through their valuation. Firms pay more dividends if investors prefer dividends to capital gains. Auditors play the role of a third-party monitor, and thus, they help firms reduce managers' expropriation of shareholders and improve the quality of accounting information. Furthermore, we also investigate dividend policy of regulated industries in both financial sector (banking, insurance, and real estate) and utilities sector (energy, telecommunications, and transportation).

This chapter analyzes how the macro-environment determines corporate dividend decisions. First, political factors including political uncertainty, economic policy uncertainty, political corruption, and democracy may have two opposite effects on dividend decisions. For example, firms learn democratic practices to improve their corporate governance, but dividend policy may be the outcome of strong corporate governance or the substitute for poor corporate governance. Second, firms in countries of high national income, low inflation, and highly developed stock markets tend to pay more dividends. A monetary restriction (expansion) reduces (increases) dividend payments, as economic shocks like financial crises and the COVID-19 may negatively affect corporate dividend policy through higher external financial constraint, economic uncertainty, and agency costs. On the other hand, they may positively influence corporate dividend policy through agency costs of debt, shareholders' bird-in-hand motive, substitution of weak corporate governance, and signaling motive. Third, social factors including national culture, religion, and language affect dividend decisions since they govern both managers' and shareholders' views and behaviors. Fourth, firms tend to reduce their dividends when they face stronger pressure to reduce pollution, produce environment-friendly products, or follow a green policy. Finally, firms have high levels of dividends when shareholders are strongly protected by laws. However, firms tend to pay more dividends in countries of weak creditor rights since dividend payments are a substitute for poor legal protection of creditors. Furthermore, corporate dividend policy changes when tax laws change the comparative tax rates on dividends and capital gains.

This chapter introduces dividend smoothing, presents theories to explain dividend smoothing behavior, and analyzes how different levels of business environment affect dividend smoothing. First, dividend smoothing describes a mechanism in which a firm is reluctant to reduce dividends and only increases dividends when its earnings increase permanently. In practice, dividend smoothing behavior is found in both developed and developing countries. Firms in developed countries are more likely to smooth dividends than those in developing countries. Second, although Miller and Modigliani (1961) posit that investors are indifferent between stable and unstable dividend payments in a perfect environment, market frictions in the real world make stable and unstable dividends have different effects on firm value. Three common frictions are information asymmetry, agency problem, and investors' demand for income smoothing. Due to information asymmetry between insiders and outsiders, firms tend to smooth their dividends to signal outside investors about their quality. In addition, dividend smoothing may be the substitute for weak corporate governance and/or the outcome of free cash absorption behavior. Besides, dividends are more convenient for investors' consumption; therefore, firms are more likely to smooth dividends in order to satisfy investors' demand for smooth income. Finally, as a special dividend decision, dividend smoothing is also affected by an internal micro (industry) and macro-environment. Dividend smoothing theories are the behind mechanisms to explain these effects.

As a financial policy, dividend policy significantly affects firm value. This chapter analyzes how stock prices react to dividend decisions. First, a dividend payment is an extraction of value; therefore, stock price theoretically drops by the dividend amount on the ex-dividend day. In practice, the price drop and the dividend magnitude are not equal because of tax clientele, short-term trading, and market microstructure. Investors are indifferent in trading stocks before and after stocks go ex-dividend if they obtain equal marginal benefits from the two trading times. The difference in tax rates on dividends and capital gains leads to the gap between the price drop and the dividend amount. Moreover, if transaction costs are considerable, investors have high incentives to short-sell stocks until they cannot obtain more profits. The final outcome of this short-term trading is the difference between the price drop and the dividend amount. Furthermore, market microstructure factors such as limit orders, bid-ask spread, and price discreteness also create this gap. Second, dividend announcements convey valuable information to outsiders. When firms announce increases (decreases) in dividends, their stock prices tend to increase (decrease). Third, dividend policy is negatively related to stock price volatility. This negative relationship is explained by duration effect, rate of return effect, arbitrage realization effect, and information effect. Empirical evidence for this relationship is found in many countries. Finally, dividend smoothing is also considered as a signal about firms' future earnings. Consequently, firms with stable dividends have higher market value. In other words, dividend stability has a positive effect on stock prices.