Wednesday, May 31, 2006

Dividends and Capital Structure

Hold on to your seats folks, this one gets exciting! Definitely I^3!

It starts off so easy: Are dividend policy and capital structure related? And if so how?

Surprisingly for two topics that have been central to corporate finance for decades, we still really do not have very good explanations to either. A new paper by Faulkender, Milbourn, and Thackor attempts to solve both problems with a new theory that suggests not only are dividends and debt related, and tied to investor uncertainty. Moreover, it appears the theory actually fits the data!

Super short version: When managers and shareholders agree on the things stock prices rise. Moreover, debt levels and dividend payout ratios drop. This key insight is shown both theoretically and empirically.

Longer version: While often studied, capital structure and dividend policy have many unanswered questions and none of our models fit the evidence very well.Hence the need to new thinking on the matter and that is what by Faulkender, Milbourn, and Thackor have brought to the table (computer screen?) in Does Corporate Performance Determine Capital Structure and Dividend Policy?

A few quick look-ins:
“..troubling is the fact that existing theories also do not explain why some firms never pay dividends whereas others consistently do, why the payment of dividends seems dependent on the firm’s stock price, and why there seem to be correlations between firms’ capital structure and dividend policy...We are thus left without a theory of dividends that squares well with these stylized facts. The evidence on capital structure is even more troubling.”
“In this paper, we address this question by developing a fresh approach with a simple model that departs from the usual agency and signaling stories. We assume that the manager wishes to maximize a weighted average of the stock prices at the initial and terminal points in time. At the initial point in time he raises the funds needed for a future project with either debt or equity, and thereby determines the firm’s capital structure. Moreover, he also decides how large a dividend to promise to pay at the next point in time. At the time that the manager makes his financial policy choices, he is aware that investors may not agree with his future project choice… project-choice disagreement arises solely from potentially different beliefs about project value rather than agency or private information problems.

* Their main point:
“higher agreement between the manager and the investors implies a higher stock price, so the model predicts leverage and dividend payout ratios to be inversely related to the firm’s stock price.
After theoretically modeling the problems, the authors empirically test their predictions and find strong support. Again in their words:
"We find that firms for which there is greater agreement (i.e., lower analyst forecast dispersion and greater performance-based compensation) have significantly less debt in their capital structure – as measured by either market or book leverage, or interest coverage – and pay out a significantly smaller fraction of the earnings in the form of dividends, measured using both the dividend payout ratio and the dividend yield.”
Good stuff!!

You probably do want to read the whole thing on this one (indeed the literature review (disguised in the introduction) is excellent and is definitely understandable for even undergraduates!)

Cite: Faulkender, Michael W., Milbourn, Todd T. and Thakor, Anjan V., "Does Corporate Performance Determine Capital Structure and Dividend Policy?" (
March 9, 2006). Available at SSRN:

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