ISBN: 0-03-028931-9
Chapter 15 Distributions to Shareholders: Dividends and Share Repurchases
Dividend policy involves the decision to pay out earnings versus retaining them for reinvestment in the firm. The key concepts covered in the chapter are listed below.
Dividend policy involves three issues: (1) What fraction of earnings should be distributed, on average, over time? (2) Should the distribution be in the form of cash dividends or stock repurchases? (3) Should the firm maintain a steady, stable dividend growth rate?
The target payout ratio is the percentage of net income paid out as cash dividends. It is based upon investors' preferences for dividends versus capital gains. In other words, whether investors prefer the distribution of stock dividends, or the repurchase of common stock, or the reinvestment of funds back into the business.
The optimal dividend policy strikes a balance between current dividends and future growth so as to maximize the firm's stock price.
Miller and Modigliani developed the dividend irrelevance theory, which holds that a firm's dividend policy has no effect on either the value of its stock or its cost of capital.
The bird-in-the-hand theory holds that the firm's value will be maximized by a high dividend payout ratio, because investors regard cash dividends as being less risky than potential capital gains. Thus, as the payout ratio increases, firm value increases and the cost of capital decreases, and vice versa.
The tax preference theory states that because long-term capital gains are subject to less generous taxes than dividends, investors prefer to have companies retain earnings rather than pay them out as dividends. Thus, as the payout ratio increases, firm value decreases and the cost of capital increases, and vice versa.
Empirical tests of the three theories have been inconclusive. Therefore, academics cannot tell corporate managers how a given change in dividend policy will affect stock prices and capital costs.
Dividend policy should take account of the information content of dividends (signaling) and the clientele effect. The information content, or signaling, effect relates to the fact that investors regard an unexpected dividend change as a signal of management's forecast of future earnings. The clientele effect suggests that a firm will attract investors who like the firm's dividend payout policy. Both factors should be considered by firms that are considering a change in dividend policy.
In practice, most firms try to follow a policy of paying a steadily increasing dividend. This policy provides investors with stable, dependable income, and departures from it give investors signals about management's expectations for future earnings.
Most firms use the residual dividend model to set the long-run target payout ratio at a level which will permit the firm to satisfy its equity requirements with retained earnings. According to the residual dividend model, dividends to be paid are calculated in the following manner:
- Dividends = Net Income –[( Equity Ratio ) x ( Total capital budget )]
A dividend reinvestment plan (DRIP) allows stockholders to have the company automatically use dividends to purchase additional shares of stock. DRIP's are popular because they allow stockholders to acquire additional shares without incurring brokerage fees.
Legal constraints, investment opportunities, availability and cost of funds from other sources, and taxes are also considered when firms establish dividend policies.
A stock split increases the number of shares outstanding. Normally, splits reduce the price per share in proportion to the increase in shares because splits merely "divide the pie into smaller slices." However, firms generally split their stocks only if (1) the price is quite high and (2) management thinks the future is bright. Therefore, stock splits are often taken as positive signals and thus boost stock prices.
A stock dividend is a dividend paid in additional shares of stock rather than in cash. Both stock dividends and splits are used to keep stock prices within an "optimal" trading range.
Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Repurchases are useful for making major changes in capital structure, as well as for distributing temporary excess cash.
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