Dividend Policy and retained Earnings

Dividend Policy and Retained Earnings.

Introduction.

Successful companies earn income. That income can then be reinvested in operating assets, used to acquire securities, used to retire debt, or distributed to stockholders.

            If the decision is made to distribute income to stockholders, three key issues arise:-

1.      What percentage should be distributed

2.      Should the distribution be as cash dividends or should the cash be passed on to shareholders by buying back some of the stock they hold.

3.      How stable should the distribution be that is, should the funds paid out from year to year be stable and dependable, which stockholders would probably prefer, or be allowed to vary with the firms cash flows and investment requirements.

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 shareholders value. Consequently, the target payout ratio which is defined as the percentage of net income to be paid out as cash dividends. So the target payout ratio 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 preferences can be considered in terms of the constant growth stock valuation model:

                        Po = D1

                                ---------

                            Ks-g

Where: Po is price of a share of stock today

            D1 is dividend per share of stock

            Ks is cost of retained earnings or required rate of return on equity.

            G is growth rate in earnings, dividends and stock prices.

If the company increases the payout ratio, it 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 re-investment, that will cause the expected growth rate to decline, and that would 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 so as to maximize the stock price.

            Optimal dividend policy.  The dividend policy that strikes a balance between current dividends and future growth and maximizes the firm’s stock price.

Investor Preference.

In this section we will examine three theories of investor preference:

1.      The dividend irrelevance theory

2.      The “bird-in-the-hand” theory

3.      The tax preference theory.

Dividend Irrelevance Theory.

            It has been argued that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. If dividend policy has no significance effects, then it would be irrelevant.  This theory therefore states that “a firm’s dividend policy has no effect on either its value or its cost of capital. 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.

            To understand MM’s argument that dividend policy is irrelevant, recognize that any shareholder can construct his or her own dividend policy. For example if a firm does not pay dividends, a shareholder who wants a 5 percent dividend can create it by selling 5 percent of his or her stock. Conversely, if a company pays a higher dividend than an investor desires, the investor can use the unwanted dividends  to buy additional shares of the company’s stock.

            Note, though, that investors who want additional dividends must incur brokerage costs to sell shares, and investors who do not want dividends must first pay taxes on the unwanted dividends and then incur brokerage costs to purchase shares with the after tax dividends. Since taxes and brokerage costs certainly exist, dividend policy may well be relevant.

Bird-in-the-Hand Theory.

            The principal conclusion of MM’s dividend irrelevance theory is that dividend policy does not affect the required rate of return on equity, Ks. 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 which are supposed to result from retaining earnings than they are of receiving dividend payments. MM called the Gordon- Lintner argument the Bird-in-the-hand fallacy because, in MM’s views, most investors plan to reinvest their dividends in the stock of the same or similar firms and in any event, the riskiness of the firm’s cash flows to investors, in the long run is determined by the riskiness of operating cash flows, not by dividend payout policy.

Tax Preference Theory.

There are three tax related reasons for thinking that investors might prefer a low dividend payout to a high payout:

a)      It should be noted that long term capital gains are taxed at a maximum rate of 28%, whereas dividend income is taxed at effective rates which go up to 36.6% in the USA. Therefore, wealthy investors who own most of the stock and receive most of the dividends might prefer to have companies retained and plow earnings back into the business.

b)      Taxes are not paid on the gain until a stock is sold. Due to time effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today.

c)      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.

Because of these tax advantages, investors may prefer to have companies retain most of their earnings. If so, investors would be willing to pay more for low-payout companies than for otherwise similar high payout companies.

USING EMPIRICAL EVIDENCE TO DECIDE WHICH THEORY IS BEST.

These three theories offer contradictory advice to corporate managers, so which, if any, should we believe?. The most logical way to proceed is to test the theories empirically. Many such tests have been conducted, but their results have been unclear. There are two reasons for this:

1.      For a valid statistical test, things other than dividend policy must be held constant, that is, the sample companies must differ only  in their dividend policies and

2.      We must be able to measure with a high degree of accuracy each sample firm’s cost of equity. Neither of these two conditions holds. We cannot find a set of publicly owned firms that differ only in their dividend policies, nor can we obtain precise estimates of the cost of equity.

Therefore, no one can establish a clear relationship between dividend policy and the cost of equity. Investors cannot be seen to uniformly prefer either higher or lower dividends. Nevertheless, individual investors do have strong preferences. Some prefer high dividends, while others prefer all capital gains. These differences among individuals help explain why it is difficult to reach any definitive conclusions regarding the optimal dividend payout. Even so, both evidence and logic suggest that investors prefer firms which follow a stable, predictable dividend policy regardless of the payout level.

OTHER DIVIDEND POLICY ISSUES

INFORMATION CONTENT, OR SIGNALING, HYPOTHESIS.

      When MM set forth their dividend irrelevance theory, they assumed that everyone that is investors and managers alike has identical information regarding the firm’s future earnings and dividend. In reality, however, different investors have different views on both the level of future dividend payments and the uncertainty inherent in those payments, and managers have better information about future prospects than public stockholders. However, MM argued differently, they noted the well established fact that corporations  are reluctant to cut dividends, hence do not raise dividends unless they anticipate higher earnings in the future. Thus, MM argued that a higher-than-expected dividend increase is a signal to investors that the firm’s management forecasts good future earnings. Conversely, a dividend reduction or a smaller-than-expected increase, is a signal that management is forecasting poor earnings in the future. MM further argued again that, price changes following dividend actions simply indicate that there is an important information, or signaling, content in dividend announcements.

CLIENTELE EFFECT.

      As indicated earlier different groups or clienteles, of stockholders prefer different dividend payout policies. For example, retired individuals generally prefer cash income, so they may want the firm to pay out a high percentage of its earnings. Therefore clientele effect is the tendency of a firm to attract a set of investors who like its dividend policy.

      It is worth noting that a firm can change from one dividend payout policy to another and then let stockholders who do not like the new policy sell to other investors who do. However frequent switching would be inefficient because of-

1.      Brokerage costs

2.      The likelihood that stockholders who are selling will have to pay capital gains taxes and

3.      A possible shortage of investors who like the firm’s newly adopted dividend policy.

Thus management should hesitant to change its dividend policy, because a change might cause current shareholders to sell their stock, forcing the stock price down. Such a price decline might be temporary, but it might also be permanent. Of course the new policy might attract an even larger clientele than the firm had before, in which case the stock price would rise.

DIVIDEND STABILITY.

      The stability of dividends is also important. Profits and cash flows vary over time, as do investment opportunities. Taken alone, this suggests that corporations should vary their dividends over time, increasing them when cash flows are large and the need for funds is low and lowering them when cash is in short supply relative to investment opportunities. However may stockholders rely on dividend to meet expenses and they would be seriously inconvenienced if the dividend stream were unstable. Further, reducing dividends to make funds available for capital investment could send incorrect signals, and that could drive down stock prices. Thus maximizing its stock price requires a firm to balance its internal needs for funds against the needs and desires of its stockholders.