Finance Chapter 8 Dividend Policy Dividend Policy The Text Makes The Point

Chapter 08 – Dividend Policy

CHAPTER 8

Dividend Policy

1. The chapter text makes the point that retired investors use mental accounting based

consumption rules, whereby they finance consumption expenditures from their income

accounts, but are reluctant to finance consumption from their asset accounts and especially

their future income accounts. The chapter text also makes the point that some individual

investors perceive a stream of cash flows to be less risky when it is framed as the sum of a

risk-free component and a risky component.

2. The issues pertaining to individual investors are the same as in question 1. During the bull

market dividends were less attractive. During the bear market, dividends became more

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3. The experiences of these investors are similar to the experiences of the shareholders in

Consolidated Edison discussed in the text. Many Con Ed shareholders were retired and relied

on the dividends from their Con Ed stock to finance a large portion of their consumption

4. Kodak established its dividend policy in terms of dividends per share. The declining share

price reflected a deteriorating competitive position as consumers shifted away from

traditional film products into digital photos. Kodak lagged its competitors in this regard.

Typically, individual investors react negatively to a decline in dividends, as they did

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stock performed poorly after October 2003. Between October 2003 and February 2008, the

stock earned a negative return.

In terms of the issues described in chapter 6, investors have reason to be concerned

about managers having access to internal cash, when those managers are excessively

optimistic, overconfident, or risk-seeking because they perceive themselves to be operating

in the domain of losses. In these circumstances, managers are prone to invest in negative net

present value projects.

5. If investors switch out of nondividend payers into dividend payers after a market decline,

prices of dividend payers might rise relative to nonpayers at that time, thereby resulting in

higher returns to dividend payers at that time. However, measuring investor preference for

6. The text states: “In the behavioral variant, managers seek to maximize BPV in a market

where many of their investors employ reference points associated with either consumption,

as in the case of self-control, or to measure gains and losses for quasi-hedonic editing

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purposes. This means that managers need to take into account that because of loss aversion,

these investors react more strongly to losses relative to their reference points more intensely

than gains of comparable magnitude. With this in mind, managers will want investors to

interpret dividend payout policy as a signal, but primarily to increase stock price rather than

to separate themselves explicitly from competitors.”

Chapter 7 describes Cogent Communications’ payout policy as follows: “In addition

to growing its dividend, and because it was less leveraged than its peers, Schaeffer stated that

the firm’s policy was to increase leverage but also pay out an additional $10 million to

investors every quarter either through a buyback or a special dividend, at the discretion of

management.”

Cogent’s payout policy conforms to behavioral signaling theory, which explains why

managers seek to set smooth dividend payouts at levels that will enable them to limit the risk

of having to reduce those payouts. Cogent set its policy for paying regular dividends as a

fixed amount per quarter, thereby setting investors’ reference points. It explicitly mentions

special dividends and repurchases as being at the discretion of management, thereby

managing investors’ expectations and reference points accordingly, in respect to additional

payouts, where the associated second reference point is presumably zero.

7. The relevant text in Chapter 2 describes a conference call that Merck had with analysts,

which Lewent described as follows: “In the fourth quarter of 2004, we had a call with

analysts. I won’t say the most important, but one of the most important questions asked was,

‘Is the dividend secure?’ And I could [answer with] an unequivocal ‘yes.’”

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The context for this “important” question was Merck having withdrawn Vioxx from the

market and facing the prospect of expensive litigation. By answering “yes” to the question,

Lewent signaled that Merck’s resources were sufficient, and its future prospects sufficiently

favorable, to enable the firm to maintain its dividend policy. In line with behavioral

signaling, an answer of “no” would likely have generated the prospect of future losses, and

given loss aversion a sharp decline in Merck’s stock price.

8. In respect to behavioral signaling, the most important decision BP made was to fix

dividend increases in dollar terms, and for the several years thereafter, to increase its

dividend at the rate Amoco had followed, $0.025 each year.

Given that BP had a different payout policy from the policy followed by Amoco, it

had to decide which group of investors found the associated dividend signal more valuable.

changes in dividends per share, the modal increase is exactly to the next threshold. In this

Chapter 08 – Dividend Policy

respect, changes in quarterly dividends cluster at zero exactly, meaning that firms mostly

maintain dividends per share, and most only consider changing its level on an annual basis.

Chapter 08 – Dividend Policy

Minicase

Case Analysis Questions

1. Given Modigliani-Miller irrelevance in a world without taxes and transaction costs, and

symmetric information, the traditional approach would focus on taxes, transaction costs, and

information signaling. The tax element pertains to Apple’s policy of managing its taxes by

maintaining most of its cash holdings outside the U.S. Therefore, paying dividends in the

U.S. involves additional transactions costs. Prior to 2012, Apple’s policy was not to pay

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2. There are two main issues, the first being the characterization of Apple’s stock as “widows

and orphans,” and the second being behavioral signaling.

The “widows and orphans” issue pertains to individual investors relying on dividend

income to fund consumption, for reasons largely related to self-control. The minicase

indicates that CEO Cook noted that Apple’s stock split was intended to appeal to a larger

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January 2015, Apple’s iPhone sales exceeded the consensus analysts forecast by 12 million,

and most importantly iPhone sales surged in China, Hong Kong and Taiwan.

3. In issuing new debt to fund dividend payouts, Apple engaged in a conventional leveraged

recap. Given Apple’s profitability, doing so might have provided the firm with additional tax

7, whereby managers who view the shares of their firms as undervalued engage in market

timing by repurchasing shares. In this respect, the minicase notes Cook’s remarks that the

planned increase in repurchases reflected Apple’s executives’ view that the firm’s stock had

been undervalued, while noting that the decision indicated “how much confidence” its

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appealing to individual (retail) investors by making it easier for them to purchase round lots,

and also because psychologically it is easier for them to imagine higher returns on stock

prices that are lower.

4. The sample period was 2009 through 2014, and the case mentions that in September 2012

Apple shares peaked above $700. From then through the end of February 2014, the stock

returned -16.5 percent while the S&P 500 returned 33.1 percent. Moreover, in March 2014,

sentiment about Apple was on the low side, investors were questioning the firm’s growth

have reflected Apple’s negative return during the period September 2012 to March 2014,

when the return on the S&P 500 was positive. Similarly, although Apple’s stock appeared to

exhibit upward drift after April 2014, over the entire period its stock did not consistently

track the returns of the UMD factor during the five-year sample period, and its mix of

downward drift during some of the sample and upward drift during the remainder of the

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sample resulted in no statistically significant effect. Nevertheless, the negative loading

coefficient suggests that Apple stock exhibited more downward drift than upward drift.

5. The most apparent behavioral issue not connected directly to the other minicase questions

pertains to the contrasting styles of Jobs and Cook. Jobs relied on the affect heuristic, and fast

System 1 thinking, whereas Cook relies more on slow System 2 thinking.

The key passages begin with the discussion of Yukari Kane’s book Haunted Empire:

Apple After Steve Jobs which compares Cook to Jobs. Kane suggested that Apple struggled

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A related issue involves Apple’s bond offering in 2014. The minicase mentions a

comment by the head of U.S. investment-grade credit at Invesco, Chuck Burge, who stated

that Apple’s bonds were “an attractive alternative” to Treasuries and that “Apple is a brand