McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7 DIVIDEND POLICY Behavioral Corporate Finance by Hersh Shefrin

1 Dividends and Individual Investors  In the behavioral approach, mental accounting and hedonic editing feature framing effects that lead individual investors to find dividends especially attractive.  Older, retired investors find dividends attractive because they view dividends as a replacement for wage and salary income.  Young, employed investors find dividends attractive because regular dividends make it easier for them to tolerate risk.

2 Microsoft and Con Ed Widows and Orphan Stock?  March 2003, Microsoft dividend initiation. July 21, 2004 issue of The Wall Street Journal indicated that Microsoft was moving in the direction of the old AT&T model, that is a “widows and orphans” stock.  Con Ed omitted dividend in 1974 to much protest. Shareholders were older, retired, and in many cases widowed, who viewed dividend income in the same way as Social Security income.

3 Behavioral Life Cycle  Behavioral life cycle hypothesis involves self-control motivated spending rules based on mental accounts for wealth. 1. current income 2. liquid assets 3. home equity and 4. future income  Don't dip into capital.  Dividend income is spendable.

4 Dividends and Risk Hedonic Editing  Risk is more tolerable when decomposed into a certain prior gain and an uncertain outcome.  Total return on a stock decomposes into a dividend yield and a capital gain.  Cash dividends play the role of the certain prior gain (bird in the hand).

5 Empirical Evidence  Investors over the age of 65 concentrate their stock holdings in firms that pay high dividends, especially if the investors are retired.  These investors hold over 80% of their stock portfolio in dividend paying stocks.  In contrast, investors under the age of 45 hold 65% of their portfolios in dividend paying stocks.

6 Contrast with Institutional Investors  Among institutional investors, pension funds and banks find dividends attractive mainly because of stricter “prudent-man” rules, rather than because of a sizeable payout.  Evidence suggests that institutional investors favor repurchases over dividend payouts.  When a firm increases its dividend payout, institutions tend to decrease their holdings.

7 How Managers Think About Dividends  Managers have developed heuristics to set dividend policies that cater to investors’ psychological needs.  John Lintner's classic 1956 survey found that managers establish long-run target payout ratios, yet smooth dividends in the short-run.  Lintner reports that managers are particularly concerned about having to rescind a dividend increase.

8 What Has Changed Since 1956?  Fewer firms currently target the dividend payout ratio. Instead, they target consistency in either the current level of dividends or the dividend growth rate.  Executives are less reluctant to omit a dividend.  Executives repurchase shares much more frequently. Exhibit 7.1

9 Asymmetry  Dividend increases occur much more frequently than dividend decreases. During 1999 there were 1,703 dividend increases or initiations. In contrast, there were only 135 decreases or omissions during that period.  The market reacts positively to announcements of repurchases and dividend increases, but more negatively to announcements of dividend decreases.

10 Managers' Beliefs  Over 80% state that there are negative consequences to reducing dividends.  Over 75% believe that dividends convey information about their firm.  Over 60% would rather raise funds to finance new investment projects than cut dividends.  About a third believe that paying dividends, instead of plowing back earnings, makes a firm’s stock less risky.

11 Attracting Institutional Investors  Just under 50% indicate that they set their policy in order to attract institutional investors to hold their stock.  About 30% cite “attracting institutional investors because they monitor management decisions.” Fewer than 15% cite "paying out dividends to reduce cash, thereby disciplining our firm." Fewer than 10% indicate that they pay dividends to show they can afford to bear costs of external funding or pass up profitable investments.

12 Attracting Individual Investors  Just over 40% mention that they set policy in order to attract individual (retail) investors.  Fewer that 30% mention the tax penalty associated with dividends.

13 Dividend Initiation Items cited by over 40% of respondents in connection with dividend initiation:  Earnings per share increasing  The influence of our institutional shareholders  Our company having extra cash/marketable securities  Having fewer profitable investments available (e.g., as our industry matures)

14 Catering  Managers appear to cater to investors' preference for dividends.  Expect stocks of dividend paying firms to have lower book-to-market equity than those of non- dividend paying firms. Citizen Utilities  Expect that the difference in these ratios would change over time, with the differential being wider during bear markets than during bull markets.