Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders? If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. | 2002, Prentice Hall, Inc. Ch. 17 - Dividend Policy and Internal Financing Stock Returns: P1 - Po + D1 Po Return = P1 - Po + D1 Po P1 - Po D1 Po Po + Return = = Stock Returns: Return = Capital Gain P1 - Po + D1 Po P1 - Po D1 Po Po + = Stock Returns: Return = Capital Gain Dividend Yield + = Stock Returns: P1 - Po + D1 Po P1 - Po D1 Po Po Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders? If we retain earnings for profitable investments, P1 - Po D1 Po Po + Return = If we retain earnings for profitable investments, dividend yield will be zero, P1 - Po D1 Po Po + Return = If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. P1 - Po D1 Po Po + Return = If we pay dividends, P1 - Po D1 Po Po + Return = If we pay dividends, stockholders receive an immediate cash reward for investing, P1 - Po D1 Po Po + Return = If we pay dividends, stockholders receive an immediate cash reward for investing, but the capital gain will decrease, since this cash is not invested in the firm. P1 - Po D1 Po Po + Return = So, dividend policy really involves 2 decisions: How much of the firm’s earnings should be distributed to shareholders as dividends, and How much should be retained for capital investment? Is Dividend Policy Important? Three viewpoints: 1) Dividends are Irrelevant. If we assume perfect markets (no taxes, no transaction costs, etc.) dividends do not matter. If we pay a dividend, shareholders’ dividend yield rises, but capital gains decrease. With perfect markets, investors are concerned only with total returns, and do not care whether returns come in the form of capital gains or dividend yields. P1 - Po D1 Po Po + Return = With perfect markets, investors are concerned only with total returns, and do not care whether returns come in the form of capital gains or dividend yields. P1 - Po D1 Po Po + Return | 2002, Prentice Hall, Inc. Ch. 17 - Dividend Policy and Internal Financing Stock Returns: P1 - Po + D1 Po Return = P1 - Po + D1 Po P1 - Po D1 Po Po + Return = = Stock Returns: Return = Capital Gain P1 - Po + D1 Po P1 - Po D1 Po Po + = Stock Returns: Return = Capital Gain Dividend Yield + = Stock Returns: P1 - Po + D1 Po P1 - Po D1 Po Po Dilemma: Should the firm use retained earnings for: a) Financing profitable capital investments? b) Paying dividends to stockholders? If we retain earnings for profitable investments, P1 - Po D1 Po Po + Return = If we retain earnings for profitable investments, dividend yield will be zero, P1 - Po D1 Po Po + Return = If we retain earnings for profitable investments, dividend yield will be zero, but the stock price will increase, resulting in a higher capital gain. P1 - Po D1 Po Po + Return = If we pay dividends, P1 - Po D1 Po Po + Return = If we pay dividends, stockholders receive an immediate cash reward for investing, P1 - Po D1 Po Po + Return = If
