Question

1. Define target payout ratio and optimal dividend policy.
2. Discuss the dividend irrelevance theory and the “bird-in-the-hand” theory, and discuss the reasons why some investors prefer dividends, while others may prefer capital gains.
3. Explain the information content, or signaling, hypothesis and the clientele effect.
4. Explain the logic of the residual dividend policy, and state why firms are more likely to use this policy in setting a long-run target than as a strict determination of dividends in a given year; explain dividend payment procedures.
5. Explain the use of dividend reinvestment plans, distinguish between the two types of plans, and discuss why the plans are popular with certain investors.

Answer 1

Target payout Ratio

A major determinant of the dividend policy of a firm is its target payout ratio. A target payout ratio is that percentage of a company's earnings which it would like to pay out to its shareholders as dividends over the long-term. Firms are conservative in setting their target dividend payout ratio with the goal of being able to maintain a stable dividend level while also retaining enough capital to grow and/or operate the business efficiently. So, target payout ratio is the payout ratio that the co. would like to achieve in the long run.
Sometimes the payout ratio is equal to the target payout ratio. Other times the payout ratio—which is dividends per share divided by earnings per share—may be higher or lower than the target rate because earnings fluctuate from quarter to quarter and year to year. That is why the target payout ratio is typically a long-term goal or average over a longer period of time.
A target payout ratio that is too high could send a negative signal to the market, and may actually put downward pressure on the stock price of the co. since the investors and analysts may feel the company isn't retaining enough capital to grow or operate as effectively as it could.
A low target payout ratio would need to be accompanied by stronger earnings growth prospects in order to attract investors, in the sense shareholders are compensated through likely future share price appreciation instead of dividends. If the company is profitable, yet not growing, investors may question why the company isn't paying out more in dividends to shareholders. Older companies with minimal growth prospects generally pay out more in dividends to reward their shareholders. With little growth in the company, the stock price is no longer likely to appreciate further.

Optimal Dividend Policy

Dividend policy Involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of financing. The payment of dividends results in the depletion of cash and hence in the depletion of total assets. In order to maintain the asset level as well as to finance the investment opportunities. the firm must obtain funds from the issue of additional equity or debt. If the firm is unable to raise external funds its growth would be affected. Thus, dividend also imply outflow of cash & lower future growth. In other words, the dividend policy of a firm affects both the shareholder's wealth and the long term growth of the firm. Hence, the optimal dividend policy should strike a balance between the current dividends & future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to 2 basic objectives - maximizing the wealth of the shareholders and providing sufficient funds for the firm's growth. The objectives are mutually exclusive, but, interrelated.     

Several recent researches have studied the impact of macroeconomic shocks on the financial policies of firms. However, they only consider the case where these macroeconomic shocks affect the profitability of firms but not the financial markets conditions. Where the profitability of firms is stationary, but interest rates and issuance costs are fluctuating, we characterize the optimal dividend policy and show that these two macroeconomic factors have opposing effects. That is all things being equal, firms distribute more dividends when interest rates are high and less when issuing costs are high.

Dividend irrelevance theory

The dividend irrelevance theory is based on the logic that investors do not need to concern themselves with a company's dividend policy since they have the option to sell a portion of their portfolio of equities if they want cash.

The dividend irrelevance theory indicates that a company’s declaration and payment of dividends should have little or no impact on the stock price. If this theory holds true, it would mean that dividends do not add value to a company’s stock price.

The crux of the argument supporting the irrelevance of dividends to valuation of the firm is that the dividend policy of a firm is the part of its financing decision. As a part of the financing decision, the dividend policy of the firm is a residual decision & dividends are a passive residual. Whether the earnings are to paid out as dividends or to be retained will depend upon the availability of investment opportunities. So when a firm has sufficient investment opportunities the firm will retain the earnings. The test of adequate investment opportunities is the relationship between between the return on investments (r) & the cost of capital (k). As long as r exceeds k , a firm has acceptable investment opportunity. With abundant investment opportunities the dividend payout ratio would be zero. When there are no profitable opportunity The D/P ratio would be 100. For situations between these two extremes the D/P ratio varies between 0 to 100.

The most comprehensive argument in support of the irrelevance of dividends is provided by the Modigliani - Miller Hypothesis. It states that the dividend policy has no effect on the share of the firm. What matters to them is the investment policy through which the firm can increase its earnings and hence the value of the firm. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income & capital appreciation, given the firm's investment policy, its dividend policy may have no influence on the market price of the shares.

Bird in the hand theory

The bird in hand is a theory that says investors prefer dividends from the stocks that they have invested in to potential capital gains because of the inherent uncertainty associated with capital gains. Based on the adage, "a bird in the hand is worth two in the bush," the bird-in-hand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains. Capital gains investing represents the "two in the bush" side of the adage "a bird in the hand is worth two in the bush."

The theory was developed as a counterpoint to the Modigliani-Miller dividend irrelevance theory, which maintains that investors don't care where their returns come from. Myron Gordon and John Lintner developed the bird-in-hand theory as a counterpoint to the Modigliani-Miller dividend irrelevance theory.
The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding stock arise from dividends or capital gains. Under the bird-in-hand theory, stocks with high dividend payouts are most sought after by investors and, consequently, have a higher market price.
Investors who believe in the bird in hand theory believe that dividends are more certain than capital gains.

Some investors prefer dividends while some others prefer capital gains

That Dividends are irrelevant or are passive residual is based on the assumption that the investors are indifferent between dividends & capital gains. So long as the firm is able to earn more that the equity capitalisation rate k_e the investors would be content with the firm retaining the earnings. in contrast ift the return is less than the k_e investors would prefer to receive the earnings (dividends).

Dividend vs. capital gain investing

Investing in capital gains is mainly predicated on conjecture. An investor may gain an advantage in capital gains by conducting extensive company, market, and macroeconomic research. However, ultimately, the performance of a stock depends on a host of factors that are out of the investor's control.

For this reason, capital gains investing represents the "two in the bush" side of the adage. Investors chase capital gains because there is a possibility that those gains may be large, but it is equally possible that capital gains may be nonexistent or, worse, negative.

Studies show that stocks that do pay a dividend, like many blue-chip stocks, often increase in price by the amount of the dividend as the book closure date approaches. Although the dividend may not actually be paid until a few days after this date, given the logistics of processing such a large number of payments, the price of the stock usually drops again the amount of the dividend. Buyers after this date are no longer entitled to the dividend. These practical examples can conflict with the dividend irrelevance theory.

Analysts conduct valuation exercises to determine a stock’s intrinsic value. These often incorporate factors, such as dividend payments, along with financial performance, and qualitative measurements, including management quality, economic factors, and an understanding of the company’s position in the industry.

Broad stock market indices such as the Dow Jones Industrial Average (DJIA) and the Standard & Poor's (S&P) 500 have averaged annual returns of up to 10% over the long-term. Finding dividends that high is difficult. Even stocks in high-dividend payout industries, such as utilities and telecommunications, tend to be max. at 5%. However, if a company has been paying a dividend yield of, for example, 5% for many years, receiving that return in a given year is more likely than earning 10% in capital gains.

During years of recession such as 2008 - 2010, the broad stock market indices posted big losses, despite trending upward over the long term. In similar years, dividend income had been more reliable and secure.
Despite the dividend irrelevance theory many investors focus on dividends when managing their portfolios. For example, a current income strategy of an investor may be to identify investments that pay above-average distributions (i.e., dividends and interest payments). Strategies focused on income are usually appropriate for investors in need of stable, established entities that will pay consistently (i.e. without risk of default or missing a dividend payment deadline). These investors might be older and/or not willing to take risks. Dividends may feature in a range of other portfolio strategies, as well, such as preservation of capital.
Blue-chip companies generally pay steady dividends. These are multinational firms including Coca-Cola, Disney, PepsiCo, Walmart, IBM, and McDonalds which are dominant leaders in their respective industries. and have built highly reputable brands, surviving multiple downturns in the economy.

As a dividend-paying stock, Coca-Cola (KO) would be a stock that fits in with a bird-in-hand theory-based investing strategy. According to Coca-Cola, the company began paying regular quarterly dividends starting in the 1920s. Further, the company has increased these payments every year for the last 56 years.

Disadvantages of the Dividends
Legendary investor Warren Buffett once opined that where investing is concerned, what is comfortable is rarely profitable. Dividend investing at 5% per year provides near-guaranteed returns and security. However, over the long term, the pure dividend investor earns is far less money than the pure capital gains that the investor would have earned. Moreover, in modern times, dividend income, while secure and comfortable, has been insufficient even to keep pace with inflation.

Information content or Signalling

• Dividend announcements have information, or signaling content about future earnings.
• Investors view dividend increases as signals of management’s plan of the future.
• Managers hate to cut dividends: increase in dividends is a signal that they think the increase is sustainable.
• Stock price increase at time of a dividend increase could be due to either :-
  Investors are interpreting it as a signal that management thinks EPS increase is sustainable (signaling hypothesis) or Investors preferring higher-dividend stocks (bird-in-the-hand theory) .

What is the Information Content or Signalling Hypothesis

1. Larger than normal dividend signals future is bright (positive). Stock price tends to increase
2. Smaller than expected increase or dividend cut is negative signal. Stock price tends to fall.
3. Normal increase of dividends has neutral effect.

The information content of dividend hypothesis is a firm-specific hypothesis which states that the managers of a firm use the dividend to signal asymmetric information about the firm's future earnings.

Information content effect means an increase or decrease in the share's price resulting form some relevant information. For example, a stock may rise in price following a positive earnings report or fall in price if the co.'s CEO is arrested. To reduce the information content effect many companies seek to price out the information by hinting or building expectations before the official announcement.

Clientele Effect

• Different groups of investors, or clienteles, prefer different dividend policies.
  Pension funds, retirees, university endowment funds are in low or zero tax bracket and prefer cash income (dividend) or go for high dividend stocks.
  Investors in peak-earning years prefer reinvestment of firm’s cash for capital gains, these clients belong to higher tax bracket and have less need for current income & hence go for low dividend stocks.
• Firm’s past dividend policy determines its current clientele of investors.
• Dividend policy change may upset the dominant clientele (shareholders) resulting in negative effect on the stock price.
• Clientele effects impede changing dividend policy. Taxes and brokerage costs hurt investors who have to switch companies.

Hence, Clientele effect explains the movement in a company's stock price according to the demands and goals of its investors. These investor demands come in reaction to a tax, dividend or other policy change which affects the shares.

The clientele effect first assumes that specific investors are primarily attracted to different company policies, and when a company's policy alters, they will adjust their stock holdings accordingly. As a result of this adjustment, stock prices may fluctuate.