Summary Reappearing Dividends

Transcription

1 Summary Reappearing Dividends A+ Why companies pay dividends? Financial economists have devoted considerable studies to answer this question. Different points of view concerning the effect of paying dividends are opposed. For Fisher Black, there was no convincing explanation for public corporations centuries-old practice of paying cash dividends to their shareholders. Two main ideas are exposed: o In the M&M model, company s value is determined solely by its earnings power and not by whether or when those earnings are distributed to investors. o Tax disadvantage of dividends dividends are taxed at both the corporate and personal levels These two arguments suggest that if dividends had any material effect on corporate values, it was likely to be negative. From another point of view, dividends provide investors with what amounts to a monitoring-and-control device that works as follow: o Companies that pay dividends increase the odds that they will be forced to return to the market for outside capital. o And to the extent that the process of raising capital from outsiders allows more intensive scrutiny by the market, the regular payment of dividends ends up increasing investors influence over the real drivers of corporate value corporate investment and operating decisions. According to Michael Jensen, dividend payouts increase the value of mature, cash-generating companies by controlling management s natural tendency to use excess capital to pursue low-return investments. High dividend payouts help management focus on maximizing profitability and value and resist the temptation to chase growth at any cost. Jensen went so far as to argue that, in order to maximize value, mature companies with limited growth opportunities should commit to pay out all their free cash flow that is, all (non-operating) cash that cannot be profitably reinvested in the firm. The topic of the paper written by Brando Julio and David Ikenberry. is to explore the fundamental causes of changes in dividends in USA. Are cash dividends reappearing and, if so, why? Why percentage of companies whose paid dividends fall down and then increase?

2 There are five plausible reasons for the return of dividends (in USA): o Bush tax cut (May 2003): lower the marginal rate on dividends to that of capital gains, thus reducing dividends tax problem. o Large companies may be using dividends to reassure investors about the quality of their earnings. o The recent surge in dividends is at least partly a consequence of internet-era startups maturing to the point where they need to rethink their payout policies. o Similar in spirit to the maturity hypothesis: dividends policy = residual outcome of a company s capital budgeting process. ( Pay out whatever cannot be reinvested to earn the cost of capital. ) o Consider behavioralist explanations: explanations that rely on investor preferences with no obvious grounding in fundamentals and thus outside the bounds of what economists tend to view as rational behavior. Why corporate boards might have become more aggressive in setting cash dividend payout? To answer that, let s see more precisely these five reasons below. The Bush Tax Cut The idea is that companies would be encouraged to pay dividends that would flow back into the economy as reinvested capital or increased consumer spending. But repurchases still retain their taxes advantage over dividends, mainly because taxes on stock repurchases are imposed only on investors who choose to sell. Another argument for why a change in marginal rates might not affect dividend policy in a substantial way comes from a recent survey of corporate chief financial officers. the majority of the responding CFOs said that taxes were not a first-order concern in deciding their companies payout policies. => 20% of the executives cited personal taxes paid by investors as an important factor affecting their policies. The executives responsible for setting dividend policy did not expect the Bush tax cut to have a material effect on their payout policies. Statistical tests confirm that there is a significant increase in dividend payout for firms in the lowest payout quintile following the tax cut. For the three highest categories, there was no statistically significant increase in payout ratios following the announcement of the tax cut plan. In sum, the Bush tax cut appear to have had an effect on corporate dividend policy. The sharp increase in the number of companies initiating dividends after the tax cut was adopted. Bush tax cut is not a complete explanation if only because the rebound in dividend started before any discussion of the legislation. Other factors must be at work.

3 Dividends, corporate governance and investor confidence Dividends may be viewed by investors as a more reliable signal of management s commitment to pay out excess capital than stock repurchases. Repurchase programs are far more flexible than dividend payouts and many companies that announce buyback programs end up buying back no share at all. For this reason, repurchase = credible indicators of management s optimism about near-term performance and dividends = interpreted by investors as a sign that management expects stability over the long run. The problem is that there is no straightforward way of measuring the extent to which the recent shift in payout policy can be explained by increased investor demand for better corporate governance. Whereas companies with moderate to high leverage ratios tended to maintain their already relatively higher dividend payout ratios, companies with low leverage ratios showed large increases in dividends starting around This pattern is consistent with the possibility that companies potentially at risk for concern over investor confidence responded by committing to pay higher dividends. Maturity hypothesis Finance theory holds that IPOs of technology and Internet firms typically should not pay dividends but should instead retain their capital to fund their growth opportunities. In at least the first few years of their existence as public companies these firms would be excepted to reinvest internally generated funds in profitable investment opportunities. But as they mature, those firms that survive will tend to have more stable cash flows and fewer investment opportunities. In sum, there is little doubt that part of the increase in dividend payouts by U.S. companies in this decade can be attributed to the maturing of new firms. In the past, such companies might have skipped this stage and chosen share repurchases as their preferred method of distribution. At present, many of these companies are adopting traditional cash dividends. Investment opportunity hypothesis Classic theories of payout policies said that dividends should be paid out of a company s free cash flow = the portion of a company s current cash flow that cannot be profitably reinvested in the business. The question is, whether the decline and subsequent rebound in dividends was related to changes in corporate investment opportunities over this period? To examine more directly whether changes in investment opportunities were affecting payout policy; two measures: o The percentage growth in total assets o The level of a company s cash acquisitions over time.

4 Catering theory said that investor demand for dividends varies with changes in investors sentiment or some other psychological motivation. Companies cater to this times-varying investor demand by paying dividends when investors place a premium on dividend-paying firm. Companies will cut their dividends when investors show signs of losing their taste for dividends. One potential proxy of investor demand for dividends is the difference in the average market-to-book ratios between dividend payers and non-payers. In sum, the catering hypothesis provides little additional explanatory power to other accounts of the recent shift to higher dividends. If investors have a strong demand for dividends, they will make themselves heard through their reaction to initiations. It appears that companies were responding to investor demand for dividends. But after adjustments for size and age, the average initiation announcement returns do not differ much from year to year. Financial economists have developed a greater appreciation for the possible role of dividends in maintaining and even increasing corporate values. A more fundamental explanation of how dividends increase value has focused on how the payment of dividends improves corporate decision-making and performance. For companies in mature industries with limited growth opportunities, the return of excess capital to investors through dividends help control management s tendency to reinvest capital in low return core business or diversifying acquisitions. As long as investors continue to respond positively to announcements of dividend increases, and as companies reduce their reliance on option-based compensation plans, there is no reason for dividends to disappear.

5 Summary of the article Reappearing Dividends Handed in by Arcan Orak, matriculation number: A+ 1 Introduction The article Reappearing Dividends is to an extent a continuation of the article Disappearing Dividends of prominent finance scholars that described the decline in dividend payouts in the early 1990s, which was mainly driven by the stock repurchase programs during that period. The aim of the article is to examine why dividends reappeared after 1999 based on five plausible reasons: 1) Bush tax cut, lowering the tax rate on dividends (Dividends and Taxes: The Bush Tax Cut) 2) Large companies without growth opportunities reassuring their investors about their earnings' quality (Dividends, Corporate Governance, and Investor Confidence) 3) Start-ups of the Internet-era began to mature and faced low growth opportunities. Thus, they had to rethink their payout policies (Maturity Hypothesis) 4) Economy-wide shrinkage of investment opportunities after a decade in the 1990s with many investment opportunities (Investment Opportunity Hypothesis) 5) Change in investor preferences for dividends without any fundamental explanation for it and companies that react to it with dividend payouts (Catering Theory) According to The Dividend Puzzle of Fischer Black there is no convincing explanation for paying dividends as in a perfect world without taxes and market imperfections the company value is driven by the companies' earnings. Additionally, Fischer Black s conclusion is based on the tax disadvantage of dividends since dividends are taxed at personal as well as corporate levels. Therefore, for Fischer Black dividends only have negative effects on corporate values. In the last decades several studies had be done in order to answer the question why companies pay dividends. According to Frank Easterbrook from the University of Chicago, dividends are a mean to monitor and control, which forces the company to return to the markets for outside capital. Michael Jensen specified Easterbrook's opinion. In his view, dividends increase the value of a mature, cash-generating 1

6 company as it directs the management to profit-maximizing decisions and prevents the management to use excess capital for low-return investments. The article shows that throughout the 1990s, the percentage of dividend payers decreased due to many IPOs, resulting in risky companies that usually are less likely to pay dividends than larger firms without significant growth opportunities. In 2001, the percentage started to increase again. However, the negative trend of dividend payers throughout the 1990s and the positive trend afterwards can also be seen for large firms whereas during that time the total amount of dividends increased despite the fact of less dividend payers in that time. This was mainly because of large companies that continued their increasing payments. There was a shift in the 1990 from paying dividends to repurchasing stocks as repurchases are a more flexible and tax-efficient way of distributing cash. In addition to it, the management signals an undervaluation of the company with repurchase programs. In 1997, the repurchases even exceeded the dividends the first time in the US history but shortly afterwards the dividends increased, leading to the question in theory whether the decline and increase of dividends represent a shift in payout policy. 2 Main Findings The paper examines the five reasons why companies became more aggressive in their dividend policy. 1) Dividends and Taxes: The Bush Tax Cut Dividend taxes were set equal to the top tax rate on long-term capital gains in 2003 in the hope that the dividends paid out will be reinvested or used as consumer spending to contribute positively to the economy. The paper suggests that a change in marginal tax rates does not affect the dividend policy substantially. According to the authors, managers act cautious in their dividend policy due to its stickiness and possible negative stock price performances. Surveyed CFOs confirmed this assumption and said that cutting the dividend tax would not affect their payout policy significantly. Nevertheless, the Bush tax cut affected the payout policy of at least some firms. Firms that have not paid dividends prior to the tax cut initiated dividends after the new tax policy. However, the effect of the Bush tax cut on the dividends rebound has to be treated with caution as the dividends started to increase prior to any tax discussion. 2

7 2) Dividends, Corporate Governance, and Investor Confidence Investors' confidence was damaged through different scandals (e.g. Enron scandal) and high agency costs due to poor governance existed. In order to distinguish good managers seeking for value-enhancing decisions from bad managers, dividends play an important role as they signal that the excess cash cannot be invested in a profitable way. Additionally, investors could see dividends as a stronger signal for the management's commitment to pay out excess cash than they see repurchases. Furthermore, the paper states that dividends can be interpreted by investors as a signal of the management's expectations about a stable long-term performance while repurchases are more a signal for the near-term performance. As it is hard to explain the extent of the shift triggered by an increasing investor demand for corporate governance, the authors used another method for an explanation. They took dividends and high leverage as substitute governance mechanisms as both reduce the risk of wasting the free cash flow. They found out that high-leveraged companies did not change their payout ratio while low-leverage companies increased their payout ratio significantly from 2000 on. 3) Maturity Hypothesis Well-known researchers such as the Nobel Prize winner Eugene Fama traced back the decline and rise in the proportion of dividend payers to the technology and Internet companies that went public in the 1980s and 1990s (decline) and became mature in the 2000s (rise). Usually mature companies pay dividends as there are no more growth opportunities and they hoard a lot of money. This is also confirmed by a simple model used by the authors which shows that companies, starting to mature considered to distribute excess cash via dividends. 4) Investment Opportunity Hypothesis Throughout the 1980s and early 1990s, the dividends (respectively repurchases) to earnings ratio declined which implies that the company used the money rather for investment opportunities than for dividends (respectively repurchases). However, this conclusion is weakened as the US economy faced a recession in the early 1990s where companies preferred to conserve capital for security and liquidity reasons. 3

8 Therefore, the authors examined the relationship between dividends and the growth in total assets as well as the takeover activities. As they expected, dividends fell during periods of assets growth and takeover activities in the late 1990s. However, from 2003 on this relationship holds not true as asset growth and takeover activities increased while dividend payouts increased as well. 5) Catering Theory According to the catering theory by Malcolm Baker and Jeff Wurgler investor demand for dividends changes over time. In this theory, companies react to the change with a change in their dividend policy in terms of catering to the investors with high dividends when investors appreciate it with a premium and low dividend when investors are not interested in getting dividends. In practice, the dividend policy tends to be sticky. Using the market-to-book ratio of dividend payers and non-payers, the findings suggest that the catering hypothesis does not explain the payout shift. However, another check of how the market reaction to dividend initiations changed over time delivers a different outcome. Suggesting that investors seeking for dividends will make themselves heard, companies were responding to the investor demand for dividends. After adjustments for size and age, there is only a slight difference in the average initiation announcements over time. Therefore, the shift in payout policy cannot be explained by changes in investor demand for dividends. 3 Own view and key learning In my view, the article is well-elaborated as it tries to tackle the main objective of the paper from many perspectives. It not only tries to find one reason for the rise of the dividends but also examines different explanations and events from this time such as the Internet-era or Bush tax policy. Additionally, the article includes different opinions from well-known researchers from the existing theory (Fischer Black or Eugene Fama) and questions them which shows the critical examination of the paper. However, what I missed in this article were some examples of companies which either supports the five reasons or weakens them. The article only mentions the case of Microsoft in few words. Furthermore, the article is based on some simple adjustments and assumptions to come closer to a solution. For instance, to measure the extent to which the payout policy is explained by an increasing investor demand for better corporate governance, the authors used dividends and leverages as substitute 4

9 corporate governance mechanisms. Therefore, the suggested conclusion has to be treated with caution. My key learning from the article is that there was not one special event that caused the rise of the dividends but several key aspects as pointed out in the five reasons. It again showed me that deciding about a payout policy is much more complicated than I could have imagined before taking the corporate finance class. It depends on many factors and current circumstances that must be well-considered so that the company maintains the balance between satisfying dividend-demanding investors and increasing the shareholder value in the long-term by using the excess cash wisely. 5

10 Massiel Morales October 23, Reading report of Corporate Finance Reappearing Dividends By Brandon Julio and David L. Ikenberry, University of Illinois. A+ I. Executive summary During the last two decades of the 20th century, the propensity of U.S. companies to pay cash dividends declined significantly. In the 1990s, corporate America continued to return large amounts of capital to shareholder, but increasingly in the form of stock repurchases rather than dividends. In this period the proportion of all U.S industrial companies paying cash dividends fell from 32% to 16%, leading some economists to conclude that dividend policy was shifting in a very fundamental way. Part of the explanation for the falling percentage of dividend payers throughout the 90s was the remarkable number of IPOs and thus newer and riskier companies. However, there was a high reversal in this trend starting in This article investigates five possible explanations why dividends are reappearing. The authors start explaining the tax cut policy implemented by Bush in 2003, their findings suggest that U.S. companies have responded to the dividend tax cut, as one might expect, although the rebound in dividends started well before tax reform became a widely discussed possibility. This article also provides evidence that some companies have chosen to use dividends in part to restore investor confidence about the quality of corporate earnings due to investor s growing concern about corporate governance. A third explanation is related to changes in corporate investment opportunities, as technology companies established in the 1990s begun to mature and the value of their growth opportunities decreased. Given the explosion of new companies during the 1990s, the authors find that part of this rebound can be explained by the maturity hypothesis by the need for such companies to pay out their excess free cash flow to reassure investors that it will not be wasted on value destroying investments. Finally, the study finds little support for behavioralist explanations in which managers cater to irrational investor preferences for dividends. All evidences explained by the authors are consistent with the idea that corporate payout policy has shifted back in favor of conventional cash dividends.

11 Massiel Morales October 23, Reading report of Corporate Finance II. Payout Dynamics: Dividends vs Stock Repurchases Before discussing explanations why dividends are reappearing, the article reviews the evidences on all corporate distributions of cash to shareholder, including stock repurchases as well as dividends. During the 1990s many U.S companies below the mega-cap level1, stock repurchases became the preferred method of retuning cash to shareholder. However, with the overall propensity to pay cash dividends declining over 20 years, one important question is the extent to which dividends have been replaced by stock repurchases, and thus the total amount of capital returned to shareholders stock repurchases plus dividends has remained unchanged. When total corporate payouts decline, it might indicate more profitable investments opportunities and be optimistic about future. Alternatively, it might suggest a shrinkage of growth opportunities or perhaps greater managerial discipline in reinvesting earnings. In this period the dividend payouts of mature and mega-cap company continued to increase. But below mega-cap company preferred stock repurchase as the main method of returning cash to shareholder. The total dollar amount of cash distributed as stock buybacks exceeded total dividend payments for the first time in U.S. history in This shift in flows from dividends to repurchases suggests a substitution effect, although, several researchers have point pointed out that dividends and stock repurchases are not perfect substitutes; companies use them in different circumstances and for different reasons. Below I describe both method of distributing cash to shareholder: Dividend Repurchase 1. Paid out of a company s permanent 1. Flexible and tax-efficient. earnings or cash flows. 2. Dividends return cash to all stockholders, 2. Cash dividends are paid out to stockholders will buybacks only to the self-selected. be treated as income in tax calculation. 3.Managers believe the firm s shares are 3. Represent a firmer commitment to return excess undervalued (or at least not overvalued) capital can be used by managers to signal their confidence in the firm s prospects 1 Mega cap generally refers to companies with a market capitalization above $300 billion. (

12 Massiel Morales October 23, Reading report of Corporate Finance In order to explore the extent to which repurchases have functioned as a substitute for dividends, the authors tested the correlation between them and finally prove that really exist a substitution effect. As can be seen in figure 3 the pronounced shift away from dividends towards repurchases that began around III. Why are dividends reappearing? As I mentioned before in 2000 the percentage of dividend payers began to turn up. The authors developed 5 hypotheses to explore the fundamental causes of this change. 1. The bush tax cut One of the arguments for the cut was the idea that companies would be encourage to pay dividends that would flow back into the economy as reinvested capital or increased consumer spending. However, repurchases still retain their tax advantage over dividends, as taxes on stock repurchases are imposed only on investors who choose to sell. This cause appears to have had effect on corporate dividend policy. Probably the most convincing sign is the sharp increase in the number of companies initiating dividends after the tax cut was adopted in 2003 Nevertheless, the fact that companies established dividend payments before any mention of the cut suggests that taxes alone would not have been a first-order motivation for this firm. Maybe other dividend policy theories influenced, as the residual outcome of a company s capital budgeting process or at least a process that is guided by the rule, Pay out whatever cannot be reinvested to earn the cost of capital. 3. Dividends and Corporate Governance Enron scandal and other corporate abuses cause investors growing concern about corporate governance.

13 Massiel Morales October 23, Reading report of Corporate Finance Dividends increases may play a role in identifying well-managed companies. Likewise, dividend may be view by investors as a more reliable signal of management s commitment to pay out excess capital than stock repurchase. The problem, however, is that there is no straightforward way of measuring the extent to which the recent shift in payout policy can be explained by increased investor demand for better corporate governance. One explanation could be that dividends and high leverage can be implemented as corporate governance mechanism to reduce the risk that companies will waste their free cash flow. 4. Maturity Hypothesis Many of the newly listed firms from the 1990s came of age and began to pay dividends. The frequency of dividend initiation and resumption increased sharply after the tax cut was enacted into law in The media age of the companies initiating pay dividends around this time was 11 years, consistent with the level of firm initiating dividends over the last 20 years. This tendency produces some doubts about if the increase in dividends payout in this decade can be attributed to the maturating of relatively new firms, since such companies might have skipped this stage and chosen share repurchase as their preferred method of distribution. 5. Investment opportunities hypothesis Dividends should be negatively related to the availability of attractive investment opportunities. The problem with this argument is that the decline payout occurred early in the 90s, when U.S economy was in recession. To examine more directly whether changes in investment opportunities were affecting payout policy, the authors looked at two measures: the percentage growth in total assets and the level of a company s cash acquisitions over time. They found moderate evidence of increased asset growth and cash acquisitions in the mid to late 1990s, which is generally consistent with the decline of cash dividends during this period. They also found a sharp decline in asset growth and takeovers that coincided with the crash in market prices early. 6. Catering theory In this hypothesis investor demand for dividends varies with changes in investor sentiment or some other psychological motivation. Paying dividend when investors place a premium on dividend-paying firm. Cut dividends when investors show signs of losing their taste of dividends.

14 Massiel Morales October 23, Reading report of Corporate Finance Market premium for dividend-paying stocks increases at about the time more companies either start or resume their dividend payout. The characteristic-adjusted dividend premium has not changed significantly since The shifts in payout policy do not appear to have been driven by changes in investor demand for dividends. IV. Conclusions Throughout the explanation of these 5 hypothesis, we can realize the function and roles that have played dividends into corporates: 1. Maintain and increase corporate values. 2. Signal management s confidence in the future. 3. Free cash flow hypothesis:how the payment of dividends improves corporate decision-making and performance. 4. Helps control management s tendency to reinvest capital in low-return core businesses or diversifying acquisitions. 5. Help managers achieve the value-maximizing balance between growth and profitability. The tax cut implemented by President Bush in 2003 was is only part of the remarkable increase in divided payments, since several companies began dividend payments before the legislation, fact that I believed is better explained with the maturity hypothesis. However, all these hypotheses are related, taken into consideration Microsoft case, in order to avoid the governance problems (hypothesis number2), taking advantage of tax cuts and considering the maturity stage of the company CEO decide to pay dividends. However, the company, set a buyback policy at the same time, which make sense with catering hypothesis and with the fact that companies have to pay attention to the clientele effect. While the change in tax policy has clearly played a role in the fundamental shift in favor of dividend, the factors explained throughout this hypothesis suggest this trend will continue in years to come.

15 Reappearing Dividends A Summary Neeti Dixit A+ The case presented reflects upon the choices made by firms for payout strategies (dividends) and relevant affecting factors from evidences of relevant researches. With an understanding from the previous article, Excess Cash and Shareholder Payout Strategies, we are aware that firms would like (in an ideal financial world) to dispense their residual cash to their investors. Of course, this step is after considering the contractual obligations of debts such as interest and principal payments. In absence of any good projects, a firm could 1) give dividends 2) buy back stock 3) sit on the remaining cash. This also reflects from the actions of selected companies, AAPL, MSFT etc. Wealth Transfer Payouts ( ) The 20-year period saw a homogeneity for capital distributed despite a decline in dividends as stock buybacks took the front seat. This was however not a common behavior as mega-cap, mature firms continued to pay dividends and complemented the slight growth in dividends in the 90s. The smaller companies took to stock buyback as their primary vehicle to distribute cash thus the total dollar amount distributed by buybacks exceeded the dividend amount for the first time ever in the US history. Does this mean buybacks have replaced dividends and do they signal same message as dividends? Stock buybacks are an interesting tax-efficient method for cash distribution as they signal similar but different messages as dividends. Besides both vehicles signaling prosperity of the firm, buybacks also convey a manager s belief that their stock is undervalued. As seen in figure 3, the total capital paid out remained at about 20% (barring 94 to 98), the buybacks started substituting dividends in about 1993 to becoming the preferred method in We see that there is a dip of about 16% in

16 Neeti Dixit in buybacks to again re-emergence until dividends make a comeback in Other evidence about large cap companies despite paying dividends in the 90s but eventually capping them though the earnings boomed shows buybacks as a preferred method. The reversal in 2001 with dividends reappearing at a revision rate of 15% in the first quarter of 2004 lead to the curious case of reappearing dividends. Reappearance of Dividends Up until the middle of 1980s, dividends were the primary mechanism of returning cash as visible from the figure 1. The decline from 1984 to 2001, possibly because of listing of many newer, riskier companies with no dependable cash flow history and unreliable future cash flows. The 90s were a period of an economic boom that lead to many dot com companies and an eventual demise. The dividends were still being paid, albeit declining, with a rise in 2004 (1000 largest industrial US companies transitioned from 79% in 1984 to 36% in 2000, with mid-cap companies roughly imitating the curve on a lower level as access to capital markets is smaller ). The re-emergence of dividends in the early 2000s can be attributed to the following five factors: Bush tax-cut in 2003: Lowering the marginal tax rate (38.15% to 15%) on dividends to that of capital gains gave some relief to companies and investors alike. It was also aimed to increase an influx of wealth in the economy through dividends. To consider the tax revision instrumental in dividends resurgence, we need to realize that dividends are sticky and managers are wary of changing payout policies easily. In addition, as per a survey amongst CFOs only about 20% responded positively towards the tax cut as an important factor. Roughly, 70% were indifferent. Hence, the Jobs and Growth tax relief reconciliation act was not entirely responsible for

17 Neeti Dixit reappearing dividends. Although the first time dividend payers took a big jump in the third quarter of 2003, the general shift before 2003 is not explained entirely (companies with dividend history restarted raising dividends in 2001, well before any hints of a possible tax cut). Quoting the findings from the article figure 7, low-dividend paying firms showed a significant increase in the first quarter of 2004 (average 13.4%) versus medium and high dividend payers (average of 1.9%). Not taking the entire credit from Bush tax cut as it reflects from the paying increments of low paying firms, we cannot completely other factors that could instigate changes in dividends. Dividends, Corporate Governance, and Investor Confidence: Good corporate governance has a direct impact on investor confidence and that reflects in the stock movements. Maintaining this confidence is important for managers as they are trusted with the capital of a shareholder. Incidents such as Enron scandal in 2001 shook investor confidence and it could have resulted to the shift in payout policies in the 2000s. Shareholders in corporations do not have the expertise and/or the resources to monitor individually insiders actions or access insiders information on the future prospects of the firms. In this scenario, dividends come as a signal to convey trust for investors. Leveraged, dividend-paying firms can be viewed as disciplined firms that shall not waste shareholder wealth on futile projects. Nevertheless, to what extent can be seen by analyzing companies with different degrees of

18 Neeti Dixit leverage and changes in their payout policies. Companies with low-leverage ratios showed a large increase in payouts vs their medium to high leveraged counterparts in the 2000s. This is in line with attempts to restore shaken investor confidence. Maturity Hypothesis: The 1990s saw a surge of technology companies that went public. Usually such companies are associated with high growth and reinvestment of their earnings therefore dividends not expected in the beginning, being a public company. This can be a potential explanation for a rise in dividends in the 2000s as ten years is an acceptable time for these companies to realize enough residual income to start paying dividends. The figure 8 shows predictions, as per the model implemented by the writers wherein they forecast the probability of a company to pay dividends based on size, industry, and maturity (as per the years in existence), and comparisons to the actual behavior of companies. As predicted, the dividends took an upwards turn in the third quarter of 2000 which is consistent with firms paying or increasing their dividends in that period as seen in other figures (refer to figure 5 & 7). This along with tax cuts implemented in 2003 is another possible reason for dividends making a comeback! Investment Opportunity Hypothesis: As described in the opening paragraph of the summary, dividends are paid from the free cash flow when there is no profit-making project available. As seen in figure 3 above, there

19 Neeti Dixit was a consistent payout of about 20% in the 80s and early 90s with a decline in the mid-90s to 16%, which can due to investments in profitable, good projects. However, this decline can also be due to the recession in US economy in the early 90s and managers would rather save the cash as a cushion. The authors investigated the changes by analyzing two measures: % growth in total assets and level of cash acquired by a company in that period. The evidence suggested a moderate growth in asset growth and cash acquisition in mid to late 90s, which coherent with the decline in dividends as cash flows were directed towards acquiring more assets. Also uncovered was a decline in asset and cash acquisition that reflects the rebound the dividends in the early 90s. In 2003 and 04, both measures grew which is opposite the investment opportunity hypothesis. Catering Theory: Malcolm Baker and Jeff Wurgler s catering theory says that managers tend to initiate dividends when investors put a relatively high stock price on dividend payer, and tend to omit dividends when investors prefer non-payers. The findings in the article speculate little explanation for the shift in payout strategies as per the average market to book ratios of payers vs non-payers. The market to book ratio of non-payers should remain higher because of higher growth rates. However, the findings show increases in dividend premiums in 1992 that do not correspond to increases in dividend paying firms. To further dissect the theory, market reaction to dividend initiation news was analyzed. After the announcement date of dividends, cumulative abnormal return, CAR (Sum of the differences between the expected return on a stock and the actual return often used to evaluate the impact of news on a stock price), was calculated in the three day window

20 Neeti Dixit from days -1 to +1 near the news. The average CAR for companies that announced dividends was statistically significant at 3.3% from , but statistically insignificant in the period from 1997 to Interestingly, the CAR jumped to 4.5% in 2000 and remained significant until 2003, which coincides with shift in dividend payments. However, with certain manipulations in the sample data (adjustments were made according to size and age of the initiating companies), there was nothing significant from the findings reflecting that catering theory might not be plausible reason for any shifts in payout strategies. Conclusion and My Opinion The article digs deeper into factors that could have affected payout strategies of companies through the period that saw economic boom, a major recession, and a tax reform. The early 80s showed dividends as the main vehicle for capital disbursements with a decline of about 16% (from 32% to 16%) in the late 90s to the lowest being 15% in However, the decline did not lead to any lesser wealth returned as the gap was filled by stock repurchase as the method of distribution. The total cash returned, however, showed a consistent growth barring a short period. While it seemed like stock buybacks have replaced dividends, dividends did make a comeback in the year Overall, we know that while dividends signal growth and management s confidence in the firm s future, dividends are sticky and can be harmful if the future is not estimated correctly. In theory, dividends look simple as any company that is in a matured state and has smooth stream of cash flows coming in every year can afford to pay dividends as there is not much innovative opportunity with profitable return. Reality, however, reveals different scenario as seen from this article. Firms generally do not change their dollar dividends frequently. This reluctance to change dividends, which results in sticky dividends, is rooted in several factors such as the firm s concern about its capability to maintain higher dividends in future periods. Another is the negative market view of dividend decreases, and the consequent drop in the stock price. Firms could be influenced by catering theory effect but in this period case, it does not seem like a major influential factor.

21 Neeti Dixit The tax relief of 2003, generally, was taken as the main driver for increasing/reappearing dividends but when we look at the time-series data, MSFT announced its dividends program earlier than the news (market changes reflect any relevant news). Personally, I lay heavy emphasis on Enron case as well. It is one of the biggest accounting scandal that lead to the dissolution of one of the biggest auditing and accounting firms (Arthur Andersen) in the world. Cases like Enron s are capable of rattling the markets and investors alike. Returning the stockholders money might be a good alternative in such cases to instill faith and reassurance. Another aspect discussed if the decline in payouts in the mid-90s was due to availability of potential profitable projects as companies would rather invest that cash dollar than dispense however, this also is negated as it was the recession period and the technology boom came in the late 90s. On further inspection of this theory, the researchers found that there was a moderate asset and cash growth mid in the late 1990s (consistent with lack of dividends) until 2003 but the dividends made a comeback too thus rejecting the investment opportunity hypothesis. We must not ignore the technology boom in the 90s wherein numerous companies took birth and while many fizzled out; quite a few survived the rough decade long phase. These company were high growth, high investment firms that went public in that time and they did not have extra money to give away as dividends. Spending a decade until 2003 could have allowed them to have regular, positive cash flows they had aged to the point where they needed to consider paying some form of dividend. The tax cut actually gave them an ideal spot. I believe all these factors mentioned above have some role to play but in varying degrees. Tax cut could be the leading actor here. Dividends are subject to not just to a firm s cash flows and availability of projects but also to macro-factors such as politics. There was a looming fear that taxes on dividends could be going up in 2012 and with the current scenario, Trump is contemplating further reductions in the taxes. Overall, dividends would not disappear, as companies will have innovations and thus profitable projects in the new economy. I am not denying the existence of stock buyback but dividends will always be the pioneer in giving a stockholder assurance.