CHAPTER 12 Dividend Policy

1
CHAPTER 12Dividend Policy

• Do investors prefer dividends?
• Signaling effects
• Residual dividend model
• Dividend reinvestment plans
• Stock repurchases
• Stock dividends and stock splits

2
What is dividend policy?

• It is the decision about how much of earnings to
  pay out as dividends versus retaining and
  reinvesting earnings in the firm.

3
What are the three elements of dividend policy?

• Dollars of dividends to be paid out in the near
  future.
• Target payout ratio Long-run policy regarding
  the average percentage of earnings to be paid out
  to stockholders.
• Should we announce our dividend policy and then
  stick with it?

4
Do investors prefer high or low payouts? There
are three theories

• Irrelevant Investors do not care what payout is
  set.
• Bird in hand Investors prefer a high payout.
• Tax preference Investors prefer a low payout in
  order to get growth and capital gains.

5
Dividend Irrelevance Theory

• Investors are indifferent between dividends and
  retention-generated capital gains. If they want
  cash, they can sell stock. If they dont want
  cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance but their
  theory is based on unrealistic assumptions (no
  taxes or brokerage costs), and hence may not be
  true.

6
Bird in the Hand Theory

• Investors think dividends are less risky than
  potential future capital gains, hence they like
  dividends.
• If so, investors would value high payout firms
  more highly, i.e., a high payout would result in
  a low kS, hence a high P0.

7
Tax Preference Theory

• Retained earnings lead to capital gains, which
  are taxed at lower rates than dividends 28
  maximum vs. up to 39.6. Capital gains taxes are
  also deferred.
• This could cause investors to prefer firms with
  low payouts, i.e., low payout results in a high
  P0.

8
What are the implications of the three theories
for managers?

• Theory Implication
• Irrelevance Any payout okay
• Bird in the Hand Set high payout
• Tax preference Set low payout
• But which, if any, is correct?

9
Possible Stock Price Effects
40 30 20 10
10
Possible Cost of Equity Effects
Cost of Equity
20 15 10
Tax Preference
Indifference
Bird in Hand
50 100 Payout
11
Have empirical tests proved which theory is most
correct?

• No. Empirical testing has not been able to
  determine which theory, if any, is correct.
• Thus managers must use judgment when setting
  policy.
• Analysis is used, but it must be applied with
  judgment.

12
What is the information content, or
signaling, hypothesis and how does it affect
dividend policy?

• Managers hate to cut dividends, so they wont
  raise dividends unless they think the increase is
  sustainable.
• Thus investors view dividend increases as signals
  of managements view of the future. (More...
  )

13

• Therefore, if a companys stock price increases
  at the time it announces a dividend increase,
  this could reflect expectations for higher future
  EPS, not a preference for dividends over
  retention and capital gains.
• Conversely, a dividend cut would be a signal that
  managers are worried about future earnings.

14

• The signaling impact constrains dividend
  decisions by imposing a large cost on a dividend
  cut and by discouraging managers from raising
  dividends until they are sure about future
  earnings.
• Managers tend to raise dividends only when they
  believe future earnings can comfortably support
  a higher dividend level and they cut dividends
  only as a last resort.

15
What is the clientele effect and how does it
affect dividend policy?

• Different groups of investors, or clienteles,
  prefer different policies, e.g. retirees need
  dividends.
• A firms past dividend policy deter-mines its
  current clientele of investors.
• Clientele effects impede changing policy. Taxes
  and brokerage costs hurt investors who switch
  companies.

16
What impact might dividend policy have on agency
costs?

• Firms with high payouts will have to go to the
  capital markets more frequently.
• Bankers will supply capital more willingly to
  better-managed firms.
• So, stockholders can worry less if the payout is
  high.

17
What is the residual dividend model?

• Find the retained earnings needed to support the
  capital budget.
• Pay out any leftover earnings (the residual) as
  dividends.
• This policy minimizes new equity issues, and
  hence flotation and signaling costs.

18
Example

• Capital budget 700,000
• Target capital structure 45 debt, 55 equity.
  Plans to maintain.
• Forecasted net income 550,000.
• How much of the 550,000 should be paid out as
  dividends?

19

• Of the 700,000 capital budget, 0.55(700,000)
  385,000 must be equity to keep at target capital
  structure. 0.45(700,000 315,000 will be
  debt.
• With 550,000 of net income, the residual
  is550,000 - 385,000 165,000 dividends
  paid.
• Payout ratio 165,000/550,000 .30 30

20
If NI were 350,000, or 700,000, what would be
the dividend be?

• NI 350,000 Need 385,000 of equity, so
  should retain the whole 350,000. Dividend 0.
• NI 700,000 Dividend 700,000-385,000
  315,000Payout 315,000/700,000 45.

21
How would a change in investment opportunities
affect the dividend under the residual dividend
policy?

• Fewer good investments would lead to a smaller
  capital budget, hence a higher dividend payout.
• More good investments would lead to a lower
  dividend payout.

22
If the firm forecasts 100,000 of depreciation
cash flow plus a net income of 550,000, what
would the residual dividend payout ratio be?

• RE breakeven shifts to right 100,000.
• Firm needs to raise only 700,000 - 100,000
  600,000.
• Equity to support the capital budget 0.55
  (600,000) 330,000. (More...)

23

• Dividends 550,000 - 330,000 220,000
• Payout ratio 220,000/550,000 40 versus
  30 previously.
• Other things held constant, the higher the
  depreciation cash flow, the higher the payout.

24
What are the advantages and disadvantages of the
residual dividend policy?

• Advantages Minimizes new stock issues, hence
  flotation costs, and neg-ative signals associated
  with new stock.
• Disadvantages Variable dividends send
  conflicting signals, increase risk, and do not
  appeal to any specific clientele. Results in
  higher required return.

25
Conclusion

• Consider residual policy when setting long-run
  target payout ratio, but dont follow it rigidly
  in the short run.
• Pay a stable, dependable dividend.

26
What is a dividend reinvestment plan (DRIP)?

• Shareholders can automatically reinvest their
  dividends in shares of the company's common
  stock. Get more shares rather than cash.
• There are two types of plans
• Open market purchase plan.
• New stock plan.

27
Open market purchase plan

• Dollars of dividends to be reinvested are turned
  over to a trustee, who buys shares on the open
  market and holds them for participating SHs.
• Brokerage costs are low because of volume
  purchases.
• Convenient and easy way to invest systematically.
• Company pays administrative costs.

28
New stock plan

• Firm issues new stock to DRIP participants, then
  keeps money otherwise used for dividends and uses
  it to buy assets.
• No fees charged. Stock is sometimes sold at
  discount from market price set about equal to
  flotation costs of underwritten stock
  offering. (More...)

29

• Only firms that need new equity capital use new
  stock plans.
• Firms with no need for new equity capital use
  open market purchase plans.
• Most NYSE listed companies have a DRIP.
  Investors like them.

30
Steps in setting up dividend policy

• Identify target capital structure.
• Forecast capital needs over planning horizon,
  often 5 years.
• Estimate annual debt and equity needs.
• Set long-run target payout ratio based on the
  residual model.

31
Stock repurchases

• Repurchases When a firm buys its own stock
  back.
• Reasons for repurchases
• An alternative to distributing cash as dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.

32
Advantages of repurchases

• Stockholders can tender or not.
• Distribute cash without setting high dividend
  that cannot be maintained.
• Treasury stock can be used in take-overs or
  resold to raise cash.
• SHs generally get capital gains rather than
  higher-taxed dividends.
• May be seen as a positive signal that managers
  think stock under-valued.

33
Disadvantages of repurchases

• May be seen as a negative signal of poor
  investment opportunities.
• Theoretically, IRS could impose penalties if
  repurchases were solely to avoid taxes on
  dividends.
• Selling SHs may not be well informed, hence
  unfair to them.
• Firm may have to bid up the price to complete
  repurchase.

34
Stock dividends vs. Stock splits

• Stock dividend Firm issues new shares in lieu
  of paying cash dividend. If 10 stock dividend,
  get 10 shares for each 100 owned.
• Stock split Firm increases the number of shares
  outstanding. If 21, gives SHs twice as many
  shares. (Could have reverse split.)
• Different accounting treatment.

35

• Both stock dividends and stock splits increase
  the number of shares outstanding, smaller pieces
  of pie.
• Unless the stock dividend or split conveys
  information, or is accompanies by another event
  like higher dividends, stock price generally
  falls so as to keep each investor's wealth
  unchanged.
• Splits/stock dividends may get the stock to an
  optimal price range.

36
When should stocks be split?

• Theres widespread belief that the optimal price
  range for stocks is 20 to 80.
• Stock splits can be used to keep the price in the
  optimal range.
• Stock splits generally occur when management is
  confident, so splits are interpreted as positive
  signals.