This chapter presents the following content: Theories of investor preferences, signaling effects, residual model, dividend reinvestment plans, stock dividends and stock splits, stock repurchases. | CHAPTER 14 Distributions to shareholders: Dividends and share repurchases Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases What is dividend policy? The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes High or low dividend payout? Stable or irregular dividends? How frequent to pay dividends? Announce the policy? 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 Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy: If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test. Implication: any payout is OK. Bird-in-the-hand theory Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high-payout firms more highly, ., a high payout would result in a high P0. Implication: set a high payout. Tax Preference Theory Retained earnings lead to long-term capital gains, which are taxed at lower rates than dividends: 20% vs. up to . Capital gains taxes are also deferred. This could cause investors to prefer firms with low payouts, ., a high payout results in a low P0. Implication: Set a low payout. Possible stock price effects 40 30 20 10 0 50% 100% Payout Stock Price ($) Bird-in-the-Hand Irrelevance Tax preference Possible cost of equity effects Tax preference Irrelevance Bird-in-the-Hand 30 25 20 15 10 5 0 50% 100% Payout Cost of Equity (%) Which theory is most correct? . | CHAPTER 14 Distributions to shareholders: Dividends and share repurchases Theories of investor preferences Signaling effects Residual model Dividend reinvestment plans Stock dividends and stock splits Stock repurchases What is dividend policy? The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes High or low dividend payout? Stable or irregular dividends? How frequent to pay dividends? Announce the policy? 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 Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy: If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Proposed by Modigliani and Miller and based on
