FN428 : Investment Banking

Lecture : Dividend Policy

 Dividend Policy : The Questions
• Profitable companies regularly face three
important questions:
• (1) How much of our free cash flow should we
pass on to shareholders?
• (2) Should we provide this cash to stockholders
by raising the dividend or by repurchasing
stock?
• (3) Should we maintain a stable, consistent
payment policy; or should we let the payments
vary as conditions change?
 The issues
that affect dividend policies

• Mature companies with stable cash flows

and limited growth opportunities tend to
return a significant amount of their cash
to shareholders either by paying
dividends or by using the cash to
repurchase common stock.
 The issues
that affect dividend policies
• By contrast, rapidly growing companies
with good investment opportunities are
prone to invest most of their available cash
in new projects rather than paying
dividends or repurchasing stock.
• Microsoft, which has long been regarded as
the epitome of a growth company : Its sales
grew from $786 million in 1989 to $93.6
billion in 2015
 Example : Growth Firms

• This translates to an annual growth rate of

nearly 21%. Much of this growth came
from large, long-term investments in new
products and technology

• Given the firm’s emphasis on growth, it

paid no dividends over most of its life.
 But high growth is not sustainable…
• Microsoft has now pays a significant
portion of its cash to shareholders.
However, the cash kept pouring in; and by
mid 04 Microsoft’s cash hoard had grown
to more than $60 billion.
• At that point, the company took some
larger steps to return cash to its
shareholders.
 But high growth is not sustainable…
• The dividend was quadrupled to 32 cents a
share in just one year.
• It announced plans to pay a one-time
special dividend of $3 a share.
• Share repurchase up to $30 billion worth
of stock in the open market.
• All told, this meant that $62.62 billion
would be provided to its shareholders in
Year 2004 alone.
 But high growth is not sustainable…

• Microsoft continued to generate a great

deal of cash. But the company’s aggressive
use of dividends and share repurchases to
return cash to shareholders in recent years
represents an important shift in policy.
 But high growth is not sustainable…
• Could we earn more on the available cash
if we kept it in the firm and used it to
invest in new projects, or would
shareholders earn more if they received
the cash and invested it in alternative
investments with the same risk?
 If the decision is made to
distribute income to stockholders..
• (1) How much should be distributed?
• (2) Should the distribution be in the form of
dividends, or buying back stock?
• (3) How stable should the distribution be?
Should the funds paid out from year to
year be stable and dependable, or should
they be varied depending on the firms’ cash
flows and investment requirements?
 Dividend or Capital Gains?

• target payout ratio—defined as the

percentage of net income to be paid out as
cash dividends
• Do investors prefer to receive dividends; or
would they rather have the firm plow the
cash back into the business, which
presumably will produce capital gains?
 Two opposing effect of Dividends

• If the company increases the payout ratio,

this will raise D1, which cause the stock
price to rise.
• However, if D1 is raised, less money will be
available for reinvestment, which will cause
the expected growth rate to decline.
 Optimal dividend policy

• As a result, the optimal dividend

policy must strike the balance between
current dividends and future growth
that maximizes the stock price.

• Next, we discuss the major theories

that have been advanced to explain
how investors regard current dividends
versus future growth
 Dividend Irrelevance Theory
• M.Miller and F.Modigliani (MM)
advanced the dividend irrelevance theory,
which stated that dividend policy has no
effect on either the price of a firm’s stock
or its cost of capital
• MM : the value of the firm depends only
on the income produced by its assets, not
on how that income is split between
dividends and retained earnings
 Dividend Irrelevance Theory

• MM assumed, among other things, that

no taxes are paid on dividends, that
stocks can be bought and sold with no
transactions costs

• MM assumption : everyone—investors
and managers alike—has the same
information regarding firms’ future
earnings.
 Dividend Irrelevance Theory
• MM argued that each shareholder can
construct his or her own dividend policy. if a
firm does not pay dividends, a shareholder
who wants a 5% dividend can “create” it by
selling 5% of stock.

• Conversely, if a company pays a higher

dividend than an investor wants, the investor
can use dividends to buy additional shares
 Dividend Irrelevance Theory
• In the real world, investors who want additional
dividends would have to incur transactions costs
to sell shares, and investors who do not want
dividends would have to pay taxes on the
unwanted dividends and then incur transactions
costs to purchase shares

• Since taxes and transactions costs do exist,

dividend policy may well be relevant and
investors may prefer policies that help them
reduce taxes and transactions costs.
 Dividend Irrelevance Theory

• The principal conclusions of MM’s dividend

irrelevance theory are

• investors are indifferent between dividends

and capital gains
• dividend policy does not affect either stock
prices or the required rate of return on
equity, ks.
 Argument 1 : Bird-in-hand fallacy
Why dividend is preferred?
• M.Gordon and J.Lintner : investors
preferred a sure dividend today to an
uncertain future capital gain. In particular,
ks declines as the dividend payout is
increased because investors are less certain
of receiving the capital gains that should
result from retaining earnings than they are
of receiving dividend payments
 Unrealistic Assumptions of MM
• most investors face transactions costs when
they sell stock; so investors who are looking
for a steady stream of income would
logically prefer that companies pay regular
dividends.
• For example, retirees who have
accumulated wealth over time and now
want annual income from their investments
probably prefer dividend-paying stocks.
 Why some investors prefer capital gain?

• income tax rate are generally higher than

capital gain tax
• Since 2003, the maximum tax rate on
dividends and long term capital gains has
been set at 15%. This change lowered the
tax disadvantage, but capital gains still have
two tax advantages over dividends.
 Why some investors prefer capital gain?

• Personal income taxes must be paid on

dividends the year they are received,
whereas taxes on capital gains are not paid
until the stock is sold (time value of money)

• if a stock is held by someone until he or she

dies, there is no capital gains tax
 Information Content, or Signaling,
Hypothesis
• An increase in the dividend is often
accompanied by an increase in the stock
price, while a dividend cut generally leads
to a stock price decline. This refute MM
• MM argue that dividend announcements
have information content, or signaling,
about future earnings. (dividend increase
only if management expect higher future
CF to support it and vice versa)
Information Content (Signaling Hypothesis)
• it is difficult to tell whether the stock price changes
that follow dividend increases or decreases reflect
only signaling effects (as MM argue) or both
signaling and dividend preference.
• For example, if a firm has good long-term
prospects but also need cash to fund current
investments, it might be tempted to cut dividend
to increase funds available for investment.
However, this action might cause the stock price to
decline because the dividend reduction can be
taken as a signal of bad future earnings, when just
the reverse is actually true
 Clientele Effect

• Clientele Effect - The tendency of a firm to

attract a set of investors that like its dividend
policy

• For example, retired individuals, pension funds

generally prefer cash income. They might invest
in electric utilities, which had an average
payout of 60% in 2008, while investors favoring
growth could invest in the software industry,
which paid out only 18%
 Clientele Effect
• different groups, or clienteles, of stockholders
prefer different dividend payout policies.

• A change in dividend policy might upset the

majority clientele and have a negative effect on
the stock’s price. This suggests that a company
should follow a stable, dependable dividend
policy so as to avoid upsetting its clientele.
 Clientele Effect
• different groups, or clienteles, of stockholders
prefer different dividend payout policies.

• A change in dividend policy might upset the

majority clientele and have a negative effect on
the stock’s price. This suggests that a company
should follow a stable, dependable dividend
policy so as to avoid upsetting its clientele.
Other factors that affect dividend policy

• May be group to the following

(1) Constraints on dividend payments
(2) investment opportunities,
(3) availability and cost of alternative sources of
capital
 Constraints
• Bond Indenture : limit dividend
• Availability of Cash
• Impairment of Capital Rule : Law state dividend
can not exceed retain earnings.

Investment Opportunities
• Number of profitable investments
• Ability to accelerate or delay investment : to
achieve stable dividend policy
availability and cost of alternative sources
of capital
• Cost of selling new stock (flotation cost)
– If cost of new stock are high, firms are better off to
set low payout ratio to increase RE for future
investment

• Management Control
– Managers are reluctant to issue new equity if they
were to retain control over the firm
 Stock split vs. Stock dividends

• Although no research support, management

believe there exist “optimal” price per share
range of $20-$80.

• Stock split – use to manage sharp price rise

– Generally interpreted as good news (signaling)
• Stock dividends – use to keep price per share in
check every year (ex 5% new share every year)
 Summary

• managers should retain earnings if and only if

they can invest the money within the firm and
earn more than stockholders can earn outside
the firm. Consequently, high-growth companies
with many good projects tend to retain a high
percentage of earnings, whereas mature
companies with a great deal of cash but limited
investment opportunities tend to have
generous cash distribution policies.