Corporate Dividend Policy and Preemptive Security Issues

Abstract

FO R some time the question of how a firm's dividend policy can be expected to influence the value of its shares has been of interest to businessmen, investors, and economists. And yet, until quite recently there existed no well-developed theory (or theories) of the relationship between dividend policy and share valuation. In the past several years, however, the work of Miller and Modigliani, Gordon, Lintner, and others has largely eliminated this deficiency.' This paper is concerned with the question of how dividend policy and share valuation are related for the case of firms that concurrently pay dividends and raise capital through the sale of preemptive security issues. The importance of this question is highlighted by the fact that a significant number of major corporations continue paying dividends while floating preemptive issues. Table 1, for example, shows a sampling of corporations that have recently issued securities to shareholders at the same time that dividends were being paid. In this paper we will argue that, given the current regulations governing the taxation of personal income, there are strong reasons to believe that a reduction in dividend payments by firms that are raising capital by preemptive security issues could lead to an increase in common share values. This general point is, we believe, implicit in several previous papers dealing with dividend policy. Nevertheless, because the argument has not hitherto been stated formally, the magnitude and implications for the theory of share valuation have been largely neglected. Our conclusions relative to the dividend policy of firms that are not anticipating acquiring funds from their stockholders are less easy to prove; nevertheless, there is some carry-over from the particular case that is studied in detail. In particular, it will become apparent that dividend policy can affect the valuation of stock in the presence of personal income taxes that distinguish between ordinary income and long-term capital gains. The present tax law allows deferral of tax payment (or complete avoidance) on capital gains, and recognized gains may be taxed at different rates from ordinary income.2