Theories of Dividend
App13A_SW_Brigham_778322_R2
12/24/02
5:14 AM
Page 13A-1
13A
ILLUSTRATION OF THE THREE DIVIDEND POLICY THEORIES
Figure 13A-1 illustrates the three alternative dividend policy theories: (1) Miller and Modigliani’s dividend irrelevance theory, (2) Gordon and Lintner’s bird-in-thehand theory, and (3) the tax preference theory. To understand the three theories, consider the case of Hardin Electronics, which has from its inception plowed all earnings back into the business and thus has never paid a dividend. Hardin’s management is now reconsidering its dividend policy, and it wants to adopt the policy that will maximize its stock price. Consider first the data presented below the graph. Each row shows an alternative payout policy: (1) Retain all earnings and pay out nothing, which is the present policy; (2) pay out 50 percent of earnings; and (3) pay out 100 percent of earnings. In the example, we assume that the company will have a 15 percent ROE regardless of which payout policy it follows, so with a book value per share of $30, EPS will be $4.50 under all payout policies.1 Given an EPS of $4.50, dividends per 0.15($30) share are shown in Column 3 under each payout policy. Under the assumption of a constant ROE, the growth rate shown in Column 4 will be g (% Retained)(ROE), and it will vary from 15 percent at a zero payout to zero at a 100 percent payout. For example, if Hardin pays out 50 percent of its earnings, then its dividend growth rate will be g 0.5(15%) 7.5%. Columns 5, 6, and 7 show how the situation would look if MM’s irrelevance theory were correct. Under this theory, neither the stock price nor the cost of equity would be affected by the payout policy—the stock price would remain constant at $30, and ks would be stable at 15 percent. Note that ks is found as the sum of the growth rate in Column 4 plus the dividend yield in Column 6. Columns 8, 9, and 10 show the situation if the bird-in-the-hand theory were true. Under this theory, investors prefer
12/24/02
5:14 AM
Page 13A-1
13A
ILLUSTRATION OF THE THREE DIVIDEND POLICY THEORIES
Figure 13A-1 illustrates the three alternative dividend policy theories: (1) Miller and Modigliani’s dividend irrelevance theory, (2) Gordon and Lintner’s bird-in-thehand theory, and (3) the tax preference theory. To understand the three theories, consider the case of Hardin Electronics, which has from its inception plowed all earnings back into the business and thus has never paid a dividend. Hardin’s management is now reconsidering its dividend policy, and it wants to adopt the policy that will maximize its stock price. Consider first the data presented below the graph. Each row shows an alternative payout policy: (1) Retain all earnings and pay out nothing, which is the present policy; (2) pay out 50 percent of earnings; and (3) pay out 100 percent of earnings. In the example, we assume that the company will have a 15 percent ROE regardless of which payout policy it follows, so with a book value per share of $30, EPS will be $4.50 under all payout policies.1 Given an EPS of $4.50, dividends per 0.15($30) share are shown in Column 3 under each payout policy. Under the assumption of a constant ROE, the growth rate shown in Column 4 will be g (% Retained)(ROE), and it will vary from 15 percent at a zero payout to zero at a 100 percent payout. For example, if Hardin pays out 50 percent of its earnings, then its dividend growth rate will be g 0.5(15%) 7.5%. Columns 5, 6, and 7 show how the situation would look if MM’s irrelevance theory were correct. Under this theory, neither the stock price nor the cost of equity would be affected by the payout policy—the stock price would remain constant at $30, and ks would be stable at 15 percent. Note that ks is found as the sum of the growth rate in Column 4 plus the dividend yield in Column 6. Columns 8, 9, and 10 show the situation if the bird-in-the-hand theory were true. Under this theory, investors prefer