ESTABLISHING THE DIVIDEND POLICY IN PRACTICE A. Setting the Target Payout Ratio: The Residual Dividend Model (Marie Sheryl Fernandez) What are the points to consider as to how much cash will be distributed to the stockholders? 1. The overriding objective is to maximize shareholder value 2. Avoid retaining income instead reinvest the firm’s earnings at higher rates of return than shareholders can earn themselves. Mature Industries - Young Firms - Produce a large amount of cash Few investments opportunities Distribute high dividends thereby attracting investor’s clienteles Produce little or no excess cash Have good investments opportunities Distribute less dividends but enjoy rising earnings and stock prices thereby attracting investors who prefer capital gains What is the difference between dividend payouts and dividend yields? DIVIDEND YIELDS a financial ratio expressing how much dividend an investor gets Aids investor in decision making Compares dividend with the market price of the stock Relevant parameter for investors who prefer income stocks with a regular stream of cash flows DIVIDEND PAYOUTS a financial ratio representing how much part of profit a company paid as a dividend Decision at the discretion of the company Compares dividend with the earnings Relevant parameter for investors who prefer growth stocks Payout Ratio. Can be interpreted in two ways: a. In the conventional way, this refers to the percentage of net income paid out as cash dividends b. As the percentage of net income distributed to stockholders through dividends and share repurchases. Payout Ratio is a function of four factors: 1. Management’s opinion about its investors’ preferences for dividends versus capital gains 2. The firm’s investment opportunities 3. The firm’s target capital structure 4. The availability and cost of external capital Various Dividend Policies/ Models 1. Residual Dividend Model. A model in which the dividend paid is set equal to net income minus the amount of retained earnings necessary to finance the firm’s optimal capital budget. The word residual implies “leftover,” and the residual policy implies that dividends are paid out of “leftover” earnings. Under this model, we assume that investors are indifferent between dividends and capital gains. Then the firm follows these four steps to establish its target payout ratio: (1) It determines the optimal capital budget; (2) given its target capital structure, it determines the amount of equity needed to finance that budget; (3) it uses retained earnings to meet equity requirements to the extent possible; and (4) it pays dividends only if more earnings are available than are needed to support the optimal capital budget. Dividends = Net income - Retained earnings required to help finance new investments Dividends = Net income – [(Target equity ratio) (Total capital budget)] This would not be bad if investors were not bothered by fluctuating dividends; but since investors do prefer stable, dependable dividends, it would not be optimal to follow the residual model in a strict sense. Therefore, firms should operate as follows: a. Estimate earnings and investment opportunities, on average, over the next 5 or so years. b. Use this forecasted information to find the average residual model number of dividends (and the payout ratio) during the planning period. c. Set a target payout policy based on the projected data. Thus, firms should use the residual policy to help set their long-run target payout ratios, but not as a guide to the payout in any one year. 2. Low-Regular-Dividend-Plus-Extras. The policy of announcing a low regular dividend that can be maintained no matter what and then when times are good, paying a designated “extra” dividend. Each company announced a low regular dividend that it was confident it could maintain “through hell or high water,” one that stockholders could count on under all conditions. Then when times were good and profits and cash flows were high, the company would pay a clearly designated extra dividend. Because investors recognized that the extras might not be maintained in the future, they did not interpret them as a signal that the companies’ earnings were permanently higher, nor did they take the elimination of the extra as a negative signal.
