A company can change its value of operations only if it changes the cost of capital or investors’ perceptions regarding expected free cash flow. This is true for all corporate decisions, including the distribution policy. How to allocate the earnings between cash dividends and investments is an important decision for the financial managers.
Investors and Distribution Ratio
Is there an optimal distribution policy that maximizes a company’s intrinsic value? The answer depends in part on investors’ preferences for returns in the form of dividend yields versus capital gains. The relative mix of dividend yields and capital gains is determined by the target distribution ratio, which is the percentage of net income distributed to shareholders through cash dividends or stock repurchases, and the target payout ratio, which is the percentage of net income paid as a cash dividend. Notice that the payout ratio must be less than the distribution ratio because the distribution ratio includes stock repurchases as well as cash dividends.
A high distribution ratio and a high payout ratio mean that a company pays large dividends and has small (or zero) stock repurchases. In this situation, the dividend yield is relatively high and the expected capital gain is low. If a company has a large distribution ratio but a small payout ratio, then it pays low dividends but regularly repurchases stock, resulting in a low dividend yield but a relatively high expected capital gain yield. If a company has a low distribution ratio, then it must also have a relatively low payout ratio, again resulting in a low dividend yield and, it is hoped, a relatively high capital gain.
Distribution Theory in Financial Management
In financial management, there are three theories regarding the distribution policy (1) the dividend irrelevance theory, (2) the dividend preference theory and (3) the tax effect theory
Dividend irrelevance theory: The original proponents of the dividend irrelevance theory were Merton Miller and Franco Modigliani (MM).8 They argued that the firm’s value is determined only by its basic earning power and its business risk. In other words, MM argued that the value of the firm depends only on the income produced by its assets, not on how this income is split between dividends and retained earnings.
In developing their dividend theory, MM made a number of important assumptions, especially the absence of taxes and brokerage costs. If these assumptions are not true, then investors who want additional dividends must incur brokerage costs to sell shares and must pay taxes on any capital gains. Investors who do not want dividends must incur brokerage costs to purchase shares with their dividends. Because taxes and brokerage costs certainly exist, dividend policy may well be relevant.
Dividend preference theory: The key assumption of the theory is that A return in the form of dividends is a sure thing, but a return in the form of capital gains is risky. In other words, a bird in the hand is worth more than two in the bush. Therefore, shareholders prefer dividends and are willing to accept a lower required return on equity. The possibility of agency costs leads to a similar conclusion. First, high payouts reduce the risk that managers will squander cash because there is less cash on hand. Second, a high-payout company must raise external funds more often than a low payout company, all else held equal. If a manager knows that the company will receive frequent scrutiny from external markets, then the manager will be less likely to engage in wasteful practices. Therefore, high payouts reduce the risk of agency costs. With less risk, shareholders are willing to accept a lower required return on equity.
Tax effect theory: Tax and dividend are taxed differently. Because dividends are in some cases taxed more highly than capital gains, investors might require a higher pre-tax rate of return to induce them to buy dividend-paying stocks. Therefore, investors may prefer that companies minimize dividends. If so, then investors should be willing to pay more for low-payout companies than for otherwise similar high-payout companies.