A. 1) What is meant by the term “distribution policy”? How have dividend payout versus stock repurchase changed over time? Distribution Policy involves three issues. 1) What fraction of earnings should be distributed? 2) Should the distribution be in the form of cash dividends or stock repurchases? 2) Should the firms maintain a steady, stable divided growth rate? The dividend payout versus stock repurchase has changed dramatically during the past 30 years. First off the total cash distributions as a percentage of net income have remained the same fairly stable at around 26% to 28%, but the mix of dividends and repurchases has changed.
The average dividend payout fell from 22.3% in 1974 to 13.8% in 1998, while the average repurchase payouts as a percentage of net income rose from 3.7% to 13.6%. Since 1985, large companies have repurchased more shares than they have issued. Ever since 1998, more cash has been returned to shareholders in repurchases then as dividend payouts. Second, companies today are less likely to pay a dividend. In 1978, about 66.5% of NYSE, AMEX, and Nasdaq firms paid a dividend. In 1999, only 20.8% paid a dividend.
A portion of this reduction can be explained by the larger number of IPO’s in the 1990’s, since young firms rarely pay a dividend. Even though that doesn’t explain the whole story, as many mature firms now don’t pay dividends. Third is that relatively small number of older, more established, and more profitable firms accounts for most of the cash distributed as dividends and finally there is a considerable variation in distribution policies, as some companies pay a high percentage of their income as dividends and some pay none.
2) The terms “irrelevance,” and “dividend preference, or bird-in-the-hand,” and “tax effects” have been used to describe three major theories regarding the way dividend payout affect a firm’s value. Explain what these terms mean, and briefly describe each theory.
Irrelevance theory was created by two men which names are Merton Miller and Franco Modigliani. They argued that the firm’s value is determined by its basic earning power and its business risk. Basically the firms depends on the income produced by its assets not on how income is split between dividend and retained earnings. To understand this theory better any shareholder can construct its own dividend policy. An example if a firm does not pay dividends and a shareholder that want to a 5% dividend can create it by selling 5% of his stock. So if investors could buy and sell their own shares and plus create their own dividend policy without incurring cost then it would truly be irrelevant.
Dividend Preference Theory that was created by Myron Gordon and John Linter argue that a stocks risk declines as dividends increase, in other words a bird in the hand is worth more than a bird in the bush meaning that’s its better receive cash in your hands from dividend than rather letting it go to the market. That’s why shareholders wand dividends and are willing to accept a lower required return on equity.
The Tax Effect Theory argues that are two reasons why stock price appreciates still is taxed more favorably than dividend income. First, due to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. So if dividend and gains are taxed the same, capital gains are never taxed sooner than dividends. Second, if a stock is held by someone until he or she dies, no capital gains tax is due at all, the beneficiaries who receive the stock can use the stock’s value on the death day as their cost basis and thus completely escape the capital gains tax.
3) What do the three theories indicate regarding the actions management should take with respect to dividend payouts? What the three theories indicate regarding the actions management should take with respect to dividend payouts is the irrelevant theory thinks that it shouldn’t be taking into action because it should be by the income produced by its assets not on how income is split between dividend and retained earnings. Dividends Preference theory basically says it’s better to receive the money from the dividend than letting it go the market and the Tax Effect theory says the dividends aren’t worth as much as there are issued.
4) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts? Some of the results that empirical studies of the dividend theories have produced are that all factors other than distribution level should be held constant, that is the sample companies should differ only in their distribution levels. Second each firms cost of equity should be measured with a high degree of accuracy. Unfortunately we cannot find a set of publicly owned firms that differ only in their distribution levels nor can they obtain their cost of equity.
That’s why nobody has been able to identify a relationship between the distribution level and the cost of equity or firm value. Although none of the empirical test are perfect, recent evidence shows that firms with higher dividend payouts also have a higher required returns. This tends to support the tax effect hypothesis, even though the size of the required return is too high to be explained by taxes. All of this can affect what you tell a manager because they make the decision to expropriate shareholders wealth and that’s because there is a high limit on the payouts.
B) Discuss 1) The information content, or signaling, hypothesis It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock, while a dividend cut generally leads to a stock price decline. Another argument was brought to attention that which was that higher-then expected dividend increase is signal to investors that the firm’s management forecasts good future earning if the opposite happens which dividend decrease and or smaller-than-expected increase then the forecasting poor future earnings. What they are basically saying that if the prices change following the dividends actions indicated that there is important information, or signaling, content in the dividend announcement.
2) The clientele effect With the clientele affect which is one of the different groups the receive dividend payout would like to change something things around like in the way they would like to get paid. A good example is that retired individuals, pension funds, and university endowment funds generally prefer cash income so they might want a high percentage on their earnings. Some investors on their peak year want to reinvest because they have less need for current investment income and would simply reinvest dividends received after first paying income taxes on those dividends.
3) Their effect on distribution policy Their effect on distribution policies can be a lot of things that could happen like how messages and data can be shared and distributed throughout the various divisions and department of the company. With the signaling effect how would the company manage their money would they like to receive more of it in cash or reinvest it in more dividend and could affect how the company benefits.
With the clientele effect it depends on what kind of investors are in the company. If they are young or if there are in their older years of life if they are getting pretty old they might not be caring about the company so much but about how they are going to be getting paid they tend to worry about they will be able to get cash fast if they need it rather than investing it and not being able to sell it later on and as fast as they want.
C) 1) Assume that SSC has $800,000 capital budget planned for the coming year. You have determined its present capital structure (60% equity and 40% debt) is optional, and its net income is forecasted at $600,000. Use the residual distribution model approach to determine SSC’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Then, explain what would happen if net income were forecasted at $400,000. At $800,000.
The SSC’s total dollar distribution will come out to be a total of $120,000. The way I got this answer was by multiplying the 60% of equity with the amount of capital budgeting which is $800,000 and came out to be $480,000 and then subtracted by the total income which is $600,000 and came out with $120,000.
Now if I switch the net income from $600,000 to $400,000 the residual distribution would be a shortage of $80,000 that would mean that the company would have to issue new common stock in order to maintain its target capital structure.
Now if the net income was raised to $800,000 the residual distribution would come out to be $320,000 which would now be able to pay their dividends. 2) In general terms, how would a change in investment opportunities affect the payout ratio under the residual distribution policy? The only way a change in investment opportunities would affect the payout ratio under the residual distribution policy would be if the investments opportunities are hard to find then the company would have extra money for their shareholders. In the residual distribution policy when the investment opportunities goes up the dividend payouts goes down and it can also be the opposite as well, when dividend payout goes up the investment opportunities goes down.
3) What are the advantages and disadvantages of the residual policy? The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital. Also, whatever negative signals are associated with stock issues would be avoided.
However, if it were applied exactly the residual model would result in dividend payments that fluctuated significantly from year to year as capital requirements and internal cash flows fluctuated. Some of the things that could happen is that it would send investors conflicting signals over time regarding the firms future prospects there could also be no specific clientele that would be attracted to the firm. These affects would cause higher required return on equity and lower flotation cost.
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