Summary 535
Explain how repurchases can (1) help stockholders hold down taxes and
(2) help firms change their capital structures.
What are three procedures a firm can use to repurchase its stock?
What are some advantages and disadvantages of stock repurchases?
How can stock repurchases help a company operate in accordance with the
residual dividend model?
Summary
Onceacompanybecomesprofitable,itmustdecidewhattodowiththecashitgener-
ates.Itmaychoosetoretaincashanduseiteithertopurchaseadditionalassetsortore-
duceoutstandingdebt.Alternatively,itmaychoosetoreturnthecashtoshareholders.
Keep in mind that every dollar that management chooses to retain is a dollar that
shareholderscouldhavereceivedandinvestedelsewhere.Therefore,managersshould
retainearningsifandonlyiftheycaninvestthemoneywithinthefirmandearnmore
thanstockholderscouldearnoutsidethefirm.Consequently,high-growthcompanies
withmanygoodprojectswilltendtoretainahighpercentageofearnings,whereasma-
turecompanieswithlotsofcashbutlimitedinvestmentopportunitieswillhavegener-
ouscashdistributions.
This basic tendency has a major influence on firms’ long-run distribution policies.
However, as we saw in this chapter, in any given year several important situations
could complicate the long-run policy. Companies with excess cash have to decide
whether to pay dividends or repurchase stock. In addition, due to the importance of
signaling and the clientele effect, companies generally find it desirable to maintain a
stable, consistent dividend policy over time. The key concepts covered in this chapter
are listed below:
Dividend policyinvolves three issues: (1) What fraction of earnings should be
distributed? (2) Should the distribution be in the form of cash dividends or
stock repurchases? (3) Should the firm maintain a steady, stable dividend growth
rate?
The optimal dividend policystrikes a balance between current dividends and
future growth so as to maximize the firm’s stock price.
Miller and Modigliani developed the dividend irrelevance theory,which holds
that a firm’s dividend policy has no effect on either the value of its stock or its cost
of capital.
The bird-in-the-hand theoryholds that the firm’s value will be maximized by a
high dividend payout ratio, because investors regard cash dividends as being less
risky than potential capital gains.
The tax preference theorystates that because long-term capital gains are subject
to less onerous taxes than dividends, investors prefer to have companies retain
earnings rather than pay them out as dividends.
Empirical testsof the three theories have been inconclusive.Therefore, acade-
micians cannot tell corporate managers how a given change in dividend policy will
affect stock prices and capital costs.
Dividend policy should take account of theinformation content of dividends
(signaling)and theclientele effect.The information content, or signaling, ef-
fect relates to the fact that investors regard an unexpected dividend change as a
signal of management’s forecast of future earnings. The clientele effect suggests
that a firm will attract investors who like the firm’s dividend payout policy. Both
Distributions to Shareholders: Dividends and Repurchases 531
