Chapter 18
Distributions to Shareholders:
Dividends and Repurchases

18-1 a. The optimal distribution policy is one that strikes a balance between dividend yield and capital gains so that the firm’s stock price is maximized.

b. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world. The “bird-in-the-hand” theory assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains because the dividend yield component, D1/P0, is less risky than the g component in the total expected return equation rS = D1/P0 + g. The tax preference theory proposes that investors prefer capital gains over dividends, because capital gains taxes can be deferred into the future, but taxes on dividends must be paid as the dividends are received.

c. The information content of dividends is a theory which holds that investors regard dividend changes as “signals” of management forecasts.
Thus, when dividends are raised, this is viewed by investors as recognition by man-agement of future earnings increases. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low dividends will attract a clientele with little need for current income, and who often have high marginal tax rates.

d. The residual distribution model states that firms should make distributions only when more earnings are available than needed to support the optimal capital budget. An extra dividend is a dividend paid, in addition to the regular dividend, when earnings permit. Firms with volatile earnings may have a low regular dividend that can be maintained even in low-profit (or high capital investment) years, and then supplement it with an extra dividend when excess funds are available.

e. The declaration date is the date on which a firm’s directors issue a statement declaring a dividend. If a company lists the stockholder as an owner on the holder-of-record date, then the stockholder receives the dividend. The ex-dividend date is the date when the right to the dividend leaves the stock. This date was established by stockbrokers to avoid confusion and is 2 business days prior to the holder of record date. If the stock sale is made prior to the ex-dividend date, the dividend is paid to the buyer.

If the stock is bought on or after the ex-dividend date, the dividend is paid to the seller. The date on which a firm actually mails dividend checks is known as the payment date.

f. Dividend reinvestment plans allow stockholders to automatically purchase shares of common stock of the paying corporation in lieu of receiving cash dividends. There are two types of plans--one involves only stock that is already outstanding, while the other involves newly issued stock. In the first type, the dividends of all participants are pooled and the stock is purchased on the open market. Participants benefit from lower transaction costs. In the second type, the company issues new shares to the participants. Thus, the company issues stock in lieu of the cash dividend.

g. In a stock split, current shareholders are given some number (or fraction) of shares for each stock owned. Thus, in a 3-for-1 split, each shareholder would receive 3 new shares in exchange for each old share, thereby tripling the number of shares outstanding. Stock splits usually occur when the stock price is outside of the optimal trading range. Stock dividends also increase the number of shares outstanding, but at a slower rate than splits. In a stock dividend, current shareholders receive additional shares on some proportional basis. Thus, a holder of 100 shares would receive 5 additional shares at no cost if a 5 percent stock dividend were declared. Stock repurchases occur when a firm repurchases its own stock. These shares of stock are then referred to as treasury stock. The higher EPS on the now decreased number of shares outstanding will cause the price of the stock to rise and thus capital gains are substituted for cash dividends.

18-2 a. From the stockholders’ point of view, an increase in the personal income tax rate would make it more desirable for a firm to retain and reinvest earnings. Consequently, an increase in personal tax rates should lower the aggregate payout ratio.

b. If the depreciation allowances were raised, cash flows would increase. With higher cash flows, payout ratios would tend to increase. On the other hand, the change in tax-allowed depreciation charges would increase rates of return on investment, other things being equal, and this might stimulate investment, and consequently reduce payout ratios. On balance, it is likely that aggregate payout ratios would rise, and this has in fact been the case.

c. If interest rates were to increase, the increase would make retained earnings a relatively attractive way of financing new investment. Consequently, the payout ratio might be expected to decline. On the other hand, higher interest rates would cause rd, rs, and firm’s MCCs to rise--that would mean that fewer projects would qualify for capital budgeting and the residual would increase (other things constant), hence the payout ratio might increase.

d. A permanent increase in profits would probably lead to an increase in dividends, but not necessarily to an increase in the payout ratio. If the aggregate profit increase were a cyclical increase that could be expected to be followed by a decline, then the payout ratio might fall, because firms do not generally raise dividends in response to a short-run profit increase.

e. If investment opportunities for firms declined while cash inflows remained relatively constant, an increase would be expected in the payout ratio.

f. Dividends are currently paid out of after-tax dollars, and interest charges from before-tax dollars. Permission for firms to deduct dividends as they do interest charges would make dividends less costly to pay than before and would thus tend to increase the payout ratio.

g. This change would make capital gains less attractive and would lead to an increase in the payout ratio.

18-3 The difference is largely one of accounting. In the case of a split, the firm simply increases the number of shares and simultaneously reduces the par or stated value per share. In the case of a stock dividend, there must be a transfer from retained earnings to capital stock. For most firms, a 100 percent stock dividend and a 2-for-1 split accomplish exactly the same thing; hence, investors may choose either one.

18-4 a. The residual distribution policy is based on the premise that, since new common stock is more costly than retained earnings, a firm should use all the retained earnings it can to satisfy its common equity requirement. Thus, the distribution under this policy is a function of the firm’s investment opportunities.

b. Yes. A more shallow plot implies that changes from the optimal capital structure have little effect on the firm’s cost of capital, hence value. In this situation, dividend policy is less critical than if the plot were V-shaped.

18-5 a. True. When investors sell their stock they are subject to capital gains taxes.

b. True. If a company’s stock splits 2 for 1, and you own 100 shares, then after the split you will own 200 shares.

c. True. Dividend reinvestment plans that involve newly issued stock will increase the amount of equity capital available to the firm.

d. False. The tax code, through the tax deductibility of interest, encourages firms to use debt and thus pay interest to investors rather than dividends, which are not tax deductible. In addition, due to a lower capital gains tax rate than the highest personal tax rate, the tax code encourages investors in high tax brackets to prefer firms who retain earnings rather than those that pay large dividends.

e. True. If a company’s clientele prefers large dividends, the firm is unlikely to adopt a residual dividend policy. A residual dividend policy could mean low or zero dividends in some years which would upset the company’s developed clientele.

f. False. If a firm follows a residual dividend policy, all else constant, its dividend payout will tend to decline whenever the firm’s investment opportunities improve.


18-1 70% Debt; 30% Equity; Capital Budget = $3,000,000; NI = $2,000,000;
PO = ?

Equity retained = 0.3($3,000,000) = $900,000.

NI $2,000,000
-Additions 900,000
Earnings Remaining $1,100,000

Payout = = 55%.

18-2 P0 = $90; Split = 3 for 2; New P0 = ?

P0 New = = $60.

18-3 Retained earnings = Net income (1 - Payout ratio)
= $5,000,000(0.55) = $2,750,000.

External equity needed:

Total equity required = (New investment)(1 - Debt ratio)
= $10,000,000(0.60) = $6,000,000.

New external equity needed = $6,000,000 - $2,750,000 = $3,250,000.

18-4 The company requires 0.40($1,200,000) = $480,000 of equity financing. If the company follows a residual dividend policy it will retain $480,000 for its capital budget and pay out the $120,000 “residual” to its shareholders as a dividend. The payout ratio would therefore be $120,000/$600,000 = 0.20 = 20%.

18-5 Equity financing = $12,000,000(0.60) = $7,200,000.

Dividends = Net income - Equity financing
= $15,000,000 - $7,200,000 = $7,800,000.

Dividend payout ratio = Dividends/Net income
= $7,800,000/$15,000,000 = 52%.

18-6 DPS after split = $0.75.

Equivalent pre-split dividend = $0.75(5) = $3.75.

New equivalent dividend = Last year’s dividend(1.09)
$3.75 = Last year’s dividend(1.09)
Last year’s dividend = $3.75/1.09 = $3.44.

18-7 Capital budget should be $10 million. We know that 50% of the $10 million should be equity. Therefore, the company should pay dividends of:

Dividends = Net income - needed equity
= $7,287,500 - $5,000,000 = $2,287,500.
Payout ratio = $2,287,500/$7,287,500 = 0.3139 = 31.39%.

18-8 a. 1. 2005 Dividends = (1.10)(2004 Dividends)
= (1.10)($3,600,000) = $3,960,000.

2. 2004 Payout = $3,600,000/$10,800,000 = 0.33 = 33%.

2005 Dividends = (0.33)(2005 Net income)
= (0.33)($14,400,000) = $4,800,000.

(Note: If the payout ratio is rounded off to 33%, 2005 dividends are then calculated as $4,752,000.)

3. Equity financing = $8,400,000(0.60) = $5,040,000.

2005 Dividends = Net income - Equity financing
= $14,400,000 - $5,040,000 = $9,360,000.

All of the equity financing is done with retained earnings as long as they are available.

4. The regular dividends would be 10% above the 2004 dividends:

Regular dividends = (1.10)($3,600,000) = $3,960,000.

The residual policy calls for dividends of $9,360,000. Therefore, the extra dividend, which would be stated as such, would be

Extra dividend = $9,360,000 - $3,960,000 = $5,400,000.

An even better use of the surplus funds might be a stock repurchase.

b. Policy 4, based on the regular dividend with an extra, seems most logical. Implemented properly, it would lead to the correct capital budget and the correct financing of that budget, and it would give correct signals to investors.

18-9 a. Capital Budget = $10,000,000; Capital structure = 60% equity, 40% debt.

Retained Earnings Needed = $10,000,000 (0.6) = $6,000,000.

b. According to the residual dividend model, only $2 million is available for dividends.

NI - Retained earnings needed for cap. projects = Residual dividend.
$8,000,000 - $6,000,000 = $2,000,000.
DPS = $2,000,000/1,000,000 = $2.00.
Payout ratio = $2,000,000/$8,000,000 = 25%.

c. Retained Earnings Available = $8,000,000 - $3.00 (1,000,000)
Retained Earnings Available = $8,000,000 - $3,000,000
Retained Earnings Available = $5,000,000.

d. No. If the company maintains its $3.00 DPS, only $5 million of retained earnings will be available for capital projects. However, if the firm is to maintain its current capital structure, $6 million of equity is required. This would necessitate the company having to issue $1 million of new common stock.

e. Capital Budget = $10 million; Dividends = $3 million; NI = $8 million.
Capital Structure = ?

RE Available = $8,000,000 - $3,000,000
= $5,000,000.

Percentage of Cap. Budget Financed with RE = = 50%.

Percentage of Cap. Budget Financed with Debt = = 50%.

f. Dividends = $3 million; Capital Budget = $10 million; 60% equity, 40% debt; NI = $8 million.

Equity Needed = $10,000,000(0.6) = $6,000,000.

RE Available = $8,000,000 - $3.00(1,000,000)
= $8,000,000 - $3,000,000
= $5,000,000.

External (New) Equity Needed = $6,000,000 - $5,000,000
= $1,000,000.

g. Dividends = $3 million; NI = $8 million; Capital structure = 60% equity, 40% debt.

RE Available = $8,000,000 - $3,000,000
= $5,000,000.

We’re forcing the RE Available = Required Equity to find the new capital budget.

Required Equity = Capital Budget (Target Equity Ratio)
$5,000,000 = Capital Budget(0.6)
Capital Budget = $8,333,333.

Therefore, if Buena Terra cuts its capital budget from $10 million to $8.33 million, it can maintain its $3.00 DPS, its current capital structure, and still follow the residual dividend policy.

h. The firm can do one of four things:

(1) Cut dividends.
(2) Change capital structure, that is, use more debt.
(3) Cut its capital budget.
(4) Issue new common stock.

Realize that each of these actions is not without consequences to the company’s cost of capital, stock price, or both.


18-10 The detailed solution for the problem is available both on the instructor’s resource CD-ROM (in the file Solution for FM11 Ch 18 P10 Build a Model.xls) and on the instructor’s side of the web site,

Southeastern Steel Company (SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC’s founders, Donald Brown and Margo Valencia, had been employed in the research department of a major integrated-steel company, but when that company decided against using the new process (which Brown and Valencia had developed), they decided to strike out on their own. One advantage of the new process was that it required relatively little capital in comparison with the typical steel company, so Brown and Valencia have been able to avoid issuing new stock, and thus they own all of the shares. However, SSC has now reached the stage where outside equity capital is necessary if the firm is to achieve its growth targets yet still maintain its target capital structure of 60 percent equity and 40 percent debt. Therefore, Brown and Valencia have decided to take the company public. Until now, Brown and Valencia have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy.
Assume that you were recently hired by Arthur Adamson & Company (AA), a national consulting firm, which has been asked to help SSC prepare for its public offering. Martha Millon, the senior AA consultant in your group, has asked you to make a presentation to Brown and Valencia in which you review the theory of dividend policy and discuss the following questions.

a. 1. What is meant by the term “distribution policy”?

Answer: Distribution policy is defined as the firm’s policy with regard to (1) the level of distributions, (2) the form of distributions (dividends or stock repurchases), and (3) the stability of distributions.

a. 2. The terms “irrelevance,” “bird-in-the-hand,” and “tax preference” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain what these terms mean, and briefly describe each theory.

Answer: Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value.
The dividend irrelevance theory was proposed by MM, but they had to make some very restrictive assumptions to “prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore, according to MM, stockholders should be indifferent between dividends and capital gains.
The “bird-in-the-hand” theory is identified with Myron Gordon and John Lintner, who argued that investors perceive a dollar of dividends in the hand to be less risky than a dollar of potential future capital gains in the bush; hence, stockholders prefer a dollar of actual dividends to a dollar of retained earnings. If the bird-in-the-hand theory is true, then investors would regard a firm with a high payout ratio as being less risky than one with a low payout ratio, all other things equal; hence, firms with high payout ratios would have higher values than those with low payout ratios.
MM opposed the Gordon-Lintner theory, arguing that a firm’s risk is dependent only on the riskiness of its cash flows from assets and its capital structure, not by how its earnings are distributed to investors.
The tax preference theory recognizes that there are two tax-related reasons for believing that investors might prefer a low dividend payout to a high payout: (1) taxes are not paid on capital gains until the stock is sold. (2) if a stock is held by someone until he or she dies, no capital gains tax is due at all--the beneficiaries who receive the stock can use the stock’s value on the death day as their cost basis and thus escape the capital gains tax.

a. 3. What do the three theories indicate regarding the actions management should take with respect to dividend payout?

Answer: If the dividend irrelevance theory is correct, then dividend payout is of no consequence, and the firm may pursue any dividend payout. If the bird-in-the-hand theory is correct, the firm should set a high payout if it is to maximize its stock price. If the tax preference theory is correct, the firm should set a low payout if it is to maximize its stock price. Therefore, the theories are in total conflict with one another.

a. 4. What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?

Answer: Unfortunately, empirical tests of the theories have been inconclusive (because firms don’t differ just with respect to payout), so we cannot tell managers whether investors prefer dividends or capital gains. Even though we cannot determine what the optimal dividend policy is, managers can use the types of analyses discussed in this chapter to help develop a rational and reasonable, if not completely optimal, dividend policy.

b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on distribution policy.

Answer: 1. Different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, many retirees, pension funds, and university endowment funds are in a low (or zero) tax bracket, and they have a need for current cash income. Therefore, this group of stockholders might prefer high payout stocks. These investors could, of course, sell some of their stock, but this would be inconvenient, transactions costs would be incurred, and the sale might have to be made in a down market. Conversely, investors in their peak earnings years who are in high tax brackets and who have no need for current cash income should prefer low payout stocks.

2. Clienteles do exist, but the real question is whether there are more members of one clientele than another, which would affect what a change in its dividend policy would do to the demand for the firm’s stock. There are also costs (taxes and brokerage) to stockholders who would be forced to switch from one stock to another if a firm changes its policy. Therefore, we cannot say whether a policy change to appeal to one particular clientele or another would lower or raise a firm’s cost of equity. MM argued that one clientele is as good as another, so in their view the existence of clienteles does not imply that one dividend policy is better than another. Still, no one has offered convincing proof that firms can disregard clientele effects. We know that stockholder shifts will occur if policy is changed, and since such shifts result in transaction costs and capital gains taxes, policy changes should not be taken lightly. Further, dividend policy should be changed slowly, rather than abruptly, in order to give stockholders time to adjust.

3. It has long been recognized that the announcement of a dividend increase often results in an increase in the stock price, while an announcement of a dividend cut typically causes the stock price to fall. One could argue that this observation supports the premise that investors prefer dividends to capital gains. However, MM argued that dividend announcements are signals through which management conveys information to investors. Information asymmetries exist--managers know more about their firms’ prospects than do investors. Further, managers tend to raise dividends only when they believe that future earnings can comfortably support a higher dividend level, and they cut dividends only as a last resort. Therefore, (1) a larger-than-normal dividend increase “signals” that management believes the future is bright, (2) a smaller-than-expected increase, or a dividend cut, is a negative signal, and (3) if dividends are increased by a “normal” amount, this is a neutral signal.

c. 1. Assume that SSC has an $800,000 capital budget planned for the coming year. You have determined that its present capital structure (60 percent equity and 40 percent debt) is optimal, and its net income is forecasted at $600,000. Use the residual distribution model approach to determine SSC’s total dollar distribution. Assume for now that the distribution is in the form of a dividend. Then, explain what would happen if net income were forecasted at $400,000, or at $800,000.

Answer: We make the following points:

a. Given the optimal capital budget and the target capital structure, we must now determine the amount of equity needed to finance the projects. Of the $800,000 required for the capital budget, 0.6($800,000) = $480,000 must be raised as equity and 0.4($800,000) = $320,000 must be raised as debt if we are to maintain the optimal capital structure:

Debt $320,000 40%
Equity 480,000 60%
$800,000 100%

b. If a residual exists--that is, if net income exceeds the amount of equity the company needs--then it should distribute the residual amount out as either dividends or stock repurchases. For now, we assume all payouts are in the form of dividends. Since $600,000 of earnings is available, and only $480,000 is needed, the residual is $600,000 - $480,000 = $120,000, so this is the amount which should be paid out as dividends. Thus, the payout ratio would be $120,000/$600,000 = 0.20 = 20%.

c. If only $400,000 of earnings were available, the theoretical break point would occur at BP = $400,000/0.6 = $666,667. Assuming the intersection of the investment opportunity set and marginal cost of capital was still at $800,000, the firm would still need $480,000 of equity. It should then retain all of its earnings and also sell $80,000 of new stock. The residual policy would call for a zero payment.

d. If $800,000 of earnings was available, the dividend would be increased to $800,000 - $480,000 = $320,000, and the payout ratio would rise to $320,000/$800,000 = 40%.

c. 2. In general terms, how would a change in investment opportunities affect the payout ratio under the residual payment policy?

Answer: A change in investment opportunities would lead to an increase (if investment opportunities were good) or a decrease (if investment opportunities were not good) in the amount of equity needed, hence in the residual dividend payout.

c. 3. What are the advantages and disadvantages of the residual policy? (Hint: don’t neglect signaling and clientele effects.)

Answer: The primary advantage of the residual policy is that under it the firm makes maximum use of lower cost retained earnings, thus minimizing flotation costs and hence the cost of capital. Also, whatever negative signals are associated with stock issues would be avoided.
However, if it were applied exactly, the residual model would result in dividend payments which fluctuated significantly from year to year as capital requirements and internal cash flows fluctuated. This would (1) send investors conflicting signals over time regarding the firm’s future prospects, and (2) since no specific clientele would be attracted to the firm, it would be an “orphan.” These signaling and clientele effects would lead to a higher required return on equity which would more than offset the effects of lower flotation costs. Because of these factors, few if any publicly owned firms follow the residual model on a year-to-year basis.
Even though the residual approach is not used to set the annual dividend, it is used when firms establish their long-run dividend policy. If “normalized” cost of capital and investment opportunity conditions suggest that in a “normal” year the company should pay out about 60 percent of its earnings, this fact will be noted and used to help determine the long-run policy.

d. What are stock repurchases? Discuss the advantages and disadvantages of a firm’s repurchasing its own shares.

Answer: A firm may distribute cash to stockholders by repurchasing its own stock rather than paying out cash dividends. Stock repurchases can be used (1) somewhat routinely as an alternative to regular dividends, (2) to dispose of excess (nonrecurring) cash that came from asset sales or from temporarily high earnings, and (3) in connection with a capital structure change in which debt is sold and the proceeds are used to buy back and retire shares.

Advantages of repurchases:

1. A repurchase announcement may be viewed as a positive signal that management believes the shares are undervalued.

2. Stockholders have a choice--if they want cash, they can tender their shares, receive the cash, and pay the taxes, or they can keep their shares and avoid taxes. On the other hand, one must accept a cash dividend and pay taxes on it.

3. If the company raises the dividend to dispose of excess cash, this higher dividend must be maintained to avoid adverse stock price reactions. A stock repurchase, on the other hand, does not obligate management to future repurchases.

4. Repurchased stock, called treasury stock, can be used later in mergers, when employees exercise stock options, when convertible bonds are converted, and when warrants are exercised. Treasury stock can also be resold in the open market if the firm needs cash. Repurchases can remove a large block of stock that is “overhanging” the market and keeping the price per share down.

5. Repurchases can be varied from year to year without giving off adverse signals, while dividends may not.

6. Repurchases can be used to produce large-scale changes in capital structure.

Disadvantages of repurchases:

1. A repurchase could lower the stock’s price if it is taken as a signal that the firm has relatively few good investment opportunities. On the other hand, though, a repurchase can signal stockholders that managers are not engaged in “empire building,” where they invest funds in low-return projects.

2. If the IRS establishes that the repurchase was primarily to avoid taxes on dividends, then penalties could be imposed. Such actions have been brought against closely held firms, but to our knowledge charges have never been brought against publicly held firms.

3. Selling shareholders may not be fully informed about the repurchase; hence they may make an uninformed decision and may later sue the company. To avoid this, firms generally announce repurchase programs in advance.

4. The firm may bid the stock price up and end up paying too high a price for the shares. In this situation, the selling shareholders would gain at the expense of the remaining shareholders. This could occur if a tender offer were made and the price was set too high, or if the repurchase was made in the open market and buying pressure drove the price above its equilibrium level.

e. Describe the series of steps that most firms take in setting dividend policy in practice.

Answer: Firms establish dividend policy within the framework of their overall financial plans. The steps in setting policy are listed below:

1. The firm forecasts its annual capital budgets and its annual sales, along with its working capital needs, for a relatively long-term planning horizon, often 5 years.

2. The target capital structure, presumably the one which minimizes the WACC while retaining sufficient reserve borrowing capacity to provide “financing flexibility,” will also be established.

3. With its capital structure and investment requirements in mind, the firm can estimate the approximate amount of debt and equity financing required during each year over the planning horizon.

4. A long-term target payout ratio is then determined, based on the residual model concept. Because of flotation costs and potential negative signaling, the firm will not want to issue common stock unless this is absolutely necessary. At the same time, due to the clientele effect, the firm will move cautiously from its past dividend policy, if a new policy appears to be warranted, and it will move toward any new policy gradually rather than in one giant step.

5. An actual dollar dividend, say $2 per year, will be decided upon. The size of this dividend will reflect (1) the long-run target payout ratio and (2) the probability that the dividend, once set, will have to be lowered, or, worse yet, omitted. If there is a great deal of uncertainty about cash flows and capital needs, then a relatively low initial dollar dividend will be set, for this will minimize the probability that the firm will have to either reduce the dividend or sell new common stock. The firm will run its corporate planning model so that management can see what is likely to happen with different initial dividends and projected growth rates under different economic scenarios.

f. What are stock dividends and stock splits? What are the advantages and disadvantages of stock dividends and stock splits?

Answer: When it uses a stock dividend, a firm issues new shares in lieu of paying a cash dividend. For example, in a 5 percent stock dividend, the holder of 100 shares would receive an additional 5 shares. In a stock split, the number of shares outstanding is increased (or decreased in a reverse split) in an action unrelated to a dividend payment. For example, in a 2-for-1 split, the number of shares outstanding is doubled. A 100% stock dividend and a 2-for-1 stock split would produce the same effect, but there would be differences in the accounting treatments of the two actions.
Both stock dividends and stock splits increase the number of shares outstanding and, in effect, cut the pie into more, but smaller, pieces. If the dividend or split does not occur at the same time as some other event which would alter perceptions about future cash flows, such as an announcement of higher earnings, then one would expect the price of the stock to adjust such that each investor’s wealth remains unchanged. For example, a 2-for-1 split of a stock selling for $50 would result in the stock price being cut in half, to $25.
It is hard to come up with a convincing rationale for small stock dividends, like 5 percent or 10 percent. No economic value is being created or distributed, yet stockholders have to bear the administrative costs of the distribution. Further, it is inconvenient to own an odd number of shares as may result after a small stock dividend. Thus, most companies today avoid small stock dividends.
On the other hand, there is a good reason for stock splits or large stock dividends. Specifically, there is a widespread belief that an optimal price range exists for stocks. The argument goes as follows: if a stock sells for about $20-$80, then it can be purchased in round lots, hence at reduced commissions, by most investors. A higher price would put round lots out of the price range of many small investors, while a stock price lower than about $20 would convey the image of a stock that is doing poorly. Thus, most firms try to keep their stock prices within the $20 to $80 range. If the company prospers, it will split its stock occasionally to hold the price down. (Also, companies that are doing poorly occasionally use reverse splits to raise their price.) Many companies do operate outside the $20 to $80 range, but most stay within it.
Another factor that may influence stock splits and dividends is the belief that they signal management’s belief that the future is bright. If a firm’s management would be inclined to split the stock or pay a stock dividend only if it anticipated improvements in earnings and dividends, then a split/dividend action could provide a positive signal and thus boost the stock price. However, if earnings and cash dividends did not subsequently rise, the price of the stock would fall back to its old level, or even lower, because managers would lose credibility.
Interestingly, one of the most astute investors of the 20th century, Warren Buffett, chairman of Berkshire-Hathaway, has never split his firm’s stock. Berkshire currently sells for over $34,000 per share, and its performance over the years has been absolutely spectacular. It may be that Berkshire’s market value would be higher if it had a 425:1 stock split, or it may be that the conventional wisdom is wrong.

g. What is a dividend reinvestment plan (drip), and how does it work?

Answer: Under a dividend reinvestment plan (DRIP), shareholders have the option of automatically reinvesting their dividends in shares of the firm’s common stock. In an open market purchase plan, a trustee pools all the dividends to be reinvested and then buys shares on the open market. Shareholders use the drip for three reasons: (1) brokerage costs are reduced by the volume purchases, (2) the drip is a convenient way to invest excess funds, and (3) the company generally pays all administrative costs associated with the operation.
In a new stock plan, the firm issues new stock to the DRIP members in lieu of cash dividends. No fees are charged, and many companies even offer the stock at a 5 percent discount from the market price on the dividend date on the grounds that the firm avoids flotation costs that would otherwise be incurred. Only firms that need new equity capital use new stock plans, while firms with no need for new stock use an open market purchase plan.