Somehow worth more than that same 1 in a bank account

somehow worth more than that same $1 in a bank account held by
the corporation
o This argument is very flawed because a shareholder can
create a bird in hand by selling some stock
o Tax and legal benefits from high dividends
 Corporate investors
• A significant tax break on dividends occurs when a corporation
owns stock in another corporation
o Granted at least 70 percent dividend exclusion
 This does not apply to capital gains, and so this
group of investors is not favorably taxed on capital
gains
 High dividend, low capital gain stocks may
therefore be more appropriate for corporations to
hold
o Also leads some corporations to hold high-yielding stocks
instead of long-term bonds because there is no similar tax
exclusion of interest payments to corporate bondholders

 Tax-exempt investors
• This group includes some of the largest investors in the economy,
such as pension funds, endowment funds, and trust funds
o These funds are set up for the benefit of others; the
managers have fiduciary responsibility to invest the
money prudently
o Also, institutions such as university endowment funds and
trust funds are frequently prohibited from spending any of
the principal
 Might prefer to hold high-dividend yield stocks so
they have some ability to spend
• Information content of dividends
o It is found with some consistency that stock prices rise when the current dividend
is unexpectedly increased, and they generally fall when the dividend is
unexpectedly decreased
o A dividend cut is often a signal that the firm is in trouble
 Usually not voluntary; signals that management does not think that the
current dividend policy can be maintained
o Management will raise the dividend only when future earnings, general cash flow,
and general prospects are expected to rise to such an extent that the dividend will
not have to be cut back later
o These reactions can be attributed to changes in the expected amount of future
dividends, not necessarily change in dividend payout policy
 Information content effect : the market’s reaction to a change in
corporate dividend payout
• The dividend changes convey information about the firm to the
market, making it difficult to interpret the effect of the dividend
policy of the firm
• The clientele effect
o The observable fact that stocks attract particular groups based on dividend yield
and the resulting tax effects
 Left with a simple supply and demand market (dividend market) for
desired dividend payouts by different companies
• If this market is in equilibrium, where all clientele are satisfied,
firms will theoretically leave their dividend payout policies
unchanged
• Establishing a dividend policy
o Residual dividend approach
 Assume firms will wish to minimize the need to sell new equity and
maintain its current capital structure
 If a firm wishes to avoid new equity sales, it will need to rely on internally
generated equity to finance new positive NPV projects
• Dividends will then only be paid out with what is left over, which
is called the residual

 A policy under which the firm’s objective is to meet its investment needs
and maintain its desired debt-equity ratio before paying dividends
•