Dividend Policy and Retained Earnings(Chapter 18).ppt

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. 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 wor