Establishing the Dividend Policy in Practice 519
equity (new common stock). This encourages firms to retain earnings so as to avoid hav-
ing to issue new stock.
When establishing a dividend policy, one size does not fit all. Some firms produce
a lot of cash but have limited investment opportunities—this is true for firms in prof-
itable but mature industries where few opportunities for growth exist. Such firms typ-
ically distribute a large percentage of their cash to shareholders, thereby attracting
investment clienteles that prefer high dividends. Other firms generate little or no
excess cash but have many good investment opportunities. Such firms generally dis-
tribute little or no cash but enjoy rising earnings and stock prices, thereby attracting
investors who prefer capital gains.
As Table 14-1 suggests, dividend payouts and dividend yields for large corporations
vary considerably. Generally, firms in stable, cash-producing industries such as utilities,
financial services, and tobacco pay relatively high dividends, whereas companies in
rapidly growing industries such as computer software tend to pay lower dividends.
For a given firm, the optimal payout ratio is a function of four factors: (1) investors’
preferences for dividends versus capital gains, (2) the firm’s investment opportunities,
(3) its target capital structure, and (4) the availability and cost of external capital. The
last three elements are combined in what we call the residual dividend model.Un-
der this model a firm follows these four steps when establishing its target payout ratio:
(1) It determines the optimal capital budget; (2) it determines the amount of equity
needed to finance that budget, given its target capital structure; (3) it uses retained
earnings to meet equity requirements to the extent possible; and (4) it pays dividends
only if more earnings are available than are needed to support the optimal capital bud-
get. The word residualimplies “leftover,” and the residual policy implies that divi-
dends are paid out of “leftover” earnings.
If a firm rigidly follows the residual dividend policy, then dividends paid in any
given year can be expressed as follows:
DividendsNetincomeRetainedearningsneededtofinancenew
investments (14-1)
Net income [(Target equity ratio)(Total capital budget)].
Forexample,supposethetargetequityratiois60percentandthefirmplanstospend
$50 million on capital projects. In that case, it would need $50(0.6)$30 million of
common equity. Then, if its net income were $100 million, its dividends would be
$100$30$70million.So,ifthecompanyhad$100millionofearningsandacapital
budget of $50 million, it would use $30 million of the retained earnings plus $50
$30$20millionofnewdebttofinancethecapitalbudget,andthiswouldkeepitscap-
italstructureontarget.Notethattheamountofequityneededtofinancenewinvest-
ments might exceed the net income; in our example, this would happen if the capital
budgetwere$200million.Inthatcase,nodividendswouldbepaid,andthecompany
wouldhavetoissuenewcommonstockinordertomaintainitstargetcapitalstructure.
Most firms have a target capital structure that calls for at least some debt, so new
financing is done partly with debt and partly with equity. As long as the firm finances
with the optimal mix of debt and equity, and provided it uses only internally generated
equity (retained earnings), then the marginal cost of each new dollar of capital will
be minimized. Internally generated equity is available for financing a certain amount
of new investment, but beyond that amount, the firm must turn to more expensive
new common stock. At the point where new stock must be sold, the cost of equity, and
consequently the marginal cost of capital, rises.
To illustrate these points, consider the case of Texas and Western (T&W) Trans-
port Company. T&W’s overall composite cost of capital is 10 percent. However, this
Distributions to Shareholders: Dividends and Repurchases 515
