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1 of 4 04/22/201107:19:51 Worksheet for Chapter 16 BOC Questions. Dividend Policy and Repurchases 3/17/03 The expected 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, which is the g term in the following equation: = + g This equation can be transformed into the constant growth stock valuation model: = increase the stock price. However, raising the dividend will lower the amount of earnings available for reinvestment and thus lower the growth rate, which will tend to lower the stock price. So, changing the dividend has two offsetting effects. As an approximation, g = (1-payout)(ROE). If the payout were increased to 100%, or 1.0, then g would drop to zero. Conversely, if payout were zero, g = ROE. Thus, increasing the dividend payout has two opposing effects on a firm's stock price, so management must seek the payout policy that balances these two forces and thereby maximizes the stock price. DIVIDEND THEORIES 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. The firm's value, they contended, is determined by its basic earning power and business risk. Therefore, since the firm's value is based only on fundamental factors, its dividend policy is irrelevant. 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. 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 have a lower effective cost than those paid today. Finally, if a stock is held until death, no capital gains tax is due at all. (The avoidance-by-death provision is scheduled to disappear in 2011.) Because of these tax advantages, investors should, according to the tax preference theory, prefer a low payout. The Theories Conflict The three theories conflict with one another, so managers get no clear signal from academic theories as to what their dividend payouts should be. There is logic behind each of the theories, and some investors undoubtedly prefer more dividends, some prefer less dividends (and more growth), and others are indifferent. Still, if there are more of one group of investors than the others, then that might lead managers to adopt the majority-held payout policy. Unfortunately, empirical tests have not been able to determine if one policy is actually the dominant one. k
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This note was uploaded on 04/22/2011 for the course BBA FIN 423 taught by Professor Mahmudulhaque during the Spring '11 term at BRAC University.

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ch16boc-model - A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17...

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