SoutheasternSteel Company (SSC) was formed 5 years ago to exploit a new continuous-castingprocess. SSC’s founders, Donald Brownand Margo Valencia, had been employed in the research department of a majorintegrated-steel company, but when that company decided against using the newprocess (which Brown and Valenciahad developed), they decided to strike out on their own. One advantage of the new process was that itrequired relatively little capital in comparison with the typical steelcompany, so Brown and Valencia have been able to avoid issuing new stock, andthus they own all of the shares. However, SSC has now reached the stage where outside equity capital isnecessary if the firm is to achieve its growth targets yet still maintain itstarget capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia havedecided to take the company public. Until now, Brown and Valenciahave paid themselves reasonable salaries but routinely reinvested all after-taxearnings in the firm, so dividend policy has not been an issue. However, before talking with potentialoutside investors, they must decide on a dividend policy.
Assume that you were recently hired byArthur Adamson & Company (AA), a national consulting firm, which has beenasked to help SSC prepare for its public offering. Martha Million, the senior AA consultant inyour group, has asked you to make a presentation to Brown and Valencia inwhich you review the theory of dividend policy and discuss the followingquestions.
a. 1. Whatis meant by the term “dividend policy”?
Answer: Dividend policy is defined as thefirm’s policy with regard to (1) the level of distributions, (2) the form ofdistributions (dividends or stock repurchases), and (3) the stability ofdistributions.
a. 2. Theterms “irrelevance,” “bird-in-the-hand,”and “tax preference” have been used to describe three major theories regardingthe way dividend payouts affect a firm’s value. Explain what these terms mean, and briefly describe each theory.
Answer: Dividend irrelevance refers to thetheory that investors are indifferent between dividends and capital gains,making dividend policy irrelevant with regard to its effect on the value of thefirm. “Bird-in-the-hand” refersto the theory that a dollar of dividends in the hand is preferred by investorsto a dollar retained in the business, in which case dividend policy wouldaffect a firm’s value.
The dividend irrelevance theory wasproposed by MM, but they had to make some very restrictive assumptions to“prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per shareof dividends reduces the growth rate in earnings and dividends, because new stockwill have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar ofdividends will reduce the stock price by exactly $1. Therefore, according to MM, stockholdersshould be indifferent between dividends and capital gains.
The “bird-in-the-hand” theory isidentified with Myron Gordon and John Lintner, who argued that investorsperceive a dollar of dividends in the hand to be less risky than a dollar ofpotential future capital gains in the bush; hence, stockholders prefer a dollarof actual dividends to a dollar of retained earnings. If the bird-in-the-hand theory is true, theninvestors would regard a firm with a high payout ratio as being less risky thanone with a low payout ratio, all other things equal; hence, firms with highpayout ratios would have higher values than those with low payout ratios.
MM opposed the Gordon-Lintner theory,arguing that a firm’s risk is dependent only on the riskiness of its cash flowsfrom assets and its capital structure, not by how its earnings are distributedto investors.
The tax preference theory recognizesthat there are two tax-related reasons for believing that investors mightprefer a low dividend payout to a high payout: (1) taxes are not paid on capital gains untilthe stock is sold. (2) 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 dayas their cost basis and thus escape the capital gains tax.
a. 3. Whatdo the three theories indicate regarding the actions management should takewith respect to dividend payout?
Answer: If the dividend irrelevance theory iscorrect, then dividend payout is of no consequence, and the firm may pursue anydividend payout. If the bird-in-the-handtheory is correct, the firm should set a high payout if it is to maximize itsstock price. If the tax preferencetheory is correct, the firm should set a low payout if it is to maximize itsstock price. Therefore, the theories arein total conflict with one another.
a. 4. Whatresults have empirical studies of the dividend theories produced? How does allthis affect what we can tell managers about dividend payouts?
Answer: Unfortunately, empirical tests of thetheories have been inconclusive (because firms don’t differ just with respectto payout), so we cannot tell managers whether investors prefer dividends orcapital gains. Even though we cannotdetermine what the optimal dividend policy is, managers can use the types ofanalyses discussed in this chapter to help develop a rational and reasonable,if not completely optimal, dividend policy.
B. Discuss (1) the informationcontent, or signaling, hypothesis, (2) the clientele effect, and (3) theireffects on distribution policy.
Answer: 1. Differentgroups, or clienteles, of stockholders prefer different dividend payout policies. For example, many retirees, pension funds, and university endowmentfunds are in a low (or zero) tax bracket, and they have a need for current cashincome. Therefore, this group ofstockholders might prefer high payout stocks. These investors could, of course, sell some of their stock, but thiswould be inconvenient, transactions costs would be incurred, and the sale mighthave to be made in a down market. Conversely, investors in their peak earnings years who are in high taxbrackets and who have no need for current cash income should prefer low payoutstocks.
2. Clienteles do exist, but the real question iswhether there are more members of one clientele than another, which wouldaffect what a change in its dividend policy would do to the demand for thefirm’s stock. There are also costs(taxes and brokerage) to stockholders who would be forced to switch from onestock to another if a firm changes its policy. Therefore, we cannot say whether a policy change to appeal to oneparticular clientele or another would lower or raise a firm’s cost ofequity. MM argued that one clientele isas good as another, so in their view the existence of clienteles does not implythat one dividend policy is better than another. Still, no one has offeredconvincing proof that firms can disregard clientele effects. We know that stockholder shifts will occur ifpolicy is changed, and since such shifts result in transaction costs andcapital gains taxes, policy changes should not be taken lightly. Further,dividend policy should be changed slowly, rather than abruptly, in order togive stockholders time to adjust.
3. It has long been recognized that the announcement of a dividendincrease often results in an increase in the stock price, while an announcementof a dividend cut typically causes the stock price to fall. One could argue that this observationsupports the premise that investors prefer dividends to capital gains. However, MM argued that dividendannouncements are signals through which management conveys informationto investors. Information asymmetriesexist--managers know more about their firms’ prospects than do investors. Further, managers tend to raise dividendsonly when they believe that future earnings can comfortably support a higherdividend level, and they cut dividends only as a last resort. Therefore, (1) alarger-than-normal dividend increase “signals” that management believes thefuture is bright, (2) a smaller-than-expected increase, or a dividend cut, is anegative signal, and (3) if dividends are increased by a “normal” amount, thisis a neutral signal.
c. 1. Assumethat SSC has an $800,000 capital budget planned for the coming year. You have determined that its present capitalstructure (60 percent equity and 40 percent debt) is optimal, and its netincome is forecasted at $600,000. Usethe residual distribution model approach to determine SSC’s total dollardistribution. Assume for now that thedistribution is in the form of a dividend. Then, explain what would happen if net income were forecasted at$400,000, or at $800,000.
Answer: We make the following points:
a. Given the optimal capital budget and thetarget capital structure, we must now determine the amount of equity needed tofinance the projects. Of the $800,000required for the capital budget, 0.6($800,000) = $480,000 must be raised asequity and 0.4($800,000) = $320,000 must be raised as debt if we are tomaintain the optimal capital structure:
Debt $320,000 40%
Equity 480,000 60%
$800,000 100%
b. If a residual exists--that is, if net incomeexceeds the amount of equity the company needs--then it should distribute theresidual amount out as either dividends or stock repurchases. For now, we assume all payouts are in theform of dividends. Since $600,000 ofearnings is available, and only $480,000 is needed, the residual is $600,000 -$480,000 = $120,000, so this is the amount which should be paid out asdividends. Thus, the payout ratiowould be $120,000/$600,000 = 0.20 = 20%.
c. If only $400,000 of earnings were available,the theoretical break point would occur at BP = $400,000/0.6 = $666,667. Assuming the intersection of the investmentopportunity set and marginal cost of capital was still at $800,000, the firmwould still need $480,000 of equity. Itshould then retain all of its earnings and also sell $80,000 of newstock. The residual policy would callfor a zero payment.
d. If $800,000 of earnings was available, thedividend would be increased to $800,000 - $480,000 = $320,000, and the payoutratio would rise to $320,000/$800,000 = 40%.
c. 2. Ingeneral terms, how would a change in investment opportunities affect the payoutratio under the residual payment policy?
Answer: A change in investment opportunities wouldlead to an increase (if investment opportunities were good) or a decrease (ifinvestment opportunities were not good) in the amount of equity needed, hencein the residual dividend payout.
c. 3. Whatare the advantages and disadvantages of the residual policy? (Hint: don’t neglect signaling and clienteleeffects.)
Answer: The primary advantage of the residual policyis that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence thecost of capital. Also, whatever negativesignals are associated with stock issues would be avoided.
However, if it were applied exactly, theresidual model would result in dividend payments which fluctuated significantlyfrom year to year as capital requirements and internal cash flowsfluctuated. This would (1) sendinvestors conflicting signals over time regarding the firm’s future prospects,and (2) since no specific clientele would be attracted to the firm, it would bean “orphan.” These signaling andclientele effects would lead to a higher required return on equity which wouldmore than offset the effects of lower flotation costs. Because of thesefactors, few if any publicly owned firms follow the residual model on ayear-to-year basis.
Even though the residual approach is notused to set the annual dividend, it is used when firms establish their long-rundividend policy. If “normalized” cost ofcapital and investment opportunity conditions suggest that in a “normal” yearthe company should pay out about 60 percent of its earnings, this fact will benoted and used to help determine the long-run policy.
d. What are stocksrepurchases? Discuss the advantages anddisadvantages of a firm’s repurchasing its own shares.
Answer: Afirm may distribute cash to stockholders by repurchasing its own stock ratherthan paying out cash dividends. Stockrepurchases can be used (1) somewhat routinely as an alternative to regulardividends, (2) to dispose of excess (nonrecurring) cash that came from assetsales or from temporarily high earnings, and (3) in connection with a capitalstructure change in which debt is sold and the proceeds are used to buy backand retire shares.
Advantagesof repurchases:
1. Arepurchase announcement may be viewed as a positive signal that managementbelieves the shares are undervalued.
2. Stockholdershave a choice--if they want cash, they can tender their shares, receive thecash, and pay the taxes, or they can keep their shares and avoid taxes. On the other hand, one must accept a cashdividend and pay taxes on it.
3. Ifthe company raises the dividend to dispose of excess cash, this higher dividendmust be maintained to avoid adverse stock price reactions. A stock repurchase, on the other hand, doesnot obligate management to future repurchases.
4. Repurchasedstock, called treasury stock, can be used later in mergers, whenemployees exercise stock options, when convertible bonds are converted, andwhen warrants are exercised. Treasurystock can also be resold in the open market if the firm needs cash. Repurchasescan remove a large block of stock that is “overhanging” the market and keepingthe price per share down.
5. Repurchasescan be varied from year to year without giving off adverse signals, whiledividends may not.
6. Repurchasescan be used to produce large-scale changes in capital structure.
Disadvantagesof repurchases:
1. Arepurchase could lower the stock’s price if it is taken as a signal that thefirm has relatively few good investment opportunities. On the other hand, though, a repurchase cansignal stockholders that managers are not engaged in “empire building,” wherethey invest funds in low-return projects.
2. Ifthe IRS establishes that the repurchase was primarily to avoid taxes ondividends, then penalties could be imposed. Such actions have been brought against closely held firms, but to ourknowledge charges have never been brought against publicly held firms.
3. Sellingshareholders may not be fully informed about the repurchase; hence they maymake an uninformed decision and may later sue the company. To avoid this, firms generally announcerepurchase programs in advance.
4. Thefirm may bid the stock price up and end up paying too high a price for theshares. In this situation, the sellingshareholders would gain at the expense of the remaining shareholders. Thiscould occur if a tender offer were made and the price was set too high, or ifthe repurchase was made in the open market and buying pressure drove the priceabove its equilibrium level.
e. Describe the series of stepsthat most firms take in setting dividend policy in practice.
Answer: Firmsestablish dividend policy within the framework of their overall financialplans. The steps in setting policy arelisted below:
1. The firm forecasts its annual capital budgetsand its annual sales, along with its working capital needs, for a relativelylong-term planning horizon, often 5 years.
2. Thetarget capital structure, presumably the one which minimizes the WACC whileretaining sufficient reserve borrowing capacity to provide “financingflexibility,” will also be established.
3. Withits capital structure and investment requirements in mind, the firm canestimate the approximate amount of debt and equity financing required duringeach year over the planning horizon.
4. Along-term target payout ratio is then determined, based on the residual modelconcept. Because of flotation costs andpotential negative signaling, the firm will not want to issue common stockunless this is absolutely necessary. Atthe same time, due to the clientele effect, the firm will move cautiously fromits past dividend policy, if a new policy appears to be warranted, and it willmove toward any new policy gradually rather than in one giant step.
5. An actual dollar dividend, say $2 per year,will be decided upon. The size of this dividend will reflect (1) the long-runtarget payout ratio and (2) the probability that the dividend, once set, willhave to be lowered, or, worse yet, omitted. If there is a great deal of uncertainty about cash flows and capitalneeds, then a relatively low initial dollar dividend will be set, for this willminimize the probability that the firm will have to either reduce the dividendor sell new common stock. The firm willrun its corporate planning model so that management can see what is likely tohappen with different initial dividends and projected growth rates under differenteconomic scenarios.
f. What are stock dividends andstock splits? What are the advantagesand disadvantages of stock dividends and stock splits?
Answer: When it uses a stock dividend, a firmissues new shares in lieu of paying a cash dividend. For example, in a 5 percent stock dividend,the holder of 100 shares would receive an additional 5 shares. In a stock split, the number of sharesoutstanding is increased (or decreased in a reverse split) in an actionunrelated to a dividend payment. Forexample, in a 2-for-1 split, the number of shares outstanding is doubled. A 100% stock dividend and a 2-for-1 stocksplit would produce the same effect, but there would be differences in theaccounting treatments of the two actions.
Both stock dividends and stock splitsincrease the number of shares outstanding and, in effect, cut the pie intomore, but smaller, pieces. If the dividend or split does not occur at the sametime as some other event which would alter perceptions about future cash flows,such as an announcement of higher earnings, then one would expect the price ofthe stock to adjust such that each investor’s wealth remains unchanged. For example, a 2-for-1 split of a stockselling for $50 would result in the stock price being cut in half, to $25.
It is hard to come up with a convincingrationale for small stock dividends, like 5 percent or 10 percent. No economic value is being created ordistributed, yet stockholders have to bear the administrative costs of thedistribution. Further, it isinconvenient to own an odd number of shares as may result after a small stockdividend. Thus, most companies todayavoid small stock dividends.
On the other hand, there is a goodreason for stock splits or large stock dividends. Specifically, there is a widespread beliefthat an optimal price range exists for stocks. The argument goes as follows: if a stock sells for about $20-$80, thenit can be purchased in round lots, hence at reduced commissions, by mostinvestors. A higher price would putround lots out of the price range of many small investors, while a stock pricelower than about $20 would convey the image of a stock that is doingpoorly. Thus, most firms try to keeptheir stock prices within the $20 to $80 range. If the company prospers, it will split its stock occasionally to holdthe price down. (Also, companies thatare doing poorly occasionally use reverse splits to raise their price.) Many companies do operate outside the $20 to$80 range, but most stay within it.
Another factor that may influence stocksplits and dividends is the belief that they signal management’s belief thatthe future is bright. If a firm’s management would be inclined to split thestock or pay a stock dividend only if it anticipated improvements in earningsand dividends, then a split/dividend action could provide a positive signal andthus boost the stock price. However, ifearnings and cash dividends did not subsequently rise,the price of the stock would fall back to its old level, or even lower, becausemanagers would lose credibility.
Interestingly, one of the most astuteinvestors of the 20th century, Warren Buffett, chairman of Berkshire-Hathaway,has never split his firm’s stock. Berkshire currently sells for over $89,000 per share, andits performance over the years has been absolutely spectacular. It may be that Berkshire’smarket value would be higher if it had a 425:1 stock split, or it may be thatthe conventional wisdom is wrong.
g. What is a dividend reinvestmentplan (drip), and how does it work?
Answer: Under a dividend reinvestment plan (DRIP),shareholders have the option of automatically reinvesting their dividends inshares of the firm’s common stock. In anopen market purchase plan, a trustee pools all the dividends to bereinvested and then buys shares on the open market. Shareholders use the dripfor three reasons: (1) brokerage costsare reduced by the volume purchases, (2) the drip is a convenient way to investexcess funds, and (3) the company generally pays all administrative costsassociated with the operation.
In a new stock plan, the firmissues new stock to the DRIP members in lieu of cash dividends. No fees are charged, and many companies evenoffer the stock at a 5 percent discount from the market price on the dividenddate on the grounds that the firm avoids flotation costs that would otherwisebe incurred. Only firms that need newequity capital use new stock plans, while firms with no need for new stock usean open market purchase plan.
18-4 The company requires 0.40($1,200,000) =$480,000 of equity financing. If thecompany follows a residual dividend policy it will retain $480,000 for itscapital budget and pay out the $120,000 “residual” to its shareholders as adividend. The payout ratio wouldtherefore be $120,000/$600,000 = 0.20 = 20%.
18-7 Capitalbudget should be $10 million since Project M shouldn’t be taken (WACC>IRR). Weknow that 50% of the $10 million should be equity. Therefore, the company should pay dividendsof:
Dividends =Net income - needed equity
=$7,287,500 - $5,000,000 = $2,287,500.
Payoutratio =$2,287,500/$7,287,500 = 0.3139 = 31.39%.
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