Dividend Policy and Retained Earnings (Chapter 18) by osq14347

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									  Dividend Policy and Retained Earnings
                  (Chapter 18)


Optimal Dividend Policy
Conflicting Theories
Other Dividend Policy Issues
Residual Dividend Theory
Stable Growth in Dividend Policy
Some Additional Considerations
Stock Dividends and Stock Splits
Stock Repurchases
              Optimal Dividend Policy
   The optimal dividend policy should maximize the
    price of the firm’s stock holding the number of shares
    outstanding constant.
                         D1
                   P0 
                        ke  g
    A decision to increase dividends will raise D1 putting
    upward pressure on P0. Increasing dividends,
    however, means reinvesting fewer dollars, lowering
    g, and putting downward pressure on P0.

   Problem: What is the correct balance between
    dividends and retained earnings?
            Conflicting Theories
   Dividend Policy is Irrelevant:
    (Dividend Irrelevance Theory)

   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

   Dividend policy is irrelevant. If dividends are too high,
    investors may use some of the funds to buy more of
    the firm’s stock. If dividends are too low, investors
    may sell off some of the stock to generate additional
    funds.
       Conflicting Theories (Continued)

   High Dividends Increase Stock Value:
    (Bird-in-the-Hand Theory)

   Dividends are less risky. Therefore, high
    dividend payout ratios will lower ke (reducing
    the cost of capital), and increase stock price.
         Conflicting Theories (Continued)

    Low Dividends Increase Stock Value:
    (Tax Preference Theory)

   Dividends received are taxable in the current period.
    Taxes on capital gains, however, 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 ke (reducing the cost
    of capital), raise g, and increase stock price.
Conflicting Theories (Continued)

 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
      94

      95

      96

      97

      98

      99

      00

      01

      02
   19

   19

   19

   19

   19

   19

   20

   20

   20
           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.

								
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