14 distributions to shareholders dividends and share repurchases

Consequently, the target payout ratio — defined as the percentage ofnet income to be paid out as cash dividends — should be based in large part oninvestors’ preferences for dividends vers

SOURCE: Cliff McBride/Tampa Tribune/Silver Image

stock price.1Here is the text of the letter sent to its stockholders in which FPL announced these changes:

Dear Shareholder, Over the past several years, we have been working hard to enhance shareholder value by aligning our strategy with a rapidly changing business environment The Energy Policy Act of 1992 has brought permanent changes to the electric industry Although we have taken effective and sometimes painful steps to prepare for these changes, one critical problem remains Our dividend payout ratio of 90 percent — the percentage of our earnings paid to shareholders as dividends — is far too high for a growth company It is well above the industry average, and it has limited the growth in the price of our stock.

To meet the challenges of this competitive marketplace and to ensure the financial strength and flexibility necessary for success, the Board of Directors has announced a change in our financial strategy that includes the following milestones:

out 60 to 65 percent of prior years’ earnings.

This means a reduction in the quarterly dividend from 62 to 42 cents per share beginning with the next payment.

rofitable companies regularly face three important

questions (1) How much of its free cash flow

should it pass on to shareholders? (2) Should it

provide this cash to stockholders by raising the dividend

or by repurchasing stock? (3) Should it maintain a

stable, consistent payment policy, or should it let the

payments vary as conditions change?

In this chapter we will discuss many of the issues

that affect a firm’s cash distribution policy As we will

see, most firms establish a policy that considers their

forecasted cash flows and forecasted capital

expenditures, and then try to stick to it The policy

can be changed, but this can cause problems because

such changes inconvenience shareholders, send

unintended signals, and convey the impression of

dividend instability, all of which have negative

implications for stock prices Still, economic

circumstances do change, and occasionally such

changes require firms to change their dividend

policies.

One of the most striking examples of a dividend

policy change occurred in May 1994, when FPL Group, a

utility holding company whose primary subsidiary is

Florida Power & Light, announced a cut in its quarterly

dividend from $0.62 per share to $0.42 At the same

time, FPL stated that it would buy back 10 million of its

common shares over the next three years to bolster its

641

1

For a complete discussion of the FPL decision, see Dennis Soter, Eugene Brigham, and Paul Evanson, “The Dividend Cut Heard

‘Round the World: The Case of FPL,” Journal of Applied Corporate Finance, Spring 1996, 4–15 Also, note that stock repurchases

are discussed in a later section of this chapter.

We appreciate your understanding and support, and we will continue to provide updates on our progress in forthcoming shareholder reports Several analysts called the FPL decision a watershed event for the electric utility industry FPL saw that its circumstances were changing — its core electric business was moving from a regulated monopoly environment to one of increasing competition, and the new environment required a stronger balance sheet and more financial flexibility than was consistent with a 90 percent payout policy.

What did the market think about FPL’s dividend policy change? The company’s stock price fell by 14 percent the day the announcement was made In the past, hundreds of dividend cuts followed by sharply lower earnings had conditioned investors to expect the worst when a company reduces its dividend — this is the signaling effect, which is discussed later in the chapter However, over the next few months, as they understood FPL’s actions better, analysts began to praise the decision and to recommend the stock As a result, FPL’s stock outperformed the average utility and soon

■ The authorization to repurchase 10 million shares of common stock over the next three years, including at least 4 million shares in the next year.

■ An earlier dividend evaluation beginning in February 1995 to more closely link dividend rates to annual earnings.

We believe this financial strategy will enhance long-term share value and will facilitate both

earnings per share and dividend growth to about 5

percent per year over the next several years.

Adding to shareholder wealth in this manner should be increasingly significant given recent

changes in the tax law, which have made

capital gains more attractive than dividend

income.

We take this action from a position of strength We are not being forced into a defensive

position by expectations of poor financial

performance Rather, it is a strategic decision to

align our dividend policy and your total return as a

shareholder with the growth characteristics of our

company.

Successful companies earn income That income can then be reinvested in ing assets, used to acquire securities, used to retire debt, or distributed to stock-holders If the decision is made to distribute income to stockholders, three key is-sues arise: (1) How much should be distributed? (2) Should the distribution be ascash dividends, or should the cash be passed on to shareholders by buying backsome of the stock they hold? (3) How stable should the distribution be; that is,should the funds paid out from year to year be stable and dependable, whichstockholders would probably prefer, or be allowed to vary with the firms’ cashflows and investment requirements, which would probably be better from the firm’s

operat-An excellent source of

recent dividend news

releases for major

corporations is available

at the web site of

Corporate Financials Online at

http://www.cfonews.com/scs By

clicking the down arrow of the “News

Category” box to the left of the screen,

students may select “Dividends” to

receive a list of companies with

dividend news Click on any company,

and you will see its latest dividend

news.

man-value Consequently, the target payout ratio — defined as the percentage of

net income to be paid out as cash dividends — should be based in large part oninvestors’ preferences for dividends versus capital gains: do investors prefer (1)

to have the firm distribute income as cash dividends or (2) to have it either purchase stock or else plow the earnings back into the business, both of whichshould result in capital gains? This preference can be considered in terms of theconstant growth stock valuation model:

re-Pˆ0⫽

If the company increases the payout ratio, this raises D1 This increase in thenumerator, taken alone, would cause the stock price to rise However, if D1israised, then less money will be available for reinvestment, that will cause the ex-pected growth rate to decline, and that will tend to lower the stock’s price.Thus, any change in payout policy will have two opposing effects Therefore,

the firm’s optimal dividend policy must strike a balance between current

div-idends and future growth so as to maximize the stock price

In this section we examine three theories of investor preference: (1) the idend irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax pref-erence theory

div-DI V I D E N D IR R E L E VA N C E TH E O R Y

It has been argued that dividend policy has no effect on either the price of afirm’s stock or its cost of capital If dividend policy has no significant effects,

then it would be irrelevant The principal proponents of the dividend

irrele-vance theory are Merton Miller and Franco Modigliani (MM).2 They arguedthat the firm’s value is determined only by its basic earning power and its busi-ness risk In other words, MM argued that the value of the firm depends only

on the income produced by its assets, not on how this income is split betweendividends and retained earnings

To understand MM’s argument that dividend policy is irrelevant, recognizethat any shareholder can in theory construct his or her own dividend policy.For example, if a firm does not pay dividends, a shareholder who wants a 5 per-cent dividend can “create” it by selling 5 percent of his or her stock Con-versely, if a company pays a higher dividend than an investor desires, the

D1

ks⫺ g.

D I V I D E N D S V E R S U S C A P I T A L G A I N S : W H A T D O I N V E S T O R S P R E F E R ?

Target Payout Ratio

The percentage of net income

paid out as cash dividends.

Optimal Dividend Policy

The dividend policy that strikes a

balance between current dividends

and future growth and maximizes

the firm’s stock price.

Dividend Irrelevance Theory

The theory that a firm’s dividend

policy has no effect on either its

value or its cost of capital.

2 Merton H Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of

Shares,” Journal of Business, October 1961, 411–433.

investor can use the unwanted dividends to buy additional shares of the pany’s stock If investors could buy and sell shares and thus create their owndividend policy without incurring costs, then the firm’s dividend policy wouldtruly be irrelevant Note, though, that investors who want additional dividendsmust incur brokerage costs to sell shares, and investors who do not want divi-dends must first pay taxes on the unwanted dividends and then incur brokeragecosts to purchase shares with the after-tax dividends Since taxes and brokeragecosts certainly exist, dividend policy may well be relevant.

com-In developing their dividend theory, MM made a number of assumptions,especially the absence of taxes and brokerage costs Obviously, taxes and bro-kerage costs do exist, so the MM irrelevance theory may not be true However,

MM argued (correctly) that all economic theories are based on simplifying sumptions, and that the validity of a theory must be judged by empirical tests,not by the realism of its assumptions We will discuss empirical tests of MM’sdividend irrelevance theory shortly

as-BI R D-I N-T H E- HA N D TH E O R Y

The principal conclusion of MM’s dividend irrelevance theory is that dividendpolicy does not affect the required rate of return on equity, ks This conclusionhas been hotly debated in academic circles In particular, Myron Gordon andJohn Lintner argued that ksdecreases as the dividend payout is increased be-cause investors are less certain of receiving the capital gains that are supposed

to result from retaining earnings than they are of receiving dividend payments.3Gordon and Lintner said, in effect, that investors value a dollar of expected div-idends more highly than a dollar of expected capital gains because the dividendyield component, D1/P0, is less risky than the g component in the total ex-pected return equation, ks⫽ D1/P0⫹ g

MM disagreed They argued that ksis independent of dividend policy, whichimplies that investors are indifferent between D1/P0 and g and, hence, be-tween dividends and capital gains MM called the Gordon-Lintner argument

the bird-in-the-hand fallacy because, in MM’s view, most investors plan to

reinvest their dividends in the stock of the same or similar firms, and, in anyevent, the riskiness of the firm’s cash flows to investors in the long run is de-termined by the riskiness of operating cash flows, not by dividend payoutpolicy

TA X PR E F E R E N C E TH E O R Y

There are three tax-related reasons for thinking that investors might prefer alow dividend payout to a high payout: (1) Recall from Chapter 2 that long-termcapital gains are taxed at a rate of 20 percent, whereas dividend income is taxed

at effective rates that go up to 39.6 percent Therefore, wealthy investors (whoown most of the stock and receive most of the dividends) might prefer to have

3Myron J Gordon, “Optimal Investment and Financing Policy,” Journal of Finance, May 1963,

264–272; and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of

Cap-ital to Corporations,” Review of Economics and Statistics, August 1962, 243–269.

Bird-in-the-Hand Theory

MM’s name for the theory that a

firm’s value will be maximized by

setting a high dividend payout

ratio.

companies retain and plow earnings back into the business Earnings growthwould presumably lead to stock price increases, and thus lower-taxed capitalgains would be substituted for higher-taxed dividends (2) Taxes are not paid onthe gain until a stock is sold Due to time value effects, a dollar of taxes paid inthe future has a lower effective cost than a dollar paid today (3) If a stock isheld by someone until he or she dies, no capital gains tax is due at all — thebeneficiaries who receive the stock can use the stock’s value on the death day astheir cost basis and thus completely escape the capital gains tax

Because of these tax advantages, investors may prefer to have companies tain most of their earnings If so, investors would be willing to pay more forlow-payout companies than for otherwise similar high-payout companies

re-IL L U S T R AT I O N O F T H E TH R E E DI V I D E N D

PO L I C Y TH E O R I E S

Figure 14-1 illustrates the three alternative dividend policy theories: (1) Millerand Modigliani’s dividend irrelevance theory, (2) Gordon and Lintner’s bird-in-the-hand theory, and (3) the tax preference theory To understand the threetheories, consider the case of Hardin Electronics, which has from its inceptionplowed all earnings back into the business and thus has never paid a dividend.Hardin’s management is now reconsidering its dividend policy, and it wants toadopt the policy that will maximize its stock price

Consider first the data presented below the graph Each row shows an native payout policy: (1) Retain all earnings and pay out nothing, which is thepresent policy, (2) pay out 50 percent of earnings, and (3) pay out 100 percent

alter-of earnings In the example, we assume that the company will have a 15 percentROE regardless of which payout policy it follows, so with a book value pershare of $30, EPS will be 0.15($30) ⫽ $4.50 under all payout policies.4Given

an EPS of $4.50, dividends per share are shown in Column 3 under eachpayout policy

Under the assumption of a constant ROE, the growth rate shown in Column

4 will be g ⫽ (% Retained)(ROE), and it will vary from 15 percent at a zeropayout to zero at a 100 percent payout For example, if Hardin pays out 50 per-cent of its earnings, then its dividend growth rate will be g ⫽ 0.5(15%) ⫽ 7.5%.Columns 5, 6, and 7 show how the situation would look if MM’s irrelevancetheory were correct Under this theory, neither the stock price nor the cost ofequity would be affected by the payout policy — the stock price would remainconstant at $30, and kswould be stable at 15 percent Note that ksis found asthe sum of the growth rate in Column 4 plus the dividend yield in Column 6.Columns 8, 9, and 10 show the situation if the bird-in-the-hand theory weretrue Under this theory, investors prefer dividends, and the more of its earningsthe company pays out, the higher its stock price and the lower its cost of equity

POSSIBLE SITUATIONS (ONLY ONE CAN BE TRUE) ALTERNATIVE

PAYOUT POLICIES MM: IRRELEVANCE BIRD-IN-THE-HAND TAX PREFERENCE PERCENT PERCENT

4 g ⫽ (% retained)(ROE) ⫽ (% retained)(15%) Example: At payout ⫽ 50%, g ⫽ 0.5(15%) ⫽ 7.5%.

5 ks ⫽ Dividend yield ⫹ Growth rate.

F I G U R E 1 4 - 1 Dividend Irrelevance, Bird-in-the-Hand,

and Tax Preference Dividend Theories

Stock Price, P0($)

15.00 11.25

Payout

Bird-in-the-Hand MM: Irrelevance Tax Preference 22.50

In our example, the bird-in-the-hand theory indicates that adopting a 100 cent payout policy would cause the stock price to rise from $30 to $40, and thecost of equity would decline from 15 percent to 11.25 percent

per-Finally, Columns 11, 12, and 13 show the situation if the tax preference ory were correct Under this theory, investors prefer companies that retainearnings and thus provide returns in the form of lower-taxed capital gainsrather than higher-taxed dividends If the tax preference theory were correct,then an increase in the dividend payout ratio from its current zero level wouldcause the stock price to decline and the cost of equity to rise

the-The data in the table are plotted to produce the two graphs shown in Figure14-1 The upper graph shows how the stock price would react to dividend pol-icy under each of the theories, and the lower graph shows how the cost of eq-uity would be affected

US I N G EM P I R I C A L EV I D E N C E T O DE C I D E

WH I C H TH E O R Y IS BE S T

These three theories offer contradictory advice to corporate managers, so which,

if any, should we believe? The most logical way to proceed is to test the theoriesempirically Many such tests have been conducted, but their results have beenunclear There are two reasons for this: (1) For a valid statistical test, things otherthan dividend policy must be held constant; that is, the sample companies mustdiffer only in their dividend policies, and (2) we must be able to measure with ahigh degree of accuracy each firm’s cost of equity Neither of these two condi-tions holds: We cannot find a set of publicly owned firms that differ only in theirdividend policies, nor can we obtain precise estimates of the cost of equity.Therefore, no one can establish a clear relationship between dividend policyand the cost of equity Investors in the aggregate cannot be seen to uniformly

prefer either higher or lower dividends Nevertheless, individual investors do

have strong preferences Some prefer high dividends, while others prefer allcapital gains These differences among individuals help explain why it is diffi-cult to reach any definitive conclusions regarding the optimal dividend payout.Even so, both evidence and logic suggest that investors prefer firms that follow

a stable, predictable dividend policy (regardless of the payout level) We will

con-sider the issue of dividend stability later in the chapter

D I V I D E N D S V E R S U S C A P I T A L G A I N S : W H A T D O I N V E S T O R S P R E F E R ?

S E L F - T E S T Q U E S T I O N S

Explain the differences among the dividend irrelevance theory, the the-hand theory, and the tax preference theory Use a graph such as Figure14-1 to illustrate your answer

bird-in-What did Modigliani and Miller assume about taxes and brokerage costswhen they developed their dividend irrelevance theory?

How did the bird-in-the-hand theory get its name?

In what sense does MM’s theory represent a middle-ground position betweenthe other two theories?

What have been the results of empirical tests of the dividend theories?

Dividend yields vary considerably in different stock markets

throughout the world In 1999 in the United States,

divi-dend yields averaged 1.6 percent for the large blue chip stocks

in the Dow Jones Industrials, 1.2 percent for a broader sample

of stocks in the S&P 500, and 0.3 percent for stocks in the

high-tech-dominated Nasdaq Outside the United States, age dividend yields ranged from 5.7 percent in New Zealand to 0.7 percent in Taiwan The accompanying table summarizes the dividend picture in 1999.

SOURCE: Alexandra Eadie, “On the Grid Looking for Dividend Yield Around the

World,” The Globe and Mail, June 23, 1999, B16 Eadie’s source was Bloomberg

Fi-nancial Services.

the firm’s future earnings and dividends In reality, however, different investorshave different views on both the level of future dividend payments and the un-certainty inherent in those payments, and managers have better informationabout future prospects than public stockholders

It has been observed that an increase in the dividend is often accompanied

by an increase in the price of a stock, while a dividend cut generally leads to astock price decline This could indicate that investors, in the aggregate, preferdividends to capital gains However, MM argued differently They noted thewell-established fact that corporations are reluctant to cut dividends, hence donot raise dividends unless they anticipate higher earnings in the future Thus,

MM argued that a higher-than-expected dividend increase is a “signal” to vestors that the firm’s management forecasts good future earnings.5Conversely,

in-a dividend reduction, or in-a smin-aller-thin-an-expected increin-ase, is in-a signin-al thin-at min-an-agement is forecasting poor earnings in the future Thus, MM argued that in-vestors’ reactions to changes in dividend policy do not necessarily show that in-vestors prefer dividends to retained earnings Rather, they argue that pricechanges following dividend actions simply indicate that there is an important

man-information, or signaling, content in dividend announcements.

Like most other aspects of dividend policy, empirical studies of signalinghave had mixed results There is clearly some information content in dividendannouncements However, it is difficult to tell whether the stock price changesthat follow increases or decreases in dividends reflect only signaling effects orboth signaling and dividend preference Still, signaling effects should definitely

be considered when a firm is contemplating a change in dividend policy

CL I E N T E L E EF F E C T

As we indicated earlier, different groups, or clienteles, of stockholders prefer

dif-ferent dividend payout policies For example, retired individuals and universityendowment funds generally prefer cash income, so they may want the firm topay out a high percentage of its earnings Such investors (and pension funds)are often in low or even zero tax brackets, so taxes are of no concern On theother hand, stockholders in their peak earning years might prefer reinvestment,because they have less need for current investment income and would simplyreinvest dividends received, after first paying income taxes on those dividends

If a firm retains and reinvests income rather than paying dividends, thosestockholders who need current income would be disadvantaged The value oftheir stock might increase, but they would be forced to go to the trouble andexpense of selling off some of their shares to obtain cash Also, some institu-tional investors (or trustees for individuals) would be legally precluded from

O T H E R D I V I D E N D P O L I C Y I S S U E S

Information Content

(Signaling) Hypothesis

The theory that investors regard

dividend changes as signals of

management’s earnings forecasts.

5 Stephen Ross has suggested that managers can use capital structure as well as dividends to give signals concerning firms’ future prospects For example, a firm with good earnings prospects can

carry more debt than a similar firm with poor earnings prospects This theory, called incentive naling, rests on the premise that signals with cash-based variables (either debt interest or dividends)

sig-cannot be mimicked by unsuccessful firms because such firms do not have the future generating power to maintain the announced interest or dividend payment Thus, investors are more likely to believe a glowing verbal report when it is accompanied by a dividend increase or a debt-financed expansion program See Stephen A Ross, “The Determination of Financial Struc-

cash-ture: The Incentive-Signaling Approach,” The Bell Journal of Economics, Spring 1977, 23–40.

selling stock and then “spending capital.” On the other hand, stockholders whoare saving rather than spending dividends might favor the low dividend policy,for the less the firm pays out in dividends, the less these stockholders will have

to pay in current taxes, and the less trouble and expense they will have to gothrough to reinvest their after-tax dividends Therefore, investors who wantcurrent investment income should own shares in high dividend payout firms,while investors with no need for current investment income should own shares

in low dividend payout firms For example, investors seeking high cash incomemight invest in electric utilities, which averaged a 73 percent payout from 1996through 2000, while those favoring growth could invest in the semiconductorindustry, which paid out only 7 percent during the same time period

To the extent that stockholders can switch firms, a firm can change from onedividend payout policy to another and then let stockholders who do not like thenew policy sell to other investors who do However, frequent switching would

be inefficient because of (1) brokerage costs, (2) the likelihood that stockholderswho are selling will have to pay capital gains taxes, and (3) a possible shortage ofinvestors who like the firm’s newly adopted dividend policy Thus, managementshould be hesitant to change its dividend policy, because a change might causecurrent shareholders to sell their stock, forcing the stock price down Such aprice decline might be temporary, but it might also be permanent — if few newinvestors are attracted by the new dividend policy, then the stock price wouldremain depressed Of course, the new policy might attract an even larger clien-tele than the firm had before, in which case the stock price would rise

Evidence from several studies suggests that there is in fact a clientele

ef-fect.6MM and others have argued that one clientele is as good as another, sothe existence of a clientele effect does not necessarily imply that one dividendpolicy is better than any other MM may be wrong, though, and neither theynor anyone else can prove that the aggregate makeup of investors permits firms

to disregard clientele effects This issue, like most others in the dividend arena,

is still up in the air

6 For example, see R Richardson Pettit, “Taxes, Transactions Costs and the Clientele Effect of

Dividends,” The Journal of Financial Economics, December 1977, 419–436.

Clientele Effect

The tendency of a firm to attract a

set of investors who like its

im-be seriously inconvenienced if the dividend stream were unstable Further,

reducing dividends to make funds available for capital investment could sendincorrect signals to investors, who might push down the stock price because theyinterpreted the dividend cut to mean that the company’s future earnings prospectshave been diminished Thus, maximizing its stock price requires a firm to balanceits internal needs for funds against the needs and desires of its stockholders.How should this balance be struck; that is, how stable and dependableshould a firm attempt to make its dividends? It is impossible to give a definitiveanswer to this question, but the following points are relevant:

1. Virtually every publicly owned company makes a five- to ten-year cial forecast of earnings and dividends Such forecasts are never madepublic — they are used for internal planning purposes only However, se-curity analysts construct similar forecasts and do make them available to

finan-investors; see Value Line for an example Further, virtually every internal

five- to ten-year corporate forecast we have seen for a “normal” companyprojects a trend of higher earnings and dividends Both managers and in-vestors know that economic conditions may cause actual results to differfrom forecasted results, but “normal” companies expect to grow

2. Years ago, when inflation was not persistent, the term “stable dividendpolicy” meant a policy of paying the same dollar dividend year after year.AT&T was a prime example of a company with a stable dividend policy —

it paid $9 per year ($2.25 per quarter) for 25 straight years Today,though, most companies and stockholders expect earnings to grow overtime as a result of retained earnings and inflation Further, dividends arenormally expected to grow more or less in line with earnings Thus,today a “stable dividend policy” generally means increasing the dividend

at a reasonably steady rate

Dividend stability has two components: (1) How dependable is thegrowth rate, and (2) can we count on at least receiving the current divi-dend in the future? The most stable policy, from an investor’s standpoint,

is that of a firm whose dividend growth rate is predictable — such a pany’s total return (dividend yield plus capital gains yield) would be rela-tively stable over the long run, and its stock would be a good hedgeagainst inflation The second most stable policy is where stockholders can

com-be reasonably sure that the current dividend will not com-be reduced — it maynot grow at a steady rate, but management will probably be able to avoidcutting the dividend The least stable situation is where earnings and cashflows are so volatile that investors cannot count on the company to main-tain the current dividend over a typical business cycle

3. Most observers believe that dividend stability is desirable Assuming thisposition is correct, investors prefer stocks that pay more predictable div-idends to stocks that pay the same average amount of dividends but in amore erratic manner This means that the cost of equity will be mini-mized, and the stock price maximized, if a firm stabilizes its dividends asmuch as possible

D I V I D E N D S T A B I L I T Y

S E L F - T E S T Q U E S T I O N S

What does the term “stable dividend policy” mean?

What are the two components of dividend stability?

E S T A B L I S H I N G T H E D I V I D E N D P O L I C Y

I N P R A C T I C E

In the preceding sections we saw that investors may or may not prefer dends to capital gains, but that they do prefer predictable to unpredictabledividends Given this situation, how should a firm determine the specific per-centage of earnings that it will pay out as dividends? While policies undoubt-edly vary from firm to firm, we describe in this section the steps that a typicalfirm takes when it establishes its target payout ratio

divi-SE T T I N G T H E TA R G E T PAY O U T RAT I O:

TH E RE S I D U A L DI V I D E N D MO D E L 7

When deciding how much cash to distribute to stockholders, two pointsshould be kept in mind: (1) The overriding objective is to maximize share-holder value, and (2) the firm’s cash flows really belong to its shareholders, somanagement should refrain from retaining income unless they can reinvest it

to produce returns higher than shareholders could themselves earn by ing the cash in investments of equal risk On the other hand, recall fromChapter 10 that internal equity (retained earnings) is cheaper than externalequity (new common stock) This encourages firms to retain earnings becausethey add to the equity base, increase debt capacity, and thus reduce the likeli-hood that the firm will have to issue common stock at a later date to fund fu-ture investment projects

invest-When establishing a dividend policy, one size does not fit all Some firmsproduce a lot of cash but have limited investment opportunities — this is truefor firms in profitable but mature industries where few opportunities forgrowth exist Such firms typically distribute a large percentage of their cash toshareholders, thereby attracting investment clienteles that prefer high divi-dends Other firms generate little or no excess cash but have many good in-vestment opportunities — this is often true of new firms in rapidly growing in-dustries Such firms generally distribute little or no cash but enjoy risingearnings and stock prices, thereby attracting investors who prefer capitalgains

As Table 14-1 suggests, dividend payouts and dividend yields for large porations vary considerably Generally, firms in stable, cash-producing indus-tries such as utilities, financial services, and tobacco pay relatively high divi-dends, whereas companies in rapidly growing industries such as computer andcable TV tend to pay lower dividends

cor-7 The term “payout ratio” can be interpreted in two ways: (1) the conventional way, where the out ratio means the percentage of net income to common paid out as cash dividends, or (2) the per- centage of net income distributed to stockholders as dividends and through share repurchases In this section, we assume that no repurchases occur Increasingly, though, firms are using the resid- ual model to determine “distributions to shareholders” and then making a separate decision as to the form of that distribution Further, an increasing percentage of the distribution is in the form of share repurchases.

For a given firm, the optimal payout ratio is a function of four factors: (1) vestor’s preferences for dividends versus capital gains, (2) the firm’s investmentopportunities, (3) its target capital structure, and (4) the availability and cost ofexternal capital The last three elements are combined in what we call the

in-residual dividend model Under this model a firm follows these four steps

when establishing its target payout ratio: (1) It determines the optimal capitalbudget; (2) it determines the amount of equity needed to finance that budget,given its target capital structure; (3) it uses retained earnings to meet equity re-quirements to the extent possible; and (4) it pays dividends only if more earn-ings are available than are needed to support the optimal capital budget The

word residual implies “leftover,” and the residual policy implies that dividends

are paid out of “leftover” earnings

If a firm rigidly follows the residual dividend policy, then dividends paid inany given year can be expressed as follows:

Dividends ⫽ Net income ⫺ Retained earnings required to help

finance new investments

⫽ Net income ⫺ [(Target equity ratio)(Total capital budget)].For example, suppose the target equity ratio is 60 percent and the firm plans tospend $50 million on capital projects In that case, it would need $50(0.6) ⫽

$30 million of common equity Then, if its net income were $100 million,its dividends would be $100 ⫺ $30 ⫽ $70 million So, if the company had

E S T A B L I S H I N G T H E D I V I D E N D P O L I C Y I N P R A C T I C E

Residual Dividend Model

A model in which the dividend

paid is set equal to net income

minus the amount of retained

earnings necessary to finance the

firm’s optimal capital budget.

T A B L E 1 4 - 1

DIVIDEND DIVIDEND

I C OMPANIES T HAT PAY H IGH DIVIDENDS

II C OMPANIES T HAT P AY L ITTLE OR N O D IVIDENDS

SOURCE: Value Line Investment Survey, CD-ROM, November 2000.

Dividend Payouts

$100 million of earnings and a capital budget of $50 million, it would use $30million of the retained earnings plus $50 ⫺ $30 ⫽ $20 million of new debt tofinance the capital budget, and this would keep its capital structure on target.Note that the amount of equity needed to finance new investments might ex-ceed the net income; in our example, this would happen if the capital budgetwere $200 million In that case, no dividends would be paid, and the companywould have to issue new common stock in order to maintain its target capitalstructure.

Most firms have a target capital structure that calls for at least some debt, sonew financing is done partly with debt and partly with equity As long as thefirm finances with the optimal mix of debt and equity, and provided it uses onlyinternally generated equity (retained earnings), then the marginal cost of eachnew dollar of capital will be minimized Internally generated equity is availablefor financing a certain amount of new investment, but beyond that amount, thefirm must turn to more expensive new common stock At the point where newstock must be sold, the cost of equity, and consequently the marginal cost ofcapital, rises

To illustrate these points, consider the case of Texas and Western (T&W)Transport Company T&W’s overall composite cost of capital is 10 percent.However, this cost assumes that all new equity comes from retained earnings

If the company must issue new stock, its cost of capital will be higher T&Whas $60 million in net income and a target capital structure of 60 percent eq-uity and 40 percent debt Provided that it does not pay any cash dividends,T&W could make net investments (investments in addition to asset replace-ments from depreciation) of $100 million, consisting of $60 million from re-tained earnings plus $40 million of new debt supported by the retained earn-ings, at a 10 percent marginal cost of capital If the capital budget exceeded

$100 million, the required equity component would exceed net income, which

is of course the maximum amount of retained earnings In this case, T&Wwould have to issue new common stock, thereby pushing its cost of capitalabove 10 percent.8

At the beginning of its planning period, T&W’s financial staff considers allproposed projects for the upcoming period Independent projects are accepted

if their estimated returns exceed the risk-adjusted cost of capital In choosingamong mutually exclusive projects, T&W chooses the project with the highestpositive NPV The capital budget represents the amount of capital that is re-quired to finance all accepted projects If T&W follows a strict residual divi-dend policy, we can see from Table 14-2 that the estimated capital budget willhave a profound effect on its dividend payout ratio

If T&W forecasts poor investment opportunities, its estimated capital get will be only $40 million To maintain the target capital structure, 40 per-cent of this capital ($16 million) must be raised as debt, and 60 percent ($24million) must be equity If it followed a strict residual policy, T&W would

bud-8 If T&W does not retain all of its earnings, its cost of capital will rise above 10 percent before its capital budget reaches $100 million For example, if T&W chose to retain $36 million, its cost of capital would increase once the capital budget exceeded $36/0.6 ⫽ $60 million To see this point, note that a capital budget of $60 million would require $36 million of equity — if the capital bud- get rose above $60 million, the company’s required equity capital would exceed its retained earn- ings, thereby requiring it to issue new common stock.

retain $24 million to help finance new investments, then pay out the remaining

$36 million as dividends Under this scenario, the company’s dividend payoutratio would be $36 million/$60 million ⫽ 0.6 ⫽ 60%

By contrast, if the company’s investment opportunities were average, its timal capital budget would rise to $70 million Here it would require $42 mil-lion of retained earnings, so dividends would be $60 ⫺ $42 ⫽ $18 million, for

op-a pop-ayout of $18/$60 ⫽ 30% Finally, if investment opportunities are good, thecapital budget would be $150 million, which would require 0.6($150) ⫽ $90million of equity T&W would retain all of its net income ($60 million), thuspay no dividends Moreover, since the required equity exceeds the retainedearnings, the company would have to issue new common stock in order tomaintain the target capital structure

Since investment opportunities and earnings will surely vary from year toyear, strict adherence to the residual dividend policy would result in unstabledividends One year the firm might pay zero dividends because it needed themoney to finance good investment opportunities, but the next year it mightpay a large dividend because investment opportunities were poor and it there-fore did not need to retain much Similarly, fluctuating earnings could alsolead to variable dividends, even if investment opportunities were stable There-fore, following the residual dividend policy would almost certainly lead to fluc-tuating, unstable dividends Thus, following the residual dividend policy would

be optimal only if investors were not bothered by fluctuating dividends ever, since investors prefer stable, dependable dividends, ks would be higher,and the stock price lower, if the firm followed the residual model in a strictsense rather than attempting to stabilize its dividends over time Therefore,firms should

How-1. Estimate the firm’s earnings and investment opportunities, on average,over the next five or so years

2. Use this forecasted information to find the residual model payout ratioand dollars of dividends during the planning period

3. Then set a target payout ratio on the basis of the projected data.

a

With a $150 million capital budget, T&W would retain all of its earnings and also issue $30 million of new stock.

T&W’s Dividend Payout Ratio with $60 Million of Net Income When Faced with Different Investment Opportunities (Dollars in Millions)

Thus, firms should use the residual policy to help set their long-run target payout tios, but not as a guide to the payout in any one year.

ra-Companies do use the residual dividend model as discussed above to helpunderstand the determinants of an optimal dividend policy, but they typicallyuse a computerized financial forecasting model when setting the target payoutratio Most larger corporations forecast their financial statements over the nextfive to ten years Information on projected capital expenditures and workingcapital requirements is entered into the model, along with sales forecasts, profitmargins, depreciation, and the other elements required to forecast cash flows.The target capital structure is also specified, and the model shows the amount

of debt and equity that will be required to meet the capital budgeting ments while maintaining the target capital structure

require-Then, dividend payments are introduced Naturally, the higher the payoutratio, the greater the required external equity Most companies use themodel to find a dividend pattern over the forecast period (generally fiveyears) that will provide sufficient equity to support the capital budget with-out having to sell new common stock or move the capital structure ratiosoutside the optimal range The end result might include a statement, in amemo from the financial vice-president to the chairman of the board, such

as the following:

We forecasted the total market demand for our products, what our share of the ket is likely to be, and our required investments in capital assets and working capital Using this information, we developed projected balance sheets and income state- ments for the period 2002–2006.

mar-Our 2001 dividends totaled $50 million, or $2 per share On the basis of projected earnings, cash flows, and capital requirements, we can increase the dividend by 8 per- cent per year This is consistent with a payout ratio of 42 percent, on average, over the forecast period Any faster dividend growth rate (or higher payout) would require

us to sell common stock, cut the capital budget, or raise the debt ratio Any slower growth rate would lead to increases in the common equity ratio Therefore, I rec- ommend that the Board increase the dividend for 2002 by 8 percent, to $2.16, and that it plan for similar increases in the future.

Events over the next five years will undoubtedly lead to differences between our forecasts and actual results If and when such events occur, we will want to reexam- ine our position However, I am confident that we can meet any random cash short- falls by increasing our borrowings — we have unused debt capacity that gives us flex- ibility in this regard.

We ran the corporate model under several recession scenarios If the economy really crashes, our earnings will not cover the dividend However, in all “reasonable” scenarios our cash flows do cover the dividend I know the Board does not want to push the dividend up to a level where we would have to cut it under bad economic conditions Our model runs indicate, though, that the $2.16 dividend can be main- tained under any reasonable set of forecasts Only if we increased the dividend to over $3 would we be seriously exposed to the danger of having to cut the dividend.

I might also note that Value Line and most other analysts’ reports are forecasting

that our dividends will grow in the 6 percent to 8 percent range Thus, if we go to

$2.16, we will be at the high end of the range, which should give our stock a boost With takeover rumors so widespread, getting the stock up a bit would make us all breathe a little easier.

ad-This company has very stable operations, so it can plan its dividends with afairly high degree of confidence Other companies, especially those in cyclicalindustries, have difficulty maintaining in bad times a dividend that is really toolow in good times Such companies set a very low “regular” dividend and thensupplement it with an “extra” dividend when times are good General Motors,

Ford, and other auto companies have followed the

low-regular-dividend-plus-extras policy in the past Each company announced a low regular

divi-dend that it was sure could be maintained “through hell or high water,” andstockholders could count on receiving that dividend under all conditions.Then, when times were good and profits and cash flows were high, the compa-nies paid a clearly designated extra dividend Investors recognized that theextras might not be maintained in the future, so they did not interpret them as

a signal that the companies’ earnings were going up permanently, nor did theytake the elimination of the extra as a negative signal In recent years, however,the auto companies and many other companies have replaced the “extras” intheir low-regular-dividend-plus-extras policy with stock repurchases

EA R N I N G S, CA S H FL O W S, A N D DI V I D E N D S

We normally think of earnings as being the primary determinant of dividends,but in reality cash flows are more important This situation is revealed in Fig-ure 14-2, which gives data for Chevron Corporation from 1979 through 2000.Chevron’s dividends increased steadily from 1979 to 1981; during that periodboth earnings and cash flows were rising, as was the price of oil After 1981, oilprices declined sharply, pulling earnings down Cash flows, though, remainedwell above the dividend requirement

Chevron acquired Gulf Oil in 1984, and it issued more than $10 billion ofdebt to finance the acquisition Interest on the debt hurt earnings immediatelyafter the merger, as did certain write-offs connected with the merger Further,Chevron’s management wanted to pay off the new debt as fast as possible All

of this influenced the company’s decision to hold the dividend constant from

1982 through 1987 Earnings improved dramatically in 1988, and the dend has increased more or less steadily since then Note that the dividendwas increased in 1991 in spite of the weak earnings and cash flow resultingfrom the Persian Gulf War More recently, in October 2000, Chevron an-nounced that it plans to merge with Texaco If the deal is ultimately com-pleted, it will be interesting to see how this merger affects Chevron’s futuredividend policy

divi-Now look at Columns 4 and 6, which show payout ratios based on earningsand on cash flows The earnings payout is quite volatile — dividends ranged

E S T A B L I S H I N G T H E D I V I D E N D P O L I C Y I N P R A C T I C E

Low-Regular-Dividend-plus-Extras

The policy of announcing a low,

regular dividend that can be

maintained no matter what, and

then when times are good paying

a designated “extra” dividend.

from 26 percent to 120 percent of earnings The cash flow payout, on the otherhand, is much more stable — it ranged from 19 percent to 44 percent Further,the correlation between dividends and cash flows was 0.79 versus 0.53 betweendividends and earnings Thus, dividends clearly depend more on cash flows,

which reflect the company’s ability to pay dividends, than on current earnings,

which are heavily influenced by accounting practices and which do not sarily reflect the ability to pay dividends

neces-PAY M E N T PR O C E D U R E S

Dividends are normally paid quarterly, and, if conditions permit, the dividend

is increased once each year For example, Katz Corporation paid $0.50 perquarter in 2001, or at an annual rate of $2.00 In common financial parlance,

we say that in 2001 Katz’s regular quarterly dividend was $0.50, and its annual

dividend was $2.00 In late 2001, Katz’s board of directors met, reviewed

pro-F I G U R E 1 4 - 2 Chevron: Earnings, Cash Flows, and Dividends, 1979–2000

1998

1980 1982 1984 1986 1988 1990 2

4 6 8 10

12

14

16

DPS EPS CFPS

2000 Year

jections for 2001, and decided to keep the 2002 dividend at $2.00 The tors announced the $2 rate, so stockholders could count on receiving it unlessthe company experienced unanticipated operating problems.

direc-The actual payment procedure is as follows:

1 Declaration date On the declaration date — say, on November 9 —

the directors meet and declare the regular dividend, issuing a statementsimilar to the following: “On November 9, 2001, the directors of KatzCorporation met and declared the regular quarterly dividend of 50 centsper share, payable to holders of record on December 7, payment to bemade on January 2, 2002.” For accounting purposes, the declared divi-dend becomes an actual liability on the declaration date If a balancesheet were constructed, the amount ($0.50) ⫻ (Number of shares out-standing) would appear as a current liability, and retained earnings would

be reduced by a like amount

2 Holder-of-record date At the close of business on the record date, December 7, the company closes its stock transfer books

holder-of-and makes up a list of shareholders as of that date If Katz Corporation isnotified of the sales before 5 P.M on December 7, then the new owner re-ceives the dividend However, if notification is received on or after De-cember 8, the previous owner gets the dividend check

659

F I G U R E 1 4 - 2 Chevron: Earnings, Cash Flows, and Dividends, 1979–2000 (continued)

YEAR DIVIDENDS PER SHARE EARNINGS PER SHARE EARNINGS PAYOUT CASH FLOW PER SHARE CASH FLOW PAYOUT

NOTE: For consistency, data have not been adjusted for a two-for-one split in 1994.

SOURCE: Value Line Investment Survey, various issues.

Declaration Date

The date on which a firm’s

directors issue a statement

declaring a dividend.

E S T A B L I S H I N G T H E D I V I D E N D P O L I C Y I N P R A C T I C E

Holder-of-Record Date

If the company lists the

stockholder as an owner on this

date, then the stockholder receives

the dividend.

3 Ex-dividend date Suppose Jean Buyer buys 100 shares of stock from John

Seller on December 4 Will the company be notified of the transfer in time

to list Buyer as the new owner and thus pay the dividend to her? To avoidconflict, the securities industry has set up a convention under which theright to the dividend remains with the stock until two business days prior

to the holder-of-record date; on the second day before that date, the right

to the dividend no longer goes with the shares The date when the right to

the dividend leaves the stock is called the ex-dividend date In this case,

the ex-dividend date is two days prior to December 7, or December 5:Dividend goes with stock: December 4

Ex-dividend date: December 5

December 6Holder-of-record date: December 7Therefore, if Buyer is to receive the dividend, she must buy the stock on

or before December 4 If she buys it on December 5 or later, Seller willreceive the dividend because he will be the official holder of record.Katz’s dividend amounts to $0.50, so the ex-dividend date is important.Barring fluctuations in the stock market, one would normally expect theprice of a stock to drop by approximately the amount of the dividend onthe ex-dividend date Thus, if Katz closed at $301⁄2 on December 4, itwould probably open at about $30 on December 5.9

4. Payment date The company actually mails the checks to the holders of

record on January 2, the payment date.

9 Tax effects cause the price decline on average to be less than the full amount of the dividend pose you were an investor in the 40 percent federal-plus-state tax bracket If you bought Katz’s stock on December 4, you would receive the dividend, but you would almost immediately pay 40 percent of it out in taxes Thus, you would want to wait until December 5, to buy the stock if you thought you could get it for $0.50 less per share Your reaction, and that of others, would influence stock prices around dividend payment dates Here is what would happen:

Sup-1. Other things held constant, a stock’s price should rise during the quarter, with the daily price increase (for Katz) equal to $0.50/90 ⫽ $0.005556 Therefore, if the price started at

$30 just after its last ex-dividend date, it would rise to $30.50 on December 4.

Payment Date

The date on which a firm actually

mails dividend checks.

S E L F - T E S T Q U E S T I O N S

Explain the logic of the residual dividend model, the steps a firm would take

to implement it, and why it is more likely to be used to establish a long-runpayout target than to set the actual year-by-year payout ratio

How do firms use planning models to help set dividend policy?

Which are more critical to the dividend decision, earnings or cash flow?Explain

Explain the procedures used to actually pay the dividend

Why is the ex-dividend date important to investors?

(footnote continues)

Ex-Dividend Date

The date on which the right to the

current dividend no longer

accompanies a stock; it is usually

two business days prior to the

holder-of-record date.

D I V I D E N D R E I N V E S T M E N T P L A N S

During the 1970s, most large companies instituted dividend reinvestment

plans (DRIPs), whereby stockholders can automatically reinvest their dividends

in the stock of the paying corporation.10 Today most larger companies offerDRIPs, and although participation rates vary considerably, about 25 percent ofthe average firm’s shareholders are enrolled There are two types of DRIPs:(1) plans that involve only “old stock” that is already outstanding and (2) plansthat involve newly issued stock In either case, the stockholder must pay taxes onthe amount of the dividends, even though stock rather than cash is received.Under both types of DRIPs, stockholders choose between continuing to re-ceive dividend checks or having the company use the dividends to buy morestock in the corporation Under the “old stock” type of plan, if a stockholderelects reinvestment, a bank, acting as trustee, takes the total funds available forreinvestment, purchases the corporation’s stock on the open market, and allo-cates the shares purchased to the participating stockholders’ accounts on a prorata basis The transactions costs of buying shares (brokerage costs) are low be-cause of volume purchases, so these plans benefit small stockholders who donot need cash dividends for current consumption

The “new stock” type of DRIP invests the dividends in newly issued stock,hence these plans raise new capital for the firm AT&T, Xerox, Union Carbide,and many other companies have had new stock plans in effect in recent years,using them to raise substantial amounts of new equity capital No fees arecharged to stockholders, and many companies offer stock at a discount of 3 per-cent to 5 percent below the actual market price The companies offer discounts

as a trade-off against flotation costs that would be incurred if new stock hadbeen issued through investment bankers rather than through the dividend rein-vestment plans

One interesting aspect of DRIPs is that they are forcing corporations to examine their basic dividend policies A high participation rate in a DRIP sug-gests that stockholders might be better off if the firm simply reduced cash div-idends, which would save stockholders some personal income taxes Quite a fewfirms are surveying their stockholders to learn more about their preferencesand to find out how they would react to a change in dividend policy A more ra-tional approach to basic dividend policy decisions may emerge from thisresearch

re-D I V I re-D E N re-D R E I N V E S T M E N T P L A N S

(Footnote 9 continued)

2. In the absence of taxes, the stock’s price would fall to $30 on December 5 and then start up

as the next dividend accrual period began Thus, over time, if everything else were held stant, the stock’s price would follow a sawtooth pattern if it were plotted on a graph.

con-3. Because of taxes, the stock’s price would neither rise by the full amount of the dividend nor fall by the full dividend amount when it goes ex-dividend.

4. The amount of the rise and subsequent fall would depend on the average investor’s marginal tax rate.

See Edwin J Elton and Martin J Gruber, “Marginal Stockholder Tax Rates and the Clientele

Ef-fect,” Review of Economics and Statistics, February 1970, 68–74, for an interesting discussion of all

A plan that enables a stockholder

to automatically reinvest dividends

received back into the stock of the

paying firm.