Question

Prompt 1
MM’s dividend irrelevance theory states that dividend policy does not affect either stock prices or the required rate of return on equity. This implies that shareholders should be indifferent as to which form of payout the firm chooses. At the same time, firms spend a good amount of resources over planning their payout policies.

• Discuss why firms spend so much time and money planning their payout policies if it doesn’t affect stock or the required rate of return on equity?

Prompt 2
Now, read the description/report below (from page 497-9 of your textbook).

We forecasted the total market demand for our products, what our share of the market is likely to be, and our required investments in capital assets and working capital. Using this information, we developed projected balance sheets and income statements for the period 2015–2019.

Our 2014 dividends totaled $50 million, or $2.00 per share. On the basis of projected earnings, cash flows, and capital requirements, we can increase the dividend by 6% per year. This would be consistent with a payout ratio of 42%, on average, over the forecast period. Any faster dividend growth rate would require us to sell common stock, cut the capital budget, or raise the debt ratio. Any slower growth rate would lead to increases in the common equity ratio. Therefore, I recommend that the Board increase the dividend for 2015 by 6%, to $2.12, and that it plan for similar increases in the future.

Events over the next 5 years will undoubtedly lead to differences between our forecasts and actual results. If and when such events occur, we should reexamine our position. However, I am confident that we can meet random cash shortfalls by increasing our borrowings—we have unused debt capacity that gives us flexibility in this regard.

We ran the corporate model under several scenarios. If the economy totally collapses, our earnings will not cover the dividend. However, in all likely scenarios our cash flows would cover the recommended dividend. I know the Board does not want to push the dividend up to a level where we would have to cut it under poor economic conditions. Our model runs indicate, though, that the $2.12 dividend could be maintained under any reasonable set of forecasts. Only if we increased the dividend to more than $3.00 would we be seriously exposed to the danger of having to reduce it.

I might also note that most analysts’ reports are forecasting that our dividends will grow in the 5% to 6% range. Thus, if we go to $2.12, we will be at the high end of the forecast range, which should give our stock a boost. With takeover rumors so widespread, getting the stock price up a bit would make us all breathe a little easier.

Finally, we considered distributing cash to shareholders through a stock repurchase program. Here we would reduce the dividend payout ratio and use the funds generated to buy our stock on the open market. Such a program has several advantages, but it would also have drawbacks. I do not recommend that we institute a stock repurchase program at this time. However, if our free cash flows exceed our forecasts, I would recommend that we use these surpluses to buy back stock. Also, I plan to continue looking into a regular repurchase program, and I may recommend such a program in the future.

• Discuss how stable this firm seems to be based on the payout policy they are undertaking.

Answer 1

Dividend Policy

Prompt 1;

This question is continuously debated in Financial Literature, ad naseum and the following discussion incorporates views from several researched and published sources and are considered extant in today’s financial world.

[All sources are cited withing the text and additional sources are cited at the end of the discussion}:

Many theories have been proposed to explain the managers time to debate the dividend policy of a company.

Some of the questions implicitly raised include but are not limited to:

1. What factors do managers consider important in deciding their company’s dividend policy?

2. Do managers perceive a relationship between themselves and their companies? Do they consider a relationship between their dividend policy and the value of the share?

3. Do managers consider last year’s dividend policy relevant in deciding the current dividend policy?

4. Do managers consider the tax status of their shareholders as an important determinant of dividend policy?

5. Do managers use dividend policy as a signal for indicating the company’s future prospects to shareholders?

6. Do managers consider dividend payment merely as a residue?

And Finally,

7. Do Managers have a vested interest in deciding Dividend policy?

Experience to dividend policy expose interesting conclusions.

• payment of dividend depends on current and expected earnings as well as the pattern of past dividends.
• managers of companies with Dividend decision of a company involves the question of how much of the net earnings should be distributed to shareholders as dividends and how much should be retained in the business. The debate of finance managers will include how much of retained earnings are internally available funds for financing the growth of companies and this involves an internal assessment on (i) Capital Expenditure, (ii) Opportunity cost against the Firm’s Cost of Capital.
• Simultaneously, managers will assess if dividends are desirable from shareholders' point of view as they are perceived by investors to increase their wealth. This return to shareholders consists of two components : (i) dividends and (ii) capital gains. However, share prices are generally affected by a large number of external players and not just alone by dividend policy of the company. This is further complicated by the fact that capital gains are perceived to be more uncertain than dividends and also, capital gains are taxed at a lesser rate than dividends.

Dividend Policy Decisions of Managers:

The dividend policy depends on the (i) availability of investment opportunities and (ii) the relationship between the firm's internal rate of return and its cost of capital. [Firms having internal rate of return greater than the cost of capital, as may be case with growth firms, would have ample profitable investment opportunities. By retaining all earnings the firm can maximize the value per share. In case of declining firms where internal rate of return is less than cost of capital the firm will be maximizing value of share by distributing 100 per cent of earnings as dividends to their shareholders].

This includes,

* Psychology: Investors tend to discount distant dividends at a higher rate than near dividends. Investors, behaving rationally, are risk-averse and, therefore, have a preference for near dividends to future dividends. According to this view, given any two companies in the same general position and the same earning power, the one paying the larger dividend will always command a higher price for its share (Graham and Dodd 1934, Gordon 1962, Kirshman 1933).

* Dividend policy of a firm is irrelevant   as it does not affect the wealth of shareholders (Miller and Modigliani 1961). According to this view, the value of the firm depends on its earnings power which is determined by the firm's investment policy. The split of earnings between dividends and retained earnings is of no significance. When a firm pays dividends, it has to raise funds externally to finance its investment plans and as a result, its advantage is offset by external financing.

* Since capital gains are taxed at lower rate than dividends and the capital gains tax is payable only when the shares are actually sold, shareholders would generally prefer low dividends Tax differential and liquidity considerations, according to this view, would attract specific pay-out clientele. Depending on ownership structure, E.G. Founder Shares in high-tax brackets will prefer low dividend paying shares (low pay-out clientele) and those in low-tax brackets will prefer high dividend paying companies (high pay-out clientele).

* Companies having more borrowing in their capital structure or planning to raise loan funds should have smaller dividend pay-out policy (John & Kalay 1982, Ang 1978). According to this view, lenders would prefer company to pay less dividends since lesser distribution of earnings would mean increase in net worth of the firm and more security to lenders. Otherwise, it will be viewed as firm maximizing returns to shareholders at the cost of lenders.   The inclusion of covenants restraining dividend payments as part of loan agreements are common.

* Some recognize that market value of shares respond to announced changes in dividend policy of companies. These responses are the result of information content in dividend changes. Managers will use the dividend changes to convey information about future earnings of the company and share price movements. This is based on the dividend-signalling hypothesis (Ross 1977). 68 Decision, Vol. 21, Nos. 1 & 2, January - June 1994

* Companies generally specify their dividend policy in terms of dividend per share or dividend rate and they do not consider modifying the pattern of dividend behaviour because of investment requirements (Lintner 1956).

Further, firms generally have target pay-out ratios in view while determining change in dividend per share or dividend rate. In practice, firms do not change their dividends per share or dividend rate immediately with changes in earnings per share; they change their dividends slowly and gradually. This means that firms have standards regarding the speed with which they attempt to move towards the full adjustment of pay out to earnings. This suggests that firms establish their dividends in accordance with the level of current earnings as well as dividend of the previous year.

The findings from various studies are not conclusive. The conclusion of Black (1976) who wrote : ""What should the corporation do about dividend policy ?" and he answers : "We don't know".

Additional Sources

1. (Walter 1963).:

2. Professor Ramesh Bhat. I.M. Pandey is Dean at Indian Institute of Management Ahmedabad. Decision, Vol. 21, Nos. 1 & 2, January – June 1994 67

Prompt 2.

The Financial Manager indicates that that the Firm could be an acquisition target. His analysis therefore has to also get the best price for stockholders

1. The firm is very stable financially as the indicative economic growth rate / pay-out ratio is excellent even in in a worse case scenario dividend can be met with cash flow.

2. Unused Debt, indicates that it is still financially unlevered and debt servicing covenants can be extracted to allow for a current dividend pay-out ratio. It WACC can be improved by after tax interest shields in the event of external borrowings is necessary

3. If market is also factoring a dividend pay-out ration UPTO $3 per share,(50% increase from current) then independent forecasts suggest current dividend ratio is achievable..