Distributions to Shareholders Dividends

Distributions to Shareholders:Dividends : 

Distributions to Shareholders:Dividends Theories of investor preferences Signaling effects Residual model Stock dividends and stock splits

What is “dividend policy”? : 

What is “dividend policy”? It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements: 1. High or low payout? 2. Stable or irregular dividends? 3. How frequent? 4. Do we announce the policy?

Do investors prefer high or low payouts? There are three theories: : 

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, hence growth.

Dividend Irrelevance Theory : 

Dividend Irrelevance Theory Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

Bird-in-the-Hand Theory : 

Bird-in-the-Hand Theory Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

Tax Preference Theory : 

Tax Preference Theory Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 39.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.

Implications of 3 Theories for Managers : 

Implications of 3 Theories for Managers Theory Implication Irrelevance Any payout OK Bird-in-the-hand Set high payout Tax preference Set low payout But which, if any, is correct???

Which theory is most correct? : 

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.

What’s the “information content,” or “signaling,” hypothesis? : 

What’s the “information content,” or “signaling,” hypothesis? Managers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

What’s the “residual dividend model”? : 

What’s the “residual dividend model”? Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends.

Slide 11: 

Using the Residual Model to Calculate Dividends Paid

Data for SSC : 

Data for SSC Capital budget: $800,000. Given. Target capital structure: 40% debt, 60% equity. Want to maintain. Forecasted net income: $600,000. How much of the $600,000 should we pay out as dividends?

Slide 13: 

Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be equity to keep at target capital structure. With $600,000 of net income, the residual is $600,000 - $480,000 = $120,000 = dividends paid. Payout ratio = $120,000/$600,000 = 20%

Stock Dividends vs. Stock Splits : 

Stock Dividends vs. Stock Splits Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned. Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

Slide 15: 

Both stock dividends and stock splits increase the number of shares outstanding, so “the pie is divided into smaller pieces.” Unless the stock dividend or split conveys information, or is accompanied by another event like higher dividends, the stock price falls so as to keep each investor’s wealth unchanged. But splits/stock dividends may get us to an “optimal price range.”