Chapter 2.

DIVIDEND/PAYOUT POLICY

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Chapter Outline

I. Dividend theories

II. Factors influencing dividend policy

III. Establishing the dividend policy in practice

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The Basics/Elements of Payout Policy

 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.

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The Basics/Elements of Payout Policy
 Dividend Decision
is a choice made by management on behalf of those stockholders
about what to do with their earnings.
theoretically, there are only two alternatives:
a) Earnings can be paid out as dividends (gives stockholders
current income) or
b) retained for reinvestment/growth in the business (retaining
earnings produces deferred income). Both options benefit
stockholders, but in different ways.
is the choice between paying more or less in near-term dividends,
i.e. implying trading off between the two stockholder benefits.
it is not a question of whether the stockholder gets a dividend or
gets nothing.
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The Basics/Elements of Payout Policy

 Background - Dividends as a Basis for Value

The relationship between dividends and value can be
viewed from the perspective of an individual investor or
from that of the market as a whole.

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The Basics/Elements of Payout Policy

• The optimal dividend policy should maximize the price of

the firm’s stock holding the number of shares outstanding
constant. D1
P0 
ke  g

• A decision to increase dividends will raise D1 putting upward

pressure on P0. Increasing dividends, however, means
reinvesting fewer dollars, lowering g, and putting downward
pressure on P0.
• Problem: What is the correct balance between dividends
and retained earnings?
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Dividend Controversy/Conflicting Theories

• The dividend controversy is whether paying or not paying

dividends affects stock price.
• The financial literature has reported numerous theories and
empirical findings concerning payout policy. None of them are
entirely right or wrong.
• The most important question about payout policy is this: Does
payout policy have a significant effect on the value of a firm?
i.e. the central issue about dividends is whether paying them
or paying larger rather than smaller dividends has a positive,
negative, or neutral effect on a firm’s stock price.

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Dividend Controversy/Conflicting Theories

• The question can also be stated in terms of stockholder

preferences.
Do shareholders prefer current or deferred income?
Presumably, doing what they prefer will make a stock more
desirable, and its price will be bid up to some extent.
In other words, we’d like to know whether it’s generally
possible for management to partially accomplish the goal of
maximizing shareholder wealth by manipulating the firm’s
dividend-paying policy.

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Relevance of Payout Policy
I. Dividend Irrelevance
a) The Residual Theory of Dividends
is a school of thought that suggests that the dividend paid by a
firm should be viewed as a residual—the amount left over after
all acceptable/viable investment opportunities have been
undertaken.
using this theory, the firm would treat the dividend decision in
three steps, as follows:
1. Determine its optimal level of capital expenditures, which
would be the level that exploits all of a firm’s positive NPV
projects.
2. Using the optimal capital structure proportions, estimate the
total amount of equity financing needed to support the
expenditures generated in Step 1.

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Relevance of Payout Policy
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.

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Relevance of Payout Policy
I. Dividend Irrelevance…
b) The Miller and Modigliani Theory
 in a perfect world (certainty, no taxes, no transactions costs, and
no other market imperfections), the firm’s value is determined
solely by the earning power and risk of its assets (investments)
and that the manner in which it splits its earnings stream
between dividends and internally retained (and reinvested)
funds does not affect the value of the firm.
under dividend irrelevance the value of eliminated dividends is
offset by growth created value in the future.
based on the homemade dividend argument, dividend policy is
irrelevant

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Homemade dividends
• Suppose individual Investor X prefers dividends per share of $100 at
both Dates 1 and 2. Would she be disappointed if informed that the
firm’s management was adopting the alternative dividend policy
(dividends of $110 and $89 on the two dates, respectively)?
• Not necessarily; she could easily reinvest the $10 of unneeded funds
received on Date 1 by buying more Wharton stock
• At 10%, this investment would grow to $11 by Date 2; investor X would
receive her desired net cash flow of $110 − 10 = $100 at Date 1 and $89
+ 11 = $100 at Date 2
• Imagine Investor Z, preferring $110 of cash flow at Date 1 and $89 of
cash flow at Date 2, finds that management will pay dividends of $100
at both Dates 1 and 2
• This investor can sell $10 worth of stock to boost his total cash at Date 1
to $110; because this investment returns 10%, Investor Z gives up $11
at Date 2 (= $10 × 1.1), leaving $100 − 11 = $89
• Our two investors can transform the corporation’s dividend policy into a
different policy by buying or selling on their own, resulting in a
homemade dividend policy
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Modigliani-Miller

• Modigliani-Miller support irrelevance.

• Investors are indifferent between dividends and retention-
generated capital gains.
• If the firm’s cash dividend is too big, you can just take the
excess cash received and use it to buy more of the firm’s
stock. If the cash dividend is too small, you can just sell a
little bit of your stock in the firm to get the cash flow you
want.
• Theory is based on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true. Need empirical
test.
Relevance of Payout Policy
I. Dividend Irrelevance…
c) The Clientele Effect
The clientele effect is the argument that different payout
policies attract different types of investors but still do not
change the value of the firm.
• Each company develops a clientele of investors whose needs
match its dividend paying characteristics, hence, the term
clientele effect.
• Tax-exempt investors may invest more heavily in firms that
pay dividends because they are not affected by the typically
higher tax rates on dividends.

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Relevance of Payout Policy

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.

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Relevance of Payout Policy

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

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Relevance of Payout Policy
II. Dividend Relevance Arguments
Dividend relevance theory is the theory, advanced by Gordon
and Lintner, that there is a direct relationship between a firm’s
dividend policy and its market value.
a) Dividend preference/Bird-in-the-hand argument/theory
is the belief, in support of dividend relevance theory which
maintains that generally stockholders prefer receiving
dividends to not receiving them.
the argument is based on the uncertainty of the future (is not
a time value of money argument).

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Relevance of Payout Policy
II. Dividend Relevance Arguments…
a) Dividend preference/Bird-in-the-hand theory…
it asserts that stockholders prefer current dividends to future
capital gains, because something paid today is more certain to
be received than something expected in the future.
investors see current dividends as less risky than future
dividends or capital gains.
dividends are less risky, thus, high dividend payout ratios will
lower ke (reducing the cost of capital), and increase stock price.
Because of the desire for current income and related factors
(e.g. Resolution of uncertainty), a high-dividend policy is best.

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Relevance of Payout Policy
II. Dividend Relevance Arguments…
b) The Signaling Effect/Information Content of Dividends
 Information content effect is the market’s reaction to a
change in corporate dividend payout
 Informational content is the information provided by the
dividends of a firm with respect to future earnings, which
causes owners to bid up or down the price of the firm’s stock.
 The agency cost theory says that a firm that commits to
paying dividends is reassuring shareholders that managers
will not waste their money.
 Studies have shown that large changes in dividends do affect
share price.
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Relevance of Payout Policy

II. Dividend Relevance Arguments…

b) The Signaling Effect/Information Content…
Managers hate to cut dividends, so they won’t raise
dividends unless they think raise is sustainable. So, investors
view dividend increases as signals of management’s view of
the future.
Generally, stock prices rise when the current dividend is
unexpectedly increased, and they fall when the dividend
is unexpectedly decreased
The fact that dividend changes convey information about
the firm to the market makes it difficult to interpret the
effect of the dividend policy of the firm

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Relevance of Payout Policy

II. Dividend Relevance Arguments…

c) Tax Preference Theory

• Retained earnings lead to long-term capital gains, which are

taxed at lower rates than dividends: 20% vs. up to 39.6%.
Capital gains taxes are also deferred.

• This could cause investors to prefer firms with low payouts,

i.e., a high payout results in a low P0.
 Possible Stock Price Effects

Stock Price ($)

Bird-in-Hand
40

30 Irrelevance

20
Tax preference

10

0 50% 100% Payout

 Possible Cost of Equity Effects

Cost of equity (%)

Tax Preference
20

15 Irrelevance

10 Bird-in-Hand

0 50% 100% Payout

Implications of 3 Theories for Managers

Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout

But which, if any, is correct???

 Which theory is most correct?

• empirical studies/testing have not provided evidence that

conclusively settles the debate about whether and how payout
policy affects firm value or determine which theory, if any, is
correct.

• thus, managers use judgment when setting policy.

• analysis is used, but it must be applied with judgment.

Factors Affecting Dividend Policy

• Real-world Factors Favoring a High/Low Dividend Payout

• Dividend policy represents the firm’s plan of action to be
followed whenever it makes a dividend decision.
• First consider five factors in establishing a dividend policy:
1. legal constraints
2. contractual constraints
3. the firm’s growth prospects
4. owner considerations
5. market considerations

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Factors Affecting Dividend Policy
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.

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Factors Affecting Dividend Policy
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.

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Factors Affecting Dividend Policy

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.

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Factors Affecting Dividend Policy
Owner Considerations
Tax status of a firm’s owners: If a firm has a large percentage of
wealthy stockholders who have sizable incomes, it may decide
to pay out a lower percentage of its earnings to allow the
owners to delay the payment of taxes until they sell the stock.
Owners’ investment opportunities: If it appears that the
owners have better opportunities externally, the firm should
pay out a higher percentage of its earnings.
Potential dilution of ownership: If a firm pays out a high
percentage of earnings, new equity capital will have to be
raised with common stock. The result of a new stock issue may
be dilution of both control and earnings for the existing
owners.
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Factors Affecting Dividend Policy

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.

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Types of Dividend Policies

Constant-Payout-Ratio Dividend Policy

A firm’s dividend payout ratio indicates the percentage of

each dollar earned that a firm distributes to the owners in
the form of cash. It is calculated by dividing the firm’s cash
dividend per share by its earnings per share.

A constant-payout-ratio dividend policy is a dividend policy

based on the payment of a certain percentage of earnings to
owners in each dividend period.

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Types of Dividend Policies

 Regular Dividend Policy

Regular dividend policy is a dividend policy based on the
payment of a fixed-dollar dividend in each period.
A regular dividend policy is often build around a target dividend-
payout ratio, which is a dividend policy under which the firm
attempts to pay out a certain percentage of earnings as a stated
dollar dividend and adjusts that dividend toward a target payout
as proven earnings increases occur.

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Types of Dividend Policies

Low-Regular-and-Extra Dividend Policy

A low-regular-and-extra dividend policy is a dividend policy
based on paying a low regular dividend, supplemented by an
additional (“extra”) dividend when earnings are higher than
normal in a given period.
An extra dividend is an additional dividend optionally paid
by the firm when earnings are higher than normal in a given
period.

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A test

1. True or false: Dividends are irrelevant

• False
• Investors prefer higher dividends to lower dividends at any
single date if the dividend level is held constant at every other
date

2. True or false: Dividend policy is irrelevant

• True, at least in the simple case
• Dividend policy by itself cannot raise the dividend at one date
while keeping it the same at all other dates; rather, dividend
policy merely establishes the trade-off between dividends at
one date and dividends at another date

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