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Good theory, little use Back  
Danny Kitchen reviews Dividend Policy - its impact on firm value by Ronald C Lease (editor) et al, Harvard Business School Press, 1999.
It is appropriate in this era of investment in high technology and internet stocks that a book should appear dealing with some fundamental tenets of financial theory and in particular the commonly perceived view that investors consider dividends largely irrelevant in determining the value of shares.

The book begins with an explanation of the ‘dividend puzzle’ - the payment of dividends versus the retention of funds for investment in increasing shareholder wealth. It then proceeds to explain share valuation using the discounted value of future dividends method. The authors then set out the Miller and Modigliani conclusion that in perfect capital markets dividend policy is irrelevant in increasing shareholder wealth. As we all know, capital markets are far from perfect and the bulk of the book goes on to address this. It covers the frictions or imperfections in the capital markets, concentrating on the major factors of tax, conflicts of interests between managers and shareholders and differential information between market participants.

The theory that, due to capital gains being taxed at a lower rate than dividend income, long-term investors should require a higher pre-tax return on shares paying dividends is not consistent with the empirical evidence. The authors conclude that there is currently no theory which satisfactorily explains the effects of tax on share prices. The book summarises the academic work undertaken to show that bondholders prefer to restrict dividend payments and that shareholders, desiring managerial efficiency, prefer to leave little discretionary cash with managers thus forcing managers to return to the capital markets to fund investments. The markets can provide more efficient monitoring of the firm than the shareholders. Finally in this section the book examines the theoretical and empirical studies of the role of dividends in signalling information to the market. Overall dividend increases generate positive returns and decreases negative ones and that the effect will be more pronounced on low growth firms. Also, management dividend behaviour still conforms to conclusions reached forty years ago that managers wish to stabilise dividends with gradual sustainable increases where appropriate, establish a target payout ratio and to avoid dividend cuts if at all possible.

In addressing the issue of share buy backs, the authors say that there are some common motives with dividend payments but that buy backs are disproportionate in their effect and often have different tax treatments. I found the conclusions, some of which I have referred to above, rather uninspiring and mostly a confirmation of what one would have thought intuitively. This is perhaps best illustrated by the final summary in which the authors say that they believe that dividend policy can have an effect on shareholder wealth due to market imperfections and that, by weighting these imperfections, management can arrive at a reasonable policy for communication to the market. As someone who has to do this, I did not find this book to be particularly helpful. In summary a good academic distillation of the literature but not much use at the sharp end.

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