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The ultimate goal of financial managers should be the maximization of shareholder wealth. Shareholder wealth can be maximized by maximizing the price of the stock. As you have learned earlier, the price of the stock is the expected present value of future cash flows.
In the late 1950s, Myron Gordon proposed modeling price on a firms dividends and growth potential: 0 = D1 P ks g Optimal Dividend Policy: To maximize price, an optimal balance must be found between current dividends (D1) and the need for growth (g).
Miller and Modigliani showed algebraically that dividend policy didnt matter:
They showed that as long as the firm was realizing the returns expected by the market, it didnt matter whether that return came back to the shareholder as dividends now, or reinvested.
The shareholder can create their own dividend by selling the stock when cash is needed.
But Miller and Modigliani made some unrealistic assumptions in developing their model:
Bird-in-the-Hand Theory
Gordon argued that a dividend-in-the-hand is worth more than the present value of a future dividend. D1 ks = +g P0 In essence, he said that the risk premium on the dividend yield is higher than on the growth rate.
There are three ways in which taxes affect the dividend preferences of shareholders.
For individual investors tax rates differ for capital gains and dividends. Taxes on capital gains are not due until the stock is sold. If the stock is held until the shareholder expires, no tax is due at all.
For years the capital gains rate was significantly below the dividend income rate, prompting many companies to retain more income, and declare smaller dividends. With the Jobs and Growth Tax Relief Reconciliation Act of 2003, the dividend tax rate has fallen sharply.
Dividend Irrelevance: If the return on investment is what the market requires, then it doesnt matter whether you get it in dividend or capital gains. Bird in the Hand Theory: Shareholders prefer dividends, and will require a higher discount rate for capital gains since they are riskier.
Tax Preference Theory: Under the old tax system, an unambiguous case could be made in favor of capital gains. The shareholder would require the same after-tax return, meaning the required return on dividends used to be higher.
This same philosophy would suggest that now higher dividends may require lower rates of return.
Two of the three theories now suggest that shareholders should prefer dividends.
Signaling:
The theories thus far have assumed that investors and managers have the same information set. When it comes to prospect for the company, managers may have better information than investors. Therefore unexpected changes in dividends may relay information to the market that it didnt know before.
Signaling - continued
Managers dont cut dividends unless the firm is in financial distress. It is therefore believed that firms do not increase dividends beyond Wall Streets expectations unless managers anticipate stronger earnings than expectations. Unexpected changes in dividends relay information to the market.
Residual Dividend Policy: Investors prefer to have the firm retain and reinvest earnings if they can earn a higher risk adjusted return than the investor can.
Residual Dividend Policy suggests that dividends should be that part of earnings which cannot be invested at a rate at least equal to the WACC.
Determine the optimal capital budget. Determine the retained earnings that can be used to finance the capital budget. Use retained earnings to supply as much of the equity investment in the capital budget as necessary. Pay dividends only if there are left-over earnings.
Stable, Predictable Dividend Policy: Due to the possibility of a negative signal to investors, many CFOs have set the policy of never reducing their dividends.
Dividends are only increased if management is certain future earnings will support such a high dividend.
A variation of this policy is one in which dividends exhibit a stable, predictable growth rate. In that instance the company has to set the policy in such a way that the growth rate can be sustained for the foreseeable future.
Pay a predictable dividend every year. Base optimal capital budget on residual retained earnings (after dividend).
Constant Payout Ratio Policy: It is possible that a company could set a policy to payout a certain percentage of earnings as dividends.
The problem is that such a policy would not fit the needs of the firms stockholders, since it would cause a great deal of volatility in dividends paid (see clientele effect spoken of earlier).
Pay a constant proportion of earnings (if positive). Base optimal capital budget on residual retained earnings.
Low Regular Dividend Plus Extras: This policy is a hybrid of the last two policies. It is meant to keep expectations low for dividends, and supplement those dividends with bonuses in good years.
Pay a predictable dividend every year. In years with good earnings pay a bonus dividend. Base optimal capital budget on residual of regular dividend and compromising with bonus for capital budgeting projects.
Dividend Policy
General Motors
$10 $8 $6 $4 $2 $0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 EPS DPS
EPS DPS
Dividend Policy
The more understandable the better. The more stable the better.