Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Dividends and Dividend
Policy
(^650) © The McGraw−Hill
Companies, 2002
run target payout ratio, and it is the fraction of the earnings the firm expects to pay as
dividends under ordinary circumstances. Again, this ratio is viewed as a long-range
goal, so it might vary in the short run if this is necessary. As a result, in the long run,
earnings growth is followed by dividend increases, but only with a lag.
One can minimize the problems of dividend instability by creating two types of div-
idends: regular and extra. For companies using this approach, the regular dividend
would most likely be a relatively small fraction of permanent earnings, so that it could
be sustained easily. Extra dividends would be granted when an increase in earnings was
expected to be temporary.
Because investors look on an extra dividend as a bonus, there is relatively little dis-
appointment when an extra dividend is not repeated. Although the extra-dividend ap-
proach appears quite sensible, few companies use it in practice. One reason is that
a share repurchase, which we discuss next, does much the same thing with some extra
advantages.
STOCK REPURCHASE: AN ALTERNATIVE TO
CASH DIVIDENDS
When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. An-
other way is to repurchaseits own stock. In 2000, for example, 2,072 firms announced
buyback programs totaling almost $300 billion.
In fact, net equity sales in the United States have actually been negative in some re-
cent years. This has occurred because corporations have actually repurchased more
stock than they have sold. Stock repurchasing has thus been a major financial activity,
and it appears that it will continue to be one.
Cash Dividends versus Repurchase
Imagine an all-equity company with excess cash of $300,000. The firm pays no divi-
dends, and its net income for the year just ended is $49,000. The market value balance
sheet at the end of the year is represented here.
There are 100,000 shares outstanding. The total market value of the equity is $1 million,
so the stock sells for $10 per share. Earnings per share, EPS, are $49,000/100,000
$.49, and the price-earnings ratio, PE, is $10/.49 20.4.
CONCEPT QUESTIONS
18.6a What is a residual dividend policy?
18.6bWhat is the chief drawback to a strict residual policy? What do many firms do in
practice?
CHAPTER 18 Dividends and Dividend Policy 623
target payout ratio
A firm’s long-term
desired dividend-to-
earnings ratio.
18.7
repurchase
Another method used to
pay out a firm’s earnings
to its owners, which
provides more preferable
tax treatment than
dividends.Market Value Balance Sheet
(before paying out excess cash)
Excess cash $ 300,000 Debt $ 0
Other assets 700,000 Equity 1,000,000
Total $1,000,000 Total $1,000,000