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Corporate Governance Best Practice

Dividend Policy: Maximizing Shareholder Value

by Harold Bierman, Jr

Executive Summary

  • Dividend policy (or distribution policy) distributes some amount of cash (possibly zero) to its investors.

  • Retained earnings is a very tax efficient (zero dividend) policy.

  • If cash is to be distributed, with most tax systems and taxed investors, share repurchase is the preferred method.

  • The choice of method is important on several different dimensions.


The amount of dividends can affect stock prices. Barsky and De Long (1993) stated:

“… changes in current and expected future dividends can account for the bulk of long-run stock price fluctuations, although much less so for short-term price movements.”1

The title of this paper could be “Distribution Policy,” since dividends are not the only way of implementing a policy aimed at financially rewarding a firm’s stockholders. The various methods of distributing cash (or not distributing cash), listed in order of preference order from an economic–finance perspective of maximizing shareholder wealth, are:

  • retained earnings;

  • share repurchase;

  • sale of firm (or part of a firm);

  • LBOs (buyouts);

  • cash dividends with a dividend reinvestment plans (DRIP);

  • cash dividends.

Retention: Tax Deferral

It has been proven that, with enough assumptions, dividend policy is not relevant to the valuation of the common stock equity of a firm. However, the proof assumes zero investor taxes; thus it does not apply to a real-world situation in which such taxes exist. With income taxes, an investor benefits from being able to defer the payment of taxes as well as from the fact that some types of income (capital gains) for individuals may be taxed at lower rates than other types of income (dividends).

If a company retains $100, earns 0.10 in one period, and then pays a dividend of $110, the investor taxed at a rate of 0.40 will net: $110 × (1 – 0.4) = $66.

If the same company had paid a dividend of $100 and if the investor also could earn 0.10 before tax and 0.06 after tax on the $60 after tax proceeds, the investor receiving the $100 dividend ($60 after tax) would have after one period: 60 × 1.06 = $63.60.

The investor is better off by $2.40 with the one-period delay in cash distribution. The investor “defers” $40 of taxes that earn 0.10, or $4. The $4 is taxed ($1.60) and the investor is better off by $2.40.

If desired, one could compute the return necessary for the firm to justify retention. It would be equal to the after-tax return (0.06) available in the market to the investor. Thus, if the corporation could earn 0.06 and then pay a dividend, the investor would net: $100 × 1.06 × (1 – 0.4) = $63.60. This is the same as the investor would net with an immediate cash dividend.

If the planning horizon is n periods instead of one period, then 0.06 still measures the return that the firm must earn to justify retention. If the earning opportunities available to the corporation are greater than 0.06, retention is more desirable than an immediate dividend.

If the planning horizon is n periods, the dollar advantage of tax deferral increases. For example, if the firm can earn 0.10 and the time horizon is 20 years with retention and then a tax rate of 0.40, the investor has:

$100 × 1.1020 × (1 – 0.4) = $100 × 6.73 × 0.6 = $404

With an immediate $100 cash dividend and the investment of $60 by the stockholder to earn 0.06 after tax for 20 years, the investor would have:

$60 × 1.0620 = $60 × 3.207 = $192

With a planning horizon of 20 years, the advantage of tax deferral is $212 for the retention of the $100 earnings. There will be 19 other years between now and the end of the 20 years that will generate comparable tax deferral savings (although of decreasing amounts).

Capital Gains

To this point, we have assumed that all income is taxed at one rate. Now we assume that a capital gains tax rate of 0.20 applies to capital gains income. This assumes that retention of earnings leads to stock price increases and that these increases can be realized by investors as capital gains.

Returning to the 20-year horizon, with retention and then capital gains taxation of 0.20, the investor would have:

$100 × 1.1020 × (1 – 0.20) = $100 × 6.73 × 0.80 = $538

The cash dividend and an after-tax earning rate of 0.06 again leads to a value of $192 after 20 years.

The net advantage of retention is $538 – $192 = $346. Capital gains taxation increases the value of retention from the $212 obtained above to $346.

Again, if we considered the tax consequences of the dividend decision for all subsequent years, the value of the difference would be even larger. Tax deferral and capital gains are two powerful factors that must be considered in deciding a distribution policy.

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Further reading


  • Bierman, Harold, Jr. Increasing Shareholder Value: Distribution Policy, A Corporate Finance Challenge. Norwell, MA: Kluwer Academic Publishers, 2001.


  • Barsky, Robert B., and J. Bradford De Long. “Why does the stock market fluctuate?” The Quarterly Journal of Economics 108:2 (May 1993): 291–311.
  • Black, Fisher. “The dividend puzzle.” Journal of Portfolio Management (Winter 1976): 5–8.
  • Dann, Larry Y. “Common stock repurchases: An analysis of returns to bondholders and stockholders.” Journal of Financial Economics 9:2 (June 1981): 113–38.
  • Liu, Y., H. Szewczyk, and Z. Zantout. “Under-reaction to dividend reductions and omissions.” Journal of Finance 63:2 (April 2008): 987–1020.
  • Miller, Merton H., and Franco Modigliani. “Dividend policy, growth, and the valuation of shares.” Journal of Business 34:4 (Jan 1961): 411–433.
  • Rundell, C. A. “From the thoughtful businessman.” Harvard Business Review 43:6 (November–December, 1965): 39.
  • Vermaelen, Theo. “Common stock repurchase and market signaling.” Journal of Financial Economics 9:2 (June 1981): 139–83.


  • Cohen, Abby Joseph. “No problem with dividend growths.” Goldman Sachs Portfolio Strategy, August 12, 1994, p. 1.
  • Grigoli, Carmine J. “The great corporate de-financing.” Merrill Lynch, March 1986, p. 5.

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