MARKET CONSIDERATIONS

One of the more recent theories proposed to explain firms’ payout decisions is called the catering theory. According to the catering theory, investors’ demands for dividends fluctuate over time. For example, during an economic boom accompanied by a rising stock market, investors may be more attracted to stocks that offer prospects of large capital gains. When the economy is in recession and the stock market is falling, investors may prefer the security of a dividend. The catering theory suggests that firms are more likely to initiate dividend payments or to increase existing payouts when investors exhibit a strong preference for dividends. Firms cater to the preferences of investors.

catering theory

A theory that says firms cater to the preferences of investors, initiating or increasing dividend payments during periods in which high-dividend stocks are particularly appealing to investors.

 REVIEW QUESTION

14–9What five factors do firms consider in establishing dividend policy? Briefly describe each of them.

14.5 Types of Dividend Policies

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The firm’s dividend policy must be formulated with two objectives in mind: providing for sufficient financing and maximizing the wealth of the firm’s owners. Three different dividend policies are described in the following sections. A particular firm’s cash dividend policy may incorporate elements of each.

CONSTANT-PAYOUT-RATIO DIVIDEND POLICY

One type of dividend policy involves use of a constant payout ratio. The dividend payout ratioindicates the percentage of each dollar earned that the firm distributes to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per share. With aconstant-payout-ratio dividend policy, the firm establishes that a certain percentage of earnings is paid to owners in each dividend period.

dividend payout ratio

Indicates the percentage of each dollar earned that a firm distributes to the owners in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per share.

constant-payout-ratio dividend policy

A dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period.

The problem with this policy is that if the firm’s earnings drop or if a loss occurs in a given period, the dividends may be low or even nonexistent. Because dividends are often considered an indicator of the firm’s future condition and status, the firm’s stock price may be adversely affected.

Example 14.6

Peachtree Industries, a miner of potassium, has a policy of paying out 40% of earnings in cash dividends. In periods when a loss occurs, the firm’s policy is to pay no cash dividends. Data on Peachtree’s earnings, dividends, and average stock prices for the past 6 years follow.

Year Earnings/share Dividends/share Average price/share
2015 −$0.50 $0.00 $42.00
2014   3.00  1.20  52.00
2013   1.75  0.70  48.00
2012  −1.50  0.00  38.00
2011   2.00  0.80  46.00
2010   4.50  1.80  50.00

Dividends increased in 2013 and in 2014 but decreased in the other years. In years of decreasing dividends, the firm’s stock price dropped; when dividends increased, the price of the stock increased. Peachtree’s sporadic dividend payments appear to make its owners uncertain about the returns they can expect.

REGULAR DIVIDEND POLICY

The regular dividend policy is based on the payment of a fixed-dollar dividend in each period. Often, firms that use this policy increase the regular dividend once a sustainable increase in earnings has occurred. Under this policy, dividends are almost never decreased.

regular dividend policy

A dividend policy based on the payment of a fixed-dollar dividend in each period.

Example 14.7

The dividend policy of Woodward Laboratories, a producer of a popular artificial sweetener, is to pay annual dividends of $1.00 per share until per-share earnings have exceeded $4.00 for 3 consecutive years. At that point, the annual dividend is raised to $1.50 per share, and a new earnings plateau is established. The firm does not anticipate decreasing its dividend unless its liquidity is in jeopardy. Data for Woodward’s earnings, dividends, and average stock prices for the past 12 years follow.

Year Earnings/share Dividends/share Average price/share
2015 $4.50 $1.50 $47.50
2014  3.90  1.50  46.50
2013  4.60  1.50  45.00
2012  4.20  1.00  43.00
2011  5.00  1.00  42.00
2010  2.00  1.00  38.50
2009  6.00  1.00  38.00
2008  3.00  1.00  36.00
2007  0.75  1.00  33.00
2006  0.50  1.00  33.00
2005  2.70  1.00  33.50
2004  2.85  1.00  35.00

Whatever the level of earnings, Woodward Laboratories paid dividends of $1.00 per share through 2012. In 2013, the dividend increased to $1.50 per share because earnings in excess of $4.00 per share had been achieved for 3 years. In 2013, the firm also had to establish a new earnings plateau for further dividend increases. Woodward Laboratories’ average price per share exhibited a stable, increasing behavior in spite of a somewhat volatile pattern of earnings.

Often, a regular dividend policy is built around a target dividend-payout ratio. Under this policy, the firm attempts to pay out a certain percentage of earnings, but rather than let dividends fluctuate, it pays a stated dollar dividend and adjusts that dividend toward the target payout as proven earnings increases occur. For instance, Woodward Laboratories appears to have a target payout ratio of around 35 percent. The payout was about 35 percent ($1.00 ÷ $2.85) when the dividend policy was set in 2004, and when the dividend was raised to $1.50 in 2013, the payout ratio was about 33 percent ($1.50 ÷ $4.60).

target dividend-payout ratio

A dividend policy under which the firm attempts to pay out a certain percentage of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occur.

LOW-REGULAR-AND-EXTRA DIVIDEND POLICY

Some firms establish a low-regular-and-extra dividend policy, paying a low regular dividend, supplemented by an additional (“extra”) dividend when earnings are higher than normal in a given period. By calling the additional dividend an extra dividend, the firm avoids setting expectations that the dividend increase will be permanent. This policy is especially common among companies that experience cyclical shifts in earnings.

low-regular-and-extra dividend policy

A dividend policy based on paying a low regular dividend, supplemented by an additional (“extra”) dividend when earnings are higher than normal in a given period.

extra dividend

An additional dividend optionally paid by the firm when earnings are higher than normal in a given period.

By establishing a low regular dividend that is paid each period, the firm gives investors the stable income necessary to build confidence in the firm, and the extra dividend permits them to share in the earnings from an especially good period. Firms using this policy must raise the level of the regular dividend once proven increases in earnings have been achieved. The extra dividend should not be a regular event; otherwise, it becomes meaningless. The use of a target dividend-payout ratio in establishing the regular dividend level is advisable.

 

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