28.Dividend Policy

CHAPTER 28 DIVIDEND POLICY Your company’s dividend policy is important for these reasons: ❍ It impacts the financing program and capital budget. ❍ It affects cash flow. A company experiencing liquid- ity problems may be forced to restrict its dividend payments. ❍ It influences investor attitudes. For example, stock- holders do not like dividends cut because they associate it with corporate financial problems. Fur- thermore, in formulating a dividend policy, the CFO must determine and fulfill the owner’s objectives. Otherwise, the stockholders may sell their shares, which in turn may lower the market price of the stock. Stockholder dissatisfaction raises the possibil- ity that control of the company may be acquired by an outside group. ❍ It lowers stockholders’ equity since dividends reduce retained earnings, and so results in a higher debt to equity ratio. If your company’s cash flows and investment require- ments are unstable, the CFO should not recommend a high regular dividend. It would be better to establish a low regular dividend that can be met even in bad years. What dividend policy is best for your company? The company’s dividend policy should maximize owner wealth while providing adequate financing for the busi- ness. When the company’s profitability increases, the CFO does not automatically raise the dividend. Generally, there is a time lag between increased earnings and the payment of a higher dividend. The CFO should be optimistic that the increased earnings will be sustained before he or she increases the dividend. If dividends are increased, they should continue to be paid at the higher rate. There are 530 Dividend Policy 531 at least four different types of dividend policies the CFO may choose from: 1. Stable dividend-per-share policy. Many companies use a stable dividend-per-share policy because it is looked upon favorably by investors. A stable div- idend implies a low-risk company. The dividend should be maintained even in loss years because the shareholders are more apt to consider the losses as temporary. Furthermore, some stockholders rely on the receipt of stable dividends for income. A stable dividend policy is also necessary for a company to be placed on a list of securities in which financial institutions (pension funds, insurance companies) invest. The inclusion on the list provides greater marketability for corporate shares. 2. Constant dividend-payout ratio (dividends per share/ earnings per share). A constant percentage of earn- ings is paid out in dividends. Because net income fluctuates, dividends paid will also vary using this policy. A problem arises if the company’s earnings fall drastically or there is a loss because the dividends paid will be significantly reduced or nonexistent. This policy will not maximize market price per share since most stockholders do not want variability in their dividend receipts. 3. A compromise policy. A compromise between the policies of a stable dollar amount and a percent- age amount of dividends is for a company to pay a lower dollar amount per share plus a percentage increment in good years. Although this policy pro- vides flexibility, it also results in uncertainty in the minds of investors as to the amount of dividends they are likely to receive. Stockholders typically do not like such uncertainty. However, this policy may be suitable when earnings vary considerably over the years. The percentage, or extra, portion of the dividend should not be paid regularly; otherwise it becomes meaningless. 4. Residual-dividend policy. When a company’s invest- ment opportunities are not stable, the CFO may wish to consider avacillating dividend policy. The amount of earnings retained depends on the availability of investment opportunities. Dividends represent the residual amount from earnings after the company’s investment needs are satisfied. 532 Dividend Policy EXAMPLE 28.1 Company A and company B are identical except for their dividend policies. Company A pays out a constant percentage of its net income (40 percent div- idends), while company B pays out a constant dollar dividend. Company B’s market price per share is higher than that of company A because the stock market looks favorably upon stable dollar dividends which imply less uncertainty. EXAMPLE 28.2 Hayes Manufacturing Company had a net income of $800,000 in 20X1. Earnings have grown at an 8 percent annual rate. Dividends in 20X1 were $300,000. In 20X2, the net income was $1.1 million. This was much higher than the typical 8 percent annual growth rate. It is anticipated that profits will be back to the 8 percent rate in future years. The investment in 20X2 was $700,000. Assuming a stable dividend payout ratio of 25 percent, the dividends to be paid in 20X2 will be $275,000 ($1,100,000 × 25%). If a stable dollar dividend policy is maintained, the 20X2 dividend payment will be $324,000 ($300,000 × 1.08). Assuming a residual dividend policy is maintained and 40 percent of the 20X2 investment is financed with debt, the 20X2 dividend will be: Equity needed = $700,000 × 60% = $420,000 Since net income exceeds the equity needed, all of the $420,000 of equity investment will be derived from net income. Dividend = $1,100,000 − $420,000 = $680,000 If the investment for 20X2 is to be financed with 80 percent debt and 20 percent retained earnings, and any net income not invested is paid out in dividends, then the dividends will be: Earnings retained = $700,000 ×20% = $140,000 Dividend = Net income − Earnings retained $960,000 = $1,100,000 −$140,000 Dividend Policy 533 In theory, how much should be paid in dividends? Theoretically, the company should retain earnings rather than distribute them when the corporate return exceeds the return investors can obtain on their money elsewhere. Furthermore, if the company obtains a return on its profits that exceeds the cost of capital, the market price of its stock will be maximized. However, theoretically the company should not keep funds for investment if it earns less of a return than what the investors can earn elsewhere. If the owners have better investment opportunities outside the company, the firm should pay a high dividend. Although theoretical considerations from a financial perspective should be taken into account when establish- ing dividend policy, the practicality of the situation is that investors expect to be paid dividends. Psychological fac- tors that may adversely impact the market price of the stock of a company that does not pay dividends come into play. What are the important variables in establishing dividend policy? A company’s dividend policy depends on many variables, some of which have already been mentioned. Other factors to be considered are: ❍ Profitability. Dividend distribution is tied toearnings. ❍ Earnings stability. A company with stable earnings is better able to distribute a higher percentage of its profit than one with unstable earnings. ❍ Tax penalties. The tax penalties for excess accumula- tion of retained earnings may result in high-dividend payouts. ❍ Financial leverage. A company with a high debt-to- equity ratio is more likely to retain profits so that it will have the funds to pay interest and principal on debt when due. ❍ Restrictive covenants. There may be a restriction in a loan agreement limiting the dividend payments. ❍ Growth rate. A rapidly growing company, even if profitable, may have to cut back on dividends to keep funds within the business for growth. ❍ Uncertainty. The payment of dividends reduces the uncertainty in stockholders’ minds about the firm’s financial condition. ❍ Ability to finance externally. A company that is able to obtain outside financing can afford to have a higher 534 Dividend Policy dividend payout ratio. When external sources of funds are limited, more earnings will be retained for planned financial needs. ❍ Age and size. An older, established, large company is usually better able to maintain dividend payments. ❍ Maintenance of control. Management that is reluctant to issue additional common stock because it does not want to dilute control of the firm will retain a higher percentage of its earnings. Internal financing enables control to be kept within. How does stock repurchase benefit or hinder the company? The purchase of treasury stock is an alternative to pay- ing dividends. Since outstanding shares will be fewer after stock has been repurchased, earnings per share will increase (assuming net income is held constant). The increase in earnings per share may result in a higher market price per share. EXAMPLE 28.3 A company earned $2.5 million in 20X1. Of this amount, it decided that 20 percent would be used to buy treasury stock. Currently, there are 400,000 shares outstanding. Market price per share is $18. The company can use $500,000 (20% × $2.5 million) to buy back 25,000 shares through a tender offer of $20 per share. The offer price of $20 is higher than the current market price of $18 because the company feels its buyback will drive up the price of existing shares due to the demand/supply relationship. Current earnings per share is: EPS = Net income Outstanding shares = $2,500,000 400,000 = $6.25 The current P/E multiple is: Market price per share Earnings per share = $18 $6.25 = 2.88 times Earnings per share after treasury stock is acquired becomes: $2,500,000 400,000 − 25,000 = $2,500,000 375,000 = $6.67 The expected market price, assuming the P/E ratio (multiple) remains the same, is: Dividend Policy 535 EXAMPLE 28.3 (continued) P/E multiple × New earnings per share = Expected market price 2.88 × $6.67 = $19.21 The benefits from a stock repurchase include: ❍ Treasury stock can be resold if additional funds are needed. If the treasury stock was acquired for a price less than the current market price, the excess increases paid-in-capital. ❍ If there is temporary excess cash, the CFO may prefer to repurchase stock than to pay a higher dividend that he or she believes cannot be maintained. ❍ Treasury stock can be used for stock options or future acquisitions. ❍ If management is holding stock, they will favor a stock repurchase rather than a dividend because of the favorable tax treatment. The disadvantages of treasury stock acquisition include: ❍ If investors believe that the company is engaging in a repurchase plan because there are no alternative good investment prospects, a decline in the mar- ket price of stock may occur. However, there are instances when this has not happened, such as when General Electric announced a plan of periodic reac- quisition of stock because of a lack of more attractive investment opportunities. ❍ If the reacquisition of stock appears to be manipula- tion, the Securities and Exchange Commission may investigate. Furthermore, if the Internal Revenue Service concludes that the repurchase is designed to avoid the payment of tax on dividends, tax penalties may be imposed because of the improper accumula- tion of earnings. . a high regular dividend. It would be better to establish a low regular dividend that can be met even in bad years. What dividend policy is best for your company? The company’s dividend policy should. CHAPTER 28 DIVIDEND POLICY Your company’s dividend policy is important for these reasons: ❍ It impacts the financing program and. she increases the dividend. If dividends are increased, they should continue to be paid at the higher rate. There are 530 Dividend Policy 531 at least four different types of dividend policies