1 Miller, & Modigliani, , “Dividend Policy, Growth and the Valuation of Shares”, (1981) 34 J. Bus. 411.CrossRefGoogle Scholar

2 For example, if the firm does not distribute dividends, its share price would rise proportionally, and investors could obtain “a home made dividend” by selling a fraction of their shares on the market and receiving capital gains. On the other hand, if dividends are paid out, and new funds are raised in the market to finance the investments, the share price would decline proportionally.

3 Under Israel's tax system, dividends and capital gains are treated differently. Capital gains are substantially favored over dividends. While individuals receiving capitai gains through trading in the securities market are exempted from taxes, shareholders receiving dividends must pay a second tier 25% income tax. Thus, shareholders of firms that distribute no dividends assume only the payment of one level corporate tax, while the remainder of the profits can be realized as an exempt capital gain through selling the appreciated stock in the stock exachange. In contrast, shareholders of firms that distribute dividends assume both the corporate tax and the individual income tax.

In the U.S., under the Tax Reform Act of 1986, tax rates on capital gains and income were equal until 1993. Still, even so, capital gains receive preferred treatment owing to the substantial benefit conferred by the ability to defer taxes. See, e.g., Fellows, , “A Comprehensive Attack on Tax Deferral”, (1990) 88 Mich. L.R. 722.CrossRefGoogle Scholar

4 See Ritter, , “The Costs of Going Public”, (1987) 19 J. Fin. Econ. 269.CrossRefGoogle Scholar

6 Black, , “The Dividend Puzzle”, (1976) 2 J. Portfolio Mgmt 5.CrossRefGoogle Scholar

6 See Aaquith, & Mullins, , “Signalling with Dividende, Stock Repurchases, and Equity Iuuee”, (1986) 16 Fin. Mgmt. 27, at 36.CrossRefGoogle Scholar

7 See Easterbrook, , “Two Agency-Coet Explanations of Dividends”, (1984) 74 Am. Econ. R. 650.Google Scholar

8 See Rozeff, , “Growth, Beta and Agency Costs as Determinants of Dividend Payout Ratios”, (1982) 5 J. Fin. Research 249Google Scholar; Lloyd, , Jahera, & Page, , “Agency Costs and Dividend Payout Ratios”, (1986) 24 Q. J. Bus. & Econ. 19Google Scholar; Jahera, , Lloyd, & Modani, , “Growth, Beta, and Agency Costs as Determinanta of Dividend”, (1986) 17 Akron Bus. & Econ. R. 65Google Scholar; Crutchley, & Hansen, , “A Test of Agency Theory of Managerial Ownership, Corporate Leverage, and Corporate Dividends”, (1989) 18(4) Fin. Mgmt 36.Google Scholar

9 See Jensen, & Meckling, , “The Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure”, (1976) 3 J. Fin. Econ. 305.CrossRefGoogle Scholar

10 Jensen, , “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers”, (1986) 76 Am. Econ. R. 323.Google Scholar

11 Easterbrook, “Two Agency-Cost Explanations of Dividends”, supra n. 7.

12 For this reason, Jensen, supra n. 10, advocated in his free cash flow theory the use of high leverage as a bonding device. The reasoning underlying the bonding effect, according to Jensen, is that while dividend distribution is discretionary, interest payments are mandatory. Defaulting on an interest payment could result in a bankruptcy filing which could have a very frustrating effect on management. To avoid a default, management must perform efficiently. High leverage is needed so as to bring default early in the path of declining efficiency.

13 Agency coete are reduced, then, only in correlation with the probability that a threatened takeover will succeed (regardless of any given dividend policy).

14 A proxy fight is not a viable option for a small stockholder. See e.g., Zampa, & McCormick, , “‘Proxy Power’ and Corporate Democracy: The Characteristics and Efficacy of Stockholder-Initiated Proxy Issues”, (1991) 60 Am. J. Econ. & Sociology 1.CrossRefGoogle Scholar

15 See Schwartz, , “Search Theory and the Tender Offer Auction”, (1986) 2 J. L Econ. & Organiz. 229Google Scholar; Crampton, & Schwartz, , “Auction Theory and Takeover Regulation”, (1991) 7 J. L Econ. & Organiz. 27.Google Scholar

16 At time t₀, the market discounts the stock price to reflect all future agency costs. Suppose that at time t₁ the firm has accumulated earnings (free cash flow). The managers can either inefficiently invest this cash or distribute it to the shareholders. The market is uncertain about which direction the management decision will take. Thus, the price will still be discounted, due to the potential agency costs regarding both the period from t₁ to the future and the cash already earned (anticipated at time t₀). If the firm chooses to distribute the cash as a dividend, potential agency costs have been avoided, ex post; thus part of the discount would be lifted and the stock price will rise. Yet, if there is no bonding regarding future dividends, the price will be discounted due to the potential agency costs from t₁ to the future. This might explain the use of “special” dividends as a defensive tactic against takeovers. See Jensen, supra n. 10; Denis, “Defensive Changes in Corporate Payout Policy: Share Repurchases and Special Dividends”, (1990) 46 J. Fin. 1433.

17 John Lintner conducted a series of interviews with corporate managers about their dividend policies. Most of the managera thought of their dividend policies in terms of the proportion of earnings that should be paid out, rather than the proportion that should be plowed back to finance growth. They felt that shareholders were entitled to an adequate portion of the firm's earnings and that the firm should have some long-term target payout ratio.

A firm that consistently adheres to its payout ratio would have to change its dividend whenever earnings changed. However, the managers in Lintner's survey were disinclined to do this. They believed that shareholders favor a constant progression in dividends. Thus, even when circumstances appear to justify a substantial increase in their firm's dividend, they would make only partial moves toward their target payment. That is, managers “smooth” dividend payments. See Lintner, , “Distribution of Incomes of Corporations among Dividends, Retained Earnings, and Taxes”, (1956) 46 Am. Econ. R. 97.Google Scholar

18 Easterbrook, supra n. 7, also argues that the stability of dividends is implied by agency costs, but I do not find his reasoning convincing. Easterbrook argues that a commitment to a fixed pattern of dividends irrespective of profit fluctuations is more likely to push the firm to the capital markets for financing investments. Yet, the mere fact that firms have a payout target which is relative to earnings is equally likely to push the firm to raise money in the capital market. Stability of dividends has to do with the phenomenon of slow adjustments towards the payout target, which is inexplicable in light of Eanterbrookb reasoning.

19 On the role of reputation in assuring contractual performance see, Klein, & Leffler, , “The Role of Market Forces in Assuring Contractual Performance”, (1981) 89 J.P.E 615.CrossRefGoogle Scholar

20 Indeed, it has been found that “[f]inancially weak firms infrequently reduce the dividend. Rather than cut the dividend, they either maintain a stable dividend or omit it altogether”. See Eddy, & Seifert, , “Dividend Changes of Financially Weak Firms», (1986) 21(4) Fin. R. 419, at 429.CrossRefGoogle Scholar

The initial sample of the Eddy & Seifert study included 216 firms that had a C rating according to Value Line in at least one quarter Dem 1978 to 1983. Of these, 125 paid no dividend at all, and 16 had only sporadic payments. The final sample included the remaining 75 firms that had at least two successive quarters of C, C+, or C++ rating and a 20% dividend change. Forty firms in this sample omitted their dividend during the period studied. Most firms did not resume their dividends during that period. In the few cases where firms did resume payment, they did so at least two years after the omission.

21 A study of dividend policy adjustment of 80 NYSE-listed firms in financial distress revealed that, in the absence of binding debt covenants, dividends are cut more often than omitted. This suggests that managerial reluctance is to the omission and not simply the reduction of dividends. Moreover, managers of firms with long dividend histories appear particularly reluctant to omit dividends. See DeAngelo, & DeAngelo, , “Dividend Policy and Financial Distress: An Empirical Investigation of Troubled NYSE Firms”, (1990) 45 J. Fin. 1415.CrossRefGoogle Scholar The sample included 80 NYSE-listed firms that had at least three annual losses during 1980–1985. These firms reported very few losses in the 10 years before the onset of financial trouble. “[O]ur sampling algorithm predominantly identified firms that were healthy prior to their initial annual loss during 1980–1985 … In short, our sample consists primarily of large, well-known industrial firms that were adversely affected by the economic downturn of the early 1980s”. Ibid., at 1417.

22 See DeAngelo & DeAngelo, ibid.

23 This explains why share repurchase plans cannot replace dividends. The former suffer from a bonding problem, since managers can time the repurchase to their advantage in an unpredictable manner. A stable repurchase plan is not feasible, and thus bonding is extremely difficult to achieve. See Barclay, & Smith, , “Corporate Payout Policy: Cash Dividends versus Open-Market Repurchases”, (1988) 22 J. Fin. Econ. 61, at 65.CrossRefGoogle Scholar

24 That is, the effect of the resulting drop in the stock price on managers would be greater than the potential agency costs resulting from the dividend cut, i.e., excess perquisites and suboptimal investment.

25 See Crockett, & Friend, , “Dividend Policy in Perspective: Can Theory Explain Behavior?”, (1988) 70 R. Earn. & Stat. 605, at 610Google Scholar (“any resulting reduction of agency costs provides a true rationale for (after-tax) dividend preference, other things equal”).

26 See Williamson, , The Economic Institution of Capitalism, (1986) 82.Google Scholar

27 Williamson did refer in his analysis to the possibility of different costs of equity to different firms based on the nature of their assets. However, he did not analyse the role that dividends could have in supplementing the governance structure.

28 See Williamson, supra n. 26, at 30–32.

29 See Williamson, Ibid., at 71 and 164, n. 17.

30 “Although a well-developed market in shares permits individual stockholders to terminate ownership easily by selling their shares, it does not follow that stockholders as a group have a limited stake in the firm. What is available to individual stockholders may be unavailable to stockholders in the aggregate … Stockholders as a group bear a unique relation to the firm. They are the only voluntary constituency whose relation with the corporation does not come up for periodic renewal … Labor, suppliers in the intermediate product market, debt-holders, and consumers all have opportunities to renegotiate terms when contracts are renewed. Stockholders, by contrast, invest for the life of the firm, and their claims are located at the end of the queue should liquidation occur”. See Williamson, supra n. 26, at 304.

31 See Williamson, ibid.

32 Ibid.

33 Raising money through the capital market has an additional monitoring function: the firm exposes itself not just to the underwriter, but to its creditors and suppliers, as well.

34 See Friend, , Longstreet, , Mendelson, , Miller, & Hess, , Investment Banking and the New Issues Market, (1967) 8Google Scholar: “Investment bankers presumably can contribute most to this allocational function of the capital markets by careful security analysis leading to appropriate pricing, and by seeing that the issue is well publicized, that all possible relevant information is developed and disclosed, and that the issue is placed as much as possible in the hands of the ultimate investors”, (emphasis added)

35 Friend et al., Ibid., at 397; and Gordon, , “The Mandatory Structure of Corporate Law”, (1989) 89 Cohim. L. R. 1549, at 1558Google Scholar: “In explaining to the issuer the trade-off of a particular charter provision against price, the underwriter is in effect the bargaining agent of prospective public shareholders as a group”.

36 Friend et al., supra n. 34, at 399: “Although many investment banker-directors were not appointed in connection with any issue, it is nevertheless true that in numerous instances representation of the investment banking firm on the boards of industrial corporations originated in connection with an issue that was brought out by the investment banking firm in question”.

37 See Ross, , Westerfield, & Jaffe, , Corporate Finance, (2nd ed., 1990) 519.Google Scholar

38 In a long-term contractual relationship, the riek of opportunism is highly likely; the performing party can reduce the quality of her performance, thereby reaping more profit from the predetermined price. Of course, the other party needs to monitor the performance, but she also needs a means to renegotiate the contract's terms in order to adjust it to new and unpredicted events.

39 True, the second group has the advantage of observing the established track record for the firm. However, the value of this advantage depends on the forecasting power that the past, in general, and the past record, in particular, have, and the level of commitment (reputation) associated with the past record of any given firm.

40 See Jensen, supra n. 10.

41 Of course, changes due to inflation, depreciation, and other movements in the market for the firm's assets are possible. So are changes due to business reality, such as losses or uninsured damages. Such changes are inherent to the original investment and should not be considered changes in the investment.

42 See e.g., Fox, , Finance and Industrial Performance in a Dynamic Economy, (1987) 164Google Scholar: “The situation where an established firm seeks muds from an intermediary is significantly different. The return on the investment opportunity being offered the intermediary will be based on the performance of the firm as a whole, not just on the project for which it is seeking funds”.

43 See Clark, , Corporate Law (1986) 599–600.Google Scholar

44 See my discussion on this issue regarding the reputation investment as bonding against agency costs, supra n. 18 and accompanying text.

45 If the firm can provide sufficient safeguards to shareholders, it might want to avoid the use of costly dividends.

46 In this respect, dividend policy ia materially different than share repurchase plans, although both methods have the same effect regarding the transfer of cash flow to shareholders. As long as share repurchase plans are unpredictable and discontinuous, they cannot perform the role of a governance instrument. See Barclay & Smith, supra n. 23.

If, however, share repurchase plans will be made predictable and continuous, then they will be rightfully treated as if they were dividends. See e.g., Jaasy, , “The Tax Treatment of Bootstrap Stock Acquisitions: The Redemption Route vs. the Dividend Route”, (1974) 87 Harv. L. R. 1469, at 1475–83Google Scholar (transactions that have the same economic substance should be given consistent tax treatment).

Thus, the influence of share repurchase plans on the firm-shareholders relationship is limited to the ex post effect resulting from the amount of equity investment refunded to shareholders. See supra n. 16. In contrast, dividend policy influences the firm-shareholders relationship in an ex ante manner, i.e., future dividends are anticipated and incorporated into the current price before actual payments have been made.

47 See Ang, , A Review of Corporate, Dividend Theories and Evidence, (1987) 36–37.Google Scholar

48 See DeAngeln & DeAngelo, supra n. 21.

49 See DeAngelo & DeAngelo, Ibid., providing evidence on such behavior by healthy firme in financial distress.

50 See Smith, , “Alternative Methods for Raising Capital: Rights versus Underwritten Offerings”, (1977) 5 J. Fin. Earn. 275.Google Scholar

51 See Hansen, & Pinkerton, , “Direct Equity Financing: A Resolution of a Paradox”, (1982) 37 J. Fin. 651.CrossRefGoogle Scholar

52 See Crutchley & Hansen, supra n. 8.

53 See Demaetz, & Lehn, , “The Structure of Corporate Ownership: Causes and Consequences”, (1985) 93 J.P.E. 1155.CrossRefGoogle Scholar

54 See Crutchley & Hansen, supra n. 8.

55 Dividend policy might be used, however, for other purposes.

56 See Crutchely & Hansen, supra n. 8.

57 Accordingly, we might observe an inverse relationship between the dividend payout ratio and the percentage of independent directors, or a positive relationship with the diffusion of shareholdings (see supra n. 8) for a given rate of return for firms within the same industry.

Two similar firms — one with a governance instrument (e.g., dividends) and one without — will be traded with different rates of return. Since the latter is riskier, higher return will be demanded. However, the firms could be traded for the same return when one offers dividend as a safeguard and the other offers debt or majority of independent directors. Thus, the comparison should account for the rate of return as well.

58 See Williamson, , Markets and Hierarchies: Analysis and Antitrust Implications, (1976) 136Google Scholar: “The resulting distortions and inefficiencies will not be viable where product market competition is extensive”.

59 See., e.g., Michel, & Shaked, , “Country and Industry Influence on Dividend Policy: Evidence from Japan and the U.S.A.”, (1986) 13(3) J. Bus. Fin. & Accon. 365, at 380CrossRefGoogle Scholar (several inter-country analyses revealed that the payout ratios - i.e., the ratio between earnings distributed as dividends and total earnings; dividends/total earnings = payout ratio - of sampled Japanese industries were higher than those of their American counterparts).

60 See Lintner, supra n. 17.

61 See Auten, & Cordes, , “Policy Watch: Cutting Capital Gains Taxes”, (1991) 5 J. Econ. Perspectives 181.CrossRefGoogle Scholar

62 Ibid., at 189.

63 Ibid., at 183.

64 See e.g., Fox, supra n. 42, at 368.

65 Baumol, , The Stock Market and Economic Efficiency (1965) 69–70.Google Scholar

66 See Stout, , “The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation”, (1988) 87 Mich.L.A. 613, at 685–692.CrossRefGoogle Scholar

67 In a study by Baumol, Haim, Malkiel, and Quandi (BHMQ), it was found that the return on retained earnings ranged from 3.0% to 4.6%, on debt from 4.2% to 14%, and on newly issued equity from 14% to 21%. The range depend« on the definition of earnings and the assumed lag between the time of investment and realization of returns. See Baumöl, , Haim, , Malkiel, & Quandt, , “Earnings Retention, New Capital and the Growth of the Firm”, (1970) 52 R. Econ. & Stat. 345.Google Scholar

These results were the subject of several methodological criticisms. See Wbittington, , “Profitability of Retained Earnings”, (1972) 54 R. Econ. & Stat. 152Google Scholar; Friend, & Husk, , “Efficiency of Corporate Investment”, (1973) 55 R. Econ. & Stat 122Google Scholar; Recette, , “Earnings Retention, New Capital and the Growth of the Firm: A Comment”, (1973) 55 R. Econ. & Stat. 127Google Scholar; Brealy, , Hodges, & Capron, , “The Return on Alternative Sources of Finance”, (1976) 58 R. Econ. & Stat. 469.Google Scholar

In a second study by BHMQ, which was redesigned to accommodate some of these criticisms (the original sample was divided into two groups), it was found that for firms which issue more than trivial amounts of new equity, the return on retained earnings (11.2%) was in the same range as the return on equity (12.3%) and on debt (9.8%). But for firms which issued insignificant amounts of new equity, the average rate of return on retained earnings was about zero. See Baumol, , Heim, , Malkiel, & Quandi, , “Efficiency of Corporate Investment: A Reply”, (1973) 55 R. Econ. & Stat. 128.Google Scholar But cf., Murali, & Welch, , “Agents, Owners, Control and Performance”, (1989) 16(3) J. Bus. Fin. & Accounting 386Google Scholar (no evidence of differential performance due to differences in agency costs between a majority owned and a widely held firm).

Also, it has been found that retained earnings tend to be invested in ventures that yield lower return and lower risk than those financed by new capital, probably due to managers' large investment in firm-specific assets, as managers' investment is less diversified than passive investor portfolios. See Mason, , “The Apologetics of Managerialism”, (1968) 31 J. Bus. 1Google Scholar; Monsen, & Downs, , “A Theory of Large Managerial Firms”, (1966) 73 J.P.E. 221.Google Scholar