536 CHAPTER 14 Distributions to Shareholders: Dividends and Repurchases
factors should be considered by firms that are considering a change in dividend
policy.
In practice, most firms try to follow a policy of paying a steadily increasing divi-
dend.This policy provides investors with stable, dependable income, and depar-
tures from it give investors signals about management’s expectations for future
earnings.
Most firms use the residual dividend modelto set the long-run target payout
ratio at a level that will permit the firm to meet its equity requirements with
retained earnings.
A dividend reinvestment plan (DRIP)allows stockholders to have the company
automatically use dividends to purchase additional shares. DRIPs are popular be-
cause they allow stockholders to acquire additional shares without brokerage fees.
Legal constraints, investment opportunities, availability and cost of funds
from other sources,and taxesare also considered when firms establish dividend
policies.
A stock splitincreases the number of shares outstanding. Normally, splits re-
duce the price per share in proportion to the increase in shares because splits
merely “divide the pie into smaller slices.” However, firms generally split their
stocks only if (1) the price is quite high and (2) management thinks the future is
bright. Therefore, stock splits are often taken as positive signals and thus boost
stock prices.
A stock dividendis a dividend paid in additional shares rather than in cash. Both
stock dividends and splits are used to keep stock prices within an “optimal” trading
range.
Under a stock repurchase plan,a firm buys back some of its outstanding stock,
thereby decreasing the number of shares, but leaving the stock price unchanged.
Repurchases substitute low-taxed capital gains for high-taxed dividends.
Questions
Define each of the following terms:
a.Optimal dividend policy
b.Dividend irrelevance theory; bird-in-the-hand theory; tax preference theory
c.Information content, or signaling, hypothesis; clientele effect
d.Residual dividend model;extra dividend
e.Declaration date; holder-of-record date; ex-dividend date; payment date
f.Dividend reinvestment plan (DRIP)
g.Stock split; stock dividend; stock repurchase
How would each of the following changes tend to affect aggregate (that is, the average for all
corporations) payout ratios, other things held constant? Explain your answers.
a.An increase in the personal income tax rate.
b.A liberalization of depreciation for federal income tax purposes—that is, faster tax write-offs.
c.A rise in interest rates.
d.An increase in corporate profits.
e.A decline in investment opportunities.
f.Permission for corporations to deduct dividends for tax purposes as they now do interest
charges.
g.A change in the Tax Code so that both realized and unrealized capital gains in any year were
taxed at the same rate as dividends.
Discuss the pros and cons of having the directors formally announce what a firm’s dividend
policy will be in the future.
14–3
14–2
14–1
532 Distributions to Shareholders: Dividends and Repurchases
