DIVIDEND POLICY

OVERVIEW Dividend policy, which is the decision whether to pay out earnings as dividends or to retain and reinvest them in the firm, has three key elements: (1) what fraction of earnings should be paid out, on average, over time? This is the target payout policy decision. (2) Should the firm attempt to maintain a steady, stable dividend growth rate, or should it vary its dividend payments from year to year depending on its internal need for funds and on its cash flows? (3) What dollar amount should the firm pay in current dividends? We also examine two related issues: stock repurchases and stock split. Dividend Policy Theories Dividend policy theories attempt to establish the relationship between a firm's payout policy and its value. In essence, they attempt to determine whether investors prefer dividends or capital gains. Dividend Irrelevance Modigliani and Miller (MM) argue that a firm's value is determined solely by its basic earnings power and its risk class. Thus, the value of the firm depends on asset investment policy only and not on how the firm's net income is split between dividends and retained earnings. This is called dividend irrelevance. MM prove their proposition, but only under a set of restrictive assumptions, including (1) Zero taxes, (2) Zero flotation and transaction costs, (3) Independence between dividend policy and equity costs (4) Symmetric information. Obviously, firms and investors do pay taxes, and firms do incur flotation costs. Thus, the MM conclusions on dividend irrelevance may not be valid under real-world conditions. Bird-In-The-Hand Theory Myron Gordon and John Lintner have proposed another theory, the bird-in-the-hand theory. Gordon and Lintner argue those rS increases as the dividend payout is reduced because investors view dividend payments as more certain than the capital gains that presumably result from retained earnings. MM call the Gordon-Lintner argument the "bird-in-the-hand fallacy" because, in MM's view, most investors are going to reinvest their dividends in the same or similar firms, and the riskiness of the firm's cash flows to investors in the long run is solely a function of the riskiness of the firm's assets. 1

Tax Preference Theory A third theory, the tax preference theory, is based on the fact that capital gains are effectively taxed at a lower rate than dividend income because taxes on capital gains are capped at 28 percent and are deferred until the end of the holding period. Because of the tax deferral feature on capital gains (and the fact that capital gains taxes are capped at 28 percent), investors should require higher rates of return on high dividend yield stocks than they do on low dividend yield stocks, other things held constant. Under the old tax laws before 1986, capital gains were taxed at a significantly lower rate as well as deferred, making the yield differentials even more pronounced. Note that each of these theories leads to a different prescription for financial managers. According to MM, there is no optimal dividend payout policy. Gordon and Lintner argue that firms should set high dividend payout ratios to maximize stock price. The tax preference theory leads to the opposite conclusion: Firms should set low dividend payout ratios.

Unfortunately, empirical testing has not produced definitive results regarding which theory is correct. OTHER DIVIDEND POLICY ISSUES There are three other issues that have a bearing on optimal dividend policy. It has been observed that an announcement of a dividend increase is often accompanied by an increase in the price of the stock. This might be interpreted by some that investors prefer dividends to capital gains, thus supporting the Gordon-Lintner hypothesis. However, MM argue that a dividend increase is a "signal" to investors that the firm's management forecasts good future earnings. Thus, MM argue that investors' reactions to dividend announcements do not necessarily show that investors prefer dividends to retained earnings. Rather, the fact that the stock price changes merely indicate that there is an important information, or signaling, content in dividend announcements.

CLIENTELE EFFECT MM also suggest that a clientele effect might exist. Some stockholders prefer current income; they would want the firm to pay out a high percentage of its earnings. Other stockholders have no need for current income; they would simply reinvest any dividends received, after first paying income taxes on the dividend income. These stockholders would want the firm to retain most of its earnings. 2

Thus, a firm attracts a specific clientele that is drawn to its dividend policy. Empirical evidence supports the contention that a clientele effect does exist, but MM argue that one clientele is as good as another, so the existence of clienteles does not imply that one payout policy is better than another. However, MM offers no proof that the aggregate makeup of investors permits firms to disregard clientele effects.

DIVIDEND POLICY AND AGENCY COSTS The relationship between dividend policy and agency costs has a bearing on the optimal dividend policy. One of the most perplexing issues in dividend policy is why firms pay dividends and then issue new securities. One potential answer is the signaling value inherent in dividends. However, it is hard to imagine that the value that arises from signaling is greater than the costs associated with new security issues. A second explanation for paying dividends relates to agency costs. An agency conflict exists between managers and stockholders, and because of this potential agency conflict, stockholders are willing to incur agency costs to monitor managerial actions. The monitoring problem is substantially reduced when firms must consistently raise external capital. For any given level of investment, the higher the dividend payout, the more frequently the firm must issue new securities. A higher payout policy thus forces firms to undergo the frequent scrutiny of the capital markets, and this appraisal process mitigates the agency problem. If the cost of paying dividends (which includes flotation for additional securities) is less than the value inherent in the additional monitoring, then large dividend payout make sense.

DIVIDEND STABILITY As we noted early, the decision as to how stable over time a firm's dividend should be is an important issue. Firms' profits and cash flows vary over time, as do their investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time. However, many stockholders rely on dividends to meet expenses. Further, dividend cuts could be interpreted by investors as signals of bad news.

How should the balance be struck? ; That is, how stable and dependable should a firm attempt to make its dividends? Although it is impossible to give a definitive answer to this question, the following points are relevant: Virtually every publicly owned company makes a 5- to 10-year financial forecast of earnings and dividends. For a "normal" company, such forecasts typically project higher earnings and dividends. Years ago, when inflation was not persistent, the term "stable dividend policy" meant a policy of paying the same dollar dividend year after year. Today, most 3

companies and stockholders expect earnings and dividends to grow over time as a result of both inflation and retention. Thus, today a stable dividend policy generally means increasing the dollar dividend at a reasonably steady rate. Companies with volatile earnings and cash flows would be reluctant to make a commitment to increase the dividend each year, but they would still plan to increase dividends when the situation warrants.

Dividend stability has two components: How dependable is the growth rate? How dependable is the current dividend? ; that is, can investors at least count on receiving the current dividend in the future? Most observers believe that dividend stability is desirable, even though statistical problems prevent empirical tests from proving the point. If this position is correct, then: 1. Investors would prefer a stock that pays more predictable dividends to one that has the same expected present value of dividends but pays them in a more erratic manner. 2. This means that the cost of equity would be minimized, and shareholder wealth maximized, if a firm stabilizes its dividends as much as possible, given its requirements to support capital growth. RESIDUAL DIVIDEND POLICY In the preceding sections we have seen that investors may or may not prefer dividends to capital gains, but they do seem to prefer predictably to unpredictable dividends. Given this situation, how should firms set their basic dividend policies? The residual dividend model is based on the premise that investors prefer to have a firm retain and reinvest earnings rather than pay them out in dividends if the rate of return the firm can earn on reinvested earnings exceeds the rate of return investors can obtain for themselves on other investments of comparable risk. Further, it is less expensive for the firm to use retained earnings than it is to issue new common stock. A firm using the residual model would follow these four steps: 2. 1. Determine the optimal capital budget. Determine the amount of equity required to finance the optimal capital budget, recognizing that the funds used will consist of both equity and debt to preserve the optimal capital structure. 3. To the extent possible, use retained earnings to supply the equity required. Pay dividends only if more earnings are available than are needed to support the optimal capital budget.

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Since both investment opportunities and earnings vary from year to year, strict adherence to the residual dividend model would result in a dividend variability-one year the firm might declare zero dividends because investment opportunities were good (or profitability poor), and the next year it might pay a large dividend because investment opportunities were poor (or profitability good). 4

Because annual use of the residual model leads to unstable dividends, it is not used to set annual dividend payments. However, it is used in conjunction with a firm's 5-year forecast to determine a long-run target payout ratio. Note that dividends are paid from cash flow and not from earnings, so target payout ratios are set more on the basis of cash flows than on earnings. Cash flows reflect a firm's ability to pay dividends, while current earnings are heavily influenced by accounting practices and do not necessarily reflect the ability to pay dividends. The actual payment procedure is as follows: 2. 1. On the declaration date, the directors meet and declare the regular dividend. At the close of the business on the holder-of-record date, the company closes its stock transfer books and makes up a list of shareholders as of that date. 3. The securities industry has set up a convention of declaring that the right to the dividend remains with the stock until four business days prior to the holder-of-record date. The date when the right to the dividend leaves the stock is called the ex-dividend date. The company actually mails the checks to the holders of record on the payment date.

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DIVIDEND REINVESTMENT PLANS During the 1970s, most large companies instituted dividend reinvestment plans (DRPs), whereby stockholders can automatically reinvest their dividends in the stock of the paying corporation. There are two types of dividend reinvestment plans: In an old stock plan, a bank (acting as trustee) takes the total mount of dividends designated for the plan, purchases the company's stock on the open market, and distributes the shares to the investors on a pro rata basis. The transaction's costs are low because of the large transaction; hence, the participating shareholders benefit. In a new stock plan, the company merely issues stock to investors in the plan in lieu of cash dividends. Often, the stock is offered at a 3 to 5 percent discount from market price. Companies may change from one type of DRP to the other, depending on their needs for additional equity capital. OTHER FACTORS THAT INFLUENCE DIVIDEND POLICY In addition to the theories and issues discussed so far, a number of other factors influence the dividend decision. 1. Bond indentures. Debt contracts often contain provisions that restrict dividend policy. These provisions are: maintaining a certain level of current ratio, the time-interestearned, and other safety ratios. 5

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Preferred stock restrictions. Typically, common dividends cannot be paid if the company has omitted (passed) its preferred dividend. 3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet value for retained earnings. This restriction, called the impairment of capital rule, is designed to protect creditors.

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Availability of cash. Dividends must be paid with cash; hence, a cash shortage may restrict dividends. Improper accumulation of earnings. The IRS can penalize a firm if it believes that the firm is improperly accumulating earnings, that is, withholding dividends for the sole purpose of investor tax avoidance. 6. Control. If management is concerned about control, then it may be reluctant to sell new common stock; hence, it may retain more earnings than it otherwise would, rather than pay dividends. In general, managers do not want to issue new common stock because: (1) new common stock requires issuance costs and (2) new common stock sales are generally perceived as negative signals.

SETTING DIVIDEND POLICY Setting dividend policy is truly an exercise in informed judgment and not a decision that can be based on a precise mathematical model. In practice, dividend policy is not an independent decision-the dividend decision is made jointly with the capital structure and capital investment decisions. In setting dividend policy, managers first consider the firm's future investment opportunities, expected internal cash flows, and target capital structure. This gives them an idea of the residual earnings that might be available for dividends. In effect, managers use the residual dividend model, but applied to a long planning period. An actual dollar dividend per share is then selected so that there is an extremely low probability that the dividend, once set, will have to be lowered, or worse yet, omitted. If there is a great deal of uncertainty in the forecasted inflows and required outflows of the firm, a conservative dividend policy (low dollar dividend and low projected growth rate) will be adopted. STOCK REPURCHASE AS A DIVIDEND POLICY Firms may distribute income to stockholders by repurchasing their own stock. These repurchased shares are called treasury stock. When outstanding shares are repurchased, the earnings per share on the remaining shares will increase, resulting in a higher market price per share. Capital gains are substituted for dividends. Many very large repurchase programs are part of a general corporate restructuring plan whereby excess capital from asset sales or the issuance of new debt is distributed to stockholders through a major one-time stock repurchase. A "regular" stock repurchase is merely a substitute for cash dividends. 6

ADVANTAGES TO REPURCHASES INCLUDE: 1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management's belief that the firm's shares are undervalued. 2. Stockholders have a choice when the firm repurchases stock, while they must accept dividend payments and pay the resulting tax. 3. Repurchases can remove a large block of stock that is overhanging the market and keeping the price per share down. 4. If the excess cash flow is believed to be temporary, management can make the distribution in the form of share repurchase rather than declare an increased cash dividend that cannot be maintained. 5. Repurchases can be used to produce large-scale changes in capital structures. DISADVANTAGES TO REPURCHASES INCLUDE: 1. The stock price may benefit more from cash dividends than from repurchases because stockholders may not be indifferent between dividends and capital gains. 2. Selling stockholders may not be fully aware of all the implications of a repurchase. 3. The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining stockholders. There are pros and cons regarding stock repurchases. Some general observations can be made: 1. 2. 3. Because of uncertainties about their tax treatment, repurchases on a regular, systematic, dependable basis is probably not a good idea. However, repurchases do offer investors an opportunity to save taxes, and, for this reason, they should be given careful consideration. Repurchases can be especially valuable to a firm that wants to make a large shift in its capital structure within a short period of time.

STOCK DIVIDENDS AND STOCK SPLITS Stock dividends and stock splits are often used to lower a firm's stock price and, at the same time, to conserve its cash resources. The effect of a stock split is an increase in the number of shares outstanding and a reduction in the par, or stated, value of the shares. For example, if a firm had 1,000 shares of stock outstanding with a par value of $100 per share, a 2-for-1 split would reduce the par value to $50 per share and increase the number of shares to 2,000. The total net worth of the firm remains unchanged 7

The stock split does not involve any cash payment, only additional certificates representing new shares.

Although the economic effects of stock splits and stock dividends are virtually identical, accountants treat them somewhat differently. Stock dividends and splits "divide a given amount of pie into smaller slices." The rationale behind using stock splits and dividends to reduce share prices lies in the belief in an optimal trading range within which large numbers of investors will be able to purchase the stock and the price will be maximized. Unless the total amount of dividends paid on shares is increased, any upward movement in the stock price following a stock split or dividend is likely to be temporary. The price will normally fall in proportion to the dilution in per share earnings and dividends unless earnings and dividends rise.