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FM II - Chapter 02, Divided Payout
FM II - Chapter 02, Divided Payout
02
DIVIDEND/PAYOUT POLICY
I. Dividend theories
The term payout policy refers to the decisions that a firm makes regarding:
whether to distribute cash to shareholders,
how much cash to distribute, and
the means by which cash should be distributed.
The decision to pay out earnings versus retaining and reinvesting them. The options
range from nothing to everything.
I. Dividend Irrelevance…
a) The Residual Theory…
3. Because the cost of RE, rr, is less than the cost of new common
stock, rn, use REs to meet the equity requirement determined
in Step 2. If REs are inadequate to meet this need, sell new
common stock. If the available REs are in excess of this need,
distribute the surplus amount—the residual—as dividends.
This view of dividends suggests that the required return of
investors, rs, is not influenced by the firm’s dividend policy, a
premise that in turn implies that dividend policy is irrelevant
in the sense that it does not affect firm value.
I. Dividend Irrelevance…
c) The Clientele Effect…
• Investors who would have to pay higher taxes on dividends may
prefer to invest in firms that retain more earnings rather than
paying dividends.
• If a firm changes its payout policy, the value of the firm will not
change—what will change is the type of investor who holds the
firm’s shares.
• The clientele effect maintains that investors choose stocks for
dividend policy, so any change in payments is disruptive.
I. Dividend Irrelevance…
c) The Clientele Effect…
Companies with high payouts will attract one group, and
low-payout companies will attract another
• Some groups (e.g., wealthy individuals) have an incentive
to pursue low-payout (or zero-payout) stocks
• Other groups (e.g., corporations) have an incentive to
pursue high-payout stocks
Clientele effect argument states that stocks attract
particular groups based on dividend yield and the resulting
tax effects
Bird-in-Hand
40
30 Irrelevance
20
Tax preference
10
15 Irrelevance
10 Bird-in-Hand
Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout
Legal Constraints
Most states prohibit corporations from paying out as cash
dividends any portion of the firm’s “legal capital,” which is
typically measured by the par value of common stock.
These capital impairment restrictions are generally established
to provide a sufficient equity base to protect creditors’ claims.
If a firm has overdue liabilities or is legally insolvent or
bankrupt, most states prohibit its payment of cash dividends.
Contractual Constraints
Often the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement.
Generally, these constraints prohibit the payment of cash
dividends until the firm achieves a certain level of earnings, or
they may limit dividends to a certain dollar amount or
percentage of earnings.
Constraints on dividends help to protect creditors from losses
due to the firm’s insolvency.
Growth Prospects
A growth firm is likely to have to depend heavily on internal
financing through retained earnings, so it is likely to pay out
only a very small percentage of its earnings as dividends.
A more established firm is in a better position to pay out a
large proportion of its earnings, particularly if it has ready
sources of financing.
Market Considerations
Catering theory is a theory that says firms cater to the
preferences of investors, initiating or increasing dividend
payments during periods in which high-dividend stocks are
particularly appealing to investors.