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Worksheet for Chapter 17 BOC Questions. Dividend Policy and Repurchases

4/21/2005 The expected return on a stock consists of two elements, dividends and capital gains. In rate of return terms, the total return consists of a dividend yield plus a capital gains yield, which is the g term in the following equation: rs D1 P0

This equation can be transformed into the constant growth stock valuation model: P0 D1 rs - g

If a company increases its dividend payout, that raises the numerator of the stock price equation, D1, and that tends to increase the stock price. However, raising the dividend will lower the amount of earnings available for reinvestment and thus lower the growth rate, which will tend to lower the stock price. So, changing the dividend has two offsetting effects. As an approximation, g = (1-payout)(ROE). If the payout were increased to 100%, or 1.0, then g would drop to zero. Conversely, if payout were zero, g = ROE. Thus, increasing the dividend payout has two opposing effects on a firm's stock price, so management must seek the payout policy that balances these two forces and thereby maximizes the stock price.

DIVIDEND THEORIES
M-M Dividend Irrelevance, or Don't Care, Theory Proposed by Merton Miller and Franco Modigliani, this theory argues that dividend policy has no effect on either the price of a firm's stock or its cost of capital. The firm's value, they contended, is determined by its basic earning power and business risk. Therefore, since the firm's value is based only on fundamental factors, its dividend policy is irrelevant. Bird-In-The-Hand, or Prefer Dividends, Theory Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed. They argued that investors regard capital gains as being riskier than dividends, hence that a dollar of dividends contributes more to stock price than a dollar of retained earnings. According to this theory,the cost of capital would decrease, and the stock price would increase, as dividend payout is increased. Tax Preference, or Dislike Dividends, Theory Still others argue that tax factors cause investors to prefer capital gains to dividends, hence to prefer a low dividend payout. First, long-term capital gains are taxed at a lower rate than dividends. In addition, capital gains are not taxed until the gain is realized. Due to the time value of money, taxes paid in the future have a lower effective cost than those paid today. Finally, if a stock is held until death, no capital gains tax is due at all. (The avoidance-by-death provision is scheduled to disappear in 2011.) Because of these tax advantages, investors should, according to the tax preference theory, prefer a low payout. These theories refer to investors' preferences in the aggregate, not for each individual investor. Clearly, specific individuals will ascribe to each of the theories, but what is relevant is how investors in the aggregate behave.

The Theories Conflict The three theories conflict with one another, so managers get no clear signal from academic theories as to what their dividend payouts should be. There is logic behind each of the theories, and some investors undoubtedly prefer more dividends, some prefer less dividends (and more growth), and others are indifferent. Still, if there are more of one group of investors than the others, then that might lead managers to adopt the majority-held payout policy. Unfortunately, empirical tests have not been able to determine if one policy is actually the dominant one.

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A B C D E F G H I J Illustration of the Effects of Dividend Policy This illustration is based on several assumptions. First, the firm has a current stock price of $30, which is also its book value. Second, its ROE is 15%, so EPS = $30(0.15) = $4.50. Third, the firm curently pays out 0% of its dividends, so DPS = $0.00. Fourth, the ROE is expected to remain constant in the future, so the sustainable growth rate (g) is determined as the product of the ROE and the fraction of earnings retained, or (1.0 - Payout %). We also assume that the total investment level is held constant, with stock being issued at the current market price, which is also book value, and the debt ratio remaining constant, so as to keep the investment level constant and the ROE stable. Book value = stock price = ROE EPS Initial Payout % $30 15% $4.50 100%

Alternative payout policies for $4.50 of EPS % payout % retain DPS g 0% 100% $0.00 15.0% 50% 50% $2.25 7.5% 100% 0% $4.50 0.0%

= ROE(1 - Payout)

If MM are correct and investors are indifferent, then the stock will sell for $30 regardless of the dividend policy. On the other hand, if Gordon is correct, the stock price will increase (from the initial $30) if the payout is raised, while if the tax preference people are correct, it will rise with lower payouts. Here are three possible outcomes, and the associated graphs, only one of which can be correct: Possible Outcomes (only one of which can be true) Payout If Bird-In-The-Hand Is Correct: If MM Irrelevance Is Correct: If Tax Preference Is Correct: P0 D1/P0 rs P0 D1/P0 rs P0 D1/P0 rs Ratio 0% 50% 100% $30 $35 $40 0.00% 6.43% 11.25% 15.0% 13.9% 11.3% $30 $30 $30 0.0% 7.5% 15.0% 15.0% 15.0% 15.0% $30 $25 $20 0.0% 9.0% 22.5% 15.0% 16.5% 22.5%

Effect of Payout on Cost of Equity Under Different Theories

Effect of Payout on Stock Price Under Different Theories

Bird
25%

Bird
$45 $40

MM
Tax
Cost of Equity

MM
Tax

20% Cost of Equity

15% 10%

$35

$30 $25
$20 $15

5%
0%

0%

20%

40%

60%

80%

100%

0%

20%

40%

60%

80%

100%

Payout Ratio

Payout Ratio

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A B C D E F G H I J K Researchers have tested the three theories by obtaining dividend yields, expected g, and payouts on groups of companies and then running regressions to see which of the lines above corresponds best to the empirical data. Here is a HYPOTHETICAL example that shows results similar to those obtained with actual data: Total Return Firm No. Payout D/P g = D/P + g Correlation between payout and D/P+G: 1 68.0% 9.9% 3.6% 13.5% r = 0.1035 Click fx > Statistical > CORREL > 2 30.0% 4.0% 10.2% 14.2% OK, and then highlight 3 95.0% 10.9% 2.0% 12.9% B104:B112 and E104:E112. R2 = 4 42.0% 6.2% 9.0% 15.2% 0.0107 Just square r. 5 70.0% 10.6% 4.0% 14.6% 6 0.0% 0.0% 11.8% 11.8% The R2 indicates that only 1.07% of the variations of 7 55.0% 7.1% 6.0% 13.1% D/P + g among the companies is explained by the payout 8 25.0% 4.6% 10.0% 14.6% ratio. Thus, total return is not influenced materially by payout. This is consistent with the MM position. 9 57.0% 6.5% 7.0% 13.5%

Graph of the Relationship Between ks and Payout

16% 15% 15% 14% 14% 13% 13% 12% 12% 11% 0% 20% 40% 60% 80% 100%
Payout Ratio

These data were just made up, but they are typical of actual research. The graph shows no particular relationship between total return and payout, and the correlation confirms this conclusion--the R square is about 1%, indicating that payout accounts for only 1% of the variation in rs among the companies. The reasons for this lack of relationship include the following: (1) we cannot measure expected g very well, so there is error in the basic data. Errors in data lower correlations. (2) The companies probably differ with respect to things other than payout. (3) Even if there were no statistical problems, some individuals prefer one policy, others another. Then, if different companies set policies to appeal to different clienteles, statistics could indicate no relationship, even though investors really do care about dividend policy. Thus, MM might win the statistical argument, even though half of all investors agree with Gordon and the other half with the tax preference people. The theoretical and empirical evidence lead us to these conclusions: (1) Some investors want one thing, others another. So, companies should decide on a dividend policy that seems best for it, given its investment opportunities, and then stick with it. It will then attract a clientile that likes that particular policy. (2) Theoretically, too many companies could decide on a given policy, leaving too few companies with the other policy to satisfy investors. This supply/demand imbalance could provide companies with opportunities to switch policies, attract investors, and thereby lower their costs of capital and raise their stock prices. However, there is no evidence of such an imbalance. So, managers have a lot of flexibility in setting dividend policy.

ks: Cost of Equity

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A B C D E F G H I J K ESTABLISHING DIVIDEND POLICY IN PRACTICE The optimal payout ratio 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. (4) The availability and cost of external capital. If we assume that MM are correct with regard to aggregate behavior (and there is no convencing evidence to the contrary), we can combine the last three elements to form the residual dividend model. According to this model, firms should determine their optimal capital budget, then determine the amount of equity needed to fund the those expenditures (based upon the target capital structure), use retained earnings to meet equity requirements to the extent possible, and then pay dividends only if more earnings are available than are needed for investments. The residual dividend model can be expressed as follows: Dividends paid = Net Income - [(Target equity ratio) x (Total capital budget)]

EXAMPLE A firm's expected net income for the current year is $250 million, its projected capital budget is $150 million, and its target equity ratio is 60%. How much of the $250 million of earning should it pay out, according to the residual model? Income: Dividends $250 = = = Cap. Budget: $150 Equity ratio: 60%

Net Income - [(Target equity ratio) x (Total capital budget)] $250 60% x $150 $160 $160 / $250 = 64%

Resulting Payout =

Changes in expected net income, the capital budget, and the equity ratio would all change dividends and the payout ratio: Effect of changes in net income Net Dividends Payout Income $160 64% $0 -$90 #DIV/0! $100 $10 10% $200 $110 55% $250 $160 64% $300 $210 70% Effect of changes in the capital budget: Capital Dividends Payout Budget $160 64% $0 $250 100% $100 $190 76% $150 $160 64% $200 $130 52% $300 $70 28% Effect of changes in the equity ratio: Equity Dividends Payout Ratio $160 64% 0% $250 100% 25% $213 85% 50% $175 70% 75% $138 55% 100% $100 40%

These results are just what one would expect--other things held constant, dividends and the payout ratio rise with increases in net income, fall with increases in the capital budget, and fall with increases in the equity ratio because then more of the capital budget must be financed with equity. Of course, all three of the inputs could be changed. For example, the firm might project a decline in net income to $200 million but good investment opportunities and thus a capital budget of $175 million. Leaving the equity ratio at 60% this would result in a sharp decline in dividends and the payout ratio, to $95 million and 48%, respectively. Management might conclude that this big reduction in dividends would upset stockholders, and that it had excess debt capacity such that it could change the equity ratio and finance more of the budget with debt. If it financed about 23% of the budget with equity and 77% with debt, it's dividends would remain constant at $160 million, though its payout ratio would rise to 80%. Note that the 77% debt would not be the firm's overall debt ratio, it would just the financing mix for the current year, and that might not have much effect on the overall debt ratio. Firms can and do examine models like ours, though more detailed, when they set dividend policy.

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