Ch_14_Tool_Kit - Ch 14 Tool Kit Chapter 14 Tool Kit for...

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Ch 14 Tool Kit 12/7/2001 Chapter 14. Tool Kit for Distributions to Shareholders: Dividends and Repurchases The return on a stock consists of two elements, dividends and capital gains. In rate of return terms, the total return consists of a dividend yield plus a capital gains yield, the g term in the following equation: = + g This equation can be transformed into the constant growth stock valuation model: = and that tends to increase the stock price. However, raising the dividend will lower the amount of earnings available for reinvestment, and thus it will lower the growth rate, which will tend to lower the stock price. (Under certain conditions, g = (1-payout)(ROE). If the payout were increase to 100%, or 1.0, then g would drop to zero.) Thus, increasing the dividend payout has two opposing effects on a firm's stock price. Management must then seek to find the payout policy that balances these two forces and thereby maximizes the stock price. DIVIDEND THEORIES M-M Dividend Irrelevance Theory Proposed by Merton Miller and Franco Modigliani, this theory argues that dividend policy has no effect on either the price of a firm's stock or its cost of capital. Firm value, they contended, is determined by basic earning power and business risk. Therefore, a firm's value is based only on Bird-In-The-Hand Theory Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed. They
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