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Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy MCOM Sem 2 Delhi University : John Lintner (1956) proposed this target-adjustment formula to describe dividend payout by a mature corporation: ∆Dividendt = κ + PAC (Target Dividendt − Dividendt−1) + et (1) ∆Dividendt is the change from the previous dividend at period t – 1, P AC < 1 is a partial adjustment coefficient, κ is a constant and et is an error term. The target dividend is the product of a target payout ratio and net income at t. The target payout ratio and the coefficients κ and P AC are assumed constant over time, although they can vary across firms.

Thus dividends are based on current net income, but smoothed. Smoothing means two related things. First, if net income includes transitory shocks, dividends are smoothed relative to income. Second, a permanent shift in expected future income does not cause an immediate proportional shift in dividends; instead dividends adapt gradually. Lintner did not derive his dividend-smoothing model. He came to it inductively, based on interviews with 28 large, public manufacturing firms. His model remains the accepted starting point for analysis of how dividends behave over time. Yet his description of dividend smoothing has, as far as we can tell, never been derived formally. We will discuss some signaling theories that suggest smoothing, but none generates Lintner’s formula. If dividends are smoothed, something else has to absorb fluctuations in operating profitability and capital investment.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Consider the budget constraint, assuming for the moment that the firm does not issue or repurchase shares: ∆Debt + Net income = CAPEX + Dividends (2) Lintner’s formula says that changes in dividends absorb only part of the changes in net income. The remainder must be absorbed by changes in borrowing (∆Debt) or by capital investment (CAPEX). If dividends follow Linter’s model and CAPEX is nailed down by the firm’s investment opportunities, then ∆Debt must soak up most of the changes in net income.

Corporate-finance theory tends to ignore the budget constraint. There are separate theories of dividends, debt and investment. But there can be no more than two separate theories. Given this period’s net income, a theory of dividends plus a theory of investment must imply a theory of debt. This paper presents a combined theory of dividends, debt and investment. We derive and interpret Lintner’s dividend-payout formula.

We also show why borrowing or lending should be the chief shock absorber in the firm’s budget constraint. Our model also can be interpreted more broadly as a theory of total payout, defined as dividends plus repurchases minus stock issues. Repurchases have been important only recently, however, and seasoned equity issues are infrequent, at least for the mature corporations that Lintner interviewed and that we have in mind.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Therefore we start with dividends, but circle back later to consider implications for total payout. It turns out that the Lintner model is a good fit to total payout by large, blue-chip U.S. corporations that pay regular dividends. We assume that financial decisions are made by a coalition of managers, who maximize the present value of their (utility from) future rents that they will take from the firm. The managers in our model are entirely self-interested and have no loyalty to outside shareholders. The shareholders have only the most basic and primitive property right, which is the ability to take over the firm and throw out the managers if sufficiently provoked.

The managers therefore have to observe a capital-market constraint: they have to deliver an adequate return to investors in each period by paying a sufficient cash dividend. In equilibrium the managers do deliver adequate returns, and shareholders do not intervene. Our model follows Myers (2000), Jin and Myers (2006) and Lambrecht and Myers (2007, 2008). But those papers assumed risk-neutral managers and did not analyze dividends, debt and investment jointly. Here we assume a more realistic utility function, with risk aversion and habit formation. We do adopt those papers’ view of managerial rents, however.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

We are not defining rents as psychological private benefits, such as the CEO’s warm glow from leading a big public firm. We define rents as real resources appropriated by a broad coalition of managers and staff, including above-market salaries, job security, generous pensions and perks. Rich labor contracts can generate a flow of rents to blue-collar employees. Rents follow naturally from agency issues and imperfect corporate governance. Rents can be efficient, however. They are necessary to reward managers’ investment in firmspecific human capital. Myers (2000) and Lambrecht and Myers (2008) also show how rents can align managers’ and shareholders’ interests if the managers maximize the present value of rents subject to a capital-market constraint. We assume perfect, frictionless financial markets.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Investors in our model do not care whether dividends are stable or erratic. (There are clienteles of investors who want smooth dividends – see Baker, Nagel, and Wurgler (2007), for example – but we do not invoke them to explain smoothing.) Debt and dividend policy turn out to be irrelevant for shareholders, as in Modigliani-Miller (1958, 1961). Our main results include the following:

1. Dividends are smoothed because managers want to smooth their flow of rents. Rents and dividends move in lockstep. An attempt to smooth rents without smoothing dividends would violate the capital-market constraint.

2. Risk aversion means that rents depend on managers’ permanent income, which is proportional to the present value of the firm’s future net income. The response of rents and dividends to transitory changes in net income is an order of magnitude less than the response to persistent changes in net income. Thus dividends smooth out transitory shocks to income.

3. Habit formation means that rents and dividends respond gradually to permanent shifts in net income. The managers’ risk aversion and habit formation together lead to dividend smoothing according to Lintner’s target-adjustment model.

4. The Lintner constant κ increases with managers’ subjective discount factor (impatience) and habit formation, but decreases with risk aversion and earnings volatility. The partial adjustment coefficient P AC decreases with habit persistence and with the market discount factor. Dividend payout increases with better investor protection.

5. We explain the ”information content of dividends,” that is, the good (bad) news conveyed by dividend increases (cuts). Managers take rents based on their forecast of the firm’s permanent income. Thus dividend changes signal managers’ view of permanent income. The smaller the firm’s P AC, the greater the stock-price response to a given unanticipated dividend change.

6. Managers do not maximize market value. They underinvest. Higher risk aversion and profit volatility increase underinvestment. Habit formation mitigates underinvestment.

7. Given investment, changes in debt absorb all changes in income that are not soaked up by changes in dividends or rents. Once managers smooth rents and dividends, the change in debt is the only free variable in the budget constraint. Thus we arrive at a theory of debt dynamics, similar to the pecking order, but not by relying on asymmetric information and adverse selection, as in Myers and Majluf (1984) and Myers (1984). Equity issues can be used to finance part of CAPEX, however.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

Linter Model: Lintner Model supports the view on stability of dividend. Some of proposition of Lintner model are:

(i)           Firms follow a long – term target payout ratio.

(ii)         Firms are more particular and careful for dividend changes than absolute dividend amount.

(iii)       Change in dividend follows change in earnings.

According to Linter Model, firms have a target payout ratio and change in dividend would occur in such a way so as to move towards this ratio. The dividend change depends upon adjustment factor. The more conservative the firm is, the more slowly it would move towards its target and lower would be adjustment rate. The model says that the dividends for a year depends partly on earnings for that year and partly on dividend for previous year which in turn depends on dividends for year before. In case of increase in earnings per share the companies increase the dividends per share gradually which helps in avoiding reduction in dividends if there is a decrease in earnings. The Lintner model can be presented as follows:

Dt = EPSt x SA x DP Ratio + (1-SA) Dt-1

                           Dt – Dividend for current year

                           EPSt – EDS for current year.

                           SA – Speed of Adjustment

                          DP Ratio – Target pay out ratio

                          Dt-1 =  Dividend for previous year.

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

We are not attempting a Theory of Everything. Our model is designed for mature, profitable, creditworthy public corporations that have access to debt and the ability to use borrowing and lending as the balancing items in their budget constraints. Our model would not apply to zero-dividend growth firms or to firms in financial distress. It would not apply to declining firms that should disinvest, as in Lambrecht and Myers (2007). Our goal is to understand dividend policy and how dividend payout interacts with borrowing and investment. Therefore we focus on mature companies that can make regular payouts to shareholders.

We analyze dividend payout policy, how dividend policy affects the firm’s stock price, and how dividend policy interacts with debt policy. We prove that rent smoothing necessarily implies dividend smoothing. We interpret the ”information content of dividends.” We also derive the managers’ optimal investment policy and its implications for payout and debt policy

Lintners Model on Corporate Dividend Behavior for Financial Management and Policy Mcom Sem 2 Delhi University

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