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Chapter 3
Dividend Policy and Theories

•Required readings:
• Ehrhardt, M.C. Brigham, E. F. (2011), Financial Management: Theory and
Practice, 13th Ed., South-Western Cengage Learning. (Chapter 14)
• Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan (2013),
Fundamentals of Corporate Finance, 10th ed. McGraw-Hill. (Chapter 17,)
 Dividend Policy
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 It’s the policy about the decision to payout earnings

versus retaining and reinvesting them.
 It includes decisions regarding:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the 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
value.
 Dividend Policy
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 The target payout ratio should be based on investor

preferences for cash dividends or capital gains.
 If the firm increases the payout ratio, D will
1
increase, and higher stock price other things
remains constant in the short run.
 On the other hand, if the firm increases D , there
1
will be less money available for reinvestment
causing g to decline. If g falls, this will lower the
stock price in the long run.
 Dividend Policy

The optimal dividend policy should strike a



balance between current dividends and future

growth so as to maximize the firm’s stock price.
Gordon Divided Discount Model
P0 = D1
Ke – g
Where, P0 - current stock price
D1- Dividend after one year
Ke – Cost of Equity
g – dividend Growth
 Dividend Policy
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 A decision to increase dividends will raise D1, and

putting upward pressure on P0 in the short run.
 Increasing dividends, however, means reinvesting
fewer dollars, lowering g, and putting downward
pressure on P0 in the long run.
 What is the correct balance between dividends and
RE?
 Dividend Theories
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 Do investors prefer high or low payouts? There are

three theories:
 Dividends are irrelevant: Investors don’t care
about payout.
 Bird in the hand: Investors prefer a high payout.
 Tax preference: Investors prefer a low payout, and
high growth.
 Cont’d………
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Dividend Irrelevance Theory

 Modigliani & Miller supports this irrelevance theory.

 Investors are indifferent between dividends and

retention (or generated capital gains).

 If the firm’s cash dividend is too big, the excess
cash can use it to buy more of the firm’s stock.
 If the firm’s cash dividend is too small, investors
can just sell a little bit of stocks to get the cash they
want.
 The dividend policy of the firm is irrelevant as it

does not affect the value of the firm.

 Cont’d……..
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 Modigliani & Miller argued that the value of the firm

depends on the firm’s earnings that result from its
investment policy.
 The theory is based on unrealistic assumptions
 No transactions costs to buy and sell securities
 No flotation costs on new issues
 No taxes
 Perfect information

 Dividend policy does not affect k

e
 Cont’d.........
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Dividend Preference (Bird-in-the-Hand) Theory

የኩባንያ ትርፍ ክፍያ አፈፃፀም
 A return in the form of dividends is a sure thing, but

a return in the form of capital gains is risky.

 A bird in the hand is worth more than two in the

bush.
 Shareholders prefer dividends and are willing to

accept a lower required return on equity.

 So, investors would value high payout firms more

highly, i.e., a high payout would result in a high P0.

 Cont’d............
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Tax Preference Theory

 Dividends received are taxable in the current period.

However, taxes on capital gains are deferred into the

future when the stock is actually sold.
 In addition, the maximum tax rate on capital gains is

usually lower than the tax rate on ordinary income.

 Therefore, low dividend payout ratios will lower k
e
(reducing the cost of capital), raise g, and increase
stock price.
 Cont’d…………
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 Which theory is most correct?

 Empirical testing has not been able to determine

which theory is correct.

 Thus, managers use judgment when setting

dividend policy.
 Other Dividend Theories
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Clientele Effect
 Different groups of investors or clienteles prefer

different dividend policies.

 Retired individuals, pension funds, and university
endowment funds prefer cash income, so they may
want the firm to pay out a high percentage of its
earnings.
 Stockholders in their peak earning years might
prefer reinvestment, because they have less need
for current income and would reinvest dividends
after paying taxes.
 Cont’d………
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 Therefore, investors who want current investment

income should own shares in high dividend payout
firms, while investors with no need for current
income should own shares in low dividend payout
firms.
 Dividend clientele effect states that high-tax bracket
investors (like individuals) prefer low dividend
payouts and low tax bracket investors (like pension
funds) prefer high dividend payouts.
 To the extent that stockholders can switch firms, a
firm can change from one dividend payout policy to
another and then let stockholders who do not like the
 Cont’d……..
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 However, frequent switching is inefficient because of

 Brokerage costs
 Stockholders will have to pay capital gain taxes,

and
 Possible shortage of investors who like the firm’s

newly adopted dividend policy.

 The new dividend policy might cause current
shareholders to sell their stock, forcing the stock
price down.
 It might also attract a larger clientele than the firm
had before and stock price would rise.
 Cont’d………
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 Evidence from several studies suggests that there is,

in fact, a clientele effect.
 However, MM and others argued that one clientele is
as good as another, so the existence of a clientele
effect does not necessarily imply that one dividend
policy is better than any other.
 Therefore, firms should avoid making drastic
changes in their dividend policy.
 Cont’d..........
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Information Content or Signaling Theory

 Different investors have different views on both

future dividend and the uncertainty inherent in those

payments, and managers have better information
about future prospects than public stockholders.
 An increase in the dividend is often accompanied by

an increase in the price of a stock and a dividend cut

leads to a stock price decline.
 Cont’d………
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 MM argued that;
 Higher than expected dividend increase is a signal

to investors that the firm’s management forecasts

good future earnings.
 Dividend reduction or smaller than expected

increase is a signal that management is forecasting

poor earnings in the future.
 Price changes following dividend actions simply

indicate that there is important information, or

signaling, content in dividend announcements.
 Cont’d……..
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Implications for Dividend Stability

 Clientele effect and information content in dividend

announcements have implications on the desirability

of stable versus volatile dividends.
 Many stockholders rely on dividends to meet

expenses, and they would be seriously

inconvenienced if the dividend stream were
unstable.
 Reducing dividends to make funds available for

capital investment could send incorrect signals to

investors, who might push down the stock price
because they interpret the dividend cut to mean
 Cont’d……….
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 Thus, maximizing stock price probably requires to

maintain a steady dividend policy.
 It means a company’s regular cash dividends

should also grow at a steady, predictable rate.

 Target Distribution Level
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Residual Dividend Model

 In deciding how much cash to distribute to

stockholders, two points should be kept in mind:

 The overriding objective is to maximize
shareholder value, and
 The firm’s cash flows really belong to its

shareholders, so a company should refrain from

retaining income unless it can reinvest that income
to produce returns higher than shareholders could
themselves earn by investing the cash in
investments of equal risk.
 Cont’d………
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 The optimal distribution ratio is a function of 4

factors:
 Investors’ preferences for dividends vs. capital

gains,
 The firm’s investment opportunities,
 Its target capital structure, and
 The availability and cost of external capital.

 The last three elements are combined in what we call

the residual distribution model.
 The word residual implies “leftover”, and residual
policy implies the distributions are paid out of
 Cont’d………
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 Under the residual distribution model firms follow

four steps when establishing their target distribution
ratio:
 Determines the optimal capital budget;
 Determines the amount of equity needed to finance

the budget, given its target capital structure

 Use reinvested earnings to meet equity
requirements to the extent possible; and
 Pay dividends or repurchases stock only if more

earnings are available than needed to support the

optimal capital budget.
 Cont’d……….
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 Residual distribution policy minimizes flotation and

equity signaling costs, consequently minimizes the
WACC.
 Residual distribution Model:

Net
Dividends = Income –
[( )( )]
Target
equity
ratio
Total
capital
.
budget
 Cont’d……….
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Example
 Capital budget: $800,000.

 Target capital structure: 40% debt, 60% equity.

 Forecasted net income: $600,000.

 How much of the $600,000 should we pay out as

dividends?
 0.6($800,000) = $480,000 must be equity to keep
at target capital structure.
 [0.4($800,000) = $320,000 will be debt.]
 Cont’d………
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 With $600,000 of net income,

 The residual is $600,000 – $480,000 = $120,000
dividends paid.
 Payout ratio = $120,000/$600,000 = 0.20 = 20%.
 Residual Distribution Model in Practice
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 Rigidly following of the residual policy would lead

to fluctuating, unstable dividends. Since investors
dislike volatile regular dividends, rs would be high
and the stock price will be low.
 Therefore, firms should use the policy as follows:
 Estimate earnings and investment opportunities, on

average, for 5 or so years.

 Find the average residual model distributions and

dollars of dividends during the planning period.

 Set a target payout ratio
 Cont’d………
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 Some companies set a very low “regular” dividend

and then supplement it with an “extra” dividend
when times are good, such as Microsoft now does.
 The low-regular-dividend-plus-extras policy
ensures that the regular dividend can be maintained
“come hell or high water” and stockholders can
count on receiving that dividend under all
conditions.
 Then, when times are good, and profits and cash

flows are high, the company can either pay a

specially designated extra dividend or repurchase
shares of stock.
 Stable Growth in Dividend
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Policy
 Most corporations attempt to maintain a stable
growth in dividend policy:
 Perhaps it leads to higher stock prices:
(Lower risk - lower ke - higher P0)
P0 = D1
Ke – g
 As a result, dividends tend to be a function of the
“sustainable growth” in earnings.
 Some Additional Considerations

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 Legal Restrictions: Dividends cannot be paid out of

the permanent capital accounts.
 Liquidity: Retained earnings and cash are not
identical.
 Access to other sources of financing.
 Stability of earnings.
 Restrictions in debt contracts.
 Ownership Control: Smaller firms may be averse to
issuing new stock due to dilution of corporate
control. Therefore, retain earnings and pay few
dividends.
 Some Additional Considerations (Cont’d....)

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 Inflation: Since replacement costs of assets are

higher in inflationary periods, more retention of
earnings may be required.
 Dividend Reinvestment Plans: Investors can
automatically reinvest dividends often at a discount
with no transaction costs. Frequently a good
investment tool.
 Stock Dividends & Stock Splits
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Stock dividends
 Dividends paid in additional shares rather than in

cash.
 It divides the pie into smaller slices without affecting

the fundamental position of the current stockholders

like stock splits.
 The value of the stock dividend is taken out of

retained earnings and placed into the permanent

capital accounts.
 Firm issues new shares instead of paying a cash

dividend. If 10%, get 10 shares for each 100

shares owned.
 Cont’d.........
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Stock Splits
 Stock splits increase the number of shares
outstanding, so “the pie is divided into smaller
pieces.” Eg. 2-for-1
 The price of each share will drop to half.
 No changes in the capital accounts.
 Par value decreases by half.

 Everything else remaining the same, stock dividends

and stock splits do not increase stockholders wealth.

 However, they are beneficial in the long-run.
 Firms generally split their stocks only if;
 The price is quite high and
 Stock Repurchases

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 The buyback of stock by the issuing firm either in the

open (secondary) market or by self-tender offer.
 Tender offer – firm states a purchase price and a
desired number of shares
 Open market – buys stock in the open market

 Stock repurchases are most relevant for firms with

large amounts of excess cash that might otherwise
generate a significant taxable transaction to investors.
 Firms must be careful not to make regular repurchases
or the tax authority may consider the capital gains as
dividends for tax purposes.
 Cont’d………
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Reasons for repurchases:

 An alternative to distributing cash as dividends.
 To dispose one-time cash from asset sales.
 Available for management stock-option plans
 Go private by repurchasing all shares from outside
stockholders
 To permanently retire the shares
 Cont’d……….
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Advantages of Stock Repurchases

 Stockholders can sell or not. With a cash dividend,

stockholders must accept the payment & pay the

taxes.
 Helps avoid setting a high dividend that cannot be

maintained.
 Repurchased stock can be used in take-over or resold

to raise cash as needed.

 Income received is capital gains rather than higher-

taxed dividends.
 Stockholders may take as a positive signal-
management thinks stock is undervalued.
 Cont’d……..
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Disadvantages of Repurchases
 Tax authority could impose penalties if repurchases

were primarily to avoid taxes on dividends.

 Selling stockholders may not be well informed,

hence be treated unfairly.

 Firms may have to bid up price to complete purchase,

thus paying too much for its own stock.

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Thank you!

The End!