Chapter 8 – Dividend Policy
Chapter Eight
Dividend Policy
OVERVIEW
Chapter 8 discusses the behavioral issues associated with dividend policy. Two
psychological phenomena, both involving mental accounting, underlie the attractiveness
of cash dividends for individual investors. The first phenomenon pertains to the use of
consumption expenditure heuristics used to exercise self-control. The second
The managers of firms cater to the dividend preferences of the investor clienteles
who hold the stocks of their firms. Older, retired investors are prone to use dividends to
fund consumption. The managers of firms whose investor clienteles are dominated by
older, retired investors will cater to investors and choose dividend payout heuristics
Chapter 8 – Dividend Policy
LEARNING OBJECTIVES
The main objective of this chapter is for students to demonstrate that they can identify the
manner in which biases and framing impact the behavior of managers, investors and
market prices in respect to dividend policy. After completing this chapter students will be
able to:
1. Explain why framing effects lead some investors, finding cash dividends
attractive, to employ dividend-based heuristics.
3. Describe heuristics that managers use to set the dividend policies of their firms.
CHAPTER OUTLINE
Traditional Approach to Payouts
The traditional approach to dividend policy begins with the MM framework,
Chapter 8 – Dividend Policy
Changes in Tax Policy
When the tax treatment of dividends became more favorable in 2003, aggregate
Dividends and Individual Investors: Psychology
Older, retired investors rely on consumption expenditure heuristics wherein
dividend income is used to finance consumption. This feature is sometimes referred to as
“widows and orphans.” Under these heuristics, dividend reductions and omissions tend to
Investors also use dividends to engage in hedonic editing, in that they choose to
frame outcomes in ways that are more pleasing to them than in ways that are less pleasing
Chapter 8 – Dividend Policy
How Managers Think About Dividends
During the 1980s and 1990s, managers shifted their form of payout from
dividends to share repurchases. Managers smoothed dividends relative to earnings, and
increased dividends more frequently than they decreased dividends. John Lintner’s
classic 1956 survey found that managers established target long-run payout ratios, but
Recent survey evidence also shows that managers believe that dividends convey
information, that they choose their dividend payout policies to attract investors, but by
Catering to Investors’ Tastes for Dividends
The experience of Citizens Utilities Company and its two classes of stock serves
to demonstrate that investors are willing to pay a premium for cash dividends. Managers
cater to investors’ tastes when they choose their dividend policies to meet investors’
needs for dividends, thereby impacting share prices. Catering might involve dividend
Chapter 8 – Dividend Policy
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
5
bear markets than in bull markets. In this regard, the price differential for the two classes
of Citizens Utilities stock is correlated with the book-to-market differential between
stocks that pay dividends and those that do not.
TEACHING TIPS FOR POWERPOINT SLIDES
Before showing the first PowerPoint slide, instructors might want to remind
students briefly what the traditional theories of dividend policy entail, emphasizing that
these theories assume that investors are immune to framing effects. Instructors might
Slides 3-10
Slides 3-10 summarize the main behavioral phenomena that underlie the tastes of
individual investors in respect to dividends. These phenomena involve mental accounting
Chapter 8 – Dividend Policy
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
6
flows in the two parts are identical.) Concept Preview Question 8.1 serves as a
springboard, enabling instructors to point out why individual investors might find the risk
of holding a stock more tolerable if they know they will receive a certain amount, such as
a dividend. Instructors might ask students to read the Behavioral Pitfalls box “Advice for
Investors” on page 116, and identify which comments pertain to the behavioral life cycle
hypothesis and which to hedonic editing.
Instructors might emphasize that investor age is an important determinant of the
role that dividends play in investor portfolios. Older, retired investors find dividends
attractive because they view dividends as a replacement for wage and salary income.
However, young, employed investors are much less concerned about funding
specifically mentioned the phrase widows-and-orphans stock in this context.
Slide 7 explains the main features of the behavioral life cycle hypothesis.
Investors divide their wealth into a series of mental accounts, and rely on mental
accounting based consumption heuristics to exercise self-control.
Chapter 8 – Dividend Policy
Slide 8
Slide 8 contrasts individual investors and institutional investors. Institutional
investors such as pension funds and banks appear to favor dividends for different reasons
than do individual investors. The main reason might be to deal with “prudent man”
requirements. Institutional investors appear to prefer share repurchases to dividend
Slide 11
Slide 11 deals with the heuristics managers use to set dividend policy in order to
cater to investors’ needs. A classic 1956 survey by John Lintner found that managers
smooth dividends in the short-run, but also establish long-run targets for dividend payout
ratios. Instructors might ask students whether a smooth dividend stream would cater to
older, retired investors who use dividends to fund consumption expenditures, or to
investors who engage in hedonic editing and treat dividends as a bird in the hand. The
answer is that dividend smoothing caters to both.
Chapter 8 – Dividend Policy
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
8
They now target dividends per share and dividend growth rates more than they target the
dividend payout ratio. And they are less reluctant to omit dividends than they once were.
Slide 13
Slide 13 makes two points about the contrast between dividend increases and
dividend decreases. First, dividend increases occur more frequently than dividend
decreases. Second, the absolute value of the market response is larger for decreases than
increases. Instructors might ask students if they might suggest any behavioral reasons
Slide 14
Slide 14 describes findings from a survey about the proportions of managers who
hold particular beliefs. Notably, more than 80 percent believe that there are negative
consequences to cutting dividends. About 75 percent believe that dividends convey
information to shareholders. More than 60 percent would not cut dividends in order to
Chapter 8 – Dividend Policy
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
9
hypothesis and hedonic editing. The belief that dividends convey information is not
directly related. However, the other three beliefs are related to behavioral phenomena.
Slides 18-19
Slides 18-19 pertain to institutional investors. Half of managers indicate that they
choose dividend policies to attract institutional investors. At the same time, most
managers do not appear to hold beliefs consistent with agency theories of dividends that
Slide 20
Slide 20 summarizes the key issues that managers indicate drive their decision to
initiate dividends. If EPS appears to be on an increasing trajectory, managers are willing
to initiate a dividend. As in the example involving Cisco Systems (Behavioral Pitfalls box
Chapter 8 – Dividend Policy
Slides 21-26
Slide 22 pertains to the relationship between catering and book-to-market equity.
If investors bid up the stock prices of firms that pay dividends, relative to the stocks of
firms that do not pay dividends, then all else being equal, dividend payers should have
lower book-to-market equity ratios. Instructors might describe the dividend policy of
Citizens Utilities, and ask how the difference in the prices of its two classes of stock
Additional Resources for Chapter 8 Available on the Web
On the web at www.mhhe.com/shefrin, instructors will find additional resources
that relate to Chapter 8. This material is intended for instructors who wish to delve into
Suggested Answers for Minicase Nipsco
Case Analysis Questions
1. Discuss Nipsco’s dividend policy in the context of the chapter text.
Chapter 8 – Dividend Policy
Answer: Nipso sought to maintain a 60 percent payout ratio tied to growing earnings
each year. Therefore, it defined its dividend policy in terms of its payout ratio. The
The chapter text also mentions that the firm claimed that the increase in its dividend
payout reflected continued improvement in the firm’s operating and financial
performance. The chapter text discussed the propensity of firms that increase their
dividend payouts to be less likely to experience future earnings decreases.
2. For those students who have read chapter 5, discuss the extent to which Nipsco’s
stock split fits the general pattern of firms who split their stocks.
Answer: In December 1997, Nipsco announced that it planned to split its stock two-for-
©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the
classroom. No reproduction or further distribution permitted without the prior written consent of
McGraw-Hill Education.
12