Dividend Policy Prepared by Keldon Bauer Dividend Basics Once a profit is earned a firm must choose whether to Reinvest in the business This shows up as an increase in retained earnings Declare a dividend Pay the earnings back to owners Dividend Mechanics Caterpillar Press Release October 12 2006 PEORIA IL Caterpillar Inc NYSE CAT today declared a quarterly cash dividend of thirty cents 0 30 per share on its common stock payable November 20 2006 to stockholders of record at the close of business October 23 2006 The thirty cent dividend maintains the dividend rate for the previous quarter and is 20 percent higher than the dividend paid one year ago and is 46 percent higher than the split adjusted dividend paid two years ago Dividend Mechanics Relevant Dates Record Date October 23 in example Date set by board of directors on which all recorded shareholders receive declared dividend at a specified future date Ex Dividend October 21 in example The date on which the stock trades without the right to receive the current dividend Begins 2 business days prior to the date of record Dividend Mechanics Relevant Dates continued Declaration Date October 12 in example Date set by board of directors makes the dividend declaration Payment Date November 20 in example The date on which the firm mails the dividend payment Tax Treatment of Dividends The Jobs and Growth Tax Relief Reconciliation Act of 2003 changed the tax treatment of dividends Before the act dividends were taxed as ordinary income Now dividends are taxed at approximately the same rate as capital gains DRIPs Many firms offer shareholders a Dividend ReInvestment Plan DRIP The shareholder can opt to receive additional shares rather than a cash dividend The transaction saves the shareholder much of the transactions costs The transaction saves the firm floatation costs Dividends or Capital Gains The ultimate goal of financial managers should be the maximization of shareholder wealth Shareholder wealth can be maximized by maximizing the price of the stock As you have learned earlier the price of the stock is the expected present value of future cash flows Dividends or Capital Gains In the late 1950s Myron Gordon proposed modeling price on a firm s dividends and growth potential D1 P0 ks g Optimal Dividend Policy To maximize price an optimal balance must be found between current dividends D1 and the need for growth g Dividends or Capital Gains The Residual Theory of Dividends Investors prefer to have the firm retain and reinvest earnings if they can earn a higher risk adjusted return than the investor can Residual Dividend Policy suggests that dividends should be that part of earnings which cannot be invested at a rate at least equal to the WACC Dividend Policy Classes Residual Dividend Policy Steps 1 Determine the optimal capital budget 2 Determine the retained earnings that can be used to finance the capital budget 3 Use retained earnings to supply as much of the equity investment in the capital budget as necessary 4 Pay dividends only if there are left over earnings Dividend Policy and Stock Price Dividend Irrelevance Theory Miller Modigliani argued that dividend policy should be irrelevant to stock price If dividends don t matter this chapter is irrelevant as well which is what most of you are thinking anyway Dividend Irrelevance Theory 1 Vt Dt Vt 1 mt 1 Pt 1 1 rt where rt Discount rate Dt Total Dividends Paid Vt 1 Firm Value t 1 nt Pt 1 mt 1 Pt 1 Amount raised in equity I t X t Dt I t Capital Investments X t Income t Dividend Irrelevance Theory 1 Vt Dt Vt 1 I t X t Dt 1 rt 1 Vt 1 I t X t 1 rt Dividends are not in the final equation Therefore dividends are irrelevant to value Dividend Irrelevance Theory Informational content Signaling Theory Managers have superior information to investors about the cash flow prospects of the firm Dividends are only increased if they are not likely to be cut in future Increased dividends are a positive signal Decreased dividends are a negative signal Dividend Irrelevance Theory Clientele Effect Tax free foundations and retirees at lower marginal tax rates prefer cash now and on a predictable basis Investors at higher marginal tax rates prefer capital gains to dividends Each firm therefore attracts the type of investor that likes its dividend policy Bird in the Hand Theory Gordon argued that a dividend in the hand is worth more than the present value of a future dividend D1 ks g P0 In essence he said that the risk premium on the dividend yield is higher than on the growth rate Factors Affecting Dividend Policy Legal Constraints State Statute Contractual Constraints Internal Constaints Growth Prospects Owner Considerations Market Considerations Current research on international dividend policy Dividend Policy Classes Regular Dividend Policy Due to the possibility of a negative signal to investors many CFOs have set the policy of never reducing their dividends Dividends are only increased if management is certain future earnings will support such a high dividend Dividend Policy Classes Regular Dividend Policy A variation of this policy is one in which dividends exhibit a stable predictable growth rate In that instance the company has to set the policy in such a way that the growth rate can be sustained for the foreseeable future Dividend Policy Classes Regular Dividend Policy Steps 1 Pay a predictable dividend every year 2 Base optimal capital budget on residual retained earnings after dividend Dividend Policy Classes Constant Payout Ratio Policy It is possible that a company could set a policy to payout a certain percentage of earnings as dividends The problem is that such a policy would not fit the needs of the firms stockholders since it would cause a great deal of volatility in dividends paid see clientele effect spoken of earlier Dividend Policy Classes Constant Payout Ratio Policy Steps 1 Pay a constant proportion of earnings if positive 2 Base optimal capital budget on residual retained earnings Dividend Policy Classes Low Regular Dividend Plus Extras This policy is a hybrid of the last two policies It is meant to keep expectations low for dividends and supplement those dividends with bonuses in good years The problem is the potential for negative signaling Dividend Policy Classes Low Regular Dividend Plus Extras Steps 1 Pay a predictable dividend every year 2 In years with good earnings pay a bonus dividend 3 Base optimal capital budget on residual of regular dividend and compromising with bonus