**DIVIDEND POLICY**

**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
we know, 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:

*Optimal Dividend Policy:*To maximize price, an optimal balance must be found between current dividends (

*D*) and the need for growth (

_{1}*g*).

**Dividend Irrelevance Theory**

Miller
and Modigliani showed algebraically that dividend policy didn’t matter:

n 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.

o They would see
it in dividend or price appreciation.

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

**Dividend Policy and Stock Price**

Dividend
Irrelevance Theory:

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

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

n

**Dividend Irrelevance Theory**

**Dividend Irrelevance Theory**

*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:

n Brokerage costs
didn’t exist.

n 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.

**Tax Preference Theory**

There
are three ways in which taxes affect the dividend preferences of shareholders.

n For individual
investors tax rates differ for capital gains and dividends.

n Taxes on capital
gains are not due until the stock is sold.

n If the stock is
held until the shareholder expires, no tax is due at all.

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.**Dividends or Capital Gains?**

Summary: Do shareholders prefer dividends or capital
gains?

n

*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.
n

*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?

n

*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.
o Today dividends
and capital gains have virtually the same tax rate.

*Signaling:*
n The theories
thus far have assumed that investors and managers have the same information
set.

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

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

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

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

n 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.

n 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.

**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.

**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.

n Dividends are
only increased if management is certain future earnings will support such a
high dividend.

**Stable, Predictable Dividend Policy**:

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

n 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.

**Stable, Predictable Dividend Policy Steps**:

1.
Pay
a predictable dividend every year.

2.
Base
optimal capital budget on residual retained earnings (after dividend).

**Constant Payout Ratio Policy**: It is possible that a company could set a policy to payout a certain percentage of earnings as dividends.

n 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).

**Constant Payout Ratio Policy Steps**:

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

2.
Base
optimal capital budget on residual retained earnings.

**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.

n The problem is
the potential for negative signaling.

**Low Regular Dividend Plus Extras Steps**:

- Pay
a predictable dividend every year.
- In
years with good earnings pay a bonus dividend.
- Base
optimal capital budget on residual of regular dividend and compromising
with bonus for capital budgeting projects.

**General Motors – Dividends**

**General Motors – Dividends**

**General Motors – Dividend History**

**Caterpillar – Dividend History**

**Internally Generated Growth**

Dividend
Payout Ratio:

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

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

Retention
Ratio:

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

n Everything else
is retained.

**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.

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.

b
= Retention Ratio

Dividend
Policy

A
company’s dividend policy depends on:

n The shareholders
of the company.

n Market
signaling.

o The more
understandable the better.

o The more stable
the better.

n The growth
potential of the company.