Chapter 15 Flashcards
Dividend Policy
The decision to pay out earnings versus retaining and reinvesting them
Dividend Irrelevance Theory
-Investors are indifferent between dividends and retention-generated capital gains
-Investors can create their own dividend policy.
If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock
- Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true.
- Need an empirical test
Why might investors prefer dividends?
-May think dividends are less risky than potential future capital gains
Why might investors prefer capital gains?
-May want to avoid transactions costs
- Maximum tax rate is the same as on dividends, but…
- –Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold
-If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains
Signaling Hypothesis
- Investors view dividend increases as signals of management’s view of the future
- Since managers hate to cut dividends, they won’t raise dividends unless they think the increase is sustainable
- However, a stock price increase at the time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends
Clientele Effect
-Different groups of investors, or clienteles, prefer different dividend policies
Firm’s past dividend policy determines its current clientele of investors
-Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who have to switch companies
Catering Theory
- A theory that suggests that investors’ preference for dividends varies over time and that corporations adapt their dividend policy to cater to the current desires of investors
- Corporate managers are more likely to initiate dividends when dividend-paying stocks are in favor
- Corporate managers are more likely to omit dividends when capital gains are preferred
Residual Dividend Model
- Find the retained earnings needed for the capital budget
- Pay out any leftover earnings (the residual) as dividends
- This policy minimizes flotation and equity signaling costs
How would a change in investment opportunities affect dividends under the residual policy?
- Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout
- More good investments would lead to a lower dividend payout
Advantage of Residual Dividend Policy
-Minimizes new stock issues and flotation costs
Disadvantages of Residual Dividend Policy
- Results in variable dividends
- Sends conflicting signals
- Increases risk
- Doesn’t appeal to any specific clientele
- Conclusion: Consider residual policy when setting long-term target payout, but don’t follow it rigidly from year to year
Setting Dividend Policy
- Forecast capital needs over a planning horizon, often 5 years
- Set a target capital structure
- Estimate annual equity needs
- Set target payout based on the residual model
- Generally, some dividend growth rate emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary
Dividend Reinvestment Plan (DRIP)
- Shareholders can automatically reinvest their dividends in shares of the company’s common stock. Get more stock than cash
- There are two types of plans:
- –Open market
- –New stock
Open Market Purchase Plan
- Dollars to be reinvested are turned over to trustee, who buys shares on the open market
- Brokerage costs are reduced by volume purchases
- Convenient, easy way to invest, thus useful for investors
New Stock Plan
- Firm issues new stock to DRIP enrollees (usually at a discount from the market price), keeps money and uses it to buy assets
- Firms that need new equity capital use new stock plans
- Firms with no need for new equity capital use open market purchase plans
