However, their finding is valid only if investors expect managers to ultimately pay out the equivalent of the present value of all future free cash flows; see Harry DeAngelo and Linda DeAngelo, "The Irrelevance of the MM Dividend Irrelevance Theorem," Journal of Financial Economics, Vol. Ghon Rhee, “The Impact of Personal Taxes on Corporate Dividend Policy and Capital Structure Decisions,” Financial Management, Summer 1990, p.
I MPLICATIONS FOR D IVIDEND S TABILITY
Companies that increased their dividends experienced profit increases in the years leading up to the increase, but did not appear to experience any profit increases afterward. Furthermore, a relatively large number of companies that expect a large permanent increase in cash flow (as opposed to profits) actually increase their dividend payments in the year preceding the increase in cash flow.
In contrast, if the firm's investment opportunities are average, its optimal capital budget would rise to $70 million. One year a company might not distribute funds because it needs cash to finance good investment opportunities, and the next year it might make a large distribution because investment opportunities are bad, so it doesn't need to hold much back.
T HE R ESIDUAL D ISTRIBUTION M ODEL IN P RACTICE
In addition, since required equity exceeds retained earnings, the company should issue some new common stock to maintain the target capital structure. Because investment opportunities and earnings are bound to vary from year to year, consistent adherence to a residual distribution policy would result in unstable distributions. Similarly, fluctuating earnings can result in volatile distributions even if investment opportunities have been stable.
Self-test Explain the logic of the residual dividend model and the steps a company would take to implement it. Firms should therefore use the residual policy to help determine their long-term target distribution ratios, but not as a guideline for distribution in any one year. Companies often use financial forecasting models in conjunction with the residual distribution model discussed here to help understand the determinants of an optimal dividend policy.
Self Test Why is the residual model used more often to set a long-term payout target than to set the actual year-to-year dividend payout ratio.
Note that there would be an arbitrage opportunity if the share price did not fall by the DPS amount. But if everyone tried to use this strategy, the increased demand would drive up the stock price on December 30 until it was no longer reliable FIGURE 1 4 - 4 Illustration of the Residual Distribution Model Used for the Benson Conglomerate ($Millions): Valuation Analysis. The opposite would happen if investors expected the share price to fall by more than the DPS.21.
Here's an important observation: Even if the stock price goes down, shareholder wealth doesn't go down. The key to solving this added complexity is to recognize that the buyback does not change the stock price. Generating cash can certainly change the share price, but the buyback itself does not change the share price.
Empirical evidence suggests that the actual decline in the share price is approximately 90% of the DPS, with all pre-tax profits stripped out by taxes. This decrease in the intrinsic value of equity equals the amount of money spent on the repurchase, $671.6. Self-Test Explain how a repurchase changes the number of shares but not the share price.
T HE P ROS AND C ONS OF D IVIDENDS AND R EPURCHASES
The firm has $12 million in short-term investments that it plans to liquidate and then distribute in a stock buyback; the company has no other financial investments or debt. Immediately before the repurchase, what is the intrinsic value of the equity and the share price?($40 million; $20/share)How many shares will be repurchased?(0.6 million)How many shares will remain after the repurchase?( 1.4 million ) Immediately after the buyback, what is the intrinsic value of the equity and the share price? ($28 million; $20/share). This procedure, which Florida Power & Light used, has much to recommend it, and it is one of the reasons for the dramatic increase in the total volume of stock buybacks.
Shareholders may not be indifferent between dividends and capital gains, and the share price could benefit more from cash dividends than from buybacks. If the company wants to acquire a relatively large portion of its shares, the price may be bid above its equilibrium level and then fall after the company ceases its buyback operations. Because of the deferred tax on capital gains, buybacks have a tax advantage over dividends as a way to distribute income to shareholders.
The danger of signaling effects requires that a company not have volatile dividend payments, which would reduce investor confidence in the company and negatively impact the cost of equity and the stock price.
O THER F ACTORS I NFLUENCING D ISTRIBUTIONS
Thus, if the IRS can demonstrate that a firm's dividend payout ratio is being deliberately lowered to help its shareholders avoid personal taxes, the firm is subject to heavy penalties. If a company needs to finance a given level of investment, it can raise equity by retaining earnings or by issuing new common stock. If flotation costs (including any negative signaling effects of an equity offering) are high, relative to
On the other hand, a high dividend payout ratio is more likely for a firm whose flotation costs are low. Flotation costs vary between firms - for example, the flotation rate is generally higher for small firms, so they tend to set low payout ratios. As described earlier, low stock flotation costs allow for a more flexible dividend policy because capital can be raised either by retaining earnings or by selling new shares.
If management is concerned about maintaining control, it may be reluctant to sell new shares; therefore, the company can retain more revenue than it otherwise would.
S UMMARIZING THE D ISTRIBUTION P OLICY D ECISION
A similar situation applies to debt policy: if the firm can adjust its debt ratio without significantly increasing costs, then it can pay the expected dividend - even if profits fluctuate - by increasing its debt ratio. Thus, in determining allocation policy, managers must begin by considering the firm's future investment opportunities relative to its anticipated internal sources of funds. Since it is better to avoid issuing new common stock, the target long-term payout ratio should be designed to allow the firm to meet all of its equity capital requirements with retained earnings.
Therefore, the actual pay ratio in any year is likely to be above or below the firm's long-term target. However, the dollar dividend should be maintained or increased as planned unless the firm's financial condition deteriorates to the point where the planned policy simply cannot be sustained. A steady or increasing stream of dividends over the long term signals that the firm's financial condition is under control.
If there is significant uncertainty regarding the free cash flow forecasts, defined here as the company's operating cash flow minus mandatory equity investments, then it is best to be conservative and set a lower current dollar dividend .
S TOCK S PLITS AND S TOCK D IVIDENDS
Stock dividends are similar to stock splits in that they "divide the pie into smaller slices" without affecting the underlying position of current shareholders. Stock splits are usually used after a sharp rise in price to produce a large decline in price. Note, however, that small stock dividends create accounting problems and unnecessary expenses, so firms today use stock splits much more often than stock dividends.25.
However, these price increases are probably due to signaling rather than a desire for a share split or dividend per se. This means that it is more expensive to trade low-priced than high-priced stocks—which in turn means that stock splits can reduce the liquidity of a company's stock. All in all, it probably makes sense to use a stock split (or stock dividend) when a company's outlook is favorable, especially if the price of its stock has gone beyond its normal trading range.27.
Powell, “The Stock Distribution Puzzle: A Synthesis of the Literature on Stock Splits and Stock Dividends,” Financial Practice and Education, Spring/Summer 1995, p.
D IVIDEND R EINVESTMENT P LANS
If the company follows a residual distribution model and pays all distributions as dividends, what will be its payout ratio. Assuming that the stock split will have no effect on the total market value of its shares, what will the company's stock price be after the stock split. The company's target capital structure is 60% equity and 40% debt, it has 1 million common shares.
If Buena Terra follows the residual model with all distributions in the form of dividends, what will the company's dividend per share and payout ratio be for the coming year. In addition, the company wants to maintain its target capital structure (60% equity, 40% debt) and its $10 million capital budget. The company is willing to cut its capital budget to meet its other goals.
Assuming that the company's projects are divisible, what will the company's capital budget be for next year.
M ICROSOFT ’ S D IVIDEND P OLICY
Start with the partial model in fileCh14 P13 Build a Model.xl on the textbook website. Fill in the missing values in the balance sheet column of the file for July 1, 2011, named Distribute as Dividends. Fill in the missing values in the balance sheet column of the file for July 1, 2011, named Distribute as Repurchase.
In the text, we point out that dividends are often much more stable than profits. In the Interim Financial Data section of the FULL COMPANY REPORT, specify the dividend announcement date, previous dividend date and payment date. The founders of SSC, Donald Brown and Margo Valencia, were employed in the research department of a large integrated steel company, but when that company decided not to use the new process (developed by Brown and Valencia), they decided to stepped out of its own.
Until now, Brown and Valencia had paid themselves reasonable salaries, but regularly reinvested all after-tax earnings in the firm, so dividend policy was not an issue.
