Dividend Policy and Retained Earnings Chapter 18

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Dividend Policy and Retained Earnings(Chapter 18)

• Optimal Dividend Policy
• Conflicting Theories
• Other Dividend Policy Issues
• Residual Dividend Theory
• Stable Growth in Dividend Policy
• Some Additional Considerations
• Stock Dividends and Stock Splits
• Stock Repurchases

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Optimal Dividend Policy

• The optimal dividend policy should maximize the
  price of the firms stock holding the number of
  shares outstanding constant.
• A decision to increase dividends will raise
  D1 putting upward pressure on P0. Increasing
  dividends, however, means reinvesting fewer
  dollars, lowering g, and putting downward
  pressure on P0.
• Problem What is the correct balance between
  dividends and retained earnings?

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Conflicting Theories

• Dividend Policy is Irrelevant
• (Dividend Irrelevance Theory)
• Assuming
• No transactions costs to buy and sell securities
• No flotation costs on new issues
• No taxes
• Perfect information
• Dividend policy does not affect ke
• Dividend policy is irrelevant. If dividends are
  too high, investors may use some of the funds to
  buy more of the firms stock. If dividends are
  too low, investors may sell off some of the stock
  to generate additional funds.

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Conflicting Theories (Continued)

• High Dividends Increase Stock Value
• (Bird-in-the-Hand Theory)
• Dividends are less risky. Therefore, high
  dividend payout ratios will lower ke (reducing
  the cost of capital), and increase stock price.

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Conflicting Theories (Continued)

• Low Dividends Increase Stock Value
• (Tax Preference Theory)
• Dividends received are taxable in the current
  period. Taxes on capital gains, however, are
  deferred into the future when the stock is
  actually sold. In addition, the maximum tax rate
  on capital gains is usually lower than the tax
  rate on ordinary income. Therefore, low dividend
  payout ratios will lower ke (reducing the cost of
  capital), raise g, and increase stock price.

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Conflicting Theories (Continued)

• Empirical Evidence
• No conclusive proof, one way or another.
• Difficult to hold the rest of the world constant
  while we study dividend policy.
• Cannot measure the cost of equity (ke) with a
  high degree of accuracy.

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Other Dividend Policy Issues

• Clientele Effect Investors needing current
  income will be drawn to firms with high payout
  ratios. Investors preferring to avoid taxes will
  be drawn to firms with lower payout ratios.
  (i.e., firms draw a given clientele, given their
  stated dividend policy). Therefore, firms should
  avoid making drastic changes in their dividend
  policy.
• Information Content Changes in dividend policy
  may be signals concerning the firms financial
  condition. A dividend increase may signal good
  future earnings. A dividend decrease may signal
  poor future earnings.

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Residual Dividend Theory

• Retain and reinvest earnings as long as returns
  on the investments exceed the returns
  stockholders could obtain on other investments of
  comparable risk. This concept is illustrated
  graphically below. A corporation should retain
  all necessary earnings to invest up to the level
  indicated by the intersection of the MCC
  (marginal cost of capital) and IOS (investment
  opportunity schedule) functions. Residual
  earnings are distributed to shareholders.

Percent
MCC
IOS
Amount of Capital (millions)
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Stable Growth in Dividend Policy

• Most corporations attempt to maintain a stable
  growth in dividend policy
• Many financial institutions invest only in
  companies with regular dividend payments.
• Perhaps leads to higher stock prices
• (Lower risk - lower ke - higher P0)
• As a result, dividends tend to be a function of
  the sustainable growth in earnings.

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Stable Growth in Dividend Policy (Cont)
Dollars Per Share
EPS
DPS
Year
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Some Additional Considerations

• Legal Restrictions Dividends cannot be paid out
  of the permanent capital accounts.
• Liquidity Retained earnings and cash are not
  identical.
• Access to other sources of financing.
• Stability of earnings.
• Restrictions in debt contracts.

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Some Additional Considerations (Continued)

• Ownership Control Smaller firms may be averse to
  issuing new stock due to dilution of corporate
  control. Therefore, retain earnings and pay few
  dividends.
• Inflation Since replacement costs of assets are
  higher in inflationary periods, more retention of
  earnings may be required.
• Dividend Reinvestment Plans Investors can
  automatically reinvest dividends often at a
  discount with no transaction costs. Frequently a
  good investment tool. Companies may use these
  plans to raise additional equity capital.

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Stock Dividends

• Accounting for stock dividends
• Retained Earnings xxxx
• Common Stock xxxx
• Paid-in-Capital xxxx
• The market value of the stock dividend is taken
  out of retained earnings and placed into the
  permanent capital accounts.
• Stock Splits
• No changes in the capital accounts.
• Par value decreased.
• Number of shares outstanding increased.

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The Impact on Stockholders Wealthof Stock
Dividends and Stock Splits

• Everything else remaining the same, stock
  dividends and stock splits do not increase
  stockholder wealth. Perhaps, however, they are
  beneficial in the long-run due to the optimal
  price range concept.
• Price may rise, however, if other variables also
  change (e.g., cash dividends increase, higher
  expected future earnings)

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Stock Repurchases(A Corporation Acquires its Own
Stock)

• Alternative to cash dividends Shares outstanding
  are reduced, EPS increases, and if the P/E does
  not change, the stock price increases. (i.e.,
  capital gains are substituted for cash
  dividends). Stock repurchases may be a sound
  strategy for firms with temporary excess cash.
• Share price too low Outstanding shares may be
  repurchased to drive the stock price up to a
  more appropriate level.
• Change the capital structure quickly Issue debt
  and use the proceeds to buy back outstanding
  stock.