Question

how do regular dividends policies function in both perfect and imperfect capital markets? And how do companies select the best dividend policy for there company?

Answer 1

In Case of Perfect Capital Markets -

The value of the shareholders' wealth is not affected by share repurchases, if capital markets are perfect. This can be seen in the following example:

Buttle Wilson and Co. has $50 m. available for distribution. Buttle has 10 m. shares outstanding. It expects to earn $2.50 a share, and the current market value per share is $25. The firm has unused cash that could be used to pay a cash dividend of $5 per share, implying an ex-dividend value of $20 per share.

Alternatively, the firm could use the $50 m. to repurchase 2 m. shares ($50,000,000/$25). Following the share repurchase, each share would be worth

10,000,000($25) -$50,000,000s 10,000, 000 2,000, 000

Thus, as long as the firm repurchases the shares at the market price of $25, a shareholder who does not sell will have the same wealth as a shareholder who does sell--$25. The difference is that the former has it in stock, the latter in cash.

If Buttle paid the $5 dividend, every shareholder would have their wealth in the same form--$5 in cash plus $20 in stock.

In case of Imperfect Capital Markets -

VALUE ENHANCING REASONS

Tax considerations:

Gains to individual shareholders from share repurchases are taxed at the capital gains rate, which is usually smaller than the tax rate on cash dividends. However, a regular policy of repurchasing shares could be disallowed by the IRS for favorable capital gains treatment.

Eliminate Small Shareholdings:

The cost of servicing a small shareholder account is roughly the same as that of servicing a large shareholder account. Hence repurchasing shares of small stockholders could reduce overall stockholder service costs.

Increase Leverage:

If the firm wishes to increase debt in its capital structure, it could borrow funds and use the proceeds to repurchases shares or offer it sshareholders the opportunity to exchange their shares for a new debt issue.

Exploit Perceived Undervaluation:

If a firm's stock is perceived by the management to be undervalued, repurchasing shares at a favorable price could increase the wealth of the firm's remaining shareholders. However, if investors believe that the share repurchase is being undertaken for this purpose, share prices will jump to reflect market belief in a higher share value. If so, the true wealth of the firm's remaining shareholders would not increase; however, the market value of their shareholdings will increase, which can be valuable for shareholders who desire liquidity.

VALUE DECREASING REASONS

Consolidation of Insider Control:

Firms sometimes purchase stock from contentious minority stockholders, sometimes at a premium (greenmail). At other times, they may do so to reduce public float--to reduce the percentage of stock held by persons not affiliated with the insider group.

Protection against Takeovers

Stock repurchases may also be designed to reduce the attractiveness of the company as an acquisition candidate, thus enhancing management's security.

These objectives may not be consistent with firm value maximization.

Companies select the best dividend policy for there company in three different methods -

Residual

Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met.

The benefits to this policy is that it allows a company to use their retained earnings or residual income to invest back into the company, or into other profitable projects before returning funds back to shareholders in the form of dividends.

As stated earlier, a company's stock price fluctuates with a rising or falling dividend. If a company's management team doesn't believe they can adhere to a strict dividend policy with consistent payouts, it might opt for the residual method. The management team is free to pursue opportunities without being constricted by a dividend policy. However, investors might demand a higher stock price relative to companies in the same industry that have more consistent dividend payouts. Another drawback to the residual method is that it can lead to inconsistent and sporadic dividend payouts resulting in volatility in the company's stock price.

Stable

Under the stable dividend policy, companies consistently pay a dividend each year regardless of earnings fluctuations. The dividend payout amount is typically determined through forecasting long-term earnings and calculating a percentage of earnings to be paid out.

Under the stable policy, companies may create a target payout ratio, which is a percentage of earnings that is to be paid to shareholders in the long-term.

The company may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or it may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the stability policy is to reduce uncertainty for investors and to provide them with income.

Hybrid

The final approach combines the residual and stable dividend policies. The hybrid is a popular approach for companies that pay dividends. As companies experience business cycle fluctuations, companies that use the hybrid approach establish a set dividend, which represents a relatively small portion of yearly income and can be easily maintained. In addition to the set dividend, companies can offer an extra dividend paid only when income exceeds certain benchmarks.