Professional Documents
Culture Documents
(Chapter 18)
Assuming:
– No transactions costs to buy and sell securities
– No flotation costs on new issues
– No taxes
– Perfect information
– Dividend policy does not affect ke
Empirical Evidence:
– No conclusive proof, one way or
another.
– Difficult to hold the rest of the world
constant while we study dividend
policy.
– Cannot measure the cost of equity
(ke) with a high degree of accuracy.
Other Dividend Policy Issues
Clientele Effect: Investors needing current income will
be drawn to firms with high payout ratios. Investors
preferring to avoid taxes will be drawn to firms with
lower payout ratios. (i.e., firms draw a given clientele,
given their stated dividend policy). Therefore, firms
should avoid making drastic changes in their dividend
policy.
Information Content: Changes in dividend policy may
be signals concerning the firm’s financial condition. A
dividend increase may signal good future earnings. A
dividend decrease may signal poor future earnings.
Residual Dividend Theory
Retain and reinvest earnings as long as returns on the investments
exceed the returns stockholders could obtain on other investments
of comparable risk. This concept is illustrated graphically below. A
corporation should retain all necessary earnings to invest up to the
level indicated by the intersection of the MCC (marginal cost of
capital) and IOS (investment opportunity schedule) functions.
Residual earnings are distributed to shareholders.
Percent
20
18
16 MCC
14
12
10
8 IOS
6
4
2
0
0 10 20 30
Amount of Capital ($millions)
Stable Growth in Dividend Policy
Most corporations attempt to maintain a stable
growth in dividend policy:
– Many financial institutions invest only in
companies with regular dividend payments.
– Perhaps leads to higher stock prices:
(Lower risk - lower ke - higher P0)
D1
P0
ke g
As a result, dividends tend to be a function of the
“sustainable growth” in earnings.
Stable Growth in Dividend Policy (Cont)
Dollars Per Share
1.8 EPS
1.6
1.4
1.2 DPS
1
0.8
0.6
0.4
0.2
0
Year
Some Additional Considerations
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.
Some Additional Considerations
(Continued)
Ownership Control: Smaller firms may be
averse to issuing new stock due to dilution of
corporate control. Therefore, retain earnings
and pay few dividends.
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. Companies may use
these plans to raise additional equity capital.
Stock Dividends
Accounting for stock dividends:
Retained Earnings xxxx
Common Stock xxxx
Paid-in-Capital xxxx
The market value of the stock dividend is taken out of
retained earnings and placed into the permanent
capital accounts.
Stock Splits
No changes in the capital accounts.
Par value decreased.
Number of shares outstanding increased.
The Impact on Stockholders’ Wealth
of Stock Dividends and Stock Splits
Everything else remaining the same, stock
dividends and stock splits do not increase
stockholder wealth. Perhaps, however, they
are beneficial in the long-run due to the
“optimal price range” concept.
Price may rise, however, if other variables
also change (e.g., cash dividends increase,
higher expected future earnings)
Stock Repurchases
(A Corporation Acquires its Own Stock)
Alternative to cash dividends: Shares outstanding are
reduced, EPS increases, and if the P/E does not
change, the stock price increases. (i.e., capital gains
are substituted for cash dividends). Stock
repurchases may be a sound strategy for firms with
“temporary” excess cash.
Share price too low: Outstanding shares may be
repurchased to drive the stock price up to a “more
appropriate” level.
Change the capital structure quickly: Issue debt and
use the proceeds to buy back outstanding stock.