Dividend Policy

1
Dividend Policy

• Chapter 16
• FIL 341
• Prepared by Keldon Bauer

2
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.

3
Dividends or Capital Gains?

• In the late 1950s, Myron Gordon proposed modeling
  price on a firms dividends and growth potential

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

4
Dividend Irrelevance Theory

• Miller and Modigliani showed algebraically that
  dividend policy didnt matter
• They showed that as long as the firm was
  realizing the returns expected by the market, it
  didnt 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.

5
Dividend Irrelevance Theory

• But Miller and Modigliani made some unrealistic
  assumptions in developing their model
• Brokerage costs didnt exist.
• Taxes didnt exist.
• They made these assumptions to simplify the
  analysis.

6
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.

7
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.

8
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.

9
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)
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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
  doesnt 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.

11
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.
• This same philosophy would suggest that now
  higher dividends may require lower rates of
  return.
• Two of the three theories now suggest that
  shareholders should prefer dividends.

12
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 didnt
  know before.

13
Information Content Hypothesis

• Signaling - continued
• Managers dont cut dividends unless the firm is
  in financial distress.
• It is therefore believed that firms do not
  increase dividends beyond Wall Streets
  expectations unless managers anticipate stronger
  earnings than expectations.
• Unexpected changes in dividends relay information
  to the market.

14
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.

15
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.

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Dividend Policy Classes

• Residual Dividend Policy Steps
• Determine the optimal capital budget.
• Determine the retained earnings that can be used
  to finance the capital budget.
• Use retained earnings to supply as much of the
  equity investment in the capital budget as
  necessary.
• Pay dividends only if there are left-over
  earnings.

17
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.

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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.

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Dividend Policy Classes

• Stable, Predictable Dividend Policy Steps
• Pay a predictable dividend every year.
• Base optimal capital budget on residual retained
  earnings (after dividend).

20
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).

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Dividend Policy Classes

• Constant Payout Ratio Policy Steps
• Pay a constant proportion of earnings (if
  positive).
• Base optimal capital budget on residual retained
  earnings.

22
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.

23
Dividend Policy Classes

• 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.

24
Dividend Policy
25
Which Policy Does Zions Use?
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The Dividend Decision Lintners Facts

• 1. Firms have longer term target dividend payout
  ratios.
• 2. Managers focus more on dividend changes than
  on absolute levels.
• 3. Dividend changes follow shifts in long-run,
  sustainable levels of earnings rather than
  short-run changes in earnings.
• 4. Managers are reluctant to make dividend
  changes that might have to be reversed.
• 5. Firms repurchase stock when they have
  accumulated a large amount of unwanted cash or
  wish to change their capital structure by
  replacing equity with debt.

27
Dividend Policy

• A companys 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.