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vestors and can reduce a ¬rm™s ¬nancial slack. Finally, lending contracts can affect a
¬rm™s dividend payouts to protect lenders™ interests.
Below we discuss the factors that are relevant to managers™ dividend decisions and
how ¬nancial analysis tools can be used in this decision process.

Dividends as a Way of Reducing Free Cash Flow Inefficiencies
As we discussed earlier, con¬‚icts of interest between managers and shareholders can
affect a ¬rm™s optimal capital structure; they also have implications for dividend policy
decisions. Stockholders of a ¬rm with free cash ¬‚ows and few pro¬table investment op-
portunities want managers to adopt a dividend policy with high payouts. This will deter
managers from growing the ¬rm by reinvesting the free cash ¬‚ows in new projects that
are not valued by stockholders or from spending the free cash ¬‚ows on management
perks. In addition, if managers of a ¬rm with free cash ¬‚ows wish to fund a new project,
most stockholders would prefer that they do so by raising new external capital rather
than cutting dividends. Stockholders can then assess whether the project is genuinely
pro¬table or simply one of management™s pet projects.

Key Analysis Questions
Earlier we discussed how ratio and cash ¬‚ow analysis can help analysts assess
whether a ¬rm faces free cash ¬‚ow inef¬ciencies, and how pro forma analysis can
help indicate the likelihood of future free cash ¬‚ow problems. The same analysis
and questions can be used to decide whether a ¬rm should initiate dividends.

Tax Costs of Dividends
What are the implications for dividend policy if dividends and capital gains are taxed,
particularly at different rates? Classical models of the tax effects of dividends predict
that if the capital gains tax rate is less than the rate on dividend income, investors will
prefer that the ¬rm either pay no dividends, so that they subsequently take gains as cap-
ital accumulation, or that the ¬rm undertakes a stock repurchase, which quali¬es as a
capital distribution. Even if capital gains are slightly higher than dividend tax rates, in-
vestors are still likely to prefer capital gains to dividends, since they do not actually have
to realize their capital gains. They can delay selling their shares and thereby defer paying
the taxes on any capital appreciation. The longer investors wait before selling their
stock, the lower the value of the capital gains tax. Only if capital gains tax rates are sub-
stantially higher than the rates on ordinary income are investors likely to favor dividend
distributions over capital gains.
Today many practitioners and theorists believe that taxes play only a minor role in
determining a ¬rm™s dividend policy, since a ¬rm can attract investors with different tax
Corporate Financing Policies

16-13 Part 3 Business Analysis and Valuation Applications

preferences. Thus, a ¬rm that wishes to pay high dividend rates will attract stockholders
that are tax-exempt institutions, which do not pay taxes on dividend income. In contrast,
a ¬rm that prefers to pay low dividend rates will attract stockholders who have high mar-
ginal tax rates and prefer capital gains to dividend income.

Dividends and Financial Slack
We discussed earlier how managers™ information advantage over dispersed investors can
increase a ¬rm™s cost of external funds. One way to avoid having to raise costly external
funds is to have a conservative dividend policy which creates ¬nancial slack in the orga-
nization. By paying only a small percentage of income as dividends and reinvesting the
free cash ¬‚ows in marketable securities, management reduces the likelihood that the ¬rm
will have to go to the capital market to ¬nance a new project.
Managers of ¬rms with high intangible assets and growth opportunities are particu-
larly likely to have an information advantage over dispersed investors, since accounting
information for these types of ¬rms is frequently a poor indicator of future performance.
Accountants, for example, do not attempt to value R&D, intangibles, or growth oppor-
tunities. These types of ¬rms are therefore more likely to face information problems and
capital market constraints. To compound this problem, high-growth ¬rms are typically
heavily dependent on external ¬nancing, since they are not usually able to fund all new
investments internally. Any capital market constraints are therefore likely to affect their
ability to undertake pro¬table new projects.
Because paying dividends reduces ¬nancial slack and is thus costly, a ¬rm™s dividend
policy can help management communicate effectively with external investors. Investors
recognize that managers will only increase their ¬rm™s dividend rate if they anticipate
that the payout does not have a serious effect on the ¬rm™s future ¬nancing options.
Thus, the decision to increase dividends can help investors appreciate management™s op-
timism about the ¬rm™s future performance and its ability to ¬nance growth.4

Key Analysis Questions
As discussed earlier for debt policy, the ¬nancial analysis tools discussed in Part
2 of the book can help analysts assess how much ¬nancial slack a ¬rm should
maintain. The same analysis and questions are relevant to dividend policy analy-
sis. Based on the answers to the earlier questions, analysts can assess whether the
¬rm™s projected cash needs for new investments are stable in relation to its oper-
ating cash ¬‚ows. If so, it makes sense for management not to pursue too high a
dividend payout and to build ¬nancial slack during boom periods to help fund in-
vestments during busts. Similarly, if the ¬rm™s ability to raise low-cost debt is lim-
ited because it is in a volatile industry or has mostly intangible assets, management
is likely to avoid high dividend payouts to reduce the risk that it will have to raise
high-cost external capital in the future or even forego a pro¬table new project.
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Corporate Financing Policies

Lending Constraints and Dividend Policy
One of the concerns of a ¬rm™s creditors is that when the ¬rm is in ¬nancial distress,
managers will pay a large dividend to stockholders. This problem is likely to be partic-
ularly severe for a ¬rm with highly liquid assets, since its managers can pay a large div-
idend without selling assets. To limit these types of games, managers agree to restrict
dividend payments to stockholders. Such dividend covenants usually require the ¬rm to
maintain certain minimum levels of retained earnings and current asset balances, which
effectively limit dividend payments when it is facing ¬nancial dif¬culties. However,
these constraints on dividend policy are unlikely to be severe for a pro¬table ¬rm.

Determining Optimal Dividend Payouts
One question that arises in using the above factors to determine dividend policy is de¬n-
ing what we mean by high, low, and medium dividend payouts. To provide a rough sense
of what companies usually consider to be high and low dividend payouts and yields, Ta-
ble 16-4 shows median dividend payout ratios and dividend yields for selected U.S. in-
dustries in 1998. Median ratios are reported for all listed companies and for NYSE
It is interesting to note that many U.S. listed companies do not pay any dividends. This
is particularly true for non-NYSE ¬rms, which probably have more attractive growth op-
portunities. The highest payouts tend to be made by public utilities, such as natural gas,
water, and electric services. For these ¬rms the median payouts tend to be roughly 60“70
percent and yields are between 3.6 percent and 4.8 percent. In contrast, ¬rms in highly
competitive industries with substantial reinvestment opportunities, such as software and
pharmaceutical, tend to have very low dividend payouts and dividend yields.
Returning to the cases of Merck and American Water Works presented earlier, it is
interesting to see that Merck has a higher dividend payout ratio than its industry median

Table 16-4 Median Dividend Payout Ratio and Dividend Yield for Selected
U.S. Industries in 1998
Dividend Payout Ratio Dividend Yield
........................................ ........................................

All Listed NYSE All Listed NYSE
Industry Firms Firms Firms Firms
Computer Software 0% 0% 0.0% 0.0%
Retail Stores 0% 18% 0.0% 0.7%
Pharmaceutical 0% 23% 0.0% 0.8%
Natural Gas 58% 58% 3.6% 3.6%
Water Supply 70% 69% 3.7% 3.9%
Electric Services 71% 71% 4.8% 4.7%
Corporate Financing Policies

16-15 Part 3 Business Analysis and Valuation Applications

(44 percent versus 23 percent). When stock repurchases are included, Merck actually
paid out more than 100 percent of its 1998 pro¬ts. Apparently the company believes that
it does not have to reinvest all of its pro¬ts to maintain its high rate of success in drug
development. It is also interesting to note that Merck uses stock repurchases as an im-
portant way to return funds to shareholders. One potential explanation for this is that
Merck does not want to commit to the current high rate of payout inde¬nitely. Its divi-
dend payout therefore represents its long-term payout commitment, and repurchases are
used for temporary increases in that rate.

A Summary of Dividend Policy
Just as it is dif¬cult to provide a simple formula to compute a ¬rm™s optimal capital
structure, it is dif¬cult to formalize the optimal dividend policy. However, we are able to
identify several factors that appear to be important:
• High-growth firms should have low dividend payout ratios, and they should use
their internally generated funds for reinvestment. This minimizes any costs from
capital market constraints on financing growth options.
• Firms with high and stable operating cash flows and few investment opportunities
should have high dividend payouts to reduce managers™ incentives to reinvest free
cash flows in unprofitable ventures.
• Firms should probably not worry too much about tax factors in setting dividend pol-
icy. Whatever their policy, they will be able to attract a clientele of investors. Firms
that select high dividend payouts will attract tax-exempt institutions or corpora-
tions, and firms that pay low or no dividends will attract individuals in high tax
• Firms™ financial covenants can have an impact on their dividend policy decisions.
Firms will try to avoid being too close to their constraints in order to minimize the
possibility of cutting their dividend.

This chapter examined how ¬rms make optimal capital structure and dividend decisions.
We show that a ¬rm™s optimal long-term capital structure is largely determined by its ex-
pected tax status, business risks, and types of assets. The bene¬ts from debt ¬nancing
are expected to be highest for ¬rms with: high marginal tax rates and few non-interest
tax shields, making interest tax shields valuable; high, stable income/cash ¬‚ows and few
new investment opportunities, increasing the monitoring value of debt and reducing the
likelihood that the ¬rm will fall into ¬nancial distress; and high tangible assets that are
not easily destroyed by ¬nancial distress.
We also show that, in the short-term, managers can deviate from their long-term op-
timal capital structure when they seek ¬nancing for new investments. In particular, man-
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Corporate Financing Policies

agers are reluctant to raise external ¬nancing, especially new equity, for fear that outside
investors will interpret their action as meaning that the ¬rm is overvalued. This informa-
tion problem has implications for how much ¬nancial slack a ¬rm is likely to need to
avoid facing these types of information problems.
Optimal dividend policy is determined by many of the same factors”¬rms™ business
risks and their types of assets. Thus, dividend rates should be highest for ¬rms with high
and stable cash ¬‚ows and few investment opportunities. By paying out relatively high
dividends, these ¬rms reduce the risk of managers investing free cash ¬‚ows in unpro¬t-
able projects. Conversely, ¬rms with low, volatile cash ¬‚ows and attractive investment
opportunities, such as start-up ¬rms, should have relatively low dividend payouts. By re-
investing operating cash ¬‚ows and reducing the amount of external ¬nancing required
for new projects, these ¬rms reduce their costs of ¬nancing.
Financial statement analysis can be used to better understand a ¬rm™s business risks,
its expected tax status, and whether its assets are primarily assets in place or growth
opportunities. Useful tools for assessing whether a ¬rm™s current capital structure and
dividend policies maximize shareholder value include accounting analysis to determine
off-balance-sheet liabilities, ratio analysis to help understand a ¬rm™s business risks, and
cash ¬‚ow and pro forma analysis to explore current and likely future investment needs.

1. Financial analysts typically measure financial leverage as the ratio of debt to equi-
ty. However, there is less agreement on how to measure debt, or even equity. How
would you treat the following items in computing this ratio? Justify your answers.
• Revolving credit agreement with bank
• Cash and marketable securities
• Deferred tax liabilities
• Preferred stock
• Convertible debt
2. Until 1987 Master Limited Partnerships (MLPs) were treated as partnerships for tax
purposes. This meant that no corporate taxes were paid by the entity. Instead, taxes
were paid by partners (at their individual tax rates) on entity profits (both distrib-
uted and undistributed). The marginal tax rate for corporations in 1987 was 34 per-
cent, compared to 33 percent for individuals in the highest tax bracket.
a. If an entity distributes all after-tax earnings as dividends and generates before-
tax earnings of $10 million, what would be the distribution to owners (after en-
tity and personal taxes) if it is organized as (1) a corporation and (2) an MLP?
b. What would be the optimal capital structure for the MLP discussed in (a)? Justify
your answer.
c. What types of dividend policy do you expect the MLP to follow? Why?
3. Finance theory implies that the debt-to-equity ratio should be computed using the
market values of debt and equity. However, most financial analysts use book val-
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16-17 Part 3 Business Analysis and Valuation Applications


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