scispace - formally typeset

Journal ArticleDOI

Why individual investors want dividends

01 Dec 2005-Journal of Corporate Finance (Elsevier)-Vol. 12, Iss: 1, pp 121-158

AbstractThe question of why individual investors want dividends is investigated by submitting a questionnaire to a Dutch investor panel. The respondents indicate that they want dividends partly because the cost of cashing in dividends is lower than the cost of selling shares. Their answers provide strong confirmation for the signaling theories of Bhattacharya (1979) [Bhattacharya, S., 1979. Imperfect information, dividend policy and the “bird in the hand” fallacy. Bell Journal of Economics 10, 259–270] and Miller and Rock (1985) [Miller, M., Modigliani, F., 1961. Dividend policy, growth and the valuation of shares. Journal of Business 34, 411–433]. They are inconsistent with the uncertainty resolution theory of Gordon (1961, 1962) [Gordon, M., 1961. The Investment, Financing, and Valuation of the Corporation, Richard D. Irwin, Homewood, IL; Gordon, M., 1962. The savings, investment and valuation of a corporation. Review of Economics and Statistics 44, 37–51.] and the agency theories of Jensen (1986) [Jensen, M.C., 1986. Agency costs of free cash flow, corporate finance and takeovers. American Economic Review 76, 323–329] and Easterbrook (1984) [Easterbrook, F.H., 1984. Two agency-cost explanations of dividends. American Economic Review 74, 650–659]. The behavioral finance theory of Shefrin and Statman (1984) [Shefrin, H.M., Statman, M., 1984. Explaining investor preference for cash dividends. Journal of Financial Economics 13, 253–282] is not confirmed for cash dividends but is confirmed for stock dividends. Finally, our results indicate that individual investors do not tend to consume a large part of their dividends. This raises some doubt as to whether a reduction or elimination of dividend taxes will stimulate the economy.

Topics: Dividend policy (67%), Corporate finance (57%), Dividend tax (56%), Dividend (56%), Free cash flow (55%)

Summary (3 min read)

1. Introduction

  • The authors test their validity as descriptions of investor behavior with direct survey research conducted on a sample of Dutch household members who constitute a voluntary panel that answers personal survey questionnaires on family financial and consumer matters every week.
  • Section 5 describes survey results and discusses how they relate to their hypotheses.

2. Theories on Why Investors Want Cash Dividends

  • A. The Miller and Modigliani (1961) dividend irrelevance theory Miller and Modigliani (1961) show that in a perfect and complete capital market the dividend policy of a firm does not affect its value.
  • It is interesting to notice that Fuller and Goldstein (2003) conclude that dividend-paying stocks have higher returns than non-dividend paying stocks, and that this effect is especially strong in declining markets.
  • De Jong et al. (2004) provide more discussion of this system and its effects on share value.
  • The authors therefore believe that there is substantial information asymmetry between management and shareholders in the Netherlands.
  • In the old tax system prevailing before January 1, 2001, dividends were treated as ordinary income and were taxed at a progressive rate.

3. Theories on Why Investors Want Stock Dividends

  • An issue that is closely related to that of cash dividends is the question of why some companies “pay” stock dividends.
  • Stock dividends may have an advantage over cash dividends because they may carry lower transaction costs.
  • An investor holding 113 shares might receive one share for 100 stock dividends.
  • Stock dividends are nothing more than a stock split and should not be taxed in the first place.
  • They argue that stock dividends are labeled as dividends.

4.1. Survey Methods and CentER Panel

  • The authors surveyed individual investors to test the theories discussed in the previous two sections.
  • Surveys complement research based on large samples and clinical studies, particularly for a question like dividend policy where the beliefs of investors are the basis for most of the theoretical models.
  • The first is that the respondents may not be representative of the population.
  • If the household does not have a television, CentERdata provides one.
  • Information about the panel can be found at http://www.centerdata.uvt.nl.

4.2. The Questionnaire

  • The authors have made large efforts to avoid the potential problems that are associated with the use of surveys.
  • First, the problem that the respondents may not be representative of the population is avoided by the use of the CentER panel.
  • The confidential nature of the respondent database precludes us interviewing any of them.
  • Therefore the questions have to be couched in plain, unambiguous language that the respondents understand.
  • Questions 1-4 determine whether the respondents own, or have owned within the last three years, shares in companies and/or investment funds.

4.3. Statistical Inference

  • These responses are both presented for the whole sample and for sub-samples according to demographic statistics, i.e., age, income and education.
  • From these interviews, the researcher creates one or more hypotheses about behavior that she can test on larger numbers of subjects or sites.
  • 17 For Questions 5-32, the authors test whether the mean and median responses are significantly different from the neutral response, and whether the responses from demographic groups are significantly different.
  • The authors still use a non-parametric two-sample test for the median responses.
  • For the difference in mean between demographic groups, the authors use a Z-test for the difference in proportions.

5.1. Overview of Survey Respondents

  • For this purpose all panel members of 16 years and older were selected.
  • These results are available on request from the authors.
  • Figure 1 gives the demographic distributions of the survey respondents.
  • It can be concluded from Figure 1 that on average investors are older, have higher income and are better educated than non-investors, which is what the authors would expect.
  • The second additional survey was submitted to the panel in the weekend of March 13, 2004.

5.2. Results for Cash Dividends

  • 19 Table 2 includes the responses to the questions on cash dividends.
  • The results indicate that individual investors do not see dividends as a way to control for possible overinvestment tendencies by management.
  • Both the mean and the median are significantly different from 4. Brav et al. (2004) try to find out from the executives why individual investors want dividends.

5.3. Results on Stock Dividends

  • The first question in Table 5 asks whether respondents consider stock dividends to be more like stock splits (response possibility 7) or like cash dividends (response possibility 1).
  • The median is significantly different from four at the 5% level.
  • The differences in scores between the different education and income groups are also not significant.
  • The second question on stock dividends (Question 29) shows that when only considering transaction costs, on average, investors prefer stock dividends compared to cash dividends.
  • All sub-samples for this question show a score that is significantly higher than 4.

5.4. Robustness Checks

  • Answers by respondents who do not want to receive dividends or who are indifferent may not be valid in testing theories of why dividends are relevant.
  • No a priori theoretical or empirical basis exists for this distinction, but it does seem possible.
  • The authors believe that investors, who prefer not to receive dividends or are indifferent, should still have valid opinions on the theories for and against dividends, since they are equally part of the market for shares.
  • The authors tested to see if this potentially confounding effect exists.
  • The results display a similar pattern to those in Tables 2-5, and so the authors have not reproduced them here.

6. Summary and conclusions

  • Most of the finance theory on dividend policy starts with the behavior of shareholders.
  • The empirical finance literature on this topic either studies share price reactions or surveys corporate executives for their opinions.
  • The authors received 555 responses from consumers that have, or recently had, investments in stocks of individual companies or investment funds.
  • The authors find that investors have a strong preference to receive dividends.
  • The results are inconsistent with the agency theories of Easterbrook (1984) and Jensen (1986).

Did you find this useful? Give us your feedback

...read more

Content maybe subject to copyright    Report

Why individual investors want dividends
Ming Dong
a
, Chris Robinson
b
, Chris Veld
c,*
a
Schulich School of Business, York University, Toronto, ON, M3J 1P3, Canada
b
Atkinson School of Administrative Studies, York University, Toronto, ON, M3J 1P3, Canada
c
Faculty of Business Administration, Simon Fraser University, Burnaby, BC, V5A 1S6, Canada
October 25, 2004
Abstract
The question of why individual investors want dividends is investigated by
submitting a questionnaire to a Dutch investor panel. The respondents indicate that they
want dividends partly because the cost of cashing in dividends is lower than the cost of
selling shares. Their answers provide strong confirmation for the signaling theories of
Bhattacharya (1979) and Miller and Rock (1985). They are inconsistent with the
uncertainty resolution theory of Gordon (1961, 1962) and the agency theories of Jensen
(1986) and Easterbrook (1984). The behavioral finance theory of Shefrin and Statman
(1984) is not confirmed for cash dividends but is confirmed for stock dividends. Finally,
our results indicate that individual investors do not tend to consume a large part of their
dividends. This raises some doubt as to whether a reduction or elimination of dividend
taxes will stimulate the economy.
JEL classification: G30; G35; G38
Keywords: Dividends; Individual investors; Survey
______________________
*
Corresponding author. Tel.: +604-268-6790; fax: +604-291-4920.
E-mail:
cveld@sfu.ca (C. Veld).
The authors thank Marcel Das and Mariëlle Klerks for their help with the CentERpanel survey.
Furthermore they are grateful to Susan Belden, Abe de Jong, George Frankfurter, David Hirshleifer, Rez
Kabir, Skander Lazrak, Elizabeth Maynes, Moshe Milevsky, Terrance Odean, Lynnette Purda, Sara Reiter,
Gordon Roberts, Pauline Shum, Yulia Veld-Merkoulova, Marno Verbeek, participants at the APFA-
conference in Hamburg (August 2002), the Multinational Finance Society Conference in Montreal (June
2003), the Financial Management Conference in Denver (October 2003), the Academy of Financial Service
Conference in Denver (October 2003), the Northern Finance Association Conference in St. John’s
(September 2004), and at seminars at the Erasmus University Rotterdam, HEC Montreal, McMaster
University, Simon Fraser University, Tilburg University, University of Calgary, University of Waterloo,
and York University for their comments and suggestions. Special thanks go to an anonymous referee and
to Jeffry Netter (the editor) for very helpful comments. They also gratefully acknowledge the financial
support of the Faculty of Economics and Business Administration at Tilburg University, the Department of
Finance at Tilburg University, the CFP Board of Standards in Denver, and Social Sciences and Humanities
Research Council of Canada. Part of the work for this paper was done while Chris Robinson was affiliated
with the Schulich School of Business at York University and Chris Veld was visiting the Schulich School
of Business at York University and was affiliated with the Faculty of Economics and Business
Administration at Tilburg University. The usual disclaimer applies.

1
1. Introduction
Our understanding of dividend policy depends on the behavior of individual
investors, from the early work of Miller and Modigliani (1961) and Gordon (1961) to the
more recent behavioral finance theories. Many empirical papers have documented
corporate dividend policy and payments, and have related the policies in various ways to
the theories based on the behavior of individual investors. While there appears to be a
general agreement that investors like dividends, there has been no empirical study of why
individual investors want dividends. We fill that gap by asking individual investors about
their attitude towards dividends.
Miller and Modigliani (1961) show that individuals can undo management’s
decisions on dividend policy in a perfect and complete capital market by either
reinvesting dividends or selling off stock, making dividend policy irrelevant. In the
United States until recently, as well as in most other countries, dividends have been taxed
more heavily than capital gains. The irrelevance theorem in combination with the
unfavorable taxation of dividends makes dividends a puzzle. Brealey and Myers (2003)
consider the dividend controversy to be one of the “10 unsolved problems in finance.”
Fama and French (2001) find that the proportion of U.S. firms paying cash dividends
has fallen from 66.5% in 1978 to 20.8% in 1999.
1
Grullon and Michaely (2002) show that
firms have gradually substituted repurchases for dividends.
2
These findings might be a
response to the dividend puzzle. Dividends have gained renewed attention recently. On
May 23, 2003, the U.S. Congress passed a “tax relief” bill that includes a major change in
1
Baker and Wurgler (2002) argue that throughout history dividends have disappeared and reappeared.
Besides that, past market crashes were characterized by a shift of investors towards dividend paying
companies. They argue that, since Internet stocks have officially crashed, dividends may reappear in the
next few years.
2
Jagannathan et al. (2000) also indicate that share repurchases are on the rise. However, they argue that
share repurchases are not a perfect substitute for cash dividends. They find that dividends are paid by firms
with higher “permanent” operating cash flows, while share repurchases are used by firms with higher
“temporary” non-operating cash flows.

2
taxation of investments.
3
Capital gains and dividends will now be taxed equally at a top
rate of 15%, eliminating the tax penalty on dividends. During the period after the bill was
proposed and before it passed, Microsoft announced that it would start paying dividends
for the first time in its 28-year history. Technology companies such as Cisco and Oracle
stated that if dividend taxes were eliminated, they would start paying dividends. This has
led to a renewed interest in why investors want dividends.
The modern literature on dividend policy has been strongly dominated by economic
modeling approaches, both in developing hypotheses and in empirical investigation of
dividend policy.
4
Brennan (1970) provides an after-tax model of dividend valuation and
the Capital Asset Pricing Model that other researchers use. Notably, Black and Scholes
(1974) find no evidence of a dividend effect and Litzenberger and Ramaswamy (1979)
find a significant effect. Many other papers grapple with this conflict and related
hypotheses, but the field of finance has not yet reached a consensus on the effect of
dividend policy on firm value. Even though many papers appear later than Black (1976),
his belief is still the current opinion (p. 5): “Why do corporations pay dividends? Why do
investors pay attention to dividends?... I claim that the answers to these questions are not
obvious at all. The harder we look at the dividend picture, the more it seems like a puzzle,
with pieces that just don’t fit together.
To shed more light on the dividend puzzle, we surveyed a unique Dutch panel of
ordinary families who answer questions on personal finance and consumption matters
weekly via an organized website/e-mail link. Since this voluntary panel is accustomed to
completing questionnaires and most of the panel members will respond, many of the
difficulties of survey research are avoided. Furthermore, a demographic profile of the
panel members is available, which allows us to better understand the survey responses
and test the dividend theories more fully. To the extent that the characteristics of Western
investors are similar, we expect our results to be relevant for other Western countries.
3
See the article “House and Senate approve $ 350 billion tax-relief bill” by Shailagh Murray, Wall
Street Journal Online, May 23, 2003.
4
For a review of this literature see e.g. Allen and Michaely (2004), Frankfurter and Wood (2002), and
Lease et al. (2000).

3
We do not include institutional investors in our survey. We are testing the theories
developed over more than 40 years relating to individual investor decisions. If
institutional investors are acting in place of their clients, then their portfolio decisions
will reflect the preferences of their clients. This is particularly true for managers of
investment funds, since the income flows directly to the beneficial owners. Our survey
looks at individual investors who hold shares directly and/or through investment funds.
The indirect holdings through pension plans are not represented.
Conducting research in the Netherlands on dividend preferences has a special
advantage, because the new Dutch tax system does not tax dividends and capital gains
differently, while the old (pre-2001) system taxed dividends more heavily than capital
gains. This tax environment provides us with an excellent setting to test dividend theories
by isolating the tax effect on dividends from other considerations. In this regard our
results should be more informative than past U.S. survey results, and also provide a
preview of investor preferences in the U.S. under the new tax law.
5
In some previous studies, including Lintner (1956), Baker et al. (1985), Baker et al.
(2002), and De Jong et al. (2003), researchers used questionnaires to find out why
companies pay dividends. A particularly interesting paper in this vein is Brav et al.
(2004), who have surveyed 384 CFOs and treasurers of mostly U.S. companies, and
conducted 23 in-depth interviews with executives on their payout policy. They find that
financial executives believe that retail investors have a strong preference for dividends,
despite the tax disadvantage. Another interesting finding is that financial executives
believe that dividends convey management’s confidence about the future. However,
managers say that they do not pay dividends as a costly signal to convey their firm’s true
value. Therefore Brav et al. (2004) conclude that they only find modest support for the
signaling hypotheses. Their survey finds little support for the agency theories of
Easterbrook (1984) and Jensen (1986).
5
The two systems are not identical. The Dutch taxation of investments is now a wealth tax; so timing
of realization of capital gains is irrelevant. The US system taxes capital gains on realization and thus a tax
timing option still exists that is not applicable to dividends.

4
The aim of our paper is to determine what individual investors believe about dividend
policy. This question is also examined by Brav et al. (2004), but they do so indirectly by
asking financial managers for the view of the investors. The managers in their
questionnaire believe that individual investors want dividends, but the reasons are not
clear. Therefore Brav et al. (2004) conclude, “At this point we can only speculate about
what causes individual investors to prefer dividends”. In this paper we try to fill this gap.
We start by summarizing the various hypotheses and conjectures that have been
advanced about investor beliefs and behavior regarding corporate dividend policy. We
test their validity as descriptions of investor behavior with direct survey research
conducted on a sample of Dutch household members who constitute a voluntary panel
that answers personal survey questionnaires on family financial and consumer matters
every week. From a sample of 2,723 household members we received 555 usable
responses from members who hold or recently held common shares and/or investment
funds.
Our results unambiguously indicate that individual investors are not indifferent to
dividends. The mean score on the question whether they want dividends was answered
with an average score of 4.98 on a scale that ranges from 1 (= I do not want dividends) to
7 (= I want dividends), with 4 being the neutral score. 60.5% of the respondents indicate
a score of 5 or above, while only 12.3% answer 3 or below. Both the mean and the
median score on this question are significantly different from 4 at the 1% level. There is a
strong confirmation of the signaling role of dividends. Our results are inconsistent with
both the free cash flow theory of Jensen (1986), and the agency theory of Easterbrook
(1984). All these results are fairly consistent with Brav et al. (2004).
The results further indicate that transaction costs are an important reason for
individuals to like dividends. Investors appear to view dividends as saving transaction
costs when they do not reinvest the dividends in the same stocks, e.g. when they want to
consume, deposit in a bank account, or reinvest the dividends in a different security.
These results are stronger for relatively old, low income and less-educated investors. The
uncertainty resolution theory of Gordon (1961, 1962) is not confirmed. Investors seem to
consider dividend-paying stocks to be more risky than non-dividend paying stocks.
Overall, investors do not believe that dividend-paying firms are less likely to manipulate

Citations
More filters

Journal ArticleDOI
Abstract: Purpose – The purpose of this research is to analyze survey results on the perception of dividends by managers of dividend‐paying firms listed on the Toronto Stock Exchange (TSX).Design/methodology/approach – Managers from a sample of 291 dividend‐paying TSX‐listed Canadian firms were surveyed about their views on dividends.Findings – The most important factors influencing dividend policy are the level of current and expected future earnings, the stability of earnings, and the pattern of past dividends. Despite dramatic differences in the level of ownership concentration between Canadian and US firms, their corresponding managers' views on the determinants of dividends are similar. Canadian managers believe that dividend policy affects firm value but express little agreement with the theory of a residual dividend policy. They express strong support for the signaling and lifecycle explanations for paying dividends, but not for the bird‐in‐the‐hand, tax‐preference and dividend clientele, agency cost, or cat...

110 citations


Journal ArticleDOI
Abstract: Risk perceptions of individual investors are studied by asking experimental questions to 2,226 members of a consumer panel. Their responses are analyzed in order to find which risk measures they implicitly use. We find that most investors implicitly use more than one risk measure. For those investors who systematically perceive risk according to the same risk measure, semi-variance of returns is most popular. Semi-variance is similar to variance, but only negative deviations fro the mean or another benchmark are taken into account. Stock investors implicitly choose for semi-variance as a risk measure, while bond investors favor probability of loss. Investors state that they consider the original investment to be the most important benchmark, followed by the risk-free rate of return, and the market return. However, their choices in the experimental questionnaire study reveal that the market return is the most important benchmark.

104 citations


Journal ArticleDOI
Abstract: We study dividend payouts of 462 U.S. bank holding companies before and during the 2007–09 financial crisis. Fama and French (2001) characteristics (size, profitability and growth opportunities) explain dividend payouts before and during the financial crisis. The agency cost hypothesis explains dividend payouts before and during (more pronouncedly) the financial crisis. The signaling hypothesis explains dividend payouts during the financial crisis. Regulatory pressure was ineffective in limiting dividend payouts by undercapitalized banks before the financial crisis. Our findings have implications for corporate finance and governance theories, and also for the regulatory reforms that are being discussed among policymakers.

85 citations


Journal ArticleDOI
Abstract: Changes in taxation of corporate dividends offer excellent opportunities to study dividend clientele effects. We explore payout policies and ownership structures around a major tax reform that took place in Finland in 2004. Consistent with dividend clienteles affecting firms' dividend policy decisions, we find that Finnish firms altered their dividend policies based on the changed tax incentives of their largest shareholders. While firms adjust their payout policies, our results also indicate that ownership structures of Finnish firms also changed around the 2004 reform, consistent with shareholder clienteles adjusting to the new tax system.

82 citations


Journal ArticleDOI
Abstract: Risk perceptions of individual investors are studied by asking experimental questions to 2226 members of a consumer panel. Their responses are analyzed in order to find which risk measures they implicitly use. We find that most investors implicitly use more than one risk measure. For those investors who systematically perceive risk according to the same risk measure, semi-variance of returns is most popular. Semi-variance is similar to variance, but only negative deviations from the mean or another benchmark are taken into account. Stock investors implicitly choose for semi-variance as a risk measure, while bond investors favor probability of loss. Investors state that they consider the original investment to be the most important benchmark, followed by the risk-free rate of return, and the market return. However, their choices in the experimental questionnaire study reveal that the market return is the most important benchmark.

82 citations


References
More filters


Posted Content
Abstract: The interests and incentives of managers and shareholders conflict over such issues as the optimal size of the firm and the payment of cash to shareholders. These conflicts are especially severe in firms with large free cash flows—more cash than profitable investment opportunities. The theory developed here explains 1) the benefits of debt in reducing agency costs of free cash flows, 2) how debt can substitute for dividends, 3) why “diversification” programs are more likely to generate losses than takeovers or expansion in the same line of business or liquidationmotivated takeovers, 4) why the factors generating takeover activity in such diverse activities as broadcasting and tobacco are similar to those in oil, and 5) why bidders and some targets tend to perform abnormally well prior to takeover.

14,358 citations


Journal ArticleDOI
Abstract: This paper considers a firm that must issue common stock to raise cash to undertake a valuable investment opportunity. Management is assumed to know more about the firm's value than potential investors. Investors interpret the firm's actions rationally. An equilibrium model of the issue-invest decision is developed under these assumptions. The model shows that firms may refuse to issue stock, and therefore may pass up valuable investment opportunities. The model suggests explanations for several aspects of corporate financing behavior, including the tendency to rely on internal sources of funds, and to prefer debt to equity if external financing is required. Extensions and applications of the model are discussed.

12,954 citations


Journal ArticleDOI
Abstract: In the hope that it may help to overcome these obstacles to effective empirical testing, this paper will attempt to fill the existing gap in the theoretical literature on valuation. We shall begin, in Section I , by examining the effects the effects of differences in dividend policy on the current price of shares in an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty. Still within this convenient analytical framework we shall go on in Section II and III to consider certain closely related issues that appear to have been responsible for considerable misunderstanding of the role of dividend policy. In particular, Section II will focus on the longstanding debate about what investors "really" capitalize when they buy shares; and Section III on the much mooted relations between price, the rate of growth of profits, and the rate of dividends per share. Once these fundamentals have been established, we shall proceed in Section IV to drop the assumption of certainty and to see the extent to which the earlier conclusions about dividend policy must be modified. Finally, in Section V , we shall briefly examine the implications for the dividend policy problem of certain kinds of market imperfections.

5,969 citations


Journal ArticleDOI
Abstract: We survey 392 CFOs about the cost of capital, capital budgeting, and capital structure. Large firms rely heavily on present value techniques and the capital asset pricing model, while small firms are relatively likely to use the payback criterion. A surprising number of firms use firm risk rather than project risk in evaluating new investments. Firms are concerned about financial flexibility and credit ratings when issuing debt, and earnings per share dilution and recent stock price appreciation when issuing equity. We find some support for the pecking-order and trade-off capital structure hypotheses but little evidence that executives are concerned about asset substitution, asymmetric information, transactions costs, free cash flows, or personal taxes.

3,850 citations


Frequently Asked Questions (2)
Q1. What contributions have the authors mentioned in the paper "Why individual investors want dividends" ?

In this paper, the question of why individual investors want to pay dividends was investigated by submitting a questionnaire to a Dutch investor panel, and the results indicated that individual investors do not tend to consume a large part of their dividends. 

The authors do not find much support for the “ irrational ” explanations of the existence of dividends, i. e. the uncertainty resolution theory of Gordon ( 1961, 1962 ) and the behavioral explanation of Shefrin and Statman ( 1984 ).