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.
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.
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