Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

18. Dividends and Dividend
    Policy

© The McGraw−Hill^641

Companies, 2002

the one with the higher payout will have to periodically sell some stock to catch up. Be-

cause this is expensive, a firm might be inclined to have a low payout.

Dividend Restrictions

In some cases, a corporation may face restrictions on its ability to pay dividends. For

example, as we discussed in Chapter 7, a common feature of a bond indenture is a

covenant prohibiting dividend payments above some level. Also, a corporation may be

prohibited by state law from paying dividends if the dividend amount exceeds the firm’s

retained earnings.

REAL-WORLD FACTORS FAVORING

AHIGHPAYOUT

In this section, we consider reasons why a firm might pay its shareholders higher divi-

dends even if it means the firm must issue more shares of stock to finance the dividend

payments.

In a classic textbook, Benjamin Graham, David Dodd, and Sidney Cottle have argued

that firms should generally have high-dividend payouts because:

1. “The discounted value of near dividends is higher than the present worth of distant
   dividends.”


2. Between “two companies with the same general earning power and same general
   position in an industry, the one paying the larger dividend will almost always sell at
   a higher price.”^4
   Two additional factors favoring a high-dividend payout have also been mentioned fre-
   quently by proponents of this view: the desire for current income and the resolution of
   uncertainty.

Desire for Current Income

It has been argued that many individuals desire current income. The classic example is

the group of retired people and others living on a fixed income, the proverbial widows

and orphans. It is argued that this group is willing to pay a premium to get a higher div-

idend yield. If this is true, then it lends support to the second claim made by Graham,

Dodd, and Cottle.

It is easy to see, however, that this argument is not relevant in our simple case. An in-

dividual preferring high current cash flow but holding low-dividend securities can eas-

ily sell off shares to provide the necessary funds. Similarly, an individual desiring a low

current cash flow but holding high-dividend securities can just reinvest the dividend.

This is just our homemade dividend argument again. Thus, in a world of no transaction

costs, a policy of high current dividends would be of no value to the stockholder.

CONCEPT QUESTIONS

18.3a What are the tax benefits of low dividends?

18.3bWhy do flotation costs favor a low payout?

614 PART SIX Cost of Capital and Long-Term Financial Policy

(^4) B. Graham, D. Dodd, and S. Cottle, Security Analysis(New York: McGraw-Hill, 1962).

18.4