DIVIDENDS VERSUS CAPITAL GAINS: WHAT DO INVESTORS PREFER?

When deciding how much cash to distribute to stockholders, financial managers must keep in mind
that the firm’s objective is to maximize shareholder 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 on investors’ 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 repurchase stock or else
plow the earnings back into the business, both of which should result in capital gains?
This preference can be considered in terms of the constant growth stock valuation model:
𝐷1
𝑝0^ =𝐾𝑠−𝑔

If the company increases the payout ratio, this raises D1. This increase in the numerator, taken
alone, would cause the stock price to rise. However, if D1 is raised, then less money will be
available for reinvestment, that will cause the expected 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 dividends
and future growth so as to maximize the stock price.
Theories of dividend policy:
(1) the dividend irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax preference
theory.
1. Dividend Irrelevance Theory: The principal proponents of the dividend irrelevance
theory are Merton Miller and Franco Modigliani (MM). They argued that the firm’s value
is determined only by its basic earning power and its business 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 between dividends and retained earnings. The theory that a firm’s
dividend policy has no effect on either its value or its cost of capital.
2. Bird-in-the-Hand Theory: Myron Gordon and John Lintner argued that ks decreases as
the dividend payout is increased because investors are less certain of receiving the capital
gains that are supposed to result from retaining earnings than they are of receiving dividend
payments. Gordon and Lintner said, in effect, that investors value a dollar of expected
dividends more highly than a dollar of expected capital gains because the dividend yield
component, D1/P0, is less risky than the g component in the total expected return equation,
ks= D1/P0+ g. MM’s name for the theory that a firm’s value will be maximized by setting
a high dividend payout ratio.
3. Tax Preference Theory: There are three tax-related reasons for thinking that investors
might prefer a low dividend payout to a high payout. If the company’s long-term capital
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 (who own most of the stock and
receive most of the dividends) might prefer to have companies retain and plow earnings
back into the business. Earnings growth would presumably lead to stock price increases,
 and thus lower-taxed capital gains would be substituted for higher-taxed dividends. Taxes
are not paid on the gain until a stock is sold. Due to time value effects, a dollar of taxes
paid in the future has a lower effective cost than a dollar paid today. If a stock is held by
someone until he or she dies, no capital gains tax is due at all—the beneficiaries who
receive the stock can use the stock’s value on the death day as their cost basis and thus
completely escape the capital gains tax.
ESTABLISHING THE DIVIDEND POLICY IN PRACTICE:
While dividend policies undoubtedly vary from firm to firm, in this section we describe the
steps that a typical firm takes when it establishes its target payout ratio.
SETTING THE TARGET PAYOUT RATIO: THE RESIDUAL DIVIDEND MODEL:
When deciding how much cash to distribute to stockholders, two points should be kept in mind:
(1) The overriding objective is to maximize shareholder value, and (2) the firm’s cash flows
really belong to its shareholders, so management should refrain from retaining income unless
they can reinvest it to produce returns higher than shareholders could themselves earn by
investing the cash in investments of equal risk. For a given firm, the optimal payout ratio is a
function of four factors: (1) investor’s preferences for dividends versus capital gains, (2) the
firm’s investment opportunities, (3) its target capital structure, and (4) the availability and cost
of external capital. The last three elements are combined in what we call the residual dividend
model. Under this model a firm follows these four steps when establishing its target payout
ratio: (1) It determines the optimal capital budget; (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 requirements to the extent possible; and (4) it pays dividends only if more earnings
are available than are needed to support the optimal capital budget.
Under residual dividend policy dividends paid in any 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)].
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.
PAYMENT PROCEDURES:
The actual payment procedure is as follows:
1. Declaration Date: The date on which a firm’s directors issue a statement declaring a
dividend.
2. 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: 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.
 4. Payment Date: The date on which a firm actually mails dividend checks.
Dividend Reinvestment Plan (DRIP): A plan that enables a stockholder to automatically
reinvest dividends received back into the stock of the paying firm.
FACTORS INFLUENCING DIVIDEND POLICY:
Factors influencing dividend policy may be grouped into four broad categories:
(1) constraints on dividend payments, (2) investment opportunities, (3) availability and cost
of alternative sources of capital, and (4) effects of dividend policy on ks.
1. Constraints:
a. Bond indentures: Debt contracts often limit dividend payments to earnings
generated after the loan was granted. Also, debt contracts often stipulate that no
dividends can be paid unless the current ratio, times-interest earned ratio, and other
safety ratios exceed stated minimums.
b. Preferred stock restrictions: Typically, common dividends cannot be paid if the
company has omitted its preferred dividend. The preferred arrearages must be
satisfied before common dividends can be resumed.
c. Impairment of capital rule: Dividend payments cannot exceed the balance sheet
item “retained earnings.” This legal restriction, known as the impairment of capital
rule, is designed to protect creditors. Without the rule, a company that is in trouble
might distribute most of its assets to stockholders and leave its debtholders out in
the cold.
d. Availability of cash: Cash dividends can be paid only with cash. Thus, a shortage
of cash in the bank can restrict dividend payments. However, the ability to borrow
can offset this factor.
e. Penalty tax on improperly accumulated earnings: To prevent wealthy
individuals from using corporations to avoid personal taxes, the Tax Code provides
for a special surtax on improperly accumulated income.
2. Investment Opportunities:
a. Number of profitable investment opportunities: If a firm typically has a large
number of profitable investment opportunities, this will tend to produce a low target
payout ratio, and vice versa if the firm’s profitable investment opportunities are few
in number.
b. Possibility of accelerating or delaying projects: The ability to accelerate or
postpone projects will permit a firm to adhere more closely to a stable dividend
policy.
3. Availability and Cost of Alternative Sources of Capital:
a. Cost of selling new stock: If a firm need to finance a given level of investment, it
can obtain equity by retaining earnings or by issuing new common stock. If
flotation costs (including any negative signaling effects of a stock offering) are
high, ke will be well above ks, making it better to set a low payout ratio and to
finance through retention rather than through sale of new common stock. On the
 other hand, a high dividend payout ratio is more feasible for a firm whose flotation
costs are low.
b. Ability to substitute debt for equity: A firm can finance a given level of
investment with either debt or equity. As noted above, low stock flotation costs
permit a more flexible dividend policy because equity can be raised either by
retaining earnings or by selling new stock.
c. Control: If management is concerned about maintaining control, it may be
reluctant to sell new stock, hence the company may retain more earnings than it
otherwise would.
4. Effects of Dividend Policy on ks:
The effects of dividend policy on ks may be considered in terms of four factors: (1)
stockholders’ desire for current versus future income, (2) perceived riskiness of
dividends versus capital gains, (3) the tax advantage of capital gains over dividends,
and (4) the information content of dividends (signaling).

Stock Dividends and Stock Splits:

Stock Split: An action taken by a firm to increase the number of shares outstanding, such as
doubling the number of shares outstanding by giving each stockholder two new shares for each
one formerly held.
Stock Dividend: A dividend paid in the form of additional shares of stock rather than in cash.

Effect on Stock Prices: If a company splits its stock or declares a stock dividend, will this
increase the market value of its stock?
1. On average, the price of a company’s stock rises shortly after it announces a stock split or
dividend.
2. However, these price increases are more the result of the fact that investors take stock
splits/dividends as signals of higher future earnings and dividends than of a desire for stock
dividends/splits per share. Since only companies whose managements think things look good
tend to split their stocks, the announcement of a stock split is taken as a signal that earnings
and cash dividends are likely to rise. Thus, the price increases associated with stock
splits/dividend are probably the result of signals of favorable prospects for earnings and
dividends, not a desire for stock splits/dividends per share.
3. If a company announces a stock split or dividend, its price will tend to rise. However, if
during the next few months it does not announce an increase in earnings and dividends, then
its stock price will drop back to the earlier level.
4. Brokerage commissions are generally higher in percentage terms on lower-priced stocks.
This means that it is more expensive to trade low-priced than high-priced stocks, and this, in
turn, means that stock splits may reduce the liquidity of a company’s shares. This particular
piece of evidence suggests that stock splits/dividends might actually be harmful, although a
lower price does mean that more investors can afford to trade in round lots (100 shares), which
carry lower commissions than do odd lots (less than 100 shares).
 Stock Repurchase: A transaction in which a firm buy back shares of its own stock, thereby
decreasing shares outstanding, increasing EPS, and, often, increasing the stock price.

Advantages of Repurchases:
1. Repurchase announcements are viewed as positive signals by investors because the
repurchase is often motivated by management’s belief that the firm’s shares are
undervalued.
2. The stockholders have a choice when the firm distributes cash by repurchasing stock—
they can sell or not sell. With a cash dividend, on the other hand, stockholders must accept
a dividend payment and pay the tax.
3. A third advantage is that a repurchase can remove a large block of stock that is
“overhanging” the market and keep the price per share down.
4. Dividends are “sticky” in the short run because managements are reluctant to raise the
dividend if the increase cannot be maintained in the future— managements dislike cutting
cash dividends because of the negative signal a cut gives.
5. Companies can use the residual model to set a target cash distribution level, then divide the
distribution into a dividend component and a repurchase component.
6. Repurchases can be used to produce large-scale changes in capital structures.
7. Companies that use stock options as an important component of employee compensation
can repurchase shares and then use those shares when employees exercise their options.
Disadvantages of Repurchases:
1. Stockholders may not be indifferent between dividends and capital gains, and the price of
the stock might benefit more from cash dividends than from repurchases.
2. The selling stockholders may not be fully aware of all the implications of a repurchase, or
they may not have all the pertinent information about the corporation’s present and future
activities.
3. The corporation may pay too high a price for the repurchased stock, to the disadvantage of
remaining stockholders.
Formulas:
𝑫𝑷𝑺
1. Dividend payout ratio (DPR) = 𝑬𝑷𝑺 ×100
2. DPS = EPS×DPR
3. Retention ratio (RR) = 1-DPR
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒛
4. Earnings per share (EPS) = 𝑵𝒐 𝒐𝒇 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
𝑬𝑩𝑰𝑻
5. Return on asset (ROA) = ×100
𝑻𝑨
𝑫𝟏 +𝑷𝟏
6. MM Model: 𝑷𝟎 = 𝟏+𝑲
𝑫
7. Gordon Model: P = 𝑲−𝑮
8. MM Model: Market price per share at the end, 𝑷𝟏 = 𝑷𝟎 (1+K)-𝑫𝟏
9. MM Model: Additional share capital, ∆n𝑷𝟏 = I-(E-n𝑫𝟏 )
 𝑰−(𝑬−𝒏𝑫𝟏 )
10. MM Model: Additional share, ∆n = 𝑷𝟏
(𝒏+∆𝒏)𝑷𝟏 −𝑰+𝑬
11. MM Model: Value of the firm, n𝑷𝟎 = 𝟏+𝑲

STARTER PROBLEMS:
14-3: Beta Industries has net income of $2,000,000 and it has 1,000,000 shares of common stock
outstanding. The company’s stock currently trades at $32 a share. Beta is considering a plan in
which it will use available cash to repurchase 20 percent of its shares in the open market. The
repurchase is expected to have no effect on either net income or the company’s P/E ratio. What
will be its stock price following the stock repurchase?
Answer: Given,
Net income= 2000000, Outstanding shares= 1000000
Current share price, 𝑃0 = 32, Repurchase=20%
What will be the stock price after repurchase?
No of shares will be repurchased = 20% of 1000000 or 200000 shares
Amount needed for repurchase = 200000×32 or 6400000
Earnings per share before repurchase = Net income/ No of shares outstanding
= 2000000/1000000 or 2
Earnings per share after repurchase = 2000000/ (1000000-200000) or 2.5
Price Earnings Ratio(P/E) = current price/EPS
= 32/2 or 16
Price per share after repurchase = EPS after repurchase ×P/E ratio
= 2.5×16 or 40
Problem- (14-10): In 2001 the Keenan Company paid dividends totaling $3,600,000 on net
income of $10.8 million. 2001 was a normal year, and for the past 10 years, earnings have grown
at a constant rate of 10 percent. However, in 2002, earnings are expected to jump to $14.4 million,
and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that
Keenan will not be able to maintain the 2002 level of earnings growth— the high 2002 earnings
level is attributable to an exceptionally profitable new product line introduced that year—and the
company will return to its previous 10 percent growth rate. Keenan’s target capital structure is 40
percent debt and 60 percent equity.
a. Calculate Keenan’s total dividends for 2002 if it follows each of the following policies:
(1) Its 2002 dividend payment is set to force dividends to grow at the long-run growth rate in
earnings.
(2) It continues the 2001 dividend payout ratio.
(3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment is financed
with debt and 60 percent with common equity).
(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the
long-run growth rate and the extra dividend being set according to the residual policy.
b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed,
but justify your answer.
c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2002 and to have
the dividend grow at 10 percent after 2002. The stock’s total market value is $180 million. What
is the company’s cost of equity?
d. What is Keenan’s long-run average return on equity? [Hint: g = (Retention rate) × (ROE) = (1.0-
Payout rate) (ROE).]

e. Does a 2002 dividend of $9,000,000 seem reasonable in view of your answers to parts c and d?
If not, should the dividend be higher or lower?
Answer:
Requirement a:
1. Total dividend for 2002 = 2001 dividends (1+0.10)
=3600000(1.10)
= 3960000
2. Payout ratio for the 2001 = 3600000/10800000
= 33%
By continuing 33% payout ratio, total dividend for the year 2002 would be
= 33% × 2002 expected net income
= 33% ×14400000
= 4800000
3. Equity amount in total capital structure is = 60% of 8400000 or 5040000
Total dividend for 2002 = Net Income- amount needed for equity finance
= 14400000-5040000
=9360000
Under residual dividend policy required equity amount would be financed from retained
earnings as long as the amount are available.
4. By maintaining constant dividend growth, the regular dividend would be above than 10%
from 2001 dividends.
Total regular dividend would be = 3600000(1.10) or 3960000
 Total dividend under residual dividend model = 9360000
Amount of extra dividend= 9360000-3960000 or 5400000
It would be a better decision to use the surplus or extra amount for stock repurchase.
Requirement b:
I recommend policy 4 because proper capital budgeting and financing would be possible through
regular dividend plus an extra.
Requirement c:
𝐷
Cost of equity, 𝐾𝑒 = 𝑃1 +g
0

9000000
= 180000000+10%

= 15%
Requirement d:
g = (1.0-Payout rate) (ROE).]
3600000
g = (1- 10800000 )(ROE)

ROE = 15%
Requirement e:
Though the cost of equity and return on equity both are 15%, I think that the dividend of 9000000
for the year 2002 may be little low. The reason behind this may be for too large capital budget that
require more dividends should be paid out.
Problem:
A company has the following stockholder’s equity amount:
Common stock, Tk 8 par 2000000
Paid in capital 1600000
Retained Earnings 8400000
Shareholders’ equity 12000000
The current market price of the stock is Tk 60 per share.
a. What will happen to this account and to the number of shares outstanding with a 20% stock
dividend?
b. With a 2 for 1 stock split?
Requirement a:
2000000
No of new share = ( )20% or 50000
8

Total amount of common stock after stock dividend = 2000000+(50000×8) or 2400000

Amount of retained earnings after stock dividend = 8400000-(50000×60) or 5400000
Amount of paid in capital after stock dividend = 1600000+ (50000×60) -(50000×8) or 4200000
Shareholders equity account after stock dividend would be:
Shareholders’ Equity Account
Particulars Tk
Common stock, 300000 shares @Tk 8 par 2400000
Paid in capital 4200000
Retained Earnings 5400000
Shareholders’ equity 12000000
Requirement b:
2
No of new total share after 2 for 1 stock split = 250000×1

= 500000
Par value of shares after stock split = 20000000/500000 or Tk 4
Shareholders’ equity section after 2 for 1 stock split would be:
Shareholders’ Equity Account
Particulars Tk
Common stock, 500000 shares @Tk 4 par 2000000
Paid in capital 1600000
Retained Earnings 8400000
Shareholders’ equity 12000000

Problem:
An engineering company has a cost of equity of 15%. The current market value of the firms is tk
3000000 at tk 30 per share. Show that under the M.M. assumptions the payment of dividend does
not affect the value of the firm. Assume values for-

New investment (I) 900000

Earnings (E) 500000
Total dividends (D) 300000
Answer:
Given, cost of capital (K) = 15% or 0.15
Current market price per share (𝑃0 )=30
No of shares (n) = 3000000/30 or 100000
New investment (I) = 900000
Earnings (E) = 500000
Dividend per share (𝐷1 )= 300000/100000 or tk 3
Effect of dividend on the value of the firm (n𝑃1 )=?
Applying M.M. Model when dividend is paid:
Share price at the end is, 𝑃1 = 𝑃0 (1+K)-𝐷1
= 30(1+0.15)-3 or 31.50
Additional share capital is, ∆n𝑃1 = I-(E-n𝐷1 )
= 900000-(500000-100000×3) or 700000
𝑰−(𝑬−𝒏𝑫𝟏 )
Additional shares are, ∆n = 𝑷𝟏

= 700000/31.50 or 22222.22
(𝒏+∆𝒏)𝑷𝟏 −𝑰+𝑬
Value of the firm is, n𝑷𝟎 = 𝟏+𝑲

(𝟏𝟎𝟎𝟎𝟎𝟎+𝟐𝟐𝟐𝟐𝟐.𝟐𝟐)𝟑𝟏.𝟓−𝟗𝟎𝟎𝟎𝟎𝟎+𝟓𝟎𝟎𝟎𝟎𝟎
= 𝟏+𝟎.𝟏𝟓

= 3000000
Applying M.M. Model when dividend is not paid:
Share price at the end is, 𝑃1 = 𝑃0 (1+K)-𝐷1
= 30(1+0.15)-0 or 34.50
Additional share capital is, ∆n𝑃1 = I-(E-n𝐷1 )
= 900000-(500000-100000×0) or 400000
𝑰−(𝑬−𝒏𝑫𝟏 )
Additional shares are, ∆n = 𝑷𝟏

= 400000/34.50 or 11594.20
(𝒏+∆𝒏)𝑷𝟏 −𝑰+𝑬
Value of the firm is, n𝑷𝟎 = 𝟏+𝑲
 (𝟏𝟎𝟎𝟎𝟎𝟎+𝟏𝟏𝟓𝟗𝟒.𝟐𝟎)𝟑𝟒.𝟓−𝟗𝟎𝟎𝟎𝟎𝟎+𝟓𝟎𝟎𝟎𝟎𝟎
= 𝟏+𝟎.𝟏𝟓

= 3000000