Group 6

Elevencionado, Nhemia M.
Bancil, Carl Emiliano B.
Eltagon, Jayzelle Ace M.
Boclaras, Herwin Mae M.
Ca-as, Hyacinth Dianne M.
Escalada, Frenzie Dionne R.

Dividends versus Capital Gains

When deciding how much cash to distribute, financial managers must keep in mind that the firm’s objective is
to maximize shareholder value. Consequently, the target payout ratio—defined as the percentage of net
income to be paid out as cash dividends—should be based in large part on investors’ preferences for dividends
versus capital gains: Do investors prefer to receive dividends; or would they rather have the firm plow the cash
back into the business, which presumably will produce capital gains? This preference can be considered in
terms of the constant growth stock valuation model.

If the company increases the payout ratio, this will raise D1, which, taken alone, will cause the stock price to
rise. However, if D1 is raised, less money will be available for reinvestment, which will cause the expected
growth rate to decline; and that will tend to lower the stock’s price. Therefore, any change in the payout policy
will have two opposing effects. As a result, the optimal dividend policy must strike the balance between current
dividends and future growth that maximizes the stock price. In the following sections, we discuss the major
theories that have been advanced to explain how investors regard current dividends versus future growth.

CASH DISTRIBUTIONS AND FIRM VALUE

A company can change its value of operations only if it changes the cost of capital or investors’ perceptions
regarding expected free cash flow. This is true for all corporate decisions, including the distribution policy. Is
there an optimal distribution policy that maximizes a company’s intrinsic value?

The relative mix of dividend yields and capital gains is determined by:

 target distribution ratio, which is the percentage of net income distributed to shareholders through
cash dividends or stock repurchases

 target payout ratio, which is the percentage of net income paid as a cash dividend.

 A high distribution ratio and a high payout ratio mean that a company pays large dividends and has
small (or zero) stock repurchases.

In this situation, the dividend yield is relatively high and the expected capital gain is low.

 If a company has a large distribution ratio but a small payout ratio, then it pays low dividends but
regularly repurchases stock, resulting in a low dividend yield but a relatively high expected capital gain
yield.

 If a company has a low distribution ratio, then it must also have a relatively low payout ratio, again
resulting in a low dividend yield and, it is hoped, a relatively high capital gain.

Do investors prefer high or low dividend payouts?

 Three theories of dividend policy:

 Dividend irrelevance: Investors don’t care about payout.

 Bird-in-the-hand: Investors prefer a high payout.

 Tax preference: Investors prefer a low payout.

 Dividend Irrelevance Theory

 The dividend irrelevance theory was created by Modigliani and Miller in 1961. The authors concluded
that dividend policy has no effect on the market value of a company or its capital structure. The idea
 behind the theory is that a company’s market value depends rather on its ability to generate earnings
and business risk.

Assumptions

The dividend irrelevance policy assumes the following:

• The capital markets are perfect

• There are neither flotation nor transaction costs

• There are no taxes

• The capital structure does not affect cost, i.e., cost of capital is constant at any proportion of debt and
equity

• Both management of companies and investors have equal access to all public and private information,
i.e., there is no arbitrage opportunity

• The cost of equity is constant at any dividend payout rate

• The dividend policy does not affect capital budgeting

Dividend irrelevance theory

 The dividend irrelevance theory states that investors may affect cash flows regardless of a company’s
dividend policy.

 If a particular investor considers the dividend is too high, the surplus will be used to buy additional
company stock.

 If an investor considers the dividend is too low, it will sell some portion of its stock to replicate the
expected dividends.

 Thus, the dividends are irrelevant to investors because they can control their own cash flows depending
on their cash needs.

 Criticism

 Critics of the dividend irrelevance theory note that none of its assumptions are realistic. Both
companies and investors are required to pay income tax. There are also flotation and transaction costs
that affect investor behavior. This allows critics to claim that in reality a company’s dividend policy
affects the value of the company, its capital structure, and investor behavior.

Dividend Preference (Bird-in-the-Hand)

A return in the form of dividends is a sure thing, but a return in the form of capital gains is risky.

 The bird in hand is a theory that says investors prefer dividends from stock investing to potential capital
gains because of the inherent uncertainty associated with capital gains. Based on the adage, "a bird in
the hand is worth two in the bush," the bird-in-hand theory states that investors prefer the certainty of
dividend payments than the possibility of substantially higher future capital gains.

Assumptions

The bird-in-hand theory by Gordon and Lintner is based on following assumptions:

• The company is financed by equity only, i.e. debt finance is not used

• The only source of finance is retained earnings, any other sources of financing are not available

• The retention ratio is constant, i.e. there is constant growth rate of earnings

• The company’s cost of capital is constant and greater than growth rate

• There is no corporate taxes

 • The basic idea behind the bird-in-hand theory by Gordon and Linntner is that low dividend payout leads
to increase in cost of capital. Therefore, the higher is dividend payout rate, the higher is stock’s price.
This relationships are shown in the figure below

 The authors believed, that investors would prefer to get paid dividend now than capital gain in a while.
In other words, dividends are more certain for investors than capital gain. They would not accept the
proposal to decrease dividend payout in order to increase retained earnings and get bigger capital
gains in the future. The longer is the period of time the greater is uncertainly, thus capital gains are
more risky for investors than dividends.

Criticism

 The idea behind criticism of the bird-in-hand theory is that investors mostly reinvest dividend by
purchasing stocks of the same or others companies. So, companies receive back the biggest portion of
dividend payouts. Thus, the value of the company or cost of capital is irrelevant to the dividend policy
and rather depends on its ability to generate earnings and business risk.

 Tax Effect(preference) Theory

 Tax preference theory is one of the major theories concerning dividend policy in an enterprise. It was
first developed by R.H. Litzenberger and K. Ramaswamy. This theory claims that investors prefer lower
payout companies for tax reasons. They based this theory on observation of American stock market,
and presented three major reasons why investors might prefer lower payout companies.

 Unlike dividend, long-term capital gains allow the investor to defer tax payment until they decide to sell
the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than
the same tax paid in the future.

 Up until 1986 in USA all dividend and only 40 percent of capital gains were taxed. At a taxation rate of
50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on long-term capital gains.
Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes.
As of 1989 dividend and capital gains tax rates are equal but deferral issue still remains.

 If a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them
on the death day at their base costs and avoid capital gains tax payment.

 The dividend decision is an integral part of a company's financial decision-making as it is explicitly

related to the other two major decisions — investment and financing decision. Corporate taxation
influences the dividend decision in more than one way. On the one hand, it influences the net income-
after-tax of the company, which, in turn, determines the capacity of the company to pay dividends, and,
on the other hand, it may have implications for the net value received by the shareholders.

 Rate of corporate tax play an important role in determining the dividend policy, amount of dividend
declared, distributed or paid by the company

 Clientele effect

 describes the change in the company’s stock price according to the demands and goals of investors in
reaction to a tax, dividend or other policy change affecting the company.
  The clientele effect assumes that investors are attracted to different company policies, and that when
a company's policy changes, investors will adjust their stock holdings

 accordingly. As a result of this adjustment, the stock price will move.

 Studies showed that investors tend to invest in firms whose dividend policy matches their preferences.

 Thus the dividend policy of firm attracts investors who like it and the supply of dividends is adjusted
according to the demand of investors.

 For example, if a public technology stock pays no dividends and reinvests all of its profits back into its
operations, it initially attracts growth investors. However, if the company stops reinvesting in its growth
and instead begins channeling money to dividend payouts, high-growth investors may be inclined to
exit their positions and seek other high-growth potential stocks. Dividend-seeking income investors may
now view the company as an attractive investment.

 Example, Consider a company that already pays dividends and has consequently attracted clientele
seeking high dividend-paying stocks. If the company should experience a downturn or elects to
decrease its dividend offerings, the dividend investors may sell their stock and reinvest the proceeds in
another company paying higher returns. As a result of a sell-off, the company's share price is apt to
decline, and that is a form of the clientele effect.

 Information Content, or Signaling, Hypothesis

 This is a theory which asserts that announcement of increased dividend payments by a company gives
strong signals about the bright future prospects of the company.

 An announcement of an increase in dividend pay out is taken very positively in the market and helps
building a very positive image of the company regarding the growth prospects and stability in the future.

Generally, dividend signaling is done by the company when it changes the amount of dividend to be
paid to shareholders.

Dividend announcements have information, or signaling content about future earnings.

 Investors view dividend increases as signals of management’s view of the future.

 Managers hate to cut dividends, so they won’t raise dividends unless they think raise is
sustainable. So, investors view dividend increases as signals of management’s view of the
future.

 Stock price increase at time of a dividend increase could be due to either

 Investors interpreting it as a signal that management thinks EPS increase is sustainable

(signaling hypothesis) or

 Investors preferring higher-dividend stocks (bird-in-the-hand theory)

 Larger than normal dividend signals future is bright (positive). Stock price tends to increase

 Smaller than expected increase or dividend cut is negative signal. Stock price tends to fall.

 Normal increase of dividends is neutral

A Tale of 2 Cash Distributions: Dividends versus Stock Repurchases

Throughout the history of organized capital markets, investors as a whole seemed to believe that companies
existed solely for the sake of generating dividends for the owners. After all, investing is the process of laying
out money today so that it will generate more money for you and your family in the future; growth in the
business means nothing unless it results in changes in your lifestyle either in the form of nicer material goods
or financial independence. Certainly, there was the odd exception – Andrew Carnegie, for example, often
pushed his Board of Directors to keep dividend payouts low, instead of reinvesting capital into property, plant,
equipment, and personnel.

So which is better, cash dividends or stock repurchases? Like so many questions, the answer is simply, “it
depends.”

If you are an investor that needs cash upon which to live or want to ensure that you, rather than management,
can allocate excess profit, you might prefer dividends.

If on the other hand, you are interested in finding a company that you truly believe can generate large profits by
reinvesting in a business that can earn high returns on equity with little on debt, you may want a firm that
repurchases stocks.

THE PROS AND CONS OF DIVIDENDS AND REPURCHASES

The advantages of repurchases can be listed as follows.

1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often
motivated by management’s belief that the firm’s shares are undervalued.

2. Stockholders have a choice when the firm distributes cash by repurchasing stock —they can sell or not sell.
Those stockholders who need cash can sell back some of their shares while others can simply retain their
stock. With a cash dividend, on the other hand, stockholders must accept a dividend payment.

3. Dividends are “sticky” in the short run because management is usually reluctant to raise the dividend if the
increase cannot be maintained in the future, and cutting cash dividends is always avoided because of the
negative signal it gives. Hence, if the excess cash flow is thought to be only temporary, management may
prefer making the distribution in the form of a stock repurchase to declaring an increased cash dividend that
cannot be maintained.

4. Companies can use the residual model to set a target cash distribution level and then divide the distribution
into a dividend component and a repurchase component. The dividend payout ratio will be relatively low, but
the dividend itself will be relatively secure, and it will grow as a result of the declining number of shares
outstanding.

The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in
the form of cash dividends, because repurchases can be varied from year to year without giving off adverse
signals. This procedure, which is what Florida Power & Light employed, has much to recommend it, and it is
one reason for the dramatic increase in the total volume of stock repurchases.

5. Repurchases can be used to produce large-scale changes in capital structures. For example, several years
ago Consolidated Edison decided to borrow $400 million and use the funds to repurchase some of its common
stock. Thus, Con Ed was able to quickly change its capital structure.

6. Companies that use stock options as an important component of employee compensation usually
repurchase shares in the secondary market and then use those shares when employees exercise their options.
This technique allows companies to avoid issuing new shares and thus diluting earnings.

Repurchases have three principal disadvantages.

1. Stockholders may not be indifferent between dividends and capital gains, and the price of the stock might
benefit more from cash dividends than from repurchases. Cash dividends are generally dependable, but
repurchases are not.

2. The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not have
all the pertinent information about the corporation’s present and future activities. However, in order to avoid
potential stockholder suits, firms generally announce repurchase programs before embarking on them.

3. The corporation may pay too much for the repurchased stock—to the disadvantage of remaining
stockholders. If the firm seeks to acquire a relatively large amount of its stock, then the price may be bid above
its equilibrium level and then fall after the firm ceases its repurchase operations.
When all the pros and cons on stock repurchases versus dividends have been totaled, where do we stand?
Our conclusions may be summarized as follows.

1. Because of the deferred tax on capital gains, repurchases have a tax advantage over dividends as a way to
distribute income to stockholders. This advantage is reinforced by the fact that repurchases provide cash to
stockholders who want cash while allowing those who do not need current cash to delay its receipt. On the
other hand, dividends are more dependable and thus are better suited for those who need a steady source of
income.

2. The danger of signaling effects requires that a company not have volatile dividend payments, which would
lower investors’ confidence in the company and adversely affect its cost of equity and its stock price. However,
cash flows vary over time, as do investment opportunities, so the “proper” dividend in the residual model sense
varies. To get around this problem, a company can set its dividend low enough to keep dividend payments
from constraining operations and then use repurchases on a more or less regular basis to distribute excess
cash. Such a procedure will provide regular, dependable dividends plus additional cash flow to those
stockholders who want it.

3. Repurchases are also useful when a firm wants to make a large shift in its capital structure, wants to
distribute cash from a one-time event such as the sale of a division, or wants to obtain shares for use in an
employee stock option plan.

OTHER FACTORS INFLUENCING DISTRIBUTIONS

Constraints

1. Bond indentures. Debt contracts often limit dividend payments to earnings generated after the loan was
granted. Also, debt contracts often stipulate that no dividends can be paid unless the current ratio, times-
interest-earned ratio, and other safety ratios exceed stated minimums.

2. Preferred stock restrictions. Typically, common dividends cannot be paid if the company has omitted its
preferred dividend. The preferred arrearages must be satisfied before common dividends can be resumed.

3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item “retained earnings.”
This legal restriction, known as the “impairment of capital rule,” is designed to protect creditors. Without the
rule, a company in trouble might distribute most of its assets to stockholders and leave its debt holders out in
the cold. (Liquidating dividends can be paid out of capital, but they must be indicated as such and must not
reduce capital below the limits stated in debt contracts.)

4. Availability of cash. Cash dividends can be paid only with cash, so a shortage of cash in the bank can
restrict dividend payments. However, the ability to borrow can offset this factor.

5. Penalty tax on improperly accumulated earnings. To prevent wealthy individuals from using corporations to
avoid personal taxes, the Tax Code provides for a special surtax on improperly accumulated income. Thus, if
the IRS can demonstrate that a firm’s dividend payout ratio is being deliberately held down to help its
stockholders avoid personal taxes, the firm is subject to heavy penalties. This factor is generally relevant only
to privately owned firms.

Alternative Sources of Capital

1. Cost of selling new stock. If a firm needs to finance a given level of investment, it can obtain equity by
retaining earnings or by issuing new common stock. If flotation costs (including any negative signaling effects
of a stock offering) are high then re will be well above rs, making it better to set a low payout ratio and to
finance through retention rather than through the sale of new common stock. On the other hand, a high
dividend payout ratio is more feasible for a firm whose flotation costs are low. Flotation costs differ among firms
—for example, the flotation percentage is generally higher for small firms, so they tend to set low payout ratios

2. Ability to substitute debt for equity. A firm can finance a given level of investment with either debt or equity.
As just described, low stock flotation costs permit a more flexible dividend policy because equity can be raised
either by retaining earnings or by selling new stock. A similar situation holds for debt policy: If the firm can
adjust its debt ratio without raising costs sharply, then it can pay the expected dividend—even if earnings
fluctuate—by increasing its debt ratio.
3. Control. If management is concerned about maintaining control, it may be reluctant to sell new stock; hence
the company may retain more earnings than it otherwise would. However, if stockholders want higher
dividends and a proxy fight looms, then the dividend will be increased.