FIN 3715 Chapter Notes - Chapter 13: Tender Offer, Net Present Value, Share Repurchase
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13 Dividend Policy and Internal Financing
The goal of a firm is to maximize the value of its common stock; the success or failure of managerial decisions
known based on their impact on the price. The policies taken regarding dividend policies and internal financing,
lead to managers influencing the price of the firm’s stock through its dividend policies. After this, the practical side
of the question is considered: The practices managers commonly follow when making decisions about paying a
dividend to its stockholders, or not. Share repurchase decisions are important in firms, many of which have
increasingly been repurchasing their shares of stock as an alternative to paying out cash dividends
The two basic components of the dividend policy:
• Dividend pay-out ratio the amount of dividends paid relative to the company’s earnings, or the ratio of
dividends paid per share divided by earnings per share.
• Stability of the dividends over time: While formulating a dividend policy, trade-offs come in to the picture.
The management decides investments and its debt–equity mix for financing the firm’s investments.
13.2 DIVIDEND POLICIES AND THE STOCKHOLDER
13.2.1 Three Basic Views
With the basic assumption that the firm plans to undertake all positive NPV investment opportunities regardless of
dividend pay, if the decision to pay a dividend interferes with the firm to make good investment, then the policy
obviously matters to the firm’s stockholders.
• View 1- A Firm’s Dividend Policy Is Irrelevant: The belief that stock prices change due to dividend
announcements and thus dividends are important is not true. In short, investors are concerned only with total
returns from investment decisions. To finance growth, the firm may:
a. Choose to issue stock, allowing internally generated funds (profits) to pay dividends and shareholders to
receive dividend income; or
b. Use internally generated funds to finance its growth, paying less in dividends but not having to issue stock,
increasing the value of their stocks.
• View 2- High Dividends Increase Stock Values: The belief that a firm’s dividend policy is unimportant
assumes an investor’s indifference about whether the increased income comes through capital gains or dividends.
Managers can control dividends, but they cannot dictate the price of the stock. The bird-in-the-hand dividend
theory tells us that investors are less certain of receiving income from capital gains than from dividends and that
the required rate for discounting capital gains is higher than for dividends. Since the dividend policy has no impact
on the company’s overall cash flows, it has no impact on the riskiness of the firm or stock.
• View 3- Low Dividends Increase Stock Values: The third view argues that dividends actually hurt the
investors based on the difference in the tax treatment of dividends versus capital gains.
13.3.2 Making Sense of Dividend Policy Theory
Both the dividend irrelevancy and high dividend philosophy are not entirely without fault. The third view, which is
essentially a tax argument against high dividends, is persuasive. Even today, although the preferential tax rate for
capital gains is limited, the “deferral advantage” of capital gains is still alive and well. Although no single definitive
answer, several plausible explanations have been developed. Some of them are:
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• The Residual Dividend Theory: Given the existence of flotation costs, the firm’s dividend policy should
therefore be as follows:
1. Accept investment if the NPV is positive.
2. Finance the equity portion of new investments first by using internally generated funds.
3. If any internally generated funds still remain after making all acceptable investments, pay dividends to the
investors. However, if all of the internal capital is needed to finance acceptable investments, pay no dividends.
According to this concept, a dividend policy is totally passive in nature and can’t affect the market price of the
• The Clientele Effect: Since reinvesting stocks means payment of taxes and pre- sale re-evaluation,
investors may not be too inclined to buy stocks that require them to “create” a dividend stream more suitable to
their purposes. Thus, firms draw a given clientele, depending upon their stated dividend policy. The clientele effect
only warns firms to avoid making capricious changes in their dividend policy.
• The Information Effect: A dividend increase that is larger than expected might signal to investors that
managers expect significantly higher earnings in the future, presenting a rosy picture of the firm’s financial
condition and earning power. Some claim that managers frequently have inside information about the firm that
cannot be made available to investors. This information asymmetry, they believe, can result in a lower or higher
stock price than would otherwise occur. Dividends, thus, become important as a communication tool, a credible
way to inform investors about future earnings, or at least no convincing way that is less costly. Thus, the payment
of dividends indirectly results in a closer monitoring of management’s investment activities.
• The Expectations Theory: Is the concept that we shouldn’t overlook the significance of the word
“expected” with reference to the dividend policy when we are making any financial decision within the firm. No
matter what the decision area, how the market price responds to a firm’s actions is not determined entirely by the
action itself; it is also affected by investors’ expectations about the ultimate decision to be made by management.
Conclusion: A firm must develop a dividend policy regardless, so here are some of the things we have learned
about the relevance of a firm’s dividend policy:
• As a firm’s investment opportunities increase, its dividend payout ratio should decrease.
• The dividend may carry greater weight than a statement by management that earnings will be
increasing or decreasing.
• If dividends influence the stock price, this is probably based on the investor’s desire to minimize or
defer taxes and on the fact that dividends can minimize agency costs.
• If the expectations theory has merit, the firm should avoid surprising investors when it comes to
its dividend decision.
• The firm’s dividend policy should effectively be treated as a long-term residual. If internal funds
remain after the firm has undertaken all acceptable investments, dividends should be paid.
In reality, the theories do not provide an equation that perfectly explains the key relationships.
However, they give us a more complete view of the world, which can only help us make better
13. 4. THE DEVIDEND DECISION IN PRACTICE
There are a number of practical considerations that will have an impact on a firm’s decision to pay dividends. Some
of them are:
• Legal Restrictions
Legal constraints fall into two categories.
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