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
EPS
1.8
1.6
1.4
DPS
1.2
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.