Financial Management

Financial Management

This course contains the basics of Financial Management

Course introduction
Test Your Caliber
Interview Questions
Pragnya Meter Exam

Financial Management

Dividend Policy

Key Chapter Concepts

  1. Dividend policy determines the ultimate distribution of the firm’s earnings between retention (that is, reinvestment) and cash dividend payments to shareholders.
  2. Factors influencing the firm’s choice of a dividend policy are examined, including
    a. Legal constraints
    b. Restrictive covenants
    c. Tax considerations
    d. Liquidity considerations
    e. Borrowing capacity and access to the capital markets
    f. Earnings stability
    g. Growth prospects
    h. Inflation
    i. Shareholder preferences
    j. Protection against dilution
  3. Alternative dividend policies include
    a. Passive residual approach
    b. Stable dollar dividend approach
    c. Constant payout ratio approach
    d. Policy of paying a small, regular dividend plus year-end extras
  4. Other important topics include
    a. How dividends are paid
    b. Stock dividends
    c. Stock splits
    d. Share repurchase as a dividend decision

Financial Challenge

Cisco Systems Shareholders Reject a Dividend Payout Proposal

Cisco Systems, Inc., is the leading supplier of Internet -working products used for linking local-area and wide-area computer networks. Its primary products include routers,ATM and LAN switches, servers, and network management software. Since its founding in 1984 by a group of Stanford computer scientists, Cisco has never paid a dividend. Its earnings per share have grown from $0.07 in 1994 to an estimated $0.70 in 2004.

In late 2002, Cisco was sitting on $21 billion dollars of cash and marketable securities. Cisco generates nearly $1 billion dollars of cash flow from operations each quarter.With this large cash horde and the continuing ability to generate even more cash, some investors began to agitate for Cisco to begin paying a dividend.At Cisco’s annual meeting, many small investors spoke in favor of a dividend. One investor said,“You know you’re getting something. Growth is fine, but at the moment it’s not doing me much good.”

Analysts, investors, and management indicated in the discussion that when a company begins to pay dividends, it is making a signal to the market regarding its ability to productively use the cash generated by the firm. While many value investors would prefer to receive a dividend, other investors believe that the payment of a dividend will be viewed as a signal that future growth is likely to be reduced.

Cisco executives indicated that they would prefer to use the cash flow to continue to buy back shares, to finance equipment leases, to acquire other companies in possession of new technologies, and to expand research and development. The matter of beginning dividend payouts was brought to a vote of shareholders in late 2002. By a ratio of 10 to 1, Cisco stockholders voted against a proposal that would have directed the board of directors to seriously consider the initiation of a quarterly dividend. The outcome of the vote was closely watched by investors in high-tech companies for dividends versus share repurchases and/or reinvestment.

This decision illustrates some of the important dividend policy issues that must be considered by management, including shareholder preferences, signaling effects of dividend policy changes, tax consequences, earnings stability, and growth prospects. These issues are discussed in this chapter.

Introduction

The value of a firm is influenced by three types of financial decisions:

  • Investment decisions
  • Financing decisions
  • Dividend decisions

Although each is presented as a separate topic in this and most financial management textbooks, these three types of financial decisions are interdependent in a number of ways. For example, the investments made by a firm determine the level of future earnings and future potential dividends; capital structure influences the cost of capital, which determines, in part, the number of acceptable investment opportunities; and dividend policy influences the amount of equity capital in a firm’s capital structure (via the retained earnings account) and, by extension, influences the cost of capital. In making these interrelated decisions, the goal is to maximize shareholder wealth.

Consider the following dividend decisions:

  1. During 1998, Kerr-McGee Corporation paid out $1.80 per share in common stock dividends, despite earning only $1.06 per share. In early 1999 Kerr -McGee’s stock fell to its lowest level in over 10 years. It has maintained the $1.80/share dividend through 2004.
  2. During 2000, Sun Microsystems had record earnings of $0.51 per share. The company has never paid a dividend. Sun’s stock price was near its all -time high. By mid-2004, Sun was trading at less than 10 percent of its all -time high price.
  3. In January 1997, General Motors announced an increase in its quarterly cash dividend by 25 percent from $0.40 to $0.50 per share, along with plans to repurchase up to $2.5 billion of its common stock (or more than 5 percent of the total outstanding) over the next 12 months.
  4. During 1992, General Motors paid out approximately $990 million ($1.40 per share) in common stock dividends (a decrease in stockholders’ equity) while, during the same period, the company sold $2.145 billion in new common stock (an increase in stockholders’ equity) and incurred $53.625 million in issuance costs.
  5. In addition to regular cash dividends, Huntington Bank has paid stock dividends (i.e., additional shares of common stock), during 13 of the past 20 years. These dividend decisions raise a number of important questions, such as:
  1. Is Kerr -McGee’s dividend policy more consistent with shareholder wealth maximization than Sun’s dividend policy? Is one dividend policy necessarily optimal for all firms?
  2. Why did Kerr -McGee pay a common stock dividend in excess of its earnings? Alternatively, would not a reduction of its dividend have been a more prudent strategy because it would conserve cash (i.e., reduce cash outflows) during this period of economic difficulty?
  3. Why did General Motors pay common stock dividends and incur the issuance costs of selling new common stock during the same time period? As an alternative to issuing new common stock, why didn’t General Motors reduce its common stock dividend temporarily until it accumulated the amount of equity funds it planned to raise externally?
  4. Why does Huntington Bank pay stock dividends when the net effect of these transactions is that total stockholders’ equity remains unchanged and each shareholder’s proportionate claim on the firm’s total earnings remains constant?
  5. What are the advantages to General Motors and its shareholders of the $2.5 billion stock repurchase program compared with paying shareholders an equivalent amount of cash dividends?
  6. Finally, on a more fundamental level, does it really matter, with respect to the maximization of shareholder wealth, what amount (or percentage of earnings) a firm pays out in dividends?

In this chapter, we seek to answer dividend policy questions such as these. This chapter begins by examining the factors that influence a company’s choice of dividend policy. Next, it considers the pros and cons of a number of different dividend policies. And, finally, it discusses the mechanics of dividend payments, along with stock dividends and share repurchase plans.

Determinants of Dividend Policy

Dividend policy determines how the earnings of a company are distributed. Earnings are either retained and reinvested in the company or are paid out to shareholders. In recent years, the retention of earnings has been a major source of equity financing for private industry. In 2003, corporations retained more than $122 billion in earnings while paying dividends of about $409 billion. Retained earnings are the most important source of equity. Retained earnings can be used to stimulate growth in future earnings and as a result can influence future share values. On the other hand, dividends provide stockholders with tangible current returns.

Industry and Company Variations in Dividend Payout Ratios

Dividend payout policies vary among different industries. As shown in Table 15.1, there is a wide variation in dividend payout ratios among different industries, ranging from 0 to 70 percent. Likewise, within a given industry, while many firms may have similar dividend payout ratios, there can still be considerable variation. For example, as illustrated in Table within the tobacco industry, the dividend payout ratios are in the 32.8 to 85.2 percent range. Within the basic chemical industry, the variation in dividend payout ratios ranges from 0 to 133.3 percent. This section examines some of the more important factors that combine to determine the dividend policy of a firm.

Legal Constraints

Most states have laws that regulate the dividend payments a firm chartered in that state can make. These laws basically state the following:

  • A firm’s capital cannot be used to make dividend payments.
  • Dividends must be paid out of a firm’s present and past net earnings.
  • Dividends cannot be paid when the firm is insolvent.

The first restriction is termed the capital impairment restriction. In some states, capital is defined as including only the par value of common stock; in others, capital is more broadly defined to also include the contributed capital in excess of par account (sometimes called capital surplus). For example, consider the following capital accounts on the balance sheet of Johnson Tool and Die Company:

If the company is chartered in a state that defines capital as the par value of common stock, then it can pay out a total of $600,000 ($1,100,000 – $500,000 par value) in dividends. If, however, the company’s home state restricts dividend payments to retained earnings alone, then Johnson Tool and Die could only pay dividends up to $200,000. Regardless of the dividend laws, however, it should be realized that dividends are paid from a firm’s cash account with an offsetting entry to the retained earnings account.

The second restriction, called the net earnings restriction, requires that a firm have generated earnings before it is permitted to pay any cash dividends. This prevents the equity owners from withdrawing their initial investment in the firm and impairing the security position of any of the firm’s creditors. The third restriction, termed the insolvency restriction, states that an insolvent company may not pay cash dividends. When a company is insolvent, its liabilities exceed its assets.

Payment of dividends would interfere with the creditors’ prior claims on the firm’s assets and therefore is prohibited.

Dividend Payout Ratios for Selected Industries

These three restrictions affect different types of companies in different ways. New firms, or small firms with a minimum of accumulated retained earnings, are most likely to feel the weight of these legal constraints when determining their dividend policies, whereas well -established companies with histories of profitable performance and large retained earnings accounts are less likely to be influenced by them.

Dividend Payout Ratios for Firms in the Tobacco 

Restrictive Covenants

Restrictive covenants generally have more impact on dividend policy than the legal constraints just discussed. These covenants are contained in bond indentures, term loans, short-term borrowing agreements, lease contracts, and preferred stock agreements. These restrictions limit the total amount of dividends a firm can pay.

Sometimes they may state that dividends cannot be paid at all until a firm’s earnings have reached a specified level. For example, the 3.75 percent preferred stock issues (Series B) of Dayton Power & Light limits the amount of common stock dividends that can be paid if the company’s net income falls below a certain level. In a dividend policy study of 80 troubled firms that cut dividends, researchers found that more than half of the firms apparently faced binding debt covenants in the years managers reduced dividends.

In addition, sinking fund requirements, which state that a certain portion of a firm’s cash flow must be set aside for the retirement of debt, sometimes limit dividend payments. Also, dividends may be prohibited if a firm’s net working capital (current assets less current liabilities) or its current ratio does not exceed a certain predetermined level.

Tax Considerations

At various times, the top personal marginal tax rates on dividend income have been higher than the top marginal tax rates on long -term capital gains income. At other times, the two top marginal tax rates have been equal. For example, prior to the 1986 Tax Reform Act, the top marginal tax rate on dividend income was 50 percent compared with 20 percent on long-term capital gains income. The 1986 Tax Reform Act eliminated this differential by taxing both dividend and capital gains income at the same marginal rate.

The Revenue Reconciliation Act of 1993 created new top marginal tax rates of 39.6 percent for dividend income and 28 percent for capital gains income for individual taxpayers.More recently, the Taxpayer Relief Act of 1997 lowered the maximum long -term capital gains rate for individuals to 20 percent and the Economic Growth and Tax Relief Reconciliation Act of 2001 reduced the top marginal tax rate on dividend income to 38.6 percent for 2002–2003. The 2003 Tax Reduction Act cut the tax rate on dividend income to 15 percent, the same as the new tax rate on capital gains income.

In spite of this equalization of tax rates on dividend and capital gains income, a tax disadvantage of dividends versus capital gains exists in that dividend income is taxed immediately (in the year it is received), but capital gains income (and corresponding taxes) can be deferred into the future. If a corporation decides to retain its earnings in anticipation of providing growth and future capital appreciation for its investors, the investors are not taxed until their shares are sold. Consequently, for most investors, the present value of the taxes on future capital gains income is less than the taxes on an equivalent amount of current dividend income. The deferral of taxes on capital gains can be viewed as an interest-free loan to the investor from the government.

Whereas the factors just explained tend to encourage corporations to retain their earnings, the IRS Code —specifically Sections 531 through 537—has the opposite effect. In essence, the code prohibits corporations from retaining an excessive amount of earnings to protect stockholders from paying taxes on dividends received. If the IRS rules that a corporation has accumulated excess earnings to protect its stockholders from having to pay personal income taxes on dividends, the firm has to pay a heavy penalty tax on those earnings. It is the responsibility of the IRS to prove this allegation, however.

Some companies are more likely to raise the suspicions of the IRS than others. For example, small closely held corporations whose shareholders are in high marginal tax brackets, firms that pay consistently low dividends, and those that have large amounts of cash and marketable securities are good candidates for IRS review.

Liquidity and Cash Flow Considerations

Recall from the previous chapter that free cash flow represents the portion of a firm’s cash flows available to service new debt, make dividend payments to shareholders, and invest in other projects. Since dividend payments represent cash outflows, the more liquid a firm is, the more able it is to pay dividends. Even if a firm has a past record of high earnings that have been reinvested, resulting in a large retained earnings balance, it may not be able to pay dividends unless it has sufficient liquid assets, primarily cash. For example, Corning, which had paid cash dividends continuously since 1945, eliminated its $0.06 per share quarterly dividend during the economic downturn of 2001.

The company was faced with a shriveling market for fiber-optic components, massive ($5.1 billion) write-downs of inventory and goodwill, and reduced cash flows. Liquidity is likely to be a problem during a long business downturn, when both earnings and cash flows often decline. Rapidly growing firms with many profitable investment opportunities also often find it difficult to maintain adequate liquidity and pay dividends at the same time.

Borrowing Capacity and Access to the Capital Markets

Liquidity is desirable for a number of reasons. Specifically, it provides protection in the event of a financial crisis. It also provides the flexibility needed to take advantage of unusual financial and investment opportunities. There are other ways of achieving this flexibility and security, however.

For example, companies frequently establish lines of credit and revolving credit agreements with banks, allowing them to borrow on short notice.Large well -established firms are usually able to go directly to credit markets with either a bond issue or a sale of commercial paper. The more access a firm has to these external sources of funds, the better able it will be to make dividend payments.

A small firm whose stock is closely held and infrequently traded often finds it difficult (or undesirable) to sell new equity shares in the markets. As a result, retained earnings are the only source of new equity.When a firm of this type is faced with desirable investment opportunities, the payment of dividends is often inconsistent with the objective of maximizing the value of the firm.

Earnings Stability

Most large widely held firms are reluctant to lower their dividend payments, even in times of financial stress. Therefore, a firm with a history of stable earnings is usually more willing to pay a higher dividend than a firm with erratic earnings.

A firm whose cash flows have been more or less constant over the years can be fairly confident about its future and frequently reflects this confidence in higher dividend payments.

Growth Prospects

A rapidly growing firm usually has a substantial need for funds to finance the abundance of attractive investment opportunities. Instead of paying large dividends and then attempting to sell new shares to raise the equity investment capital it needs, this type of firm usually retains larger portions of its earnings and avoids the expense and inconvenience of public stock offerings. Table illustrates the relationship between earnings growth rates and dividend payout ratios for selected companies. Note that the companies with the highest dividend payout ratios tend to have the lowest growth rates and vice versa.

Inflation

In an inflationary environment, funds generated by depreciation often are not sufficient to replace a firm’s assets as they become obsolete. Under these circumstances, a firm may be forced to retain a higher percentage of earnings to maintain the earning power of its asset base. Inflation also has an impact on a firm’s working capital needs. In an atmosphere of rising prices, actual dollars invested in inventories and accounts receivable tend to increase to support the same physical volume of business.

And, because the dollar amounts of accounts payable and other payables requiring cash outlays are higher with rising prices, transaction cash balances normally have to be increased. Thus, inflation can force a firm to retain more earnings as it attempts to maintain its same relative preinflation working capital position.

Recent Dividend Payout Ratios and Earnings Growth

Shareholder Preferences

In a closely held corporation with relatively few stockholders, management may be able to set dividends according to the preferences of its stockholders. For example, assume that the majority of a firm’s stockholders are in high marginal tax brackets. They probably favor a policy of high earnings retention, resulting in eventual price appreciation, over a high payout dividend policy.

However, high earnings retention implies that the firm has enough acceptable capital investment opportunities to justify the low payout dividend policy. In addition, recall that the IRS does not permit corporations to retain excessive earnings if they have no legitimate investment opportunities. Also, a policy of high retention when investment opportunities are not available is inconsistent with the objective of maximizing shareholder wealth.

In a large corporation whose shares are widely held, it is nearly impossible for a financial manager to take individual shareholders’ preferences into account when setting dividend policy. Some wealthy stockholders who are in high marginal income tax brackets may prefer that a company reinvest its earnings (i.e., low payout ratio) to generate long -term capital gains. Other shareholders, such as retired individuals and those living on fixed incomes (sometimes referred to as “widows and orphans”), may prefer a high dividend rate.

These shareholders may be willing to pay a premium for common stock in a compan that provides a higher dividend yield. Large institutional investors that are in a zero income tax bracket, such as pension funds, university endowment funds, philanthropic organizations (e.g., Ford Foundation), and trust funds, may prefer a high dividend yield for reasons different from those of private individual stockholders. First, endowment and trust funds are sometimes prohibited from spending the principal and must limit expenditures to the dividend (and/or interest) income generated by their investments.

Second, pension and trust funds have a legal obligation to follow conservative investment strategies, which have been interpreted by the courts to mean investments in companies that have a record of regular dividend payments. It has been argued that firms tend to develop their own “clientele” of investors. This clientele effect, originally articulated by Merton Miller and Franco Modigliani, indicates that investors will tend to be attracted to companies that have dividend policies consistent with the investors’ objectives.

Some companies, such as public utilities, that pay out a large percentage (typically 70 percent or more) of their earnings as dividends have traditionally attracted investors who desire a high dividend yield. In contrast, growth-oriented companies, which pay no (or very low) dividends, have tended to attract investors who prefer earnings retention and greater price appreciation. Empirical studies generally support the existence of a dividend clientele effect.

Protection Against Dilution

If a firm adopts a policy of paying out a large percentage of its annual earnings as dividends, it may need to sell new shares of stock from time to time to raise the equity capital needed to invest in potentially profitable projects. If existing investors do not or cannot acquire a proportionate share of the new issue, their percentage ownership interest in the firm is diluted. Some firms choose to retain more of their earnings and pay out lower dividends rather than risk dilution.

One of the alternatives to high earnings retention, however, involves raising external capital in the form of debt. This increases the financial risk of the firm, ultimately raising the cost of equity capital and at some point lowering share prices.If the firm feels that it already has an optimal capital structure, a policy of obtaining all external capital in the form of debt is likely to be counterproductive, unless sufficient new equity capital is retained or acquired in the capital markets to offset the increased debt.

Dividend Policy and Firm Value

There are two major schools of thought among finance scholars regarding the effect dividend policy has on a firm’s value. Although Miller and Modigliani argue that dividend policy does not have a significant effect on a firm’s value,11 Myron Gordon, David Durand, and John Lintner have argued that it does. Each viewpoint is discussed in this section.

Arguments for the Irrelevance of Dividends

The group led by Miller and Modigliani (MM) contends that a firm’s value is determined solely by its investment decisions and that the dividend payout ratio is a mere detail. They maintain that the effect of any particular dividend policy can be exactly offset by other forms of financing, such as the sale of new common equity shares. This argument depends on a number of key assumptions, however, including the following:

  • No taxes. Under this assumption, investors are indifferent about whether they receive either dividend income or capital gains income.
  • No transaction costs. This assumption implies that investors in the securities of firms paying small or no dividends can sell at no cost any number of shares they wish in order to convert capital gains into current income.
  • No issuance costs. If firms did not have to pay issuance costs on the issue of new securities, they could acquire needed equity capital at the same cost, regardless of whether they retained their past earnings or paid them out as dividends. The payment of dividends sometimes results in the need for periodic sales of new stock.
  • Existence of a fixed investment policy. According to MM, the firm’s investment policy is not affected by its dividend policy. Furthermore, MM claim that it is investment policy, not dividend policy, that really determines a firm’s value.

Informational Content MM realize that there is considerable empirical evidence indicating that changes in dividend policy influence stock prices. As discussed later in this chapter, many firms favor a policy of reasonably stable dividends. An increase in dividends conveys a certain type of information to the shareholders, such as an expectation of higher future earnings. Similarly, a cut in dividends may be viewed as conveying unfavorable information about the firm’s earnings prospects. MM argue that this informational content of dividend policy influences share prices, not the pattern of dividend payments per se.

Signaling Effects In effect, changes in dividend payments represent a signal to investors concerning management’s assessment of the future earnings and cash flows of the company. Management, as an insider, is perceived as having access to more complete information about future profitability than is available to investors outside the company. Dividend changes are thought to provide unambiguous signals about the company’s future prospects —information that cannot be conveyed fully through other methods, such as annual reports and management presentations before security analysts. The signaling effect of changes in dividends is similar to the signaling effect of changes in capital structure discussed in Chapter .

Clientele Effect MM also claim that the existence of clienteles of investors favoring a particular firm’s dividend policy should have no effect on share value. They recognize that a firm that changes its dividend policy could lose some stockholders to other firms with a more appealing dividend policy. This, in turn, may cause a temporary reduction in the price of the firm’s stock.

Other investors, however, who prefer the newly adopted dividend policy will view the firm as being undervalued and will purchase more shares. In the MM world, these transactions occur instantaneously and at no cost to the investor, the net result being that a stock’s value remains unchanged.

Arguments for the Relevance of Dividends

Scholars belonging to the second school of thought argue that share values are indeed influenced by the division of earnings between dividends and retention. Basically, they contend that the MM propositions are reasonable —given MM’s restrictive assumptions —but that dividend policy becomes important once these assumptions are removed.

Risk Aversion Specifically, Gordon asserts that shareholders who are risk averse may prefer some dividends over the promise of future capital gains because dividends are regular, certain returns, whereas future capital gains are less certain. This is sometimes referred to as the “bird -in -the-hand” theory. According to Gordon, dividends reduce investors’ uncertainty, causing them to discount a firm’s future earnings at a lower rate, thereby increasing the firm’s value.

In contrast, failure to pay dividends increases investors’ uncertainty, which raises the discount rate and lowers share prices. Although there is some empirical evidence to support this argument, it is difficult to decide which is more valid—the MM informational content (or signaling effect) of dividends approach or the Gordon uncertainty resolution approach.

Transaction Costs If the assumption of no transaction costs for investors is removed, then investors care whether they are paid cash dividends or receive capital gains. In the MM world, investors who own stock paying low or no dividends could periodically sell a portion of their holdings to satisfy current income requirements. In actuality, however, brokerage charges and odd-lot differentials make such liquidations expensive and imperfect substitutes for regular dividend payments.

Taxes Removal of the no-tax assumption also makes a difference to shareholders. As discussed earlier, shareholders in high income tax brackets may prefer low (or no) dividends and reinvestment of earnings within the firm because of the ability to defer taxes into the future (when the stock is sold) on such income. In his study of dividend policy from 1920 to 1960, John A. Brittain found evidence in support of this proposition.In general, he found that rising tax rates tend to reduce dividend payout rates.

Issuance (Flotation) Costs The existence of issuance costs on new equity sales also tends to make earnings retention more desirable. Given a firm’s investment policy, the payout of earnings the firm needs for investments requires it to raise external equity. External equity is more expensive, however, because of issuance costs. Therefore, the use of external equity will raise the firm’s cost of capital and reduce the value of the firm. In addition, the cost of selling small issues of equity to meet investment needs is likely to be prohibitively high for most firms. Therefore, firms that have sufficient investment opportunities to profitably use their retained funds tend to favor retention.

Agency Costs It has also been argued that the payment of dividends can reduce agency costs between shareholders and management.The payment of dividends reduces the amount of retained earnings available for reinvestment and requires the use of more external equity funds to finance growth. Raising external equity funds in the capital markets subjects the company to the scrutiny of regulators (such as the SEC) and potential investors, thereby serving as a monitoring function of managerial performance.

Conclusions Regarding Dividend Relevance The empirical evidence as to whether dividend policy affects firm valuation is mixed. Some studies have found that, because of tax effects, investors require higher pretax returns on high-dividend payout stocks than on low-dividend payout stocks.Other studies have found that share prices are unaffected by dividend payout policy. Many practitioners believe that dividends are important, both for their informational content and because external equity capital is more expensive than retained equity.Thus, when establishing an optimal dividend policy, a firm should consider shareholder preferences along with investment equity.

Dividend Policy and Firm Value

There are two major schools of thought among finance scholars regarding the effect dividend policy has on a firm’s value. Although Miller and Modigliani argue that dividend policy does not have a significant effect on a firm’s value, Myron Gordon, David Durand, and John Lintner have argued that it does. Each viewpoint is discussed in this section.

Arguments for the Irrelevance of Dividends

The group led by Miller and Modigliani (MM) contends that a firm’s value is determined solely by its investment decisions and that the dividend payout ratio is a mere detail. They maintain that the effect of any particular dividend policy can be exactly offset by other forms of financing, such as the sale of new common equity shares. This argument depends on a number of key assumptions, however, including the following:

  • No taxes. Under this assumption, investors are indifferent about whether they receive either dividend income or capital gains income.
  • No transaction costs. This assumption implies that investors in the securities of firms paying small or no dividends can sell at no cost any number of shares they wish in order to convert capital gains into current income.
  • No issuance costs. If firms did not have to pay issuance costs on the issue of new securities, they could acquire needed equity capital at the same cost, regardless of whether they retained their past earnings or paid them out as dividends. The payment of dividends sometimes results in the need for periodic sales of new stock.
  • Existence of a fixed investment policy. According to MM, the firm’s investment policy is not affected by its dividend policy. Furthermore, MM claim that it is investment policy, not dividend policy, that really determines a firm’s value.

Informational Content MM realize that there is considerable empirical evidence indicating that changes in dividend policy influence stock prices. As discussed later in this chapter, many firms favor a policy of reasonably stable dividends. An increase in dividends conveys a certain type of information to the shareholders, such as an expectation of higher future earnings. Similarly, a cut in dividends may be viewed as conveying unfavorable information about the firm’s earnings prospects. MM argue that this informational content of dividend policy influences share prices, not the pattern of dividend payments per sec.

Signaling Effects In effect, changes in dividend payments represent a signal to investors concerning management’s assessment of the future earnings and cash flows of the company. Management, as an insider, is perceived as having access to more complete information about future profitability than is available to investors outside the company. Dividend changes are thought to provide unambiguous signals about the company’s future prospects —information that cannot be conveyed fully through other methods, such as annual reports and management presentations before security analysts. The signaling effect of changes in dividends is similar to the signaling effect of changes in capital structure discussed in Chapter.

Clientele Effect MM also claim that the existence of clienteles of investors favoring a particular firm’s dividend policy should have no effect on share value. They recognize that a firm that changes its dividend policy could lose some stockholders to other firms with a more appealing dividend policy. This, in turn, may cause a temporary reduction in the price of the firm’s stock. Other investors, however, who prefer the newly adopted dividend policy will view the firm as being undervalued and will purchase more shares. In the MM world, these transactions occur instantaneously and at no cost to the investor, the net result being that a stock’s value remains unchanged.

Arguments for the Relevance of Dividends

Scholars belonging to the second school of thought argue that share values are indeed influenced by the division of earnings between dividends and retention. Basically, they contend that the MM propositions are reasonable —given MM’s restrictive assumptions —but that dividend policy becomes important once these assumptions are removed.

Risk Aversion Specifically, Gordon asserts that shareholders who are risk averse may prefer some dividends over the promise of future capital gains because dividends are regular, certain returns, whereas future capital gains are less certain. This is sometimes referred to as the “bird -in -the -hand” theory. According to Gordon, dividends reduce investors’ uncertainty, causing them to discount a firm’s future earnings at a lower rate, thereby increasing the firm’s value. In contrast, failure to pay dividends increases investors’ uncertainty, which raises the discount rate and lowers share prices. Although there is some empirical evidence to support this argument, it is difficult to decide which is more valid —the MM informational content (or signaling effect) of dividends approach or the Gordon uncertainty resolution approach.

Transaction Costs If the assumption of no transaction costs for investors is removed, then investors care whether they are paid cash dividends or receive capital gains. In the MM world, investors who own stock paying low or no dividends could periodically sell a portion of their holdings to satisfy current income requirements. In actuality, however, brokerage charges and odd -lot differentials make such liquidations expensive and imperfect substitutes for regular dividend payments.

Taxes Removal of the no -tax assumption also makes a difference to shareholders. As discussed earlier, shareholders in high income tax brackets may prefer low (or no) dividends and reinvestment of earnings within the firm because of the ability to defer taxes into the future (when the stock is sold) on such income. In his study of dividend policy from 1920 to 1960, John A. Brittain found evidence in support of this proposition.In general, he found that rising tax rates tend to reduce dividend payout rates.

Issuance (Flotation) Costs The existence of issuance costs on new equity sales also tends to make earnings retention more desirable. Given a firm’s investment policy, the payout of earnings the firm needs for investments requires it to raise external equity. External equity is more expensive, however, because of issuance costs. Therefore, the use of external equity will raise the firm’s cost of capital and reduce the value of the firm. In addition, the cost of selling small issues of equity to meet investment needs is likely to be prohibitively high for most firms. Therefore, firms that have sufficient investment opportunities to profitably use their retained funds tend to favor retention.

Agency Costs It has also been argued that the payment of dividends can reduce agency costs between shareholders and management.The payment of dividends reduces the amount of retained earnings available for reinvestment and requires the use of more external equity funds to finance growth. Raising external equity funds in the capital markets subjects the company to the scrutiny of regulators (such as the SEC) and potential investors, thereby serving as a monitoring function of managerial performance.

Conclusions Regarding Dividend Relevance The empirical evidence as to whether dividend policy affects firm valuation is mixed. Some studies have found that, because of tax effects, investors require higher pretax returns on high -dividend payout stocks than on low-dividend payout stocks.Other studies have found that share prices are unaffected by dividend payout policy. Many practitioners believe that dividends are important, both for their informational content and because external equity capital is more expensive than retained equity.Thus, when establishing an optimal dividend policy, a firm should consider shareholder preferences along with investment opportunities and the relative cost of retained equity versus externally raised equity.

Dividend Policies

The previous sections examined a number of practical considerations that influence a firm’s board of directors in determining an “optimal” dividend policy. In this section, several alternative dividend strategies are discussed.

Passive Residual Policy

The passive residual policy suggests that a firm should retain its earnings as long as it has investment opportunities that promise higher rates of return than the required rate. For example, assume that a firm’s shareholders could invest their dividends in stocks of similar risk with an expected rate of return (dividends plus capital gains) of 18 percent. This 18 percent figure, then, would constitute the required rate of return on the firm’s retained earnings. As long as the firm can invest these earnings to earn this required rate or more, it should not pay dividends (according to the passive residual policy) because such payments would require either that the firm forgo some acceptable investment opportunities or raise necessary equity capital in the more expensive external capital markets.

Interpreted literally, the residual theory implies that dividend payments will vary from year to year, depending on available investment opportunities. There is strong evidence, however, that most firms try to maintain a rather stable dividend payment record over time. Of course, this does not mean that firms ignore the principles of the residual theory in making their dividend decisions because dividends can be smoothed out from year to year in two ways.First, a firm can choose to retain a larger percentage of earnings during years when funding needs are large. If the firm continues to grow, it can manage to do this without reducing the dollar amount of the dividend. Second, a firm can borrow the funds it needs, temporarily raise its debt -to-equity ratio, and avoid a dividend cut in this way.

Because issue costs are lower for large offerings of long -term debt, long -term debt capital tends to be raised in large, lumpy sums. If many good investment opportunities are available to a firm during a particular year, this type of borrowing is preferable to cutting back on dividends.

The firm will need to retain earnings in future years to bring its debt-to-equity ratio back in line. A firm that has many good investment opportunities for a number of years may eventually be forced to cut its dividend and/or sell new equity shares to meet financing requirements and maintain an optimal capital structure.

The residual theory also suggests that “growth” firms will normally have lower dividend payout ratios than firms in mature, low-growth industries. As shown earlier in Table, companies with low growth rates (such as Consolidated Edison and Cascade National Gas) tend to have rather high payout ratios, whereas firms with high growth rates (such as Dell and Target) tend to have rather low payout ratios.

Stable Dollar Dividend Policy

Evidence indicates that most firms —and stockholders —prefer reasonably stable dividend policies. This stability is characterized by a rather strong reluctance to reduce the dollar amount of dividends from one period to the next. Similarly, increases in the dollar dividend rate normally are not made until the firm’s management is satisfied that future earnings will be high enough to justify the larger dividend.

Thus, although dividend rates tend to follow increases in earnings, they also tend to lag behind them to a certain degree. Figure illustrates the relationship between corporate dividends and profits since 1960. It is apparent from this chart that aggregate dividend payments fluctuate much less than corporate earnings.

There has been a strong upward trend in the amount of dividends paid, with very few years showing significant reductions. This is in sharp contrast to the more erratic record of corporate earnings. More specifically, Figure shows the dividend and earnings history of Kerr -McGee Corporation (oil and gas exploration and production and specialty chemicals). Although there has been an upward trend in dividends over time, dividend increases tend to lag earnings increases. Annual dividend payments are also more stable than earnings figures. Note, for instance, the dramatic growth in earnings in 1996, yet dividends were increased only by $0.09 per share. Also, despite a significant earnings decline in 1992, the dividend rate was actually increased by $0.04 per share. In 2002, the company experienced a loss per share of $4.74, yet continued to pay its $1.80 dividend.

Historic Pattern of Profits and Dividends for U.S. Corporations

Investors prefer stable dividends for a variety of reasons. For instance, many investors feel that dividend changes possess informational content; they equate changes in a firm’s dividend levels with profitability. A cut in dividends may be interpreted as a signal that the firm’s longrun profit potential has declined. Similarly, a dividend increase is seen as a verification of the expectation that future profits will increase. In addition, many shareholders need and depend on a constant stream of dividends for their cash income requirements.

Although they can sell off some of their shares as an alternative source of current income, associated transaction costs and odd-lot charges make this an imperfect substitute for steady dividend income. Some managers feel that a stable and growing dividend policy tends to reduce investor uncertainty concerning future dividend streams. They believe investors will pay a higher price for the stock of a firm that pays stable dividends, thereby reducing the firm’s cost of equity.

And, finally, stable dividends are legally desirable. Many regulated financial institutions— such as bank trust departments, pension funds, and insurance companies—are limited as to the types of common stock they are allowed to own. To qualify for inclusion in these “legal lists,” a firm must have a record of continuous and stable dividends. The failure to pay a dividend or the reduction of a dividend amount can result in removal from these lists. This, in turn, reduces the potential market for the firm’s shares and may lead to price declines. As shown in Figure, Kerr-McGee maintained its per share dividend during the 1998 –1999 period and in 2002, even though its earnings per share were less than this amount in each of those years.

Dividends and Earnings per Share for Kerr-McGee Corporation

Other Dividend Payment Policies

Some firms have adopted a constant payout ratio dividend policy. A firm that uses this approach pays out a certain percentage of each year’s earnings —for example, 40 percent— as dividends. If the firm’s earnings vary substantially from year to year, dividends also will fluctuate. (The late Penn Central Company had adopted this type of dividend payout policy at one time.)

As shown earlier in Figure , the aggregate dividend payout ratio for U.S. corporations has generally ranged between 35 and 77 percent. This finding supports the notion that firms try to maintain fairly constant payout ratios over time.

On a year to -year basis, however, these payout ratios vary substantially. For example, the aggregate payout ratio was about 77 percent during 2001, a recession year, and only about 36 percent during 1965, a year of relative prosperity. Because of the reluctance to reduce dividends, payout ratios tend to increase when profits are depressed and decrease as profits increase.

Other firms choose to pay a small quarterly dividend plus year -end extras. This policy is especially well suited for a firm with a volatile earnings record, volatile year -to-year cash needs, or both. Even when earnings are low, the firm’s investors can count on their regular dividend payments.When earnings are high and no immediate need for these excess funds exists, the firm declares a year -end extra dividend. This policy gives management the flexibility to retain funds as needed and still satisfy investors who desire to receive some  guaranteed” level of dividend payments. U.S. Steel, DuPont, and General Motors have all followed this policy from time to time. Figure shows how this policy has affected General Motors.

Although actual dividend payments have varied dramatically from year to year (compare this figure, for example, with Figure , which shows Kerr -McGee’s earnings and dividends), only in 1993, after three years of huge losses, were dividends cut below $1.20, the “regular” rate in effect in 1975.

Entrepreneurial ISSUES

Dividend Policy

Small firms typically differ significantly from larger,more mature firms in terms of the dividend policies they follow. For example, one study of the financial differences between small and large firms found that the average dividend payout ratio for large firms was in excess of 40 percent, whereas the average dividend payout ratio for small firms was less than 3 percent.a The study found that the majority of small firms that were planning an initial public stock offering paid no dividends at all in the year prior to their stock offering.

What are the reasons for this dramatic difference in dividend policies between large and small firms? First, it is likely that many small firms are in the rapid growth phase of their business development. During this early phase, the firm is often short of funds needed to finance planned investments and increases in working capital. Another aspect related to the growth phase argument is that small firms typically have restricted access to capital markets, relative to larger firms. A small, closely held firm has no easy way to raise equity capital other than the retention of earnings. If new shares of stock can be sold, the owners risk a loss of control.

In addition, stock offerings for small firms are extremely expensive, both in terms of transactions costs and minority interest discounts (as well as marketability) that investors demand.

Another reason dividend policies differ between small and large firms is because many small firms are closely held by only one or a few owners, and the dividend policy of these firms frequently reflects the income preferences of these individuals. If funds are retained in the firm, taxes are postponed until a distribution is made at some time in the future or until the firm is sold.

As firms mature, their need for funds to support rapid growth declines, and their access to capital markets improves. At this point, they show a tendency to begin or increase dividend payouts. For example, Intel, which was founded in 1968, paid no cash dividends until 1982. Since then, the company has been steadily increasing its annual cash dividend payments. Intel’s dividend payout ratio remains fairly low, reflecting the fact that, despite its large size (sales of $26 billion in 2001),the company still has significant growth opportunities.

Clearly, the dividend policies of small and large firms differ significantly. Small firms often pay out a smaller percentage of their earnings than larger firms because small firms tend to be growing rapidly and have limited access to the capital markets for other sources of funds to support their growth.

How Dividends Are Paid

In most firms, the board of directors holds quarterly or semiannual meetings to evaluate the firm’s past performance and decide the level of dividends to be paid during the next period. Changes in the amount of dividends paid tend to be made rather infrequently— especially in firms that follow a stable dividend policy —and only after there is clear evidence that the firm’s future earnings are likely to be either permanently higher or permanently lower than previously reported levels.

Most firms follow a dividend declaration and payment procedure similar to that outlined in the following paragraphs. This procedure usually revolves around a declaration date, an ex-dividend date, a record date, and a payment date.

Dividends and Earnings per Share for General Motors

Figure is a timeline that illustrates the Ford Motor Company’s dividend payment procedure. The firm’s board of directors meets on the declaration date—Tuesday, January 15 —to consider future dividends. They declare a dividend on that date, which will be payable to shareholders of record on the record date, Thursday, January 31. On that date, the firm makes a list from its stock transfer books of those shareholders who are eligible to receive the declared dividend.

The major stock exchanges require two business days prior to the record date for recording ownership changes. The day that begins this 2-day period is called the ex-dividend date—in this case, Tuesday, January 29. Investors who purchase stock prior to January 29 are eligible for the January 29 dividend; investors who purchase stock on or after January 29 are not entitled to the dividend. On January 29 the ex -dividend date, one would expect the stock price to decline by the amount of the dividend because this much value has been removed from the firm. Empirical evidence indicates that, on average, stock prices decline by less than the amount of the dividend on the ex -dividend day.

The payment date is normally four weeks or so after the record date—in this case,March 1. On this date, Ford makes dividend payments to the holders of record.

Dividend Reinvestment Plans

In recent years, many firms have established dividend reinvestment plans (DRIPS). Under these plans, shareholders can have their dividends automatically reinvested in additional shares of the company’s common stock. There are two types of dividend reinvestment plans. One type involves the purchase of existing stock, and the other type involves the purchase of newly issued stock.

The first type of plan is executed through a bank that, acting as a trustee, purchases the stock on the open market and then allocates it on a pro rata basis to the participating shareholders. In the second type of plan, the cash dividends of the participants are used to purchase, often at a small discount (up to 5 percent) from the market price, newly issued shares of stock.

This second type of plan enables the firm to raise substantial amounts of new equity capital over time as well as reduce the cash outflows required by dividend payments. The advantage of a dividend reinvestment plan to shareholders is that it represents a convenient method for them to purchase additional shares of the company’s common stock while saving brokerage commissions. The primary disadvantage is that shareholders must pay taxes on the cash dividends reinvested in the company, even though they never receive any cash.

Key Dates in the Ford Motor Company’s Dividend Payment

Stock Dividends and Stock Splits

A stock dividend is the payment of additional shares of stock to common stockholders. It involves making a transfer from the retained earnings account to the other stockholders’ equity accounts.For example, the Colonial Copies Company has the following common stockholders’ equity:

INTERNATIONAL ISSUES

Dividend Policies for Multinational Firms

Dividend payments from foreign subsidiaries represent the primary means of transferring funds to the parent company. Many factors determine the dividend
payments that are made back to the parent, including tax effects, exchange risk, political risk, the availability of funds, the financing requirements of the foreign subsidiary, and the existence of exchange controls. Taxes in the host country play a significant role in determining a multinational firm subsidiary’s dividend policy.

For example, in Germany, the tax rate on earnings paid out as dividends is much lower than the tax rate on retained earnings. When the parent is located in a country with a strong currency and the subsidiary is located in a country with a weak currency, there will be a tendency to rapidly transfer a greater portion of the subsidiary’s earnings to the parent to minimize the exchange rate risk. In the face of high political risk, the parent may require the subsidiary to transfer all locally generated funds to the parent except for those funds necessary to meet the working capital and planned capital expenditure needs of the subsidiary.

As is true for domestic enterprises, large and more mature foreign subsidiaries tend to remit a greater proportion of their earnings to the parent, reflecting the reduced growth opportunities and needs for funds that exist in larger firms.Also, when the foreign subsidiary has good access to capital within th host country, it tends to pay larger dividends to the parent because funds needed for future expansion can be obtained locally.

Finally, some countries with balance -of-payments problems often restrict the payment of dividends from the subsidiary back to the parent. Many firms require that the payout ratio for foreign subsidiaries be set equal to the payout ratio of the parent.The argument in favor of this strategy is that it requires each subsidiary to bear an equal proportionate burden of the parent’s dividend policy. However, even when this strategy is adopted, it often is modified on a country -by-country basis to reflect the considerations

Suppose the firm declares a 10 percent stock dividend and existing shareholders receive 10,000 (10% *100,000) new shares. Because stock dividend accounting is usually based on the predividend market price, a total of $200,000 (10,000 shares*an assumed market price of $20 per share) is transferred from the firm’s retained earnings account to the other stockholders’ equity accounts. Of this $200,000, $50,000 ($5 par *10,000 shares) is added to the common stock account and the remaining $150,000 is added to the contributed capital in excess of par account. Following the stock dividend, Colonial has the following common stockholders’ equity:

The net effect of this transaction is to increase the number of outstanding shares and to redistribute funds among the firm’s capital accounts. The firm’s total stockholders’ equity remains unchanged, and each shareholder’s proportionate claim to the firm’s earnings remains constant. For example, if Colonial Copies Company has 100,000 shares outstanding prior to a 10 percent stock dividend and its total earnings are $200,000 ($2 per share), a stockholder who owns 100 shares has a claim on $200 of the firm’s earnings. Following the 10 percent stock dividend, earnings per share decline to $1.82 ($200,000/110,000 shares).

The stockholder who originally owned 100 shares now has 110 shares but continues to have a claim on only $200 (110 shares*$1.82 per share) of the firm’s earnings. Because each shareholder’s proportionate claim on a firm’s net worth and earnings remains unchanged in a stock dividend, the market price of each share of stock should decline in proportion to the number of new shares issued. This relationship can be expressed as follows:

                            Pre–stock dividend price
Post–stock dividend price = ——————————————
                            1 + Percentage stock dividend rate

In the Colonial Copies example, a $20 pre–stock dividend price should result in a poststock dividend price of

                             $20
Post–stock dividend price = ————
                           1 + 0.10
                          = $18.18

If a stockholder’s wealth prior to the dividend is $2,000 (100 shares*$20 per share), postdividend wealth should also remain at $2,000 (110 shares*$18.18 per share). In essence, all a stock dividend does is increase the number of pieces of paper in the stockholders’ hands.Nevertheless, there are a number of reasons why firms declare stock dividends. First, a stock dividend may have the effect of broadening the ownership of a firm’s shares because existing shareholders often sell their stock dividends.Second, in the case of a firm that already pays a cash dividend, a stock dividend results in an effective increase in cash dividends, providing that the per -share dividend rate is not reduced.

(It is rare for a firm to declare a stock dividend and reduce its cash dividend rate at the same time.) And, finally, the declaration of stock dividends effectively lowers the per-share price of a stock, thereby possibly broadening its investment appeal. Investors seem to prefer stocks selling in approximately the $15 to $70 price range because more investors will be financially able to purchase 100 -share round lots. Round lots of 100 shares are more desirable for investors to own because lower transactions costs are associated with their purchase and sale.Stock splits are similar to stock dividends in that they have the effect of increasing the number of shares of stock outstanding and reducing the price of each outstanding share.

From an accounting standpoint, stock splits are accomplished by reducing the par value of existing shares of stock and increasing the number of shares outstanding. For example, in a two -for-one stock split, the number of shares would be doubled. Although stock splits have an impact similar to stock dividends, they normally are not considered an element of a firm’s dividend policy.

Share Repurchases as Dividend Decisions

In addition to the reasons discussed in Chapter  for repurchasing stock, share repurchases can be undertaken as part of the firm’s dividend decision. According to the passive residual dividend policy, a firm that has more funds than it needs for investments should pay a cash dividend to shareholders. In lieu of, or in addition to, cash dividends, some firms also repurchase outstanding shares from time to time. Since the 1980s, share repurchases have become increasingly popular.

One study found that aggregate repurchases represented 26 percent of common stock earnings over the 1983–1997 period, compared with only 3 percent during the 1973–1977 period.The volume of announced share repurchases was approximately $177 billion in 1996.29 Over a 3-year period from 1995 to 1997, IBM bought back over $20 billion of its common stock.

Companies engaging in large buyback programs typically have large cash flows and an insufficient number of positive NPV investments in which to invest. For example, Quaker Oats (acquired by PepsiCo in 2001) repurchased 20 million shares during the late 1980s and early 1990s and was planning the repurchase of an additional 5 million shares.

Quaker Oats treasurer Janet K. Cooper explained, “We spend on new products, we make acquisitions, and we raise the dividend, and we still can’t soak up all the cash.”Firms that are under threat of a hostile takeover sometimes announce large share repurchase programs designed to drain “excess” cash from the firm, thereby making it a less desirable takeover target.

Procedures for Repurchasing Shares

Firms carry out share repurchase programs in a number of ways. For example, a company may buy directly from its stockholders in what is termed a tender offer; it may purchase the stock in the open market; or it may privately negotiate purchases from large holders, such as institutions.When a firm initiates a share repurchase program through a tender offer, it is, in effect, giving shareholders a put option—an option to sell their shares at a fixed price above the current market price for a limited period of time.
Repurchased shares become known as treasury stock.

Treasury stock is often used to facilitate mergers and acquisitions; to satisfy the conversion provisions of some preferred stock and debentures, as well as the exercise of warrants; and to meet the need for new shares in executive stock options and employee stock purchase plans. From the stockholders’ perspective, share repurchases increase earnings per share for the remaining outstanding shares and also increase stock prices, assuming that investors continue to apply the same price-to-earnings (P/E) ratio to the earnings per share before and after repurchase.

(Recall from Chapter that the P/E ratio is equal to the price per share divided by the earnings per share.) For example, if a stock sells for $40 per share and earns $8 per share, its P/E multiple is 5 (40/8). The P/E multiple indicates the value placed by investors on a dollar of a firm’s earnings. It is influenced by a number of factors, including earnings prospects and investors’ perceptions regarding a firm’s risk. Normally, a firm will announce its intent to buy back some of its own shares so that investors will know why there is sudden additional trading in the stock.

An announcement of repurchase is also useful to current shareholders, who may not want to sell their shares before they have had an opportunity to receive any price appreciation expected to result from the repurchase program.

Share Repurchase Example

Suppose that the Hewlett-Packard (H-P) Company (electronic equipment manufacturer) plans to distribute to its shareholders $750 million in the form of either a one-time extra cash dividend or a share repurchase. The company has expected earnings of $625 million during the coming year and approximately 250 million shares currently outstanding. The current (ex-dividend) market price of H-P stock is $50 per share.

The company can pay a one-time extra cash dividend of $3 per share ($750 million divided by 250 million shares). Alternatively, it can make a tender offer at $53 per share for 14,150,943 shares ($750 million divided by $53 per share).

If H-P decides to declare a one-time extra cash dividend of $3 per share, shareholder wealth would be $53 per share, consisting of the $50 (ex-dividend) share price plus the $3 dividend. The effect on shareholder wealth before and after the stock repurchase is shown in Table, assuming that the price –earnings (P/E) ratio remains the same at 20 ($50 stock price per share divided by $2.50 earnings per share). If H-P repurchases $750 million worth of its common stock (at $53 per share), then shareholder wealth is $53 per share, with $3 of this value representing price appreciation. Note that the pretax returns to shareholders are the same under each alternative.

Hewlett-Packard Company Share Repurchase

Ignoring taxes, transaction costs, and other market imperfections, shareholders should be indifferent between equivalent returns from cash dividends and share repurchases. In other words, the value of the firm should not be affected by the manner in which returns (cash dividends versus capital gains) are paid to shareholders. However, empirical studies suggest that share repurchases do increase stock prices (i.e., value of the firm).Some reasons why this occurs are examined next.

Tax Considerations

In the context of dividend decisions, tax considerations have historically been the primary reason why firms decided to repurchase their own stock in lieu of, or in addition to, payment of cash dividends. Because taxes on capital gains can be deferred into the future (when the stock is sold), whereas taxes on an equivalent amount of dividend income have to be paid in the current year, firms still have substantial tax reasons to make distributions in the form of share repurchases.

Although a stock repurchase program seems like a desirable way of distributing a firm’s earnings, repurchases may be deterred by the IRS. Specifically, the IRS may not permit a firm to follow a policy of regular stock repurchases as an alternative to cash dividends, because repurchase plans convert cash dividends to capital gains. The IRS looks upon regular repurchases
as essentially equivalent to cash dividends and requires that they be taxed accordingly.

Financial Flexibility

Substituting discretionary stock repurchases for all or part of regular cash dividends (i.e., stable dollar dividend policy) provides a company with greater financial flexibility. Under such a strategy, when the company has profitable uses for its funds, it can defer the buyback of its stock (and the corresponding cash outflows) until a more appropriate time in the future. The company thus avoids incurring the costs associated with raising the external equity capital needed to finance investments. Likewise, when the company accumulates excess funds, it can undertake periodic stock repurchases.

Signaling Effects

Like the signaling effects of cash dividend increases, share repurchases can also have a positive impact on shareholder wealth. A share repurchase may represent a signal to investors that management expects the firm to have higher earnings and cash flows in the future.

Advantages and Disadvantages

Let us summarize the advantages and disadvantages of share repurchases as an addition to, or as a substitute for, cash dividends.

Advantages Share repurchases effectively convert dividend income into capital gains income. Shareholders in high (marginal) income tax brackets may prefer capital gains income because of the ability to defer taxes into the future (when the stock is sold). Also, share repurchases provide the firm with greater financial flexibility in timing the payment of returns to shareholders. Finally, share repurchases can represent a signal to investors that the company expects to have higher earnings and cash flows in the future.

Disadvantages A company may overpay for the stock that it repurchases. If the stock price declines, the share repurchase represents an unprofitable use of the company’s resources. Also, a share repurchase may trigger IRS scrutiny (and possible tax penalties) if the buyback is viewed as a way for shareholders to avoid taxes on cash dividends. Finally, some current shareholders may be unaware of the share repurchase program and may sell their shares before the expected benefits (i.e., price appreciation) occur.

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