Dividend

A dividend is a distribution of profits by a corporation to its shareholders. Dividends are typically paid in cash, though they may also be paid in shares or in other assets. The decision to pay a dividend, and the amount, is made by the board of directors and is subject to the legal rules that govern distributions.

Forms

Dividends may take several forms. Cash dividends are the most common, and they are paid in the currency of the company. Stock dividends are paid in additional shares, and they increase the number of shares outstanding without changing the total value of the company.

Other forms include property dividends, paid in assets, and scrip dividends, which are promises to pay at a later date. Companies may also return cash to shareholders by repurchasing shares, which is an alternative to dividends and has different tax and signalling implications.

Policy

Dividend policy concerns the proportion of earnings that a firm distributes to shareholders and the proportion that it retains. The decision involves a trade-off between the return of cash to shareholders and the retention of funds for investment.

Several theories explain dividend policy. The signalling theory holds that dividends convey information about the prospects of the firm, since managers are reluctant to cut dividends and will therefore pay them only when they expect to sustain them. The agency theory holds that dividends reduce the cash available to managers and thereby mitigate the agency problem between managers and shareholders.

The clientele theory holds that different investors prefer different dividend policies, depending on their tax position and their need for income. Firms therefore attract investors whose preferences match their policy.

Taxation

The taxation of dividends affects the decision to pay them and the choice between dividends and retention. In many systems, dividends are taxed twice, once at the corporate level and again at the shareholder level, which discourages distribution. Some systems provide relief to mitigate this double taxation, either by imputation or by reduced rates.

The tax treatment of dividends relative to capital gains affects the choice between dividends and share repurchases, since capital gains are often taxed at lower rates and are taxed only on realisation. Changes in tax law can therefore shift the form of distributions.

Empirical Patterns

Empirically, dividends are concentrated among large, mature, and profitable firms. Younger firms and firms with high investment opportunities tend to pay lower dividends, since they retain earnings to finance growth. The proportion of firms paying dividends has declined in some markets, and the use of share repurchases has increased.

Dividend policy is also associated with the payout ratio, the proportion of earnings distributed, and with the dividend yield, the ratio of the dividend to the share price. These measures are used by investors to assess the income and the valuation of a stock.

Dividend Smoothing

Empirical research has documented that firms smooth their dividends, adjusting them gradually in response to changes in earnings rather than moving them in line with every fluctuation. Managers are reluctant to cut dividends, because a cut conveys negative information and is often followed by a fall in the share price.

The reluctance to cut dividends implies that a firm will raise its dividend only when it expects the higher level to be sustainable. Dividends therefore convey information about the management's assessment of the firm's prospects, and they are used by investors in forming expectations.

Dividend smoothing also implies that the payout ratio fluctuates with earnings, rising in good years and falling in bad years, while the dividend per share is more stable. This pattern is consistent with the signalling theory of dividend policy.

Share Repurchases

Share repurchases are an alternative to dividends for returning cash to shareholders. A repurchase reduces the number of shares outstanding, which raises earnings per share and often the share price. Repurchases offer flexibility, since they do not commit the firm to a continuing payment, and they are taxed differently from dividends.

The choice between dividends and repurchases depends on the tax treatment, on the preferences of investors, and on the signal that each conveys. Repurchases may signal that management believes the shares are undervalued, while dividends signal confidence in the sustainability of earnings.

The growth of repurchases has been associated with changes in executive compensation, since repurchases can raise earnings per share and thereby the value of stock-based compensation. This has raised questions about whether repurchases are used to manage earnings and to benefit insiders.

Dividend Policy and Investment

The payout decision affects the resources available for investment. A firm that pays high dividends retains less, and it must therefore rely more on external finance for its investment. The choice between internal and external finance depends on the cost and the availability of each.

The relationship between payout policy and investment is relevant to the debate about whether firms underinvest. Some argue that the pressure to distribute cash leads to short-termism and to underinvestment. Others argue that the discipline imposed by the obligation to pay out cash improves the allocation of capital and reduces wasteful spending.

The empirical evidence is mixed. The relationship between payout and investment varies across firms and over time, and it depends on the investment opportunities available and on the cost of external finance.

Summary

Dividend policy is a central element of corporate finance, and it reflects the trade-off between returning cash to shareholders and retaining funds for investment. The evidence on smoothing, on the choice between dividends and repurchases, and on the relationship between payout and investment informs the analysis.

See also

• Financial Asset
• Tax Base
• Rate of Return