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DIVIDEND POLICY THEORY AND PRACTICE
DIVIDEND DECISIONS • Dividends refer to that portion of a firm’s net earnings which are paid out to the shareholders • Since dividends are distributed out of the profits, alternative to the payment of dividends is the retention of the earnings/profits • The retained earnings constitute an easily accessible important source of financing the investment requirement of the firm.
DIVIDEND DECISIONS • There is, thus a type of inverse relationship between retained earnings and cash dividends i.e. larger retentions, lesser dividends and vice versa • Dividends decision is a major corporate decision in the sense that the firm has to chose between distributing the profits to the shareholders and ploughing them back into the business and the choice depends on the effect of the decision on the firm’s value.
DIVIDEND DECISIONS • Profitable companies regularly face 3 questions: • How much of its free cash flow should it pass on to shareholders? • Should dividends be paid as cash dividend or by repurchasing stock? • Should it maintain a stable, consistent payment policy or should it let the payment vary as conditions change
PAY-OUT RATIO • It refers to the percentage of net income to be paid out as cash dividend. • It should be based in large part on investors preferences for dividends vs capital gains i.e. do investors prefer • To have the firm distribute income as cash dividends • To have it either repurchase stock or else plough the earnings back into the business, both of which should result in capital gains
PAY-OUT RATIO • Recall the constant growth stock valuation model • Po= D1/Ks – g • If the company increases the pay-out ratio this raises D1 which would cause the stock price to rise • If D1 is raised, then less funds will be available for growth therefore g will decline, thus the stock price also declines • Therefore dividends policy have two opposing effects. • Optimal dividend policy is that policy which strikes a balance between current dividends and future growth and maximizes the firm’s stock price
Optimal Dividend Policy • The optimal dividend policy should maximize the price of the firm’s 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?
Conflicting Theories • 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 firm’s stock. • If dividends are too low, investors may sell off some of the stock to generate additional funds.
DIVIDEND IRRELEVANCE THEORY • This is the theory that a firm’s policy has no effect in either its value or its cost of capital • MM argued that a firm’s value is determined only by its basic earnings power and its business risk • They argued that the value of the firm depends only on its income produced by its assets not on how this income is split between dividends and retained earnings
DIVIDEND IRRELEVANCE THEORY • MM noted that any shareholder can in theory construct his/her own dividend policy. • If a firm does not pay dividends a shareholder who wants a 5% dividend can create it by selling 5% of his/her stock or • If a company pays a higher dividend than an investor desires , the investor can use the unwanted dividends to buy additional shares of the company’s stock. • Therefore investors could buy and sell shares, they can create their own dividend policy without incurring cost, the firm’s policy would therfore be irrelevant
DIVIDEND IRRELEVANCE THEORY • Note: investors who want additional dividends must incur brokerage costs to sell shares and investors who do not want dividends must first pay taxes on unwanted dividends and incur brokerage costs to purchase shares with after-tax dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be relevant
BIRD-IN-HAND THEORY • Gordon & Lintner argued that cost of equity (Ks) decreases as the dividend pay-out is increased because investors are less certain of receiving the capital gains that are supposed to result from retaining earnings than they are receiving from dividend payments
BIRD-IN-HAND THEORY • High Dividends Increase Stock Value: • Dividends are less risky. Therefore, high dividend payout ratios will lower ke (reducing the cost of capital), and increase stock price.
BIRD-IN-HAND THEORY • They argued that investors value a dollar of expected dividends more highly than dollar of expected capital gains because the dividend yield component ,D1/P0 is less risky than the g component in the total expected return equation. • Ks= D1/Po + g
BIRD-IN-HAND THEORY • It is based on the logic that what is available at present is preferable to what may be available in the future. • Basing his model on this argument, Gordon and Linter argue that the future is uncertain and the more distant the future is, the more uncertain it is likely to be. • Therefore, investors would be inclined to pay a higher price for shares on which current dividends are paid
TAX PREFERENCE THEORY • Low Dividends Increase Stock Value • There are two tax related reasons for thinking that investors might prefer a low dividend pay-out to high pay-out: • Long-term capital gains are generally taxed at lower rate, whereas dividend income is taxed at effective rates (marginal rates), therefore wealthy investors (who own most of the stock and receive most of the dividends) might prefer to have companies retain and plough back earnings into the business • Taxes are not paid on the gain until a stock is sold. Due to time value effects the amount of taxes paid in the future has a lower effective cost than the amount paid today
TAX PREFERENCE THEORY • Because of these tax advantages, investors may prefer to have companies retain most of their earnings. • Therefore investors would be willing to pay more for low pay-out companies than for otherwise similar high pay-out companies
INFROMATION CONTENT/SIGNALING THEORY • The theory states that investors regard dividend changes as signals of management’s earnings forecasts • It has been observed that an increase in dividends is often accompanied by an increase in the price of the stock, while a reduction in dividends generally leads to a stock price decline • It means therefore that investors prefer dividends to capital gains
INFROMATION CONTENT/SIGNALING THEORY • MM argued that companies are reluctant to reduce dividends and hence do not raise unless they anticipate higher earnings in the future. • Thus MM argued that a higher than expected dividend increase is a signal to investors that the firm’s management forecasts good future earnings
INFROMATION CONTENT/SIGNALING THEORY • Conversely, a dividend reduction or a smaller than expected increase is a signal that the firm’s management is forecasting poor earnings in the future. • According to MM, therefore investors reactions to changes in dividend policy do not necessary mean that investors prefer dividend to retained earnings. • Rather, they argued the price changes following dividends actions simply indicate that there is an important information or signaling content in dividend announcements
CLIENTELE EFFECT • This the tendency of a firm to attract a set of investors who like its dividend policy • Different groups or clienteles of stock holders prefer dividend payout policies e.g. • Retires, the poor and the old etc generally prefer cash income, so they may want the firm to payout a high percentage of earnings.
CLIENTELE EFFECT • On the other hand, investors in their peak earnings years might prefer re-investment, because they have less need for current investment income and would simply reinvest dividends received after paying income taxes on these dividends • Investors who want current investment income should own shares in high dividend payout firms and vice versa
DIVIDEND POLICIES • RESIDUAL DIVIDEND MODEL • Dividend paid is equal to net income minus the amount of retained earnings necessary to finance the firm’s optimal capital budget • The determines the optimal budget • Determines the amount of equity needed to finance that budget given its target capital structure • It uses retained earnings to meet equity requirements to the extent possible • It pays dividends only if more earnings are available than are needed
Residual Dividend model • 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)
DIVIDEND POLICIES • STABLE DIVIDEND POLICY • This is where the dividend growth rate is predictable • The shareholders can also be certain that the current dividend will not be reduced. • It may not grow at a stable rate but management will probably be able to avoid reducing the dividend
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.
Stable Growth in Dividend Policy (Cont) Dollars Per Share EPS DPS Year
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.
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.
STOCK SPLIT • This is an action taken by a firm to increase the number of shares outstanding e.g. doubling the number of shares outstanding by giving each stock holder two new shares for each one formally held • No changes in the capital accounts. • Par value decreased. • Number of shares outstanding increased.
STOCK DIVIDENDS • This dividend paid in the form of additional shares of stock rather than cash • Effects: • The price of a stock rises shortly after a company announces a stock split or stock dividend • The price increases are as a result of investors taking split/dividends as signals of higher future earnings • However if during the next few months it does not announce an increase in earnings and dividends , then stock price will go back to the earlier level
FACTORS AFFECTING DIVIDEND POLICY • They may be grouped into four broad categories: • Constraints on dividends • Investment opportunities • Availability and cost of alternative sources of capital • Effects of dividend policy on cost of capital
1. CONTRANTS • BOND HOLDERS. Debt contracts often limit dividend payments to earnings after loan was granted • PREFERRED STOCK RESTRICTIONS. Common dividends cannot be paid if company has not omitted its preferred dividend • IMPAIREMENT OF CAPITAL RULE. Dividends payments cannot exceed the balance sheet item retained earnings. It is designed to protect creditors
2. INVESTMENT OPPORTUNITIES • Number of profitable investment opportunities available • Possibility of accelerating or delaying projects will permit a firms to adhere more closely to stable dividend policy
3. ALTERNATIVE SOURCES OF CAPITAL • Cost of selling new stock. If the floatation are high it is better to have a low payout ratio and finance through retained earnings • Ability to substitute debt for equity. If a firm can finance a given level of investment with either debt or equity. Low flotation cost will permit a more flexible dividend policy because equity can either be raised by retained earnings or by selling new stock • Control. If the management is concerned about maintaining control, it may be reluctant to sell new stock .
4. EFFECTS OF DIVIDEND POLICY ON COST OF CAPITAL • It may be considered in terms of four factors • Shareholders desire for current versus future income • Perceived riskiness of dividends versus capital gains • The tax advantage of capital gains over dividends • The information content of dividends • The important of each factor in terms of its effect on cost of capital varies from firm to firm depending on the make-up of its current and possible future stockholders
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.
