Dividends and Dividend Policy

In December 1999, General Electric Company (better known as GE) announced a broad plan to reward stockholders for the recent success of the firm's business. Under the plan, GE would (1) boost its quarterly dividend by 17 percent from 35 cents per share to 41 cents per share, (2) expand its plans to buy back its common stock by as much as $5 billion, and (3) undertake a three-for-one stock split, meaning that each existing common share would be replaced with three new ones. Investors cheered, bidding the stock price up by 2.9 percent on the day of the announcement. Why were investors so pleased? To find out, this chapter explores all three of these actions and their implications for shareholders.

Dividend policy is an important subject in corporate finance, and dividends are a major cash outlay for many corporations. In 1995 alone, for example, New York Stock Exchange-listed firms paid out in excess of $130 billion in cash dividends. At the same time, however, about 25 percent of the listed companies paid no dividend at all.

At first glance, it may seem obvious that a firm would always want to give as much as possible back to its shareholders by paying dividends. It might seem equally obvious, however, that a firm could always invest the money for its shareholders instead of paying it out. The heart of the dividend policy question is just this: Should the firm pay out money to its shareholders, or should the firm take that money and invest it for its shareholders?

It may seem surprising, but much research and economic logic suggest that dividend policy doesn't matter. In fact, it turns out that the dividend policy issue is much like the capital structure question. The important elements are not difficult to identify, but the interactions between those elements are complex and no easy answer exists.

Dividend policy is controversial. Many implausible reasons are given for why dividend policy might be important, and many of the claims made about dividend policy are economically illogical. Even so, in the real world of corporate finance, determining the most appropriate dividend policy is considered an important issue. It could be that financial managers who worry about dividend policy are wasting time, but it could also be true that we are missing something important in our discussions.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

18. Dividends and Dividend Policy

© The McGraw-Hill Companies, 2002

PART SIX Cost of Capital and Long-Term Financial Policy

In part, all discussions of dividends are plagued by the "two-handed lawyer" problem. President Truman, while discussing the legal implications of a possible presidential decision, asked his staff to set up a meeting with a lawyer. Supposedly Mr. Truman said, "But I don't want one of those two-handed lawyers." When asked what a two-handed lawyer was, he replied, "You know, a lawyer who says, 'On the one hand I recommend you do so and so because of the following reasons, but on the other hand I recommend that you don't do it because of these other reasons.'"

Unfortunately, any sensible treatment of dividend policy will appear to have been written by a two-handed lawyer (or, in fairness, several two-handed financial economists). On the one hand, there are many good reasons for corporations to pay high dividends, but, on the other hand, there are also many good reasons to pay low dividends.

In this chapter, we will cover three broad topics that relate to dividends and dividend policy. First, we describe the various kinds of dividends and how dividends are paid. Second, we consider an idealized case in which dividend policy doesn't matter. We then discuss the limitations of this case and present some real-world arguments for both high-and low-dividend payouts. Finally, we conclude the chapter by looking at some strategies that corporations might employ to implement a dividend policy, and we discuss share repurchases as an alternative to dividends.

Stocks and Shares Retirement Rescue

Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

Get My Free Ebook

Post a comment