Dividend Policy

When deciding how much cash to distribute to stockholders, financial managers must keep in
mind that the firm’s objective is to maximize shareholders’ wealth. Consequently, the target
payout ratio- defined as the percentage of net income to be paid out as cash dividends- should be
based in large part on investors’ preferences for dividend versus capital gains. Do investors
prefer;
To have the firm distribute income as cash dividends
To have it either repurchase stock or else plow the earnings back into the business. Both of
which should result in capital gains.
This preference can be considered in terms of the constant growth stock valuation model:
D 0 (1+ g) D 1
P0 = =
R-g R-g
If the company increases the payout ratio, this raises D1. This increase in the numerator, taken
alone, would cause the stock price to rise.
D 0 (1+g) 5 D 0 (1+ g) 8
P0 = = P0 = =
R-g 0 . 13-0.10 = 166.67 R-g 0 . 13-0 .10 = 266.67

However, if D1 is raised, then less money will be available for reinvestment that will cause the
expected growth rate to decline and that will tend to lower the stock price.
Particular Scenario 1 Scenario 2
EBIT 5,000,000 5,000,000
Less. Interest Expense (1,000,000) (1,000,000)
EBT 4,000,000 4,000,000
Less. Income Tax 40% (1,600,000) (1,600,000)
EAT 2,400,000
Less. Dividend 20% 480,000
Retained Earnings 80% 1,920,000
Growth rate = 0.80* 16%ROE) = 12.8%
EAT 2,400,000
Less. Dividend 40% (960,000)
Retained Earnings 60% 1,440,000
Growth rate = 0.60* 16%ROE) = 9.6%

Thus, any change in payout policy will have two opposing effects. Therefore, the firm’s optimal
dividend policy must strike a balance between current dividends and future growth so as to
maximize the stock price.
With respect to the investors’ preference, there are three following theories.
Dividend Irrelevance Theory
Dividend policy has no effect on either the price of a firm’s stock or its cost of capital. If it so,
then it would be irrelevant. MM argued that the firm’s value is determined only by its earning
power and its business risk.
In other words, MM argued that the value of the firm depends only on the income
produced by its assets and not on how this income is split between dividends and retained
earings.
To understand MM’s argument, recognize that any shareholder can in theory construct his or her
own dividend policy. For example, if a firm does not pay dividends, a shareholder who wants a
5% dividend can “create” it by selling 5% of his or her stock.

Conversely, 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.

If investors could buy and sell shares and thus create their own dividend policy without
incurring costs, then the firm’s dividend policy would truly be irrelevant.

Note, though, that investors who want additional dividends must incur brokerage costs to sell
shares and pay taxes on any capital gains. Investors who do not want dividends incur brokerage
costs to purchase shares with their dividends. Because taxes and brokerage costs certainly exist,
dividend policy may well be relevant.

In developing their dividend theory, MM made a number of assumptions, especially the absence
of taxes and brokerage costs. Obviously, taxes and brokerage costs do exist, so the MM
irrelevance theory may not be true.

However, MM argued (correctly) that all economic theories are based on simplifying
assumptions, and that the validity of a theory must be judged by empirical tests, not by the
realism of its assumptions. We will discuss empirical tests of MM’s dividend irrelevance theory
shortly.

Bird in the Hand Theory

The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not
affect the required rate of return on equity, rs. This conclusion has been hotly debated in
academic circles.

In particular, Myron Gordon and John Lintner argued that rs decreases as the dividend
payout is increased because investors are less certain of receiving the capital gains that are
supposed to result from retaining earnings than they are of receiving dividend payments.
Gordon and Lintner said, in effect, that investors value a dollar of expected dividends more
highly than a dollar of expected capital gains because the dividend yield component is less
risky than the expected capital gain.

MM disagreed. They argued that rs is independent of dividend policy, which implies that
investors are indifferent between dividends and capital gains.

MM called the Gordon-Lintner argument the bird-in-the-hand fallacy because, in MM’s view,
most investors plan to reinvest their dividends in the stock of the same or similar firms, and, in
any event, the risk of the firm’s cash flows to investors in the long run is determined by the risk
of operating cash flows, not by dividend payout policy.

Tax Preference Theory

Depends on the tax on dividend and capital gains. If tax on dividend is higher than the tax on
capital gains, then investor would prefer capital gain over dividends or the other way around.
Although investors in the aggregate cannot be shown to clearly prefer either higher or lower
distribution levels, the evidence does show that individual investors have strong preferences.
Evidence also shows that investors prefer stable, predictable dividend payouts (regardless of the
payout level), and that they interpret dividend changes as signals about firms’ future prospects

Different Dividend Policy Issues

Clientele Effects
Different groups, or clienteles, of stockholders prefer different dividend payout policies. For
example, retired individuals, pension funds, and university endowment funds generally prefer
cash income, so they may want the firm to pay out a high percentage of its earnings. Such
investors are often in low or even zero tax brackets, so taxes are of no concern.

On the other hand, stockholders in their peak earning years might prefer reinvestment, because
they have less need for current investment income and would simply reinvest dividends received,
after first paying income taxes on those dividends.

Information Content or Signaling Hypothesis

When MM set forth their dividend irrelevance theory, they assumed that everyone— investors
and managers alike—has identical information regarding a firm’s future earnings and dividends.
In reality, however, different investors have different views on both the level of future dividend
payments and the uncertainty inherent in those payments, and managers have better information
about future prospects than public stockholders.

It has been observed that an increase in the dividend is often accompanied by an increase in the
price of a stock, while a dividend cut generally leads to a stock price decline. Some have argued
that this indicates that investors prefer dividends to capital gains.

However, MM argued differently. They noted the well-established fact that corporations are
reluctant to cut dividends, hence do not raise dividends 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.

Conversely, a dividend reduction, or a smaller-than expected increase, is a signal that

management is forecasting poor earnings in the future.

Thus, MM argued that investors’ reactions to changes in dividend policy do not necessarily show
that investors prefer dividends to retained earnings. Rather, they argue that price changes
following dividend actions simply indicate that there is an important information, or signaling,
content in dividend announcements.

Target Payout Ratio

The Residual Distribution Model
When deciding how much cash to distribute to stockholders, two points should be kept in mind:
(1) The overriding objective is to maximize shareholder value, and (2) the firm’s cash flows
really belong to its shareholders, so management should refrain from retaining income unless
they can reinvest it to produce returns higher than shareholders could themselves earn by
investing the cash in investments of equal risk.

When establishing a distribution policy, one size does not fit all. Some firms produce a lot of
cash but have limited investment opportunities—this is true for firms in profitable but mature
industries where few opportunities for growth exist. Such firms typically distribute a large
percentage of their cash to shareholders, thereby attracting investment clienteles that prefer high
dividends. Other firms generate little or no excess cash since they have many good investment
opportunities. Such firms generally distribute little or no cash but enjoy rising earnings and stock
prices, thereby attracting investors who prefer capital gains.

For example, suppose the target equity ratio is 60% and the firm plans to spend $50 million on
capital projects.

In that case, it would need $50(0.6) =$30 million of common equity.

Then, if its net income were $100 million, its distributions would be $100 - $30 = $70 million.

So, if the company had $100 million of earnings and a capital budget of $50 million, it would use
$30 million of the retained earnings plus $50 - $30 = $20 million of new debt to finance the
capital budget, and this would keep its capital structure on target.

Dividend payment procedures

Declaration date
Holder-of-record date
Ex-dividend date
Payment Date

November 21, 2019: Declaration date—board announces holder-ofrecord date, payment date, and
dividend amount
December 17, 2019: One business day prior to ex-dividend date— owner of stock at closing time
on this day will receive dividend on payment date even if the owner sells the
stock the next day.
December 18, 2019: Ex-dividend date—two business days prior to the announced holder-of-record
date. Any purchaser on or after this date will not get dividend.
December 19, 2019: Purchaser on or after this date doesn’t get the dividend because it is after the ex-
dividend date.
December 20, 2019: Holder-of-record date—used to determine ex-dividend date. Purchaser on or
after this date will not get the dividend because it is after the ex-dividend date.
January 10, 2020: Payment date—Dividend is paid to whoever owned the stock at closing the day
prior to the ex-dividend date.

Dividend Vs Stock Repurchase

Questions
1- Axel Telecommunications has a target capital structure that consists of 70% debt and
30% equity. The company anticipates that its capital budget for the upcoming year will
be $3,000,000. If Axel reports net income of $2,000,000 and it follows a residual
distribution model with all distributions as dividends, what will be its dividend payout
ratio?

Solution

2000,000 – (0.30) (3000,000) = 1100,000

1100,000 / 2000,000 =55%

2- Petersen Company has a capital budget of $1.2 million. The company wants to maintain a
target capital structure which is 60% debt and 40% equity. The company forecasts that its
net income this year will be $600,000. If the company follows a residual distribution
model and pays all distributions as dividends, what will be its payout ratio?

Solution
600,000 (0.40) (1200,000) =120,000
120,000 / 600,000 =20%

3- The Welch Company is considering three independent projects, each of which requires a
$5 million investment. The estimated internal rate of return (IRR) and cost of capital for
these projects are presented below:

Project H (high risk): Cost of capital = 16%; IRR = 20%

Project M (medium risk): Cost of capital = 12%; IRR = 10%
Project L (low risk): Cost of capital = 8%; IRR = 09%
Note that the projects’ cost of capital varies because the projects have different levels of risk.
The company’s optimal capital structure calls for 50% debt and 50% common equity. Welch
expects to have net income of $7,287,500. If Welch bases its dividends on the residual model (all
distributions are in the form of dividends), what will its payout ratio be?

4- Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has
paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders
expect the dividend to remain constant for the next several years. The company’s target
capital structure is 60% equity and 40% debt; it has 1,000,000 shares of common equity
outstanding; and its net income is $8 million. The company forecasts that it would require
$10 million to fund all of its profitable (that is, positive NPV) projects for the upcoming
year.

a. If Buena Terra follows the residual model and makes all distributions as dividends, how much
retained earnings will it need to fund its capital budget?

b. If Buena Terra follows the residual model with all distributions in the form of dividends, what
will be the company’s dividend per share and payout ratio for the upcoming year?

c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will
be available for the firm’s capital budget?

d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain
a $10 million capital budget without having to raise new common stock?
e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend; that is, it
wishes to maintain the $3.00 dividend for the next year. Also assume that the company was
committed to funding all profitable projects and was willing to issue more debt (along with the
available retained earnings) to help finance the company’s capital budget. Assume that the
resulting change in capital structure has a minimal impact on the company’s composite cost of
capital, so that the capital budget remains at $10 million. What portion of this year’s capital
budget would have to be financed with debt?

f. Suppose once again that Buena Terra’s management wants to maintain the $3.00 DPS. In
addition, the company wants to maintain its target capital structure (60% equity, 40% debt), and
maintain its $10 million capital budget. What is the minimum dollar amount of new common
stock that the company would have to issue in order to meet each of its objectives?

g. Now consider the case where Buena Terra’s management wants to maintain the $3.00 DPS
and its target capital structure, but it wants to avoid issuing new common stock. The company is
willing to cut its capital budget in order to meet its other objectives. Assuming that the
company’s projects are divisible, what will be the company’s capital budget for the next year?

h. What actions can a firm that follows the residual distribution policy take when its forecasted
retained earnings are less than the retained earnings required to fund its capital budget?