Dividend Policy Introduction - Financial Management

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.

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