Distributions to shareholders

Dividend and share repurchases

Other dividend policy issues
• There are few other things effect the dividend policies
• 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
• 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.
• Theory is based on unrealistic assumptions -no taxes or brokerage
costs
• Modigliani-Miller support irrelevance
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.
• Gordon supported this theory
Tax Preference Theory
• Retained earnings lead to long-term capital gains, which are taxed at
lower rates than dividends: 20% 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

Theory Implication

Irrelevance Any payout OK

Bird in the hand Set high payout
Tax preference Set low payout
Possible Stock Price Effects
Stock Price ($)
Bird-in-Hand
40

30 Irrelevance

20
Tax preference
10

0 50% 100% Payout

 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.
Why the firms pay dividends
• Despite the tax disadvantage of dividends and the costs associated
with external equity issues, firms pay dividends.
• There are several reasons for paying dividends.
• Possible reasons for paying dividends are:
• investors preference,
• information signalling and
• clientele effects.
PLAUSIBLE REASSONS FOR PAYING
DIVIDENDS
• INVESTORS PREFERENCE FOR DIVIDENDS:
• if taxes and transaction costs are ignored, dividends and capital
receipts should be perfect substitutes. But still there is demand for
dividends.
• Shefrin and statman offered explanations for the demand of the
dividends are because of the behavioural principles.
• Due to aversion for regret investors prefer dividends than capital
gains.
“information content,” or “signaling,”
hypothesis
• Stock price changes after dividend increase or decrease do not
demonstrate a preference for dividends over retained earnings, rather
such price changes simply indicate that dividend announcements
have information content, or signalling about the future earnings.
• A raise in the pay out ratio indicates that the management is
anticipating higher earnings in the future
• The reduction in the pay out ratio is a signal that management
forecasts poor future earnings
the “clientele effect”
• Clientele: different groups of stockholders that prefer different dividend pay out
policies.
• Ex: The low income aged people and the young people who are in their peak
earning years.
• High payout ratio satisfies low income aged shareholder, young shares holders
prefer low payout ratio with high growth
• All this suggests clientele effect exists, which means that firms have different
clienteles and the clienteles have different preference
• Changing dividend policy might upset one category of the clientele and have
negative effect on share price.
• Hence, company should follow a stable dependable dividend policy.
the “residual dividend model
The firms optimal pay out ratio is set equal to net income minus the
amount of retained earnings necessary to finance firm’s optimal capital
budget
Dividend= net income- retained earnings required to help finance new
investments
Dividends= net income-[ (target equity ratio)(total capital budget)]