Dividend policy

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Dividend policy

• Theories of investor preferences
• Signaling effects
• Residual model
• Dividend reinvestment plans
• Stock dividends and stock splits
• Stock repurchases

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• When deciding how much cash to distribute to
  stockholders, financial managers must keep in
  mind that the firms objective is to maximize
  shareholder value.
• Thus, the target payout ratio should be based on
  investor preferences for cash dividends or
  capital gains.
• If the firm increases the payout ratio, D1 will
  increase, resulting in a higher stock price other
  things being equal.

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• However, if the firm increases D1, there will be
  less money available for reinvestment causing g
  to decline (remember g equals the retention ratio
  times ROE). If g falls, this will lower the stock
  price.
• Therefore, when setting the optimal dividend
  policy the financial manager should strike a
  balance between current dividends and future
  growth so as to maximize the firms stock price.

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What is dividend policy?

• Its the decision to pay out earnings versus
  retaining and reinvesting them. Includes these
  elements
• 1. High or low payout?
• 2. Stable or irregular dividends?
• 3. How frequent?
• 4. Do we announce the policy?

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

• Dividends are irrelevant Investors dont care
  about payout.
• Bird in the hand Investors prefer a high
  payout.
• Tax preference Investors prefer a low payout,
  hence growth.

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Dividend Irrelevance Theory

• Modigliani-Miller support irrelevance.
• Investors are indifferent between dividends and
  retention-generated capital gains.
• If the firms cash dividend is too big, you can
  just take the excess cash received and use it to
  buy more of the firms stock. If the cash
  dividend is too small, you can just sell a little
  bit of your stock in the firm to get the cash
  flow you want.
• Theory is based on unrealistic assumptions (no
  taxes or brokerage costs), hence may not be true.
  Need empirical test.

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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 high P0.

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Tax Preference Theory

• Retained earnings lead to long-term capital
  gains, which are taxed at lower rates than
  dividends 20 vs. up to 39.6. Capital gains
  taxes are also deferred.
• This could cause investors to prefer firms with
  low payouts, i.e., a high payout results in a low
  P0.

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Implications of 3 Theories for Managers
Theory
Implication
Irrelevance
Any payout OK
Bird in the hand
Set high payout
Tax preference
Set low payout
But which, if any, is correct???
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Possible Stock Price Effects
Stock Price ()
Bird-in-Hand
40
Irrelevance
30
20
Tax preference
10
Payout
50
100
0
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Possible Cost of Equity Effects
Cost of equity ()
Tax Preference
20
15
Irrelevance
Bird-in-Hand
10
Payout
50
100
0
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Which theory is most correct?

• Empirical testing has not been able to determine
  which theory, if any, is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with
  judgment.

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Whats the information content, or signaling,
hypothesis?

• Managers hate to cut dividends, so wont raise
  dividends unless they think raise is sustainable.
  So, investors view dividend increases as signals
  of managements view of the future.
• Therefore, a stock price increase at time of a
  dividend increase could reflect higher
  expectations for future dividends themselves, not
  to a change in the dividend payout policy.

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Whats the clientele effect?

• Different groups of investors, or clienteles,
  prefer different dividend policies.
• The dividend clientele effect states that
  high-tax bracket investors (like individuals)
  prefer low dividend payouts and low tax bracket
  investors (like corporations and pension funds)
  prefer high dividend payouts. So different
  groups desire different levels of dividends.
• Clientele effects impede changing dividend
  policy. Taxes brokerage costs hurt investors
  who have to switch companies.

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Whats the residual dividend model?

• Find the retained earnings needed for the capital
  budget.
• Pay out any leftover earnings (the residual) as
  dividends only if more earnings are available
  than are needed to support the optimal capital
  budget.
• This policy minimizes flotation and equity
  signaling costs, hence minimizes the WACC.

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Using the Residual Model to Calculate Dividends
Paid
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Data for SSC

• Capital budget 800,000. Given.
• Target capital structure 40 debt, 60 equity.
  Want to maintain.
• Forecasted net income 600,000.
• How much of the 600,000 should we pay out as
  dividends?

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Of the 800,000 capital budget, 0.6(800,000)
480,000 must be equity to keep at target capital
structure. 0.4(800,000) 320,000 will be
debt. With 600,000 of net income, the residual
is 600,000 480,000 120,000 dividends
paid. Payout ratio 120,000/600,000
0.20 20.
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How would a drop in NI to 400,000 affect the
dividend? A rise to 800,000?

• NI 400,000 Need 480,000 of equity, so
  should retain the whole 400,000. Dividends 0.
• NI 800,000 Dividends 800,000 480,000
  320,000. Payout 320,000/800,000 40.

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

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

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Advantages and Disadvantages of the Residual
Dividend Policy

• Advantages Minimizes new stock issues and
  flotation costs.
• Disadvantages Results in variable dividends,
  sends conflicting signals, increases risk, and
  doesnt appeal to any specific clientele.
• Conclusion Consider residual policy to help set
  their long-run target payout ratios, but not as a
  guide to the payout in any one year.

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Setting Dividend Policy

• Forecast capital needs over a planning horizon,
  often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges.
  Maintain target growth rate if possible, varying
  capital structure somewhat if necessary.

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Dividend Payout Ratios forSelected Industries
Industry Payout ratio Banking 38.29 Computer
Software Services 13.70 Drug 38.06 Electric
Utilities (Eastern U. S.) 67.09 Internet
n/a Semiconductors 24.91 Steel 51.96 Tobacco 55
.00 Water utilities 67.35
None of the internet companies included in the
Value Line Investment Survey paid a dividend.
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Stock Repurchases
Repurchases Buying own stock back from
stockholders.

• Reasons for repurchases
• As an alternative to distributing cash as
  dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.

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Advantages of Repurchases

• Stockholders can sell or not. With a cash
  dividend, stockholders must accept the payment
  and pay the taxes.
• Helps avoid setting a high dividend that cannot
  be maintained.
• Repurchased stock can be used in take-overs or
  resold to raise cash as needed.
• Income received is capital gains rather than
  higher-taxed dividends.
• Stockholders may take as a positive
  signal--management thinks stock is undervalued.

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Disadvantages of Repurchases

• IRS could impose penalties if repurchases were
  primarily to avoid taxes on dividends.
• Selling stockholders may not be well informed,
  hence be treated unfairly.
• Firm may have to bid up price to complete
  purchase, thus paying too much for its own stock.

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Stock Dividends vs. Stock Splits

• Stock dividend Firm issues new shares in lieu
  of paying a cash dividend. If 10, get 10 shares
  for each 100 shares owned.
• Stock split Firm increases the number of shares
  outstanding, say 21, but the price of each share
  will drop to half.

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Both stock dividends and stock splits increase
the number of shares outstanding, so the pie is
divided into smaller pieces. Unless the stock
dividend or split conveys information, or is
accompanied by another event like higher
dividends, the stock price falls so as to keep
each investors wealth unchanged. But
splits/stock dividends may get us to an optimal
price range.
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When should a firm consider splitting its stock?

• Theres a 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 are interpreted as positive signals.