Dividend PolicySupplement to Chapter 17

FIL 341

Prepared by Keldon Bauer

Dividends or Capital Gains? The ultimate goal of financial managers

should be the maximization of shareholder wealth.

Shareholder wealth can be maximized by maximizing the price of the stock.

As you have learned earlier, the price of the stock is the expected present value of future cash flows.

Dividends or Capital Gains? In the late 1950s, Myron Gordon proposed

modeling price on a firm’s dividends and growth potential:

gk

DP

s 1

0̂

Optimal Dividend Policy: To maximize price, an optimal balance must be found between current dividends (D1) and the need for growth (g).

Dividend Irrelevance Theory Miller and Modigliani showed algebraically

that dividend policy didn’t matter: They showed that as long as the firm was

realizing the returns expected by the market, it didn’t matter whether that return came back to the shareholder as dividends now, or reinvested. They would see it in dividend or price appreciation.

The shareholder can create their own dividend by selling the stock when cash is needed.

Dividend Policy and Stock Price Dividend Irrelevance Theory:

Miller/Modigliani argued that dividend policy should be irrelevant to stock price.

If dividends don’t matter, this chapter is irrelevant as well (which is what most of you are thinking anyway).

Dividend Irrelevance Theory

Vr

D V m P

r

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V n P

m P

I X D

I

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tt

t t t t

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t

t t t

t t

t t t

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where Discount rate

Total Dividends Paid

Firm Value @ t +1 =

Amount raised in equity

=

Capital Investments

Income @ t

Dividend Irrelevance Theory

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Dividends are not in the final equation!

Therefore, dividends are irrelevant to value!

Dividend Irrelevance Theory But Miller and Modigliani made some

unrealistic assumptions in developing their model: Brokerage costs didn’t exist. Taxes didn’t exist.

They made these assumptions to simplify the analysis.

Bird-in-the-Hand Theory Gordon argued that a dividend-in-the-hand is

worth more than the present value of a future dividend.

In essence, he said that the risk premium on the dividend yield is higher than on the growth rate.

gP

Dks

0

1

Tax Preference Theory There are three ways in which taxes affect the

dividend preferences of shareholders. For individual investors tax rates differ for capital

gains and dividends. Taxes on capital gains are not due until the stock

is sold. If the stock is held until the shareholder expires,

no tax is due at all.

Tax Preference Theory For years the capital gains rate was

significantly below the dividend income rate, prompting many companies to retain more income, and declare smaller dividends.

With the Jobs and Growth Tax Relief Reconciliation Act of 2003, the dividend tax rate has fallen sharply.

Tax Preference TheoryJumping on the Dividend Bandwagon: The tax cut makes equity attractive in more ways than one

The dividend tax cut signed into law by President Bush in late May already is leading some publicly traded companies to boost the dividends they pay shareholders, hoping it will help the share price. And even those that can't afford to offer much in the way of dividends may find a way to benefit from other parts of the tax law changes. Last week Goldman Sachs and Bank of America joined the companies that have jumped on the dividend bandwagon. Goldman last week more than doubled its dividend to $0.25 per share, and BofA raised its quarterly dividend 25% to $0.80, from $0.64. One of the first companies to anticipate the dividend tax cut was Microsoft Corp., which announced its first-ever annual dividend, of $0.16, in January. . . . Still, it's equity dividends that have suddenly become more attractive to investors. That has many publicly traded companies suddenly revisiting how they use their free cash. Many now are favoring dividends over their previous stock-boosting efforts, such as tax-advantaged share buybacks. (Britt Erica Tunick, from Investment Dealers Digest, June 30, 2003)

Dividends or Capital Gains? Summary: Do shareholders prefer dividends

or capital gains? Dividend Irrelevance: If the return on

investment is what the market requires, then it doesn’t matter whether you get it in dividend or capital gains.

Bird in the Hand Theory: Shareholders prefer dividends, and will require a higher discount rate for capital gains since they are riskier.

Dividends or Capital Gains? Tax Preference Theory: Under the old tax

system, an unambiguous case could be made in favor of capital gains. The shareholder would require the same after-tax return, meaning the required return on dividends used to be higher. Today dividends and capital gains have virtually the

same tax rate.

Information Content Hypothesis Signaling:

The theories thus far have assumed that investors and managers have the same information set.

When it comes to prospect for the company, managers may have better information than investors.

Therefore unexpected changes in dividends may relay information to the market that it didn’t know before.

Information Content Hypothesis Signaling - continued

Managers don’t cut dividends unless the firm is in financial distress.

It is therefore believed that firms do not increase dividends beyond Wall Street’s expectations unless managers anticipate stronger earnings than expectations.

Unexpected changes in dividends relay information to the market.

Clientele Effect Hypothesis Tax-free foundations and retirees at lower

marginal tax rates prefer cash now and on a predictable basis.

Investors at higher marginal tax rates might prefer capital gains to dividends. With capital gains they can better time their tax liabilities.

Each firm, therefore, attracts the type of investor that likes its dividend policy.

Dividend Policy in Practice Residual Dividend Policy: Investors prefer to

have the firm retain and reinvest earnings if they can earn a higher risk adjusted return than the investor can. Residual Dividend Policy suggests that dividends

should be that part of earnings which cannot be invested at a rate at least equal to the WACC.

Dividend Policy Classes Residual Dividend Policy Steps:

1 Determine the optimal capital budget.2 Determine the retained earnings that can be used to

finance the capital budget.3 Use retained earnings to supply as much of the

equity investment in the capital budget as necessary.

4 Pay dividends only if there are left-over earnings.

Dividend Policy Classes Stable, Predictable Dividend Policy: Due to

the possibility of a negative signal to investors, many CFOs have set the policy of never reducing their dividends. Dividends are only increased if management is

certain future earnings will support such a high dividend.

Dividend Policy Classes Stable, Predictable Dividend Policy:

A variation of this policy is one in which dividends exhibit a stable, predictable growth rate.

In that instance the company has to set the policy in such a way that the growth rate can be sustained for the foreseeable future.

Dividend Policy Classes Stable, Predictable Dividend Policy Steps:

1 Pay a predictable dividend every year.2 Base optimal capital budget on residual retained

earnings (after dividend).

Dividend Policy Classes Constant Payout Ratio Policy: It is possible

that a company could set a policy to payout a certain percentage of earnings as dividends. The problem is that such a policy would not fit

the needs of the firms stockholders, since it would cause a great deal of volatility in dividends paid (see clientele effect spoken of earlier).

Dividend Policy Classes Constant Payout Ratio Policy Steps:

1 Pay a constant proportion of earnings (if positive).

2 Base optimal capital budget on residual retained earnings.

Dividend Policy Classes Low Regular Dividend Plus Extras: This

policy is a hybrid of the last two policies. It is meant to keep expectations low for dividends, and supplement those dividends with bonuses in good years. The problem is the potential for negative

signaling.

Dividend Policy Classes Low Regular Dividend Plus Extras Steps:

1 Pay a predictable dividend every year.2 In years with good earnings pay a bonus

dividend.3 Base optimal capital budget on residual of regular

dividend and compromising with bonus for capital budgeting projects.

General Motors – Dividends

0

2

4

6

8

10

12

14

16

1993 1995 1997 1999 2001

SpecialDividend

DPS

EPS

General Motors – Dividends

General Motors – Dividend History

Caterpillar – Dividend History

Internally Generated Growth Dividend Payout Ratio:

The company can only pay for its own growth if it retains earnings.

The stockholder is more certain of earnings if the firm pay out part of “earnings” as dividends.

IncomeNet

DividendsCash RatioPayout

Internally Generated Growth Retention Ratio:

The retention ratio depends on what proportion of earnings is paid-out as dividends.

Everything else is retained.

RatioPayout 1IncomeNet

Dividends)- (Income RatioRetention

The Internal Growth Rate The internal growth rate tells us how much

the firm can grow assets using retained earnings as the only source of financing.

bROA - 1

bROA RateGrowth Internal

b = Retention Ratio

The Sustainable Growth Rate The sustainable growth rate tells us how

much the firm can grow by using internally generated funds and issuing debt to maintain a constant debt ratio.

bROE-1

bROE RateGrowth eSustainabl

b = Retention Ratio

Dividend Policy A company’s dividend policy depends on:

The shareholders of the company. Market signaling.

The more understandable the better. The more stable the better.

The growth potential of the company.