Dividend Policy

Supplement 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:
ˆ D1
P0 
ks  g
 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
1
Vt 
1  rt
 
Dt  Vt 1  mt 1 Pt 1

where rt  Discount rate

Dt  Total Dividends Paid
Vt 1  Firm Value @ t +1 = nt Pt 1
mt 1 Pt 1  Amount raised in equity

= I t  X t  Dt 
I t  Capital Investments
X t  Income @ t
Dividend Irrelevance Theory

Vt 
1
1  rt

Dt  Vt 1  I t   X t  Dt  
1

1  rt

Vt 1  I t  X t
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.
D1
ks  g
P0
 In essence, he said that the risk premium on
the dividend yield is higher than on the growth
rate.
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 Theory
Jumping 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
16
14
12
Special
10 Dividend
8 DPS

6
EPS
4
2
0
1993 1995 1997 1999 2001
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.

Cash Dividends
Payout Ratio 
Net Income
 Internally Generated Growth
 Retention Ratio:
 The retention ratio depends on what proportion of
earnings is paid-out as dividends.
 Everything else is retained.

(Income - Dividends)
Retention Ratio   1  Payout Ratio
Net Income
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.

ROA  b
Internal Growth Rate 
1 - ROA  b

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.
ROE  b
Sustainable Growth Rate 
1 - ROE  b

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.