Dividend and Share Repurchase Policies

Every year, a company three options as to what it can do with earnings in order to create value for shareholders:

1. Reinvest in the business;
2. Pay cash dividends to shareholders; and/or
3. Buy back shares.

Note that option 1 assumes that company management profitably reinvests in the company, otherwise value can actually be destroyed.

Keep in mind that paying dividends reduces a company’s retained earnings, which is a reduction to equity in the capital structure.

Dividend Payout Policy

A company’s dividend payout policy is the amount and timing of its dividend payout.

Payout Ratio: The percent of net income that is paid out in dividends (recall that dividends are not expensed and thus not part of the net income calculation).

Example: A company with net income of $100 million pays out $60 million in dividends; therefore it has a payout ratio of 60% or 0.60 and retained earnings will increase by $40 million.

Cash Dividend Policy types include:

Residual Dividend Approach

• This is where a firm does not pay dividends until the equity portion of its capital budget is funded.
• Under the residual approach a firm must determine if attractive (i.e. NPV positive) capital projects exist.
• A disadvantage of the residual approach is that it can lead to inconsistency in dividend payouts, making it difficult for investors to set return expectations.
• When investors have difficulty forecasting returns they may place higher return requirements on equity, which raises the firm’s cost of equity capital.

Longer-Term Residual Dividend Approach

• A version of the simple residual approach, under this policy management designs a capital budget for the next five to ten years, which leads to steadier dividend payments to shareholders.
• Consistent expectations around dividend payments can lower investor required return on equity, which in turn lowers the firm’s cost of equity capital.

Stable Dividend Policy

• Under this approach, management makes a calculation about the firm’s long-term sustainable earnings and announces the payment of stable dividends to shareholders.