Bebczuk

CHAPTER 4:
ASYMMETRIC INFORMATION AND DIVIDEND POLICY

The study of dividend policy is an especially active area of debate both in the world of finance as well as in the academic arena. Such interest is fully justified. In view of the relationship between dividends and stock prices, the topic is crucial to understand both the primary stock market -where new issues of shares are carriedout-, and the secondary stock market -in which shares already in circulation are negotiated-. From the perspective of the finance manager, a false impression could be created that the only relevant market is the primary one, ignoring that liquidity -the ability to transfer an asset at any moment- encourages demand for all financial instruments. Last but not least, in the previous chapter weemphasised that retained earnings are the main source of investment financing, and the volume of retained earnings depends not only on the availability cash flows but also on the dividend policy of the firm.
As part of our treatment, we will try to clarify some confusing ideas that surround dividend analysis. For example, it is commonly stated that a shareholder should feel attracted toward thosestocks providing high dividends. We will prove that if information problems are ignored such an assertion is as convincing as it is false. To spur the reader’s curiosity, let us jump to the final conclusion now: for tax reasons, the shareholder benefits if the company does not distribute dividends at all. However, countering this, information problems do make it desirable for the company todisburse dividends.

4.1 Dividend policy in the world

To give more substance to our discussion we will take a look at the following data, which displays retained earnings over total earnings in individual countries (sometimes referred to as retention ratio):

|Country |Retained earnings/Total earnings |
| ||
|Developed Countries | |
| | |
|United States |0.457 |
|Japan |0.414 |
|Germany |0.168 |
|United Kingdom|0.212 |
| | |
|Latin America | |
| | |
|Argentina |0.867 |
|Chile |0.949 |
|Colombia|0.911 |
|Mexico |0.973 |
|Venezuela |0.956 |
| | |

Information as of 1994.

Source: Rojas-Suarez L. and S. Weisbrod (1997), “Financial Markets and the Behaviour of Private Savings inLatin America”, in Hausmann R. and H. Reisen, eds., Promoting Savings in Latin America, IDB/OECD, Washington D.C.

These figures do not allow us to identify a clear pattern at the international level. Nevertheless, one can observe that in Latin America a minimal portion is distributed (in all the cases, less than 15%), while in the developed countries the payout ratio (dividends overearnings) is invariably higher than 50% of earnings.
Before we discuss this further, the difference between cash dividends, stock dividends and share repurchases must be clear. Our discussion will be centred on cash dividends, representing a transfer of money from the firm to their shareholders. Stock dividends are nothing more than an illusion, since the shareholder receives new shares but no...