Chapter-5 Dividend Policy.ppt

Chapter 5: Dividend policy Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases MBA DECEMBER 2023  In deciding how much cash to distribute to stockholders, financial managers mu...

Chapter 5: Dividend policy Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases MBA DECEMBER 2023  In deciding how much cash to distribute to stockholders, financial managers must keep in mind that the firm’s objective is to maximize shareholder value. Thus, the target payout ratio should be based on investor preferences for cash dividends or capital gains. If the firm increases the payout ratio, dividend(D1) will increase, resulting in a higher stock price(Po) other things being equal. MBA DECEMBER 2023  However, if the firm increases D1, there will be less money available for reinvestment causing growth(g) to decline (remember g equals the retention ratio times ROE). If g falls, this will lower the stock price. Therefore, when setting the optimal dividend policy the financial manager should strike a balance between current dividends and future growth so as to maximize the firm’s stock price. MBA DECEMBER 2023 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? MBA DECEMBER 2023 Do investors prefer high or low payouts? There are three theories: Dividends are irrelevant: Investors are indifferent about payout. Bird in the hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth. MBA DECEMBER 2023  Dividend Irrelevance Theory Modigliani-Miller support irrelevance. Investors are indifferent between dividends and retention-generated capital gains. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend is too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test. MBA DECEMBER 2023  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 P 0. Short-termism, and no tax effect considered. MBA DECEMBER 2023  Tax Preference Theory Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 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. MBA DECEMBER 2023 Implications of 3 Theories for Managers Theory Implication Irrelevance Any payout OK Bird in the hand Set high payout Tax preference Set low payout MBA DECEMBER 2023  Possible Stock Price Effects Stock Price ($) Bird-in-Hand 40 30 Irrelevance 20 Tax preference 10 0 50% 100% Payout MBA DECEMBER 2023  Possible Cost of Equity Effects Cost of equity (%) Tax Preference 20 15 Irrelevance 10 Bird-in-Hand 0 50% 100% Payout MBA DECEMBER 2023  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. MBA DECEMBER 2023  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 dividends themselves, not to a change in the dividend payout policy. MBA DECEMBER 2023  What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend policies. The dividend clientele effect states that high-tax bracket investors (like individuals) prefer low dividend payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. So different groups desire different levels of dividends. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies. MBA DECEMBER 2023  What’s the “residual dividend model”? Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends only if more earnings are available than are needed to support the optimal capital budget. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC. MBA DECEMBER 2023  Using the Residual Model to Calculate Dividends Paid Net Dividends = income – [( )( )] Target equity ratio Total capital budget. MBA DECEMBER 2023  Data for a company 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? MBA DECEMBER 2023 Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be equity to keep at target capital structure. [0.4($800,000) = $320,000 will be debt.] 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%. MBA DECEMBER 2023  How would a drop in NI to $400,000 affect the dividend? A rise to $800,000? NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends = 0. NI = $800,000: Dividends = $800,000 – $480,000 = $320,000. Payout = $320,000/$800,000 = 40%. MBA DECEMBER 2023 How would a change in investment opportunities affect dividend under the residual policy? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout. MBA DECEMBER 2023 Advantages and Disadvantages of the Residual Dividend Policy Advantages: Minimizes new stock issues and flotation costs. Disadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele. Conclusion: Consider residual policy to help set their long-run target payout ratios, but not as a guide to the payout in any one year. MBA DECEMBER 2023  Setting Dividend Policy Forecast capital needs over a planning horizon, often 5 years. Set a target capital structure. Estimate annual equity needs. Set target payout based on the residual model. Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary. MBA DECEMBER 2023  Stock Repurchases Repurchases: Buying own stock back from stockholders. Reasons for repurchases: As an alternative to distributing cash as dividends. To dispose of one-time cash from an asset sale. To make a large capital structure change. MBA DECEMBER 2023  Advantages of Repurchases Stockholders can sell or not. With a cash dividend, stockholders must accept the payment and pay the taxes. Helps avoid setting a high dividend that cannot be maintained. Repurchased stock can be used in take- overs 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. MBA DECEMBER 2023  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. Firm may have to bid up price to complete purchase, thus paying too much for its own stock. MBA DECEMBER 2023  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, but the price of each share will drop to half. MBA DECEMBER 2023  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. Stock splits can be used to keep the price in the MBA optimal range. DECEMBER 2023 Thank You! MBA DECEMBER 2023