CH13 - CHAPTER 13 Dividend Policy and Internal Financing...

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CHAPTER 13 Dividend Policy and Internal Financing Orientation : In determining the firm’s dividend policy, two issues are important: the dividend payout ratio and the stability of the dividend payment over time. In this regard, the financial manager should consider the investment opportunities available to the firm and any preference that the company’s investors have for dividend income or capital gains. Also, stock dividends, stock splits, or stock repurchases can be used to supplement or replace cash dividends. I. The tradeoffs in setting a firm’s dividend policy A. If a company pays a large dividend, it will 1. have a low retention of profits within the firm, and 2. need to rely heavily on a new common stock issue for equity financing. B. If a company pays a small dividend, it will 1. have a high retention of profits within the firm, and 2. will not need to rely heavily on a new common stock issue for equity financing since the profits retained for reinvestment will provide the needed equity financing. II. The importance of a firm’s dividend policy depends on the impact of the dividend decision on the firm’s stock price. That is, given a firm’s capital budgeting and borrowing decisions, what is the impact of the firm’s dividend policies on the stock price? 208
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III. Three views about the importance of a firm’s dividend policy. A. View 1: Dividends do not matter 1. Assume that the dividend decision does not change the firm’s capital budgeting and financing decisions. 2. Assume perfect markets, which means: a. There are no brokerage commissions when investors buy and sell stocks. b. New securities can be issued without incurring any flotation cost. c. There is no income tax—personal or corporate. d. Information is free and equally available to all investors. e. There are no conflicts of interest between management and stockholders. 3. Under the foregoing assumptions, it may be shown that the market price of a corporation’s common stock is unchanged under different dividend policies. If the firm increases the dividend to its stockholders, it has to offset this increase by issuing new common stock in order to finance the available investment opportunities. If, on the other hand, the firm reduces its dividend payment, it has more funds available internally to finance future investment projects. In either policy, the present value of the resulting cash flows to be accrued to the current investors is independent of the dividend policy. By varying the dividend policy, only the type of return is affected (capital gains versus dividend income), not the total return. 209
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B. View 2: High dividends increase stock value 1. Dividends are more predictable than capital gains because management can control dividends, while they cannot dictate the price of the stock. Thus, investors are less certain of receiving income from capital gains than from dividend income. The incremental risk associated with capital gains relative to dividend income should, therefore, cause us to use a higher required rate in
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This note was uploaded on 04/16/2008 for the course FIN 100 taught by Professor N/a during the Spring '08 term at Baylor.

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CH13 - CHAPTER 13 Dividend Policy and Internal Financing...

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