Which theory is most correct?

 Empirical testing has not been able to

determine which theory, if any, is
correct.
 Thus, managers use judgment when
setting policy.
 Analysis is used, but it must be
applied with judgment.

14-1
Dividend preference theory
 Investors prefer a more certain
dividend today to a more uncertain
capital gain tomorrow.
 The longer is the period of time the
greater is uncertainly, thus capital
gains are more risky for investors
than dividends.

14-2
Tax effect theory
 a dollar of capital gain due at some
point in the future will be taxed at a
later date than a dollar of dividends
paid today.
 When you receive a dividend you
can't postpone the tax liability.
 dividends are taxed every year while
capital gains are not taxed until the
stock is sold; 14-3
Dividend irrelevance theory
 Clientele effect
 Information content or signaling
hypothesis

14-4
What’s the “clientele effect”?
 Different groups of investors, or
clienteles, prefer different dividend
policies.
 If a firm retains and reinvests income
rather than paying dividends, those
stockholders who need current
income would be disadvantaged

14-5
What’s the “clientele effect”?
 Investors who want current
investment income should own shares
in high-dividend payout firms, while
investors with no need for current
investment income should own shares
in low-dividend payout firms

14-6
Switching Dividend Policy
 Brokerage costs
 Likelihood that stockholders who are
selling will have to pay capital gains
taxes
 Possible shortage of investors who
like the firm’s newly adopted dividend
policy

14-7
What’s the “information content,”
or “signaling,” hypothesis?
 Managers hate to cut dividends, so they
won’t raise dividends unless they think
raise is sustainable. So, investors view
dividend increases as signals of
management’s view of the future.
 Price changes following dividend actions
simply indicate that there is important
information or signaling content in
dividend announcement

14-8
What is the “residual dividend
model”?
 Objective is to maximize shareholder’s
value
 The firm’s cash flows really belong to its
shareholder

14-9
What is the “residual dividend
model”?
 Firstuses earnings to finance new
projects, then distributes the remainder
as dividends.
 Distributions are paid out of “leftover”
earnings
 This policy minimizes flotation and
equity signaling costs, hence minimizes
the WACC.

14-10
 Residual dividend model
 Target   Total 
   
Dividends  Net Income -  equity    capital 
 ratio   budget 
  

14-11
 Example
Consider the case of Texas and Western Transport
Company which has 60M in net income and a target
capital structure of 60% equity and 40% debt.
If T&W forecasts poor investment opportunities,
then its estimated capital budget will be only $40
million. To maintain the target capital structure, 40%
($16 million) of this capital must be raised as debt and
60% ($24 million) must be equity. If it followed a strict
residual policy, T&W would retain $24 million of its $60
million earnings to help finance new investments and
then distribute the remaining $36 million to
shareholders.
14-12
Example

14-13