CP

512 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases

Successful companies earn income. That income can then be reinvested in operating

assets, used to acquire securities, used to retire debt, or distributed to stockholders. If

the decision is made to distribute income to stockholders, three key issues arise:

(1) How much should be distributed? (2) Should the distribution be as cash dividends,

or should the cash be passed on to shareholders by buying back some of the stock they

hold? (3) How stable should the distribution be; that is, should the funds paid out from

year to year be stable and dependable, which stockholders would probably prefer, or

be allowed to vary with the firms’ cash flows and investment requirements, which

would probably be better from the firms’ standpoint? These three issues are the pri-

mary focus of this chapter, but we also consider two related issues, stock dividends and

stock splits.

Dividends versus Capital Gains: What Do Investors Prefer?

Whendecidinghowmuchcashtodistributetostockholders,financialmanagersmust

keepinmindthatthefirm’sobjectiveistomaximizeshareholdervalue.Consequently,

thetargetpayoutratio—definedasthepercentageofnetincometobepaidoutascash

dividends—shouldbebasedinlargepartoninvestors’preferencesfordividendsversus

capitalgains:doinvestorsprefer(1)tohavethefirmdistributeincomeascashdividends

or(2)tohaveiteitherrepurchasestockorelseplowtheearningsbackintothebusiness,

bothofwhichshouldresultincapitalgains?Thispreferencecanbeconsideredinterms

oftheconstantgrowthstockvaluationmodel:

If the company increases the payout ratio, this raises D 1. This increase in the numer-

ator, taken alone, would cause the stock price to rise. However, if D 1 is raised, then

less money will be available for reinvestment, that will cause the expected growth rate

to decline, and that will tend to lower the stock’s price. Thus, any change in payout

policy will have two opposing effects. Therefore, the firm’s optimal dividend policy

must strike a balance between current dividends and future growth so as to maximize

the stock price.

In this section we examine three theories of investor preference: (1) the dividend

irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax preference

theory.

Dividend Irrelevance Theory

It has been argued that dividend policy has no effect on either the price of a firm’s

stock or its cost of capital. If dividend policy has no significant effects, then it would be

irrelevant.The principal proponents of the dividend irrelevance theoryare Merton

Miller and Franco Modigliani (MM).^2 They argued that the firm’s value is determined

only by its basic earning power and its business risk. In other words, MM argued that

the value of the firm depends only on the income produced by its assets, not on how

this income is split between dividends and retained earnings.

To understand MM’s argument that dividend policy is irrelevant, recognize that

any shareholder can in theory construct his or her own dividend policy. For example,

Pˆ 0 

D 1

rsg

.

(^2) Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,”
Journal of Business,October 1961, 411–433.
The textbook’s web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 14
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.
An excellent source of re-
cent dividend news for ma-
jor corporations is available
at the web site of Corporate
Financials Online at
http://www.cfonews.
com/scs. By clicking the
down arrow of the “News
Category” box to the left of
the screen, students may se-
lect “Dividends” to receive
a list of companies with divi-
dend news. Click on any
company, and you will see
its latest dividend news.

508 Distributions to Shareholders: Dividends and Repurchases