EDABS 202 - CFM - Lecture Session 08 · DIVIDEND POLICY What is “dividend policy”? nIt’s the decision to pay out earnings versus retaining and reinvesting them. Includes these

Topic 4.03 9/15/19

BUSINESS VALUATION, CAPITAL STRUCTURE & DIVIDEND POLICY

TOPIC04BUSINESSVALUATION.CAPITALSTRUCTURE&DIVIDENDPOLICY

EDABS 202 – Corporate Financial Management (CFM)

Conducted by Nadun KumaraMBA(USJP), ACMA(UK), CGMA(USA), BA(Hons)(UK), DipPsychOrg(UK)

TOPIC04- 03DIVIDENDPOLICY

EDABS 202 – Corporate Financial Management (CFM)

Conducted by Nadun KumaraMBA(USJP), ACMA(UK), CGMA(USA), BA(Hons)(UK), DipPsychOrg(UK)

Topic 4.03 9/15/19


What is “dividend policy”?

n It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements:1. High or low payout?2. Stable or irregular dividends?3. How frequent?4. Do we announce the policy?

Do investors prefer high or low payouts? There are three theories:

nDividends are irrelevant: Investors don’t care about payout.

nBird-in-the-hand: Investors prefer a high payout.

nTax preference: Investors prefer a low payout, hence growth.

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Dividend Irrelevance Theory

n Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

nModigliani-Miller support irrelevance.nTheory is based on unrealistic

assumptions (no taxes or brokerage costs), hence may not be true.

Bird-in-the-Hand Theory

n Investors think dividends are less risky than potential future capital gains, hence they like dividends.

n If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P0.

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Tax Preference Theory

nRetained earnings lead to capital gains, which are taxed at lower rates than dividends.

nThis could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P0.

Implications of 3 Theories for Managers

Theory ImplicationIrrelevance Any payout OKBird-in-the-hand Set high payoutTax preference Set low payout

But which, if any, is correct???

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Possible Stock Price Effects

Stock Price ($)

Payout 50% 100%

40

30

20

10

Bird-in-Hand

Indifference

Tax preference

0

Possible Cost of Equity Effects

Cost of equity (%)

Payout 50% 100%

15

20

10

Tax Preference

Indifference

Bird-in-Hand

0

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Which theory is most correct?

nEmpirical testing has not been able to determine which theory, if any, is correct.

nThus, managers use judgment when setting policy.

nAnalysis is used, but it must be applied with judgment.

What’s the “information content,” or “signaling,” hypothesis?

nManagers hate to cut dividends, so won’t raise dividends unless they think raise is sustainable. So, investors view dividend increases as signals of management’s view of the future.

nTherefore, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

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What’s the “clientele effect”?

nDifferent groups of investors, or clienteles, prefer different dividend policies.

nFirm’s past dividend policy determines its current clientele of investors.

nClientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

What’s the “residual dividend model”?

nFind the retained earnings needed for the capital budget.

nPay out any leftover earnings (the residual) as dividends.

nThis policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

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Using the Residual Model to Calculate Dividends Paid

Dividends = – .Netincome

Targetequityratio

Totalcapitalbudget[ ]))((

How would a change in investment opportunities affect dividend under the

residual policy?

nFewer good investments would lead to smaller capital budget, hence to a higher dividend payout.

nMore good investments would lead to a lower dividend payout.

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Advantages and Disadvantages of the Residual Dividend Policy

nAdvantages: Minimizes new stock issues and flotation costs.

nDisadvantages: Results in variable dividends, sends conflicting signals, increases risk, and doesn’t appeal to any specific clientele.

nConclusion: Consider residual policy when setting target payout, but don’t follow it rigidly.

Setting Dividend Policy

nForecast capital needs over a planning horizon, often 5 years.

nSet a target capital structure.nEstimate annual equity needs.nSet target payout based on the

residual model.nGenerally, some dividend growth rate

emerges. Maintain target growth rate if possible, varying capital structure somewhat if necessary.

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THANK YOU..!

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EDABS 202 - CFM - Lecture Session 08 · DIVIDEND POLICY What is “dividend policy”? nIt’s the decision to pay out earnings versus retaining and reinvesting them. Includes these