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Dividend Irrelevance Theory, Bird-in-the-Hand Theory, Tax Preference Theory are discussed in this lecture.
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Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases
When deciding how much cash to distribute to stockholders, financial managers must keep in mind that the firm’s objective is to maximize shareholder value. Thus, the target payout ratio should be based on investor preferences for cash dividends or capital gains. If the firm increases the payout ratio, D1 will increase, resulting in a higher stock price other things being equal.
What is “dividend policy”? It’s the decision to pay out earnings versus retaining and reinvesting them. Includes these elements:
Dividends are irrelevant: Investors don’t care about payout. Bird in the hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth.
Bird-in-the-Hand Theory Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high P 0
Tax Preference Theory Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to 39.6%. Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low P 0
Possible Stock Price Effects Stock Price ($) 50% 100% Payout 40 30 20 10 Bird-in-Hand Irrelevance Tax preference 0
Possible Cost of Equity Effects Cost of equity (%) 50% 100% Payout 15 20 10 Tax Preference Irrelevance Bird-in-Hand 0
Managers 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. Therefore, a stock price increase at time of a dividend increase could reflect higher expectations for future dividends themselves, not to a change in the dividend payout policy.
What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend policies. The dividend clientele effect states that high- tax bracket investors (like individuals) prefer low dividend payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. So different groups desire different levels of dividends. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.
Using the Residual Model to Calculate Dividends Paid Dividends = –. Net income Target equity ratio Total capital budget
Data for SSC Capital budget: $800,000. Given. Target capital structure: 40% debt, 60% equity. Want to maintain. Forecasted net income: $600,000. How much of the $600,000 should we pay out as dividends?
NI = $400,000: Need $480,000 of equity, so should retain the whole $400,000. Dividends = 0. NI = $800,000: Dividends = $800,000 – $480,000 = $320,000. Payout = $320,000/$800,000 = 40%.
How would a change in investment opportunities affect dividend under the residual policy? Fewer good investments would lead to smaller capital budget, hence to a higher dividend payout. More good investments would lead to a lower dividend payout.