We now discuss the amount and timing of dividends.

When a company is deciding on a dividend policy there are some guiding principles:

• A firm's objective is to maximize shareholder value.
• A firm's cash flows belong to its shareholders. It should pay the excess cash to shareholders if there are not enough investments that earn its hurdle rate.
• Since retained earnings are cheaper than new common stocks, a firm should retain earnings to meet equity requirements.

Stable Dividend Policy

Dividend stability is important. It has two components: 1. how stable is the dividend growth rate? 2. how stable is the amount of dividend per year? As a firm's profits and cash flows typically vary over time, theoretically a firm should vary its dividends accordingly. However, fluctuating dividend policy can force stock price down in the short-run. Therefore, if a firm stabilizes its dividends as much as possible, its cost of equity will be minimized and its stock price will be maximized.

The "stable dividend policy" generally means increasing the dividend at a reasonably steady rate.

A firm's target payout ratio is the percentage of net income paid out as dividends.

In a classic study, Lintner surveyed a number of managers in the 1950's and asked how they set their dividend policy. Most of the respondents said that there was a target proportion of earnings that determined their policy. One firm's policy might be to pay out 40% of earnings as dividends whereas another company might have a target of 50%. This would suggest that dividends change with earnings. Empirically, dividends are slow to adjust to changes in earnings. Lintner suggested an empirical model whereby changes in dividends are linked to the level of the earnings, the target payout and the adjustment rate. He asserts that more "conservative" companies would be slower to adjust to the target payout if earnings increased. The following details his research.

Suppose that a firm always stuck to a target payout ratio. Then the dividend payment in the coming year (D₁) would equal a constant proportion of earnings per share (EPS₁).
D₁ = target ratio x EPS₁.
The dividend change would equal D₁ - D₀ = target change = target ratio x EPS₁ - D₀

A firm that always stuck to its payout ratio would have to change its dividend whenever earnings changed. But the managers in Lintner's survey were reluctant to do this. They believed that shareholders prefer a steady progression in dividends. Therefore, even if circumstances appeared to warrant a large increase in their company's dividend, they would move only partway toward their target payment. Their dividend changes therefore seemed to conform to the following model:
D₁ - D₀ = adjustment rate x target change = adjustment rate x (target ratio x EPS₁ - D₀)

The more conservative the company, the more slowly it would move toward its target and, therefore, the lower would be its adjustment rate.

Example

• Target payout ratio: 50%
• Adjustment factor: 0.2
• EPS₀: $1. D0: $0.5
• EPS₁: $1.5 D₁: ?

D₁ = $0.5 + 0.2 x (0.5 x 1.5 - 0.5) = $0.55.

Therefore, even though earnings increased 50% from $1 to $1.5, the dividend would only incrementally increase by about 10% from $0.5 to $0.55.

Constant Dividend Payout Ratio Policy

A company using such a policy applies a target dividend payout ratio to current earnings; therefore, dividends are more volatile than with a stable dividend policy.

The policy guards against overpayments as well as underpayment of dividends because management cannot pay dividends if there are no profits, and it cannot withhold them when profits are earned. From the shareholders' viewpoint, this method involves uncertainty and irregularity in regard to the expected dividends.

Residual Dividend Approach (Optional)

Some firms use this model to set the long-run target payout ratio at a level which will permit the firm to satisfy its equity requirements with retained earnings. It states that the dividend paid out is equal to the earnings achieved for that year less the retained earnings required for the financing of the company's optimal capital budget.

A firm follows four steps in this model:

• It determines the optimal capital budget.
• It determines the amount of equity needed to finance that budget, given its target capital structure.
• It uses retained earnings to meet equity requirements to the extent possible.
• It pays dividends only if more earnings are available than are needed to support the optimal capital budget.

Residual means left over i.e., dividends are only paid out if there are earnings left over after steps 1 to 3 have been complied with.

• Pros: by following the residual dividend policy, the firm can meet its target capital structure at the optimal cost of capital, thus maximizing the shareholders' value.
• Cons: since investment opportunities and earnings surely vary over time, a firm that strictly follows the residual dividend policy will have unstable dividends.

Conclusion: Firms should use the residual policy to help set their long-run target payout ratios, but not as a guide to the payout in any one year. Many firms forecast their optimal capital budget for the next five to ten years. The residual from that process will be allocated to dividends and paid out on a steadier, more even basis over the same period. This is called the longer-term residual approach which involves allocating all funds designated for shareholder - including both cash dividends and share repurchases - paying out a more stable cash dividend to shareholders and allocating a more flexible amount to share repurchases.

Example

• Earnings: $100.
• Target D/E ratio: 40/60.
• Planned capital spending: $50.
• Financed from new debt: $50 x 0.4 = $20.
• Financed from retained earnings: $50 x 0.6 = $30.
• Residual dividend: $100 - $30 = $70.
• Implied payout ratio: 70/100 = 70%.

Global Trends in Payout Policy

• A large decline in the number of companies that pay cash dividends in most developed countries.
• An increase in the number of companies that do share repurchases in the U.S. and Europe.