Dividend Policy

1. 14 Dividend Policy

2. Introduction • This chapter examines the factors that influence a company’s choice of dividend policy. • Pros and cons of dividend policies • Mechanics of dividend payments • Stock dividends • Share repurchase plans

3. Influencing the Value of the Firm • Investment Decisions • Determine the level of future earnings and future potential dividends • Financing Decisions • Influence the cost of capital, which can determine the number of acceptable investment opportunities • Dividend Decisions • Influence the amount of equity capital in a firm’s capital structure and the cost of capital In making these interrelated decisions, the goal is to maximize shareholder wealth.

4. Determinants of Dividend Policy • Dividend policy determines how the earnings of a company are distributed. Earnings are either retained and reinvested in the company or are paid out to shareholders. • In recent years, the retention of earnings has been a major source of equity financing for private industry.

5. Determinants of Dividend Policy • Retained earnings are the most important source of equity. Retained earnings can be used to stimulate growth in future earnings and as a result can influence future share values. • On the other hand, dividends provide stockholders with tangible current returns.

6. Variations in payout Legal constraints Restrictive covenants Tax considerations Liquidity and CF considerations Borrowing capacity Access to capital markets Earnings stability Growth prospects Inflation Shareholder preference Protection against dilution Determinants of Dividend Policy

7. Industry and Company Variations in Dividend Payout Ratios • Dividend payout policies vary among different industries. As shown in Table 14.1, there is a wide variation in dividend payout ratios among different industries, ranging from 0.4 to 104 percent.

8. Industry and Company Variations in Dividend Payout Ratios • Likewise, within a given industry, while many firms may have similar dividend payout ratios, there can still be considerable variation. • For example, as illustrated in Table 14.2, within the tobacco industry, the dividend payout ratios are in the 31.5 to 85.0 percent range. Within the basic chemical industry, the variation in dividend payout ratios ranges from 15.7 to 160.7 percent.

9. Legal Constraints • Most states have laws that regulate the dividend payments a firm chartered in that state can make. These laws basically state the following: • A firm’s capital cannot be used to make dividend payments. (capital impairment restriction) • Dividends must be paid out of a firm’s present and past net earnings. (net earnings restriction) • Dividends cannot be paid when the firm is insolvent. (insolvency restriction)

10. Legal Constraints • The first restriction is termed the capital impairment restriction. • In some states, capital is defined as including only the par value of common stock; in others, capital is more broadly defined to also include the contributed capital in excess of par account (sometimes called capital surplus).

11. Legal Constraints • For example, consider the following capital accounts on the balance sheet of Johnson Tool and Die Company: Common stock ($5 par; 100,000 shares) $500,000 Contributed capital in excess of par $400,000 Retained earnings $200,000 Total common stockholders’ equity $1,100,000

12. Legal Constraints • If the company is chartered in a state that defines capital as the par value of common stock, then it can pay out a total of $600,000 ($1,100,000  $500,000 par value) in dividends. • If, however, the company’s home state restricts dividend payments to retained earnings alone, then Johnson Tool and Die could only pay dividends up to $200,000.

13. Legal Constraints • Regardless of the dividend laws, however, it should be realized that dividends are paid from a firm’s cash account with an offsetting entry to the retained earnings account.

14. Legal Constraints • The second restriction, called the net earnings restriction, requires that a firm have generated earnings before it is permitted to pay any cash dividends. This prevents the equity owners from withdrawing their initial investment in the firm and impairing the security position of any of the firm’s creditors.

15. Legal Constraints • The third restriction, termed the insolvency restriction, states that an insolvent company may not pay cash dividends. When a company is insolvent, its liabilities exceed its assets. Payment of dividends would interfere with the creditors’ prior claims on the firm’s assets and therefore is prohibited.

16. Legal Constraints • These three restrictions affect different types of companies in different ways. New firms, or small firms with a minimum of accumulated retained earnings, are most likely to feel the weight of these legal constraints when determining their dividend policies, whereas well-established companies with histories of profitable performance and large retained earnings accounts are less likely to be influenced by them.

17. Restrictive Covenants • Restrictive covenants generally have more impact on dividend policy than the legal constraints just discussed. These covenants are contained in bond indentures, term loans, short-term borrowing agreements, lease contracts, and preferred stock agreements.

18. Restrictive Covenants • These restrictions limit the total amount of dividends a firm can pay. Sometimes they may state that dividends cannot be paid at all until a firm’s earnings have reached a specified level. • For example, the 3.75 percent preferred stock issues (Series B) of Dayton Power & Light limits the amount of common stock dividends that can be paid if the company’s net income falls below a certain level.

19. Restrictive Covenants • In a dividend policy study of 80 troubled firms that cut dividends, researchers found that more than half of the firms apparently faced binding debt covenants in the years managers reduced dividends.

20. Restrictive Covenants • In addition, sinking fund requirements, which state that a certain portion of a firm’s cash flow must be set aside for the retirement of debt, sometimes limit dividend payments. • Also, dividends may be prohibited if a firm’s net working capital (current assets less current liabilities) or its current ratio does not exceed a certain predetermined level.

21. Tax Considerations • At various times the top personal marginal tax rates on dividend income have been higher than the top marginal tax rates on long-term capital gains income. At other times the two top marginal tax rates have been equal.

22. Tax Considerations • For example, prior to the 1986 Tax Reform Act, the top marginal tax rate on dividend income was 50 percent compared with 20 percent on long-term capital gains income. • The 1986 Tax Reform Act eliminated this differential by taxing both dividend and capital gains income at the same marginal rate.

23. Tax Considerations • The Revenue Reconciliation Act of 1993 created new top marginal tax rates of 39.6 percent for dividend income and 28 percent for capital gains income for individual taxpayers.

24. Tax Considerations • More recently, the Taxpayer Relief Act of 1997 lowered the maximum long-term capital gains rate for individuals to 20 percent and the Economic Growth and Tax Relief Reconciliation Act of 2001 reduced the top marginal tax rate on dividend income to 38.6 percent for 2002-2003, with further periodic reductions to a top rate of 35.0 percent in 2006 and thereafter.

25. Tax Considerations • Thus, under current tax laws, there is a tax benefit for many individuals to receive distributions in the form of capital gains income (that arises when a firm retains and reinvests earnings in the company) rather than as cash dividends.

26. Tax Considerations • Another tax disadvantage of dividends versus capital gains is that dividend income is taxed immediately (in the year it is received), but capital gains income (and corresponding taxes) can be deferred into the future.

27. Tax Considerations • If a corporation decides to retain its earnings in anticipation of providing growth and future capital appreciation for its investors, the investors are not taxed until their shares are sold. Consequently, for most investors, the present value of the taxes on future capital gains income is less than the taxes on an equivalent amount of current dividend income.

28. Tax Considerations • The deferral of taxes on capital gains can be viewed as an interest-free loan to the investor from the government.

29. Tax Considerations • Whereas the factors just explained tend to encourage corporations to retain their earnings, the IRS Code has the opposite effect. In essence, the code prohibits corporations from retaining an excessive amount of earnings to protect stockholders from paying taxes on dividends received.

30. Tax Considerations • If the IRS rules that a corporation has accumulated excess earnings to protect its stockholders from having to pay personal income taxes on dividends, the firm has to pay a heavy penalty tax on those earnings. It is the responsibility of the IRS to prove this allegation, however.

31. Tax Considerations • Some companies are more likely to raise the suspicions of the IRS than others. • For example, small closely held corporations whose shareholders are in high marginal tax brackets, firms that pay consistently low dividends, and those that have large amounts of cash and marketable securities are good candidates for IRS review.

32. Liquidity and Cash Flow Considerations • Recall from the previous chapter that free cash flow represents the portion of a firm’s cash flows available to service new debt, make dividend payments to shareholders, and invest in other projects. • Since dividend payments represent cash outflows, the more liquid a firm is, the more able it is to pay dividends.

33. Liquidity and Cash Flow Considerations • Even if a firm has a past record of high earnings that have been reinvested, resulting in a large retained earnings balance, it may not be able to pay dividends unless it has sufficient liquid assets, primarily cash.

34. Liquidity and Cash Flow Considerations • Liquidity is likely to be a problem during a long business downturn, when both earnings and cash flows often decline. • Rapidly growing firms with many profitable investment opportunities also often find it difficult to maintain adequate liquidity and pay dividends at the same time.

35. Borrowing Capacity and Access to the Capital Markets • Liquidity is desirable for a number of reasons. Specifically, it provides protection in the event of a financial crisis. It also provides the flexibility needed to take advantage of unusual financial and investment opportunities.

36. Borrowing Capacity and Access to the Capital Markets • There are other ways of achieving this flexibility and security, however.For example, companies frequently establish lines of credit and revolving credit agreements with banks, allowing them to borrow on short notice. Large well-established firms are usually able to go directly to credit markets with either a bond issue or a sale of commercial paper.

37. Borrowing Capacity and Access to the Capital Markets • The more access a firm has to these external sources of funds, the better able it will be to make dividend payments.

38. Borrowing Capacity and Access to the Capital Markets • A small firm whose stock is closely held and infrequently traded often finds it difficult (or undesirable) to sell new equity shares in the markets. As a result, retained earnings are the only source of new equity. When a firm of this type is faced with desirable investment opportunities, the payment of dividends is often inconsistent with the objective of maximizing the value of the firm.

39. Earnings Stability • Most large widely held firms are reluctant to lower their dividend payments, even in times of financial stress. Therefore, a firm with a history of stable earnings is usually more willing to pay a higher dividend than a firm with erratic earnings.

40. Earnings Stability • A firm whose cash flows have been more or less constant over the years can be fairly confident about its future and frequently reflects this confidence in higher dividend payments.

41. Growth Prospects • A rapidly growing firm usually has a substantial need for funds to finance the abundance of attractive investment opportunities. Instead of paying large dividends and then attempting to sell new shares to raise the equity investment capital it needs, this type of firm usually retains larger portions of its earnings and avoids the expense and inconvenience of public stock offerings.

42. Growth Prospects • Table 14.3 illustrates the relationship between earnings growth rates and dividend payout ratios for selected companies. Note that the companies with the highest dividend payout ratios tend to have the lowest growth rates and vice versa.

43. Shareholder Preferences • In a closely held corporation with relatively few stockholders, management may be able to set dividends according to the preferences of its stockholders. • For example, assume that the majority of a firm’s stockholders are in high marginal tax brackets. They probably favor a policy of high earnings retention, resulting in eventual price appreciation, over a high payout dividend policy.

44. Shareholder Preferences • However, high earnings retention implies that the firm has enough acceptable capital investment opportunities to justify the low payout dividend policy. • In addition, recall that the IRS does not permit corporations to retain excessive earnings if they have no legitimate investment opportunities.

45. Shareholder Preferences • Also, a policy of high retention when investment opportunities are not available is inconsistent with the objective of maximizing shareholder wealth.

46. Shareholder Preferences • In a large corporation whose shares are widely held, it is nearly impossible for a financial manager to take individual shareholders’ preferences into account when setting dividend policy.

47. Shareholder Preferences • Some wealthy stockholders who are in high marginal income tax brackets may prefer that a company reinvest its earnings (i.e., low payout ratio) to generate long-term capital gains.

48. Shareholder Preferences • Other shareholders, such as retired individuals and those living on fixed incomes (sometimes referred to as “widows and orphans”), may prefer a high dividend rate. These shareholders may be willing to pay a premium for common stock in a company that provides a higher dividend yield.

49. Shareholder Preferences • Large institutional investors that are in a zero income tax bracket, such as pension funds, university endowment funds, philanthropic organizations (e.g., Ford Foundation), and trust funds, may prefer a high dividend yield for reasons different from those of private individual stockholders.

50. Shareholder Preferences • First, endowment and trust funds are sometimes prohibited from spending the principal and must limit expenditures to the dividend (and/or interest) income generated by their investments.