Distributions to Shareholders:
Dividends and Repurchases
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
17-1 Investors who prefer a high payout policy would generally (a) need current cash income and (b) be in a low income tax bracket. Those who prefer a low payout would not need cash currently and would be in a high tax bracket. Universities and other tax-exempt institutions, and many retirees, are examples of those who prefer cash dividends, while people in their peak earning years often prefer low payouts.
If someone holds a low payout stock and wants more cash income, he or she can sell the stock and buy a high payout stock, but that would result in brokerage ...view middle of the document...
Most investors prefer to have companies retain and reinvest earnings in order to generate earning growth and capital gains.
MM Indifference. MM argue that argue that only a stock’s earnings and business risk determine its price. Suppose stocks H and L have the same risk and the same earnings, but H pays more of its earnings out as dividends and has the higher price. MM argue that investors could sell H and buy L. L’s share price should rise faster than H’s because it is plowing back more of its earnings. L’s investors who want more dividends could sell enough of their shares to make up for the dividend shortfall. They prove that this would result in higher cash flows. They then argue that arbitrage would occur until H and L sold at the same price.
Had L’s stock had the higher price, then its holders who did not want dividends could sell it, buy H, and then use the excess dividends to buy more of H’s stock.
MM’s argument assumes that there are no transactions costs involved in stock transactions. They also assume no taxes. The existence of differential taxes on dividends versus capital gains, and transactions costs, make perfect arbitrage impossible, and in this situation an individual investor could prefer one type stock or the other. Then, if there are more of the investors who prefer either high or low payouts, the indifference theory will not be true in the aggregate.
Bird in the Hand. There’s an old proverb that says “a bird in the hand is worth two in the bush.” Myron Gordon, who developed the Discounted Dividend Model, argued that investors think a dividend in the hand is less risky than a potential capital gain in the bush. This leads to the conclusion that rs falls as the payout ratio is increased. MM criticized Gordon and called his position “the bird in the hand fallacy.” MM argued that most investors take dividends and then reinvest them in the stock of the same or similar companies, which exposes them to the same risk as if the companies had simply kept the dividends and invested the proceeds without passing them through investors’ hands.
Tax Preference. Others have argued that lower taxes on capital gains cause the majority of investors to prefer retention and capital gains to higher dividends and higher taxes.
Empirical tests have tried to relate stock prices or P/E ratios to dividend payout. If we could find a sample of companies that varied only with respect to their payout policies, then we could plot P/E’s and prices against payout, and if the pattern that emerged was like one of those shown in the following graphs, then this would support one of the theories. However, it is impossible to find companies that vary only in their payouts.
Things other than payout are simply never held constant. In particular expected growth rates vary across companies, so a high price could be associated with a high expected growth rate, not necessarily a high...