Chapter 14 Distributions to Shareholders: Dividends and Share Repurchases 447such as utilities, food, and tobacco pay relatively high dividends, whereas compa-
nies in rapidly growing industries such as computer software and biotechnology
tend to pay lower dividends. Average dividends also differ signi! cantly across
countries. Higher payout ratios in some countries can be partially explained by
lower tax rates on earnings distributed as cash dividends relative to applicable rates
on reinvested income. This biases the dividend policy toward higher payouts.
For a given! rm, the optimal payout ratio is a function of four factors:
(1) management’s opinion about its investors’ preferences for dividends versus
capital gains, (2) the! rm’s investment opportunities, (3) the! rm’s target capital
structure, and (4) the availability and cost of external capital. These factors are
combined in what we call the residual dividend model. First, under this model,
we assume that investors are indifferent between dividends and capital gains.
Then the! rm follows these four steps to establish its target payout ratio: (1) It
determines the optimal capital budget; (2) given its target capital structure, it
determines the amount of equity needed to! nance that budget; (3) it uses retained
earnings to meet equity requirements to the extent possible; and (4) it pays divi-
dends only if more earnings are available than are needed to support the optimal
capital budget. The word residual implies “leftover,” and the residual policy implies
that dividends are paid out of “leftover” earnings.
If a! rm rigidly follows the residual dividend policy, dividends paid in any
given year can be expressed in the following equation:
Dividends! Net income " Retained earnings r^! nance new in^ vestmentsequir^ ed t^ o help^
Dividends! Net income " [(Target equity ratio)(Total capital budget)]
For example, suppose the company has $100 million of earnings, it has a target
equity ratio of 60%, and it plans to spend $50 million on capital projects. In that
case, it would need $50(0.6)! $30 million of common equity plus $20 million of
new debt to! nance the capital budget. That would leave $100 " $30! $70 million
available for dividends, which would result in a 70% payout ratio.
Note that the amount of equity needed to! nance the capital budget
might exceed the net income; in the preceding example, if the capital budget was
$100/Equity percentage! $100/0.6! $166.67 million, no dividends would be
Residual Dividend
Model
A model in which the
dividend paid is set equal
to net income minus the
amount of retained
earnings necessary to
finance the firm’s optimal
capital budget.Residual Dividend
Model
A model in which the
dividend paid is set equal
to net income minus the
amount of retained
earnings necessary to
finance the firm’s optimal
capital budget.Company Industry
Dividend
PayoutDividend
Yield
I. COMPANIES THAT PAY HIGH DIVIDENDS
Verizon Communications Telecommunications 83.63% 4.50%
Bank of America Corporation Banking 72.61 6.86
Southern Copper Mining 71.02 5.85
Pfizer, Inc. Pharmaceuticals 52.24 6.41
AT&T Inc. Telecommunications 51.31 4.12
II. COMPANIES THAT PAY NO DIVIDENDS
Amazon.com Online retail 0.00% 0.00%
Cisco Systems Computer hardware/software " "
Dell Inc. Personal computers " "
eBay Inc. Internet software and services " "
Genentech Inc. Biotechnology " "
Source: Value Line Investment Survey, May 15, 2008.
Tabl e 14 - 1 Dividend Payouts in 2008