Dividend Policy and Retained Earnings
by
Charles Lamson
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The Marginal Principle of Retained Earnings In theory, CEOs and board members members concerned about dividends should ask, "How can the best use of the funds be made?" The rate of return that the corporation can achieve on retained earnings for the benefit of stockholders must be compared to what stockholders could earn if the funds were paid to them in dividends. This is known as the marginal principle of retained earnings. Each potential project to be financed by internally generated funds must provide a higher rate of return than the stockholder could achieve on other investments. We speak of this as the opportunity cost of using stockholder funds. Life Cycle Growth and Dividends One of the major influences on dividends is the corporate growth rate in sales and the subsequent return on assets. Figure 1 shows a corporate life cycle and the corresponding dividend policy that is most likely to be found at each stage. A small firm in the initial stages of development (Stage I) pays no dividends because it needs all its profits (if there are any) for reinvestment in new productive assets. If the firm is successful in the marketplace, the demand for its products will create growth in sales, earnings, and assets, and the firm will move into Stage II. At this stage sales and returns on assets will be growing at an increasing rate, and earnings will be reinvested. In the early part of Stage II, stock dividends (distribution of additional shares) may be instituted and, in the latter part of Stage II, low cash dividends may be started to inform investors that the firm is profitable but cash is needed for internal Investments.  After the growth period the firm enters Stage III. The expansion of sales continues, but at a decreasing rate, and returns on investment may decline as more competition enters the market and tries to take away the firm's market share. During this period the firm is more and more capable of paying cash dividends, as the asset expansion rate slows and external funds become more readily available. Stock dividends and stock splits are still coming in the expansion phase, and the dividend payout ratio usually increases from a low level of 5 to 15 percent of earnings to a moderate level of 20 to 30 percent of earnings. Finally, at Stage IV, maturity, the firm maintains a stable growth rate in sales similar to that of the economy as a whole; and, when risk premiums are considered, its returns on assets level out to those of the industry and the economy. In unfortunate cases firms suffer declines in sales if product innovation and diversification have not occurred over the years. In stage four, assuming maturity rather than decline, dividends might range from 35 to 40 percent of earnings. These percentages will be different from industry to industry, depending on the individual characteristics of the company, such as operating and financial leverage and the volatility of sales and earnings over the business cycle. As the discussion continues in the next several posts, more will be said about stock dividends, stock splits, the availability of external funds, and other variables that affect the dividend policy of the firm.  Dividends as a Passive Variable In the preceding analysis, dividends were used as a passive decision variable: They are to be paid only if the corporation cannot make better use of the funds for the benefit of stockholders. The active decision variable is retained earnings. Management decides how much retained earnings will be spent for internal corporate needs, and the residual (the amount left after internal expenditures) is paid to the stockholders in cash dividends. An Incomplete Theory The only problem with the residual theory of dividends is that we have not recognized how stockholders feel about receiving dividends. If the stockholders' only concern is achieving the highest return on their investment, either in the form of corporate retained earnings remaining in the business or as current dividends paid out, then there is no issue. But if stockholders have a preference for current funds, for example, over retained earnings, then our theory is incomplete. The issue is not only whether reinvestment of retained earnings or dividends provides the highest return, but also how stockholders react to the two alternatives. While some researchers maintain that stockholders are indifferent to the division of funds between retained earnings and dividends (holding investment opportunities constant), others disagree. So there is no conclusive proof one way or the other, the judgment of most researchers is that investors have some preference between dividends and retained earnings (Block & Hirt, 2005, p. 535). Arguments for the Relevance of Dividends A strong case can be made for the relevance of dividends because they resolve uncertainty in the minds of investors. Though retained earnings reinvested in the business theoretically belong to common stockholders, there is still an air of uncertainty about their eventual translation into dividends. Thus, it can be hypothesized that the stockholders might apply a higher discount rate and assign a lower valuation to funds that are retained in the business as opposed to those that are paid out.  It is also argued that dividends may be viewed more favorably than retained earnings because of the information content of dividends. In essence the corporation is telling the stockholder, "We are having a good year, and we wish to share the benefits with you." If the dividend per share is raised, then the information content of the dividend increase is quite positive while a reduction in the dividend generally has negative information content. Even though the corporation may be able to generate the same or higher returns with the funds than the stockholder and perhaps provide even greater dividends in the future, some researchers find that "in an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear-cut means of making a statement that speaks louder than a thousand words" (Miller & Modigliani, "Dividend Policy, Growth and Valuation of Shares," Journal of Business 34 (October 1961), pp. 411-33) The primary contention in arguing for the relevance of dividend policy is that stockholders' needs and preferences go beyond the marginal principle of retained earnings. The issue is not only who can best utilize the funds (the corporation or the stockholder) but also what are the stockholders preferences. In practice it appears that most corporations adhere to the following logic. First investment opportunities relative to a required return (marginal analysis) are determined. This is then tempered by some subjective notion of stockholders' desires. Corporations with unusual growth prospects and high rates of return on internal Investments generally pay a relatively low dividend (or no dividend). For the more mature firm, an analysis of both investment opportunities and stockholder preferences may indicate that a higher rate of pay out is necessary.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 533-535* end |
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