Model for evaluating dividend policy
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:
This equation can be transformed into the constant growth stock valuation model:
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.
conditions, g = (1-payout)(ROE).
If the payout were increased 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.
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 fundamental factors, and dividend
Others, including Myron Gordon, who developed the DCF stock valuation model, disagreed.
They argued that
investors regard capital gains as being riskier than dividends, hence that a dollar of dividends contributes
more to stock price than a dollar of retained earnings. According to this theory, the cost of capital would
decrease, and the stock price would increase, as dividend payout is increased.
Tax Preference Theory
Still others argue that tax factors cause investors to prefer capital gains to dividends, hence to prefer a low
dividend payout. First, long-term capital gains are taxed at a lower rate than dividends.
In addition, capital
gains are not taxed until the gain is realized.
Due to the time value of money, taxes paid in the future will have
a lower effective cost than those paid today.
Finally, if a stock is held until death, no capital gains tax is due at
Because of these tax advantages, investors should prefer a low payout.
Thus, as dividend payout increases, the
cost of capital for the firm would increase and the stock price would decrease.
The Theories Conflict