Dividend Policy and Retained Earnings
(Chapter 18)
Optimal Dividend Policy
Conflicting Theories
Other Dividend Policy Issues
Residual Dividend Theory
Stable Growth in Dividend Policy
Some Additional Considerations
Stock Dividends and Stock Splits
Stock Repurchases
Optimal Dividend Policy

The optimal dividend policy should maximize the
price of the firm’s stock holding the number of shares
outstanding constant.
D1
P0 
ke  g
A decision to increase dividends will raise D1 putting
upward pressure on P0. Increasing dividends,
however, means reinvesting fewer dollars, lowering g,
and putting downward pressure on P0.

Problem: What is the correct balance between
dividends and retained earnings?
Conflicting Theories

Dividend Policy is Irrelevant:
(Dividend Irrelevance Theory)

Assuming:
– No transactions costs to buy and sell securities
– No flotation costs on new issues
– No taxes
– Perfect information
– Dividend policy does not affect ke

Dividend policy is irrelevant. If dividends are too high,
investors may use some of the funds to buy more of
the firm’s stock. If dividends are too low, investors
may sell off some of the stock to generate additional
funds.
Conflicting Theories (Continued)

High Dividends Increase Stock Value:
(Bird-in-the-Hand Theory)

Dividends are less risky. Therefore, high
dividend payout ratios will lower ke (reducing
the cost of capital), and increase stock price.
Conflicting Theories (Continued)


Low Dividends Increase Stock Value:
(Tax Preference Theory)
Dividends received are taxable in the current period.
Taxes on capital gains, however, are deferred into the
future when the stock is actually sold. In addition, the
maximum tax rate on capital gains is usually lower
than the tax rate on ordinary income. Therefore, low
dividend payout ratios will lower ke (reducing the cost
of capital), raise g, and increase stock price.
Conflicting Theories (Continued)
 Empirical
Evidence:
– No conclusive proof, one way or
another.
– Difficult to hold the rest of the world
constant while we study dividend
policy.
– Cannot measure the cost of equity
(ke) with a high degree of accuracy.
Other Dividend Policy Issues


Clientele Effect: Investors needing current income will
be drawn to firms with high payout ratios. Investors
preferring to avoid taxes will be drawn to firms with
lower payout ratios. (i.e., firms draw a given clientele,
given their stated dividend policy). Therefore, firms
should avoid making drastic changes in their dividend
policy.
Information Content: Changes in dividend policy may
be signals concerning the firm’s financial condition. A
dividend increase may signal good future earnings. A
dividend decrease may signal poor future earnings.
Residual Dividend Theory

Retain and reinvest earnings as long as returns on the investments
exceed the returns stockholders could obtain on other investments
of comparable risk. This concept is illustrated graphically below. A
corporation should retain all necessary earnings to invest up to the
level indicated by the intersection of the MCC (marginal cost of
capital) and IOS (investment opportunity schedule) functions.
Residual earnings are distributed to shareholders.
Percent
20
18
16
14
12
10
8
6
4
2
0
MCC
IOS
0
10
20
30
Amount of Capital ($millions)
Stable Growth in Dividend Policy

Most corporations attempt to maintain a stable
growth in dividend policy:
– Many financial institutions invest only in
companies with regular dividend payments.
– Perhaps leads to higher stock prices:
(Lower risk - lower ke - higher P0)
D1
P0 
ke  g
As a result, dividends tend to be a function of the
“sustainable growth” in earnings.
Stable Growth in Dividend Policy (Cont)
Dollars Per Share
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
EPS
DPS
Year
Some Additional Considerations





Legal Restrictions: Dividends cannot be paid
out of the permanent capital accounts.
Liquidity: Retained earnings and cash are not
identical.
Access to other sources of financing.
Stability of earnings.
Restrictions in debt contracts.
Some Additional Considerations
(Continued)

Ownership Control: Smaller firms may be
averse to issuing new stock due to dilution of
corporate control. Therefore, retain earnings
and pay few dividends.
 Inflation: Since replacement costs of assets
are higher in inflationary periods, more
retention of earnings may be required.
 Dividend Reinvestment Plans: Investors can
automatically reinvest dividends often at a
discount with no transaction costs. Frequently
a good investment tool. Companies may use
these plans to raise additional equity capital.
Stock Dividends


Accounting for stock dividends:
Retained Earnings xxxx
Common Stock xxxx
Paid-in-Capital
xxxx
The market value of the stock dividend is taken out of
retained earnings and placed into the permanent
capital accounts.
Stock Splits

No changes in the capital accounts.
 Par value decreased.
 Number of shares outstanding increased.
The Impact on Stockholders’ Wealth
of Stock Dividends and Stock Splits

Everything else remaining the same, stock
dividends and stock splits do not increase
stockholder wealth. Perhaps, however, they
are beneficial in the long-run due to the
“optimal price range” concept.
 Price may rise, however, if other variables
also change (e.g., cash dividends increase,
higher expected future earnings)
Stock Repurchases
(A Corporation Acquires its Own Stock)



Alternative to cash dividends: Shares outstanding are
reduced, EPS increases, and if the P/E does not
change, the stock price increases. (i.e., capital gains
are substituted for cash dividends). Stock
repurchases may be a sound strategy for firms with
“temporary” excess cash.
Share price too low: Outstanding shares may be
repurchased to drive the stock price up to a “more
appropriate” level.
Change the capital structure quickly: Issue debt and
use the proceeds to buy back outstanding stock.