Payout Policies

In this section, we shall discuss the three types of dividend policies:

Stable Dividend Policy

A stable dividend policy is one where the dividends paid do not reflect short-term volatility in earnings. It is the most common because managers are not willing to reduce dividends paid out to shareholders. Companies that use this type of policy base dividends on a long-term forecast of sustainable earnings; hence, earnings growth also increases.

Unlike the constant dividend payout policy and residual dividend policy explained later in this LOS, this method has lower uncertainty about dividend levels in the future for shareholders. A stable dividend policy can be modeled as a process of continuous adjustments to reach a target payout ratio based on long-term sustainability. John Lintner is credited for developing the target payout adjustment model. The model concludes that:

1. Companies have a target payout ratio that is based on long-term sustainable earnings.
2. To managers, the level of dividend is not as important a dividend changes.
3. Companies reduce the dividends only as a last resort.

$$\text{Expected dividend}=(\text{Previous dividend})+[(\text{Expected earnings})\times  (\text{Target payout ratio})-\\ (\text{Previous dividend})]\times(\text{Adjustment factor})$$

$$\text{Expected increase in dividends}=(\text{Expected earnings}\times\text{Target payout ratio}–\\ \text{Previous dividend})\times\text{Adjustment factor}$$

Example: Dividends using a Stable Dividend Policy

Maxi Inc. earned $4.00 per share and paid a regular dividends of $1 last year. The company now estimates earnings of $4.70 and has a target payout ratio of 40% with an adjustment period of 4 years.

The expected dividend for the current year is closest to:

Solution

$$\text{Expected dividend}=(\text{Previous dividend})+[(\text{Expected earnings})\times  (\text{Target payout ratio})-\\ (\text{Previous dividend})]\times(\text{Adjustment factor})$$

$$\begin{align*}\text{Expected dividend}&=$1 + [($4.70× 0.4 ˗ $1) × (\frac{1}{4})\\&=$1.22\end{align*}$$

Constant Dividend Payout Ratio Policy

In a constant dividend payout ratio policy, the dividend paid out is a constant percentage of net income. Thus, as earnings fluctuate, so will the dividends in the short term. The policy is rarely applied in practice.

Question

McGill Ltd had earnings of $3.00 per share and paid a regular dividend of $1. The company estimates that the earnings for the current year will be $3.7 and has a target payout ratio of 30% with an adjustment period of 4 years.

The expected dividend for the current year is closest to:

1. $ 3.70.
2. $ 1.03.
3. $ 3.00.

Solution

The correct answer is B.

Expected dividend= (Previous dividend) + [(Expected earnings) × (Target payout ratio) ˗ (Previous dividend)] × (Adjustment factor)

= $1+ [($ 3.7×0.3 – $1) × (1/4)

= $1.03

Reading 18: Analysis of Dividends and Share Repurchases

LOS 18 (g) Compare stable dividend with constant dividend payout ratio,  and calculate the dividend under each policy.