Li-Ion was formed 5 years ago to exploit a new process for manufacturing lithium ion batteries.
One advantage of the new process was that it required relatively little capital in comparison
with the typical battery company, so the founders have been able to avoid issuing new stock,
and thus they own all of the shares. However, Li-Ion has now reached the stage in which
outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its
target capital structure of 60% equity and 40% debt. Therefore, Li-Ion's management has
decided to take the company public. Until now, the founders have paid themselves reasonable
salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not
been an issue. However, before talking with potential outside investors, they must decide on a
Assume that you were recently hired by Arthur Adamson & Company (AA), a national
consulting firm, which has been asked to help Li-Ion prepare for its public offering. Martha
Millon, the senior AA consultant in your group, has asked you to make a presentation to Li-Ion
in which you review the theory of dividend policy and discuss the following questions.
1) What is meant by the term dividend policy?
Dividend policy is defined as the firm's policy with regard to paying out earnings as
dividends versus retaining them for reinvestment in the firm. Dividend policy really
involves three key issues: (1) How much should be distributed? (2) Should the
distribution be as cash dividends, or should the cash be passed on to shareholders by
buying back some of the stock they hold? (3) How stable should the distribution be,
that is, should the funds paid out from year to year be stable and dependable, which
stockholders would probably prefer, or be allowed to vary with the firm's cash flows
and investment requirements, which would probably be better from the firm's
2) Explain briefly the dividend irrelevance theory that was put forward by Modigliani and
Miller. What were the key assumptions underlying their theory?
Dividend irrelevance refers to the theory that investors are indifferent between
dividends and capital gains, making dividend policy irrelevant with regard to its effect on
the value of the firm.
The dividend irrelevance theory was proposed by MM, but they had to make some very
restrictive assumptions to prove it. These assumptions include, among other things,
that no taxes are paid on dividends, that stocks can be bought and sold with no
transactions costs, and that everyone--investors and managers alike--has the same
information regarding firms' future earnings. MM argued that paying out a dollar per
share of dividends reduces the growth rate in earnings and dividends, because new stock
will have to be sold to replace the capital paid out as dividends. Under their
assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore,
Dividend Policy Handout.docx Page 1
according to MM, stockholders should be indifferent between dividends and capital
3) Discuss why some investors may prefer high-dividend-paying stocks, while other
investors prefer stocks that pay low or nonexistent dividends.
Investors might prefer dividends to capital gains because they may regard dividends as
less risky than potential future capital gains. If this were so, then investors would value
high-payout firms more highly--that is, a high-payout stock would have a high price.
Investors might prefer low-payout firms or capital gains to dividends because they may
want to avoid transactions costs--that is, having to reinvest the dividends and incurring
brokerage costs, not to mention taxes. The maximum tax rate on dividends is the same
as it is for capital gains; however, taxes on dividends are due in the year they are
received, while taxes on capital gains are due whenever the stock is sold. In addition, if
an investor holds a stock until his/her death, the beneficiaries can use the date of the
death as the cost-basis date and escape all previously accrued capital gains.
4) Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and
(3) their effects on dividend policy.
1. It has long been recognized that the announcement of a dividend increase often
results in an increase in the stock price, while an announcement of a dividend cut
typically causes the stock price to fall. One could argue that this observation
supports the premise that investors prefer dividends to capital gains. However,
MM argued that dividend announcements are signals through which management
conveys information to investors. Information asymmetries exist--managers
know more about their firms' prospects than do investors. Further, managers
tend to raise dividends only when they believe that future earnings can
comfortably support a higher dividend level, and they cut dividends only as a last
resort. Therefore, (1) a larger-than-normal dividend increase signals that
management believes the future is bright, (2) a smaller-than-expected increase,
or a dividend cut, is a negative signal, and (3) if dividends are increased by a
normal amount, this is a neutral signal.
2. Different groups, or clienteles, of stockholders prefer different dividend payout
policies. For example, many retirees, pension funds, and university endowment
funds are in a low (or zero) tax bracket, and they have a need for current cash
income. Therefore, this group of stockholders might prefer high-payout stocks.
These investors could, of course, sell some of their stock, but this would be
inconvenient, transactions costs would be incurred, and the sale might have to
be made in a down market. Conversely, investors in their peak earnings years
who are in high-tax brackets and who have no need for current cash income
should prefer low-payout stocks.
3. Clienteles do exist, but the real question is whether there are more members of
one clientele than another, which would affect what a change in its dividend
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policy would do to the demand for the firm's stock. There are also costs (taxes
and brokerage) to stockholders who would be forced to switch from one stock
to another if a firm changes its dividend policy. Therefore, we cannot say
whether a dividend policy change to appeal to one particular clientele or another
would lower or raise a firm's cost of equity. MM argued that one clientele is as
good as another, so in their view the existence of clienteles does not imply that
one dividend policy is better than another. Still, no one has offered convincing
proof that firms can disregard clientele effects. We know that stockholder shifts
will occur if dividend policy is changed, and since such shifts result in transactions
costs and capital gains taxes, dividend policy changes should not be taken lightly.
Further, dividend policy should be changed slowly, rather than abruptly, in order
to give stockholders time to adjust.
5) Assume that Li-Ion has an $800,000 capital budget planned for the coming year. You
have determined that its present capital structure (60% equity and 40% debt) is optimal,
and its net income is forecasted at $600,000. Use the residual dividend model approach
to determine Li-Ion's total dollar dividend and payout ratio. In the process, explain
what the residual dividend model is. Then, explain what would happen if net income
were forecasted at $400,000, or at $800,000.
We make the following points:
1. Given the optimal capital budget and the target capital structure, we must now
determine the amount of equity needed to finance the projects. Of the
$800,000 required for the capital budget, 0.6($800,000) = $480,000 must be
raised as equity and 0.4($800,000) = $320,000 must be raised as debt if we are
to maintain the optimal capital structure:
Debt $320,000 40%
Equity 480,000 60%
2. If a residual exists--that is, if net income exceeds the amount of equity the
company needs--then it should pay the residual amount out in dividends. Since
$600,000 of earnings is available, and only $480,000 is needed, the residual is
$600,000 - $480,000 = $120,000, so this is the amount that should be paid out
as dividends. Thus, the payout ratio would be $120,000/$600,000 = 0.20 = 20%.
3. If only $400,000 of earnings were available, the firm would still need $480,000 of
equity. It should then retain all of its earnings and also sell $80,000 of new stock.
The residual policy would call for a zero dividend payment.
4. If $800,000 of earnings were available, the dividend would be increased to
$800,000 - $480,000 = $320,000, and the payout ratio would rise to
$320,000/$800,000 = 40%.
Dividend Policy Handout.docx Page 3
Does Apple Pay Dividends on their stock? You may be surprised, but yes Apple (ticker symbol â€“ AAPL) does indeed pay a dividend. In fact, the company has been raising their dividend for 9 consecutive years (as of 2021) â€¦ which is impressive.
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