Payout Policy

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Dividend policy

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
firms 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.

 However, if the firm increases D1, there

will be less money available for
reinvestment causing g to decline
(remember g equals the retention ratio
times ROE). If g falls, this will lower the
stock price.
Therefore, when setting the optimal
dividend policy the financial manager
should strike a balance between current
dividends and future growth so as to
maximize the firms stock price.

DIVIDEND POLICY
DIVIDEND POLICY IS DEFINED AS
THE FIRMS POLICY WITH
REGARD TO PAYING OUT
EARNINGS AS DIVIDENDS
VERSUS RETAINING THEM FOR
REINVESTMENT IN THE FIRM.

ESTABLISHING THE PAYOUT LEVEL

The optimal payout for a firm is a function of four factors. (1)

Investors' preferences for dividends versus capital gains. (2)
The firm's investment opportunities. (3) Its target capital
structure. And (4), the availability and cost of external
capital.
The last three elements can be combined into what has
become the residual distribution model. Within the residual
model, firms must determine the optimal capital budget,
determine the amount of equity needed to fund the capital
budget (based upon the target capital structure), use
retained earnings to meet equity requirements whenever
possible

Disadvantages of Repurchases
IRS could impose penalties if repurchases were
primarily to avoid taxes on dividends.
Selling stockholders may not be well informed,
hence be treated unfairly.
Firm may have to bid up price to complete
purchase, thus paying too much for its own
stock.

Stock dividend VS STOCK SPLITS

stock dividend vs stock splits Stock

dividend: Firm issues new shares in lieu
of paying a cash dividend. If 10%, get 10
shares for each 100 shares owned.
Stock split: Firm increases the number of
shares outstanding, say 2:1, but the price
of each share will drop to half.

WHAT DO THE THREE THEORIES INDICATE

REGARDING THE ACTIONS MANAGEMENT
SHOULD TAKE WITH RESPECT TO DIVIDEND
POLICY?

DIVIDEND THEORIES
M-M Dividend Irrelevance
Theory
Bird-In-The-Hand Theory
Tax Preference Theory
and The Theories Conflict

the relationships between dividend policy,

stock price, and the cost of equity under
each dividend policy theory

Answer the problem

How would a drop in NI to $400,000

affect the dividend? A rise to $800,000?

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%.

In general terms, how would a change in investment

opportunities affect the payout ratio under the residual
payment policy?

a change in investment opportunities would

lead to an increase (if investment
opportunities were good) or a decrease (if
investment opportunities were not good) in
the amount of equity needed, hence in the
residual dividend payout.