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Chapter Across the Disciplines


12
Why This Chapter Matters To You
Accounting: You need to understand the
types of dividends and payment proce-
dures for them because you will need to
record and report the declaration and pay-
ment of dividends; you also will provide

Dividend the financial data that management must
have to make dividend decisions.
Information systems: You need to under-
Policy stand types of dividends, payment proce-
dures, and the financial data that the firm
must have to make and implement divi-
dend decisions.
Management: In order to make appropri-
ate dividend decisions for the firm, you
need to understand types of dividends, the
factors that affect dividend policy, types of
dividend policies, and arguments about
the relevance of dividends.
Marketing: You need to understand fac-
LEARNING GOALS tors affecting dividend policy because you
may want to argue that the firm would be
Understand cash dividend payment
LG1 better off keeping funds for the develop-
procedures and the role of dividend
ment of new products, rather than paying
reinvestment plans.
them out as dividends.
Describe the residual theory of
LG2
Operations: You need to understand fac-
dividends and the key arguments with
tors affecting dividend policy because you
regard to dividend irrelevance and
may find that the firm’s dividend policy
relevance.
imposes limitations on expansion.
Discuss the key factors involved in
LG3
formulating a dividend policy.
Review and evaluate the three basic
LG4
types of dividend policies.
Evaluate stock dividends from
LG5
accounting, shareholder, and
company points of view.
Explain stock splits and stock
LG6
repurchases and the firm’s motivation
for undertaking each of them.




462
463
CHAPTER 12 Dividend Policy



D ividends represent a source of cash flow to stockholders and provide infor-
mation about the firm’s performance. Some stockholders expect to receive
dividends. Others are content to see an increase in stock price and no dividends.
The firm’s dividend policy depends on various factors. This chapter considers
whether dividends matter to stockholders and explains the key factors in divi-
dend policy, basic types of dividend policies, and alternative forms of dividends.




Dividend Fundamentals
LG1


Expected cash dividends are the key return variable from which owners and
investors determine share value. They represent a source of cash flow to stock-
holders and provide information about the firm’s current and future perfor-
mance. Because retained earnings, earnings not distributed to owners as divi-
retained earnings
dends, are a form of internal financing, the dividend decision can significantly
Earnings not distributed to
owners as dividends; a form of affect the firm’s external financing requirements. In other words, if the firm needs
internal financing.
financing, the larger the cash dividend paid, the greater the amount of financing
that must be raised externally through borrowing or through the sale of common
or preferred stock. (Remember that although dividends are charged to retained
earnings, they are actually paid out of cash.) The first thing to know about cash
dividends is the procedures for paying them.


Cash Dividend Payment Procedures
Whether and in what amount to pay cash dividends to corporate stockholders is
decided by the firm’s board of directors at quarterly or semiannual meetings. The
past period’s financial performance and future outlook, as well as recent divi-
dends paid, are key inputs to the dividend decision. The payment date of the cash
dividend, if one is declared, must also be established.


Amount of Dividends
Whether dividends should be paid, and if so, in what amount, are important deci-
sions that depend primarily on the firm’s dividend policy. Most firms have a set
policy with respect to the periodic dividend, but the firm’s directors can change
this amount, largely on the basis of significant increases or decreases in earnings.


Relevant Dates
If the directors of the firm declare a dividend, they also typically issue a state-
ment indicating the dividend decision, the record date, and the payment date.
This statement is generally quoted in the Wall Street Journal and other financial
date of record (dividends)
Set by the firm’s directors, the news media.
date on which all persons whose
names are recorded as
Record Date All persons whose names are recorded as stockholders on the
stockholders receive a declared
date of record set by the directors receive a declared dividend at a specified future
dividend at a specified future
time. These stockholders are often referred to as holders of record.
time.
464 PART 4 Long-Term Financial Decisions


Because of the time needed to make bookkeeping entries when a stock is
traded, the stock begins selling ex dividend 2 business days prior to the date of
ex dividend
Period, beginning 2 business record. Purchasers of a stock selling ex dividend do not receive the current divi-
days prior to the date of record,
dend. A simple way to determine the first day on which the stock sells ex dividend
during which a stock is sold
is to subtract 2 days from the date of record; if a weekend intervenes, subtract 4
without the right to receive the
days. Ignoring general market fluctuations, the stock’s price is expected to drop
current dividend.
by the amount of the declared dividend on the ex dividend date.

Payment Date The payment date, also set by the directors, is the actual
payment date
Set by the firm’s directors, the date on which the firm mails the dividend payment to the holders of record. It is
actual date on which the firm
generally a few weeks after the record date. An example will clarify the various
mails the dividend payment to the
dates and the accounting effects.
holders of record.

At the quarterly dividend meeting of Rudolf Company, a distributor of office
EXAMPLE
products, held on June 10, the directors declared an $0.80-per-share cash divi-
dend for holders of record on Monday, July 1. The firm had 100,000 shares of
common stock outstanding. The payment date for the dividend was August 1.
Before the dividend was declared, the key accounts of the firm were as follows:
Cash $200,000 Dividends payable $ 0
Retained earnings 1,000,000
When the dividend was announced by the directors, $80,000 of the retained
earnings ($0.80 per share 100,000 shares) was transferred to the dividends
payable account. The key accounts thus became
Cash $200,000 Dividends payable $ 80,000
Retained earnings 920,000
Rudolf Company’s stock began selling ex dividend 2 business days prior to
the date of record, which was June 27. This date was found by subtracting 4 days
(a weekend intervened) from the July 1 date of record. Purchasers of Rudolf’s
stock on June 26 or earlier received the rights to the dividends; those who pur-
chased the stock on or after June 27 did not. Assuming a stable market, Rudolf’s
stock price was expected to drop by approximately $0.80 per share when it
began selling ex dividend on June 27. On August 1 the firm mailed dividend
checks to the holders of record as of July 1. This produced the following balances
in the key accounts of the firm:
Cash $120,000 Dividends payable $ 0
Retained earnings 920,000
The net effect of declaring and paying the dividend was to reduce the firm’s total
assets (and stockholders’ equity) by $80,000.


Dividend Reinvestment Plans
dividend reinvestment plans
Today many firms offer dividend reinvestment plans (DRIPs), which enable
(DRIPs)
Plans that enable stockholders to stockholders to use dividends received on the firm’s stock to acquire additional
use dividends received on the
shares—even fractional shares—at little or no transaction cost. Some companies
firm’s stock to acquire additional
even allow investors to make their initial purchases of the firm’s stock directly
shares—even fractional
from the company without going through a broker. With DRIPs, plan partici-
shares—at little or no transac-
pants typically can acquire shares at about 5 percent below the prevailing market
tion cost.
465
CHAPTER 12 Dividend Policy


price. From its point of view, the firm can issue new shares to participants more
economically, avoiding the underpricing and flotation costs that would accom-
pany the public sale of new shares. Clearly, the existence of a DRIP may enhance
the market appeal of a firm’s shares.


Review Questions

12–1 Who are holders of record? When does a stock sell ex dividend?
12–2 What benefit is available to participants in a dividend reinvestment plan?
How might the firm benefit?




The Relevance of Dividend Policy
LG2

Numerous theories and empirical findings concerning dividend policy have been
reported in the financial literature. Although this research provides some interest-
ing insights about dividend policy, capital budgeting and capital structure deci-
sions are generally considered far more important than dividend decisions. In
other words, good investment and financing decisions should not be sacrificed
for a dividend policy of questionable importance.
A number of key questions have yet to be resolved: Does dividend policy
matter? What effect does dividend policy have on share price? Is there a model
that can be used to evaluate alternative dividend policies in view of share value?
Here we begin by describing the residual theory of dividends, which is used as a
backdrop for discussion of the key arguments in support of dividend irrelevance
and then those in support of dividend relevance.


The Residual Theory of Dividends
The residual theory of dividends is a school of thought that suggests that the div-
residual theory of dividends
A school of thought that suggests idend paid by a firm should be viewed as a residual—the amount left over after
that the dividend paid by a firm all acceptable investment opportunities have been undertaken. Using this
should be viewed as a residual—
approach, the firm would treat the dividend decision in three steps, as follows:
the amount left over after all
acceptable investment opportu-
Step 1 Determine its optimal level of capital expenditures, which would be the
nities have been undertaken.
level generated by the point of intersection of the investment opportuni-
ties schedule (IOS) and weighted marginal cost of capital (WMCC)
schedule (see Chapter 10).
Step 2 Using the optimal capital structure proportions (see Chapter 11), esti-
mate the total amount of equity financing needed to support the expen-
ditures generated in Step 1.
Step 3 Because the cost of retained earnings, kr, is less than the cost of new com-
mon stock, kn, use retained earnings to meet the equity requirement deter-
mined in Step 2. If retained earnings are inadequate to meet this need, sell
new common stock. If the available retained earnings are in excess of this
need, distribute the surplus amount—the residual—as dividends.
466 PART 4 Long-Term Financial Decisions


According to this approach, as long as the firm’s equity need exceeds the amount
of retained earnings, no cash dividend is paid. The argument for this approach is
that it is sound management to be certain that the company has the money it
needs to compete effectively. This view of dividends suggests that the required
return of investors, ks, is not influenced by the firm’s dividend policy—a premise
that in turn implies that dividend policy is irrelevant.

Overbrook Industries, a manufacturer of canoes and other small watercraft, has
EXAMPLE
available from the current period’s operations $1.8 million that can be retained
or paid out in dividends. The firm’s optimal capital structure is at a debt ratio of
30%, which represents 30% debt and 70% equity. Figure 12.1 depicts the firm’s
weighted marginal cost of capital (WMCC) schedule along with three investment
opportunities schedules. For each IOS, the level of total new financing or invest-
ment determined by the point of intersection of the IOS and the WMCC has been
noted. For IOS1, it is $1.5 million, for IOS2 $2.4 million, and for IOS3 $3.2 mil-
lion. Although only one IOS will exist in practice, it is useful to look at the possi-
ble dividend decisions generated by applying the residual theory in each of the
three cases. Table 12.1 summarizes this analysis.
Table 12.1 shows that if IOS1 exists, the firm will pay out $750,000 in divi-
dends, because only $1,050,000 of the $1,800,000 of available earnings is
needed. A 41.7% payout ratio results. For IOS2, dividends of $120,000 (a payout
ratio of 6.7%) result. Should IOS3 exist, the firm would pay no dividends (a 0%
payout ratio), because its retained earnings of $1,800,000 would be less than the
$2,240,000 of equity needed. In this case, the firm would have to obtain addi-
tional new common stock financing to meet the new requirements generated by
the intersection of the IOS3 and WMCC. Depending on which IOS exists, the


FIGURE 12.1
Weighted Average Cost of Capital and IRR (%)




WMCC and IOSs WMCC
WMCC and IOSs for
25
Overbrook Industries


20


15
IOS3
IOS2
10
IOS1

5



0 1 1.5 2 2.4 3 3.2 4 5
Total New Financing or Investment ($000,000)
467
CHAPTER 12 Dividend Policy


TABLE 12.1 Applying the Residual Theory of Dividends to
Overbrook Industries for Each of Three IOSs
(Shown in Figure 12.1)

Investment opportunities schedules

Item IOS1 IOS2 IOS3

(1) New financing or investment (Fig. 12.1) $1,500,000 $2,400,000 $3,200,000
(2) Retained earnings available (given) $1,800,000 $1,800,000 $1,800,000
(3) Equity needed [70% (1)] 1,050,000 1,680,000 2,240,000
0a
(4) Dividends [(2) (3)] $ 750,000 $ 120,000 $
(5) Dividend payout ratio [(4) (2)] 41.7% 6.7% 0%
aInthis case, additional new common stock in the amount of $440,000 ($2,240,000 needed $1,800,000
available) would have to be sold; no dividends would be paid.




firm’s dividend would in effect be the residual, if any, remaining after all accept-
able investments had been financed.


Arguments for Dividend Irrelevance
The residual theory of dividends implies that if the firm cannot invest its earnings
to earn a return (IRR) that is in excess of cost (WMCC), it should distribute the
earnings by paying dividends to stockholders. This approach suggests that divi-
dends represent an earnings residual rather than an active decision variable that
affects the firm’s value. Such a view is consistent with the dividend irrelevance
dividend irrelevance theory
Miller and Modigliani’s theory theory put forth by Merton H. Miller and Franco Modigliani (M and M).1 They
that in a perfect world, the firm’s argue that the firm’s value is determined solely by the earning power and risk of
value is determined solely by the
its assets (investments) and that the manner in which it splits its earnings stream
earning power and risk of its
between dividends and internally retained (and reinvested) funds does not affect
assets (investments) and that the
this value. M and M’s theory suggests that in a perfect world (certainty, no taxes,
manner in which it splits its
earnings stream between no transactions costs, and no other market imperfections), the value of the firm is
dividends and internally retained unaffected by the distribution of dividends.
(and reinvested) funds does not
However, studies have shown that large changes in dividends do affect share
affect this value.
price. Increases in dividends result in increased share price, and decreases in divi-
dends result in decreased share price. In response, M and M argue that these
effects are attributable not to the dividend itself but rather to the informational
informational content
The information provided by the content of dividends with respect to future earnings. In other words, say
dividends of a firm with respect M and M, it is not the preference of shareholders for current dividends (rather
to future earnings, which causes
than future capital gains) that is responsible for this behavior. Instead, investors
owners to bid up or down the
view a change in dividends, up or down, as a signal that management expects
price of the firm’s stock.
future earnings to change in the same direction. An increase in dividends is viewed
as a positive signal, and investors bid up the share price; a decrease in dividends is
a negative signal that causes a decrease in share price as investors sell their shares.


1. Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of Shares,” Journal of
Business 34 (October 1961), pp. 411–433.
468 PART 4 Long-Term Financial Decisions


M and M further argue that a clientele effect exists: A firm attracts share-
clientele effect
The argument that a firm attracts holders whose preferences for the payment and stability of dividends correspond
shareholders whose preferences to the payment pattern and stability of the firm itself. Investors who desire stable
for the payment and stability of
dividends as a source of income hold the stock of firms that pay about the same
dividends correspond to the
dividend amount each period. Investors who prefer to earn capital gains are
payment pattern and stability of
more attracted to growing firms that reinvest a large portion of their earnings,
the firm itself.
favoring growth over a stable pattern of dividends. Because the shareholders get
what they expect, M and M argue, the value of their firm’s stock is unaffected by
dividend policy.
In summary, M and M and other proponents of dividend irrelevance argue
that, all else being equal, an investor’s required return—and therefore the value
of the firm—is unaffected by dividend policy for three reasons:

1. The firm’s value is determined solely by the earning power and risk of its
assets.
2. If dividends do affect value, they do so solely because of their informational
content, which signals management’s earnings expectations.
3. A clientele effect exists that causes a firm’s shareholders to receive the divi-
dends they expect.

These views of M and M with respect to dividend irrelevance are consistent
with the residual theory, which focuses on making the best investment decisions
to maximize share value. The proponents of dividend irrelevance conclude that
because dividends are irrelevant to a firm’s value, the firm does not need to have
a dividend policy. Although many research studies have been performed to vali-
date or refute the dividend irrelevance theory, none has been successful in provid-
ing irrefutable evidence.



Arguments for Dividend Relevance
The key argument in support of dividend relevance theory is attributed to
dividend relevance theory
The theory, advanced by Gordon Myron J. Gordon and John Lintner,2 who suggest that there is, in fact, a direct
and Lintner, that there is a direct relationship between the firm’s dividend policy and its market value. Fundamen-
relationship between a firm’s
tal to this proposition is their bird-in-the-hand argument, which suggests that
dividend policy and its market
investors see current dividends as less risky than future dividends or capital
value.
gains. “A bird in the hand is worth two in the bush.” Gordon and Lintner argue
bird-in-the-hand argument
that current dividend payments reduce investor uncertainty, causing investors to
The belief, in support of dividend
discount the firm’s earnings at a lower rate and, all else being equal, to place a
relevance theory, that investors
higher value on the firm’s stock. Conversely, if dividends are reduced or are not
see current dividends as less
paid, investor uncertainty will increase, raising the required return and lowering
risky than future dividends or
capital gains. the stock’s value.
Although many other arguments related to dividend relevance have been put
forward, empirical studies fail to provide conclusive evidence in support of the
intuitively appealing dividend relevance argument. In practice, however, the
actions of both financial managers and stockholders tend to support the belief that


2. Myron J. Gordon, “Optimal Investment and Financing Policy,” Journal of Finance 18 (May 1963), pp. 264–272,
and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to Corporations,”
Review of Economics and Statistics 44 (August 1962), pp. 243–269.
469
CHAPTER 12 Dividend Policy


dividend policy does affect stock value.3 Because we focus on the day-to-day be-
havior of firms, the remainder of this chapter is consistent with the belief that divi-
dends are relevant—that each firm must develop a dividend policy that fulfills the
goals of its owners and maximizes their wealth as reflected in the firm’s share price.


Review Questions

12–3 Does following the residual theory of dividends lead to a stable dividend?
Is this approach consistent with dividend relevance?
12–4 Contrast the basic arguments about dividend policy advanced by Miller
and Modigliani (M and M) and by Gordon and Lintner.




Factors Affecting Dividend Policy
LG3

The firm’s dividend policy represents a plan of action to be followed whenever
dividend policy
The firm’s plan of action to be the dividend decision is made. Firms develop policies consistent with their goals.
followed whenever a dividend Before we review some of the popular types of dividend policies, we discuss the
decision is made.
factors the are considered in establishing a dividend policy. These include legal
constraints, contractual constraints, internal constraints, the firm’s growth pros-
pects, owner considerations, and market considerations.


Legal Constraints
Most states prohibit corporations from paying out as cash dividends any portion of
the firm’s “legal capital,” which is typically measured by the par value of common
stock. Other states define legal capital to include not only the par value of the com-
mon stock, but also any paid-in capital in excess of par. These capital impairment
restrictions are generally established to provide a sufficient equity base to protect
creditors’ claims. An example will clarify the differing definitions of capital.

The stockholders’ equity account of Miller Flour Company, a large grain proces-
EXAMPLE
sor, is presented in the following table.


Miller Flour Company
Stockholders’ Equity

Common stock at par $100,000
Paid-in capital in excess of par 200,000
Retained earnings 140,000
Total stockholders’ equity $440,000




3. A common exception is small firms, because they frequently treat dividends as a residual remaining after all
acceptable investments have been initiated. Small firms follow this course of action because they usually do not have
ready access to capital markets. The use of retained earnings therefore is a key source of financing for growth, which
is generally an important goal of a small firm.
470 PART 4 Long-Term Financial Decisions


In states where the firm’s legal capital is defined as the par value of its common
stock, the firm could pay out $340,000 ($200,000 $140,000) in cash dividends
without impairing its capital. In states where the firm’s legal capital includes all
paid-in capital, the firm could pay out only $140,000 in cash dividends.

An earnings requirement limiting the amount of dividends is sometimes
imposed. With this restriction, the firm cannot pay more in cash dividends than
the sum of its most recent and past retained earnings. However, the firm is not
prohibited from paying more in dividends than its current earnings.4

Assume that Miller Flour Company, from the preceding example, in the year just
EXAMPLE
ended has $30,000 in earnings available for common stock dividends. As the pre-
ceding table indicates, the firm has past retained earnings of $140,000. Thus it
excess earnings
can legally pay dividends of up to $170,000.
accumulation tax
The tax the IRS levies on
If a firm has overdue liabilities or is legally insolvent or bankrupt, most states
retained earnings above
$250,000 when it determines prohibit its payment of cash dividends. In addition, the Internal Revenue Service
that the firm has accumulated prohibits firms from accumulating earnings to reduce the owners’ taxes. If the
an excess of earnings to
IRS can determine that a firm has accumulated an excess of earnings to allow
allow owners to delay paying
owners to delay paying ordinary income taxes on dividends received, it may levy
ordinary income taxes on
an excess earnings accumulation tax on any retained earnings above $250,000.
dividends received.



Contractual Constraints
Often the firm’s ability to pay cash dividends is constrained by restrictive provi-
sions in a loan agreement. Generally, these constraints prohibit the payment of
cash dividends until a certain level of earnings has been achieved, or they may
limit dividends to a certain dollar amount or percentage of earnings. Constraints
on dividends help to protect creditors from losses due to the firm’s insolvency.


Internal Constraints
The firm’s ability to pay cash dividends is generally constrained by the amount of
liquid assets (cash and marketable securities) available. Although it is possible for
a firm to borrow funds to pay dividends, lenders are generally reluctant to make
such loans because they produce no tangible or operating benefits that will help
the firm repay the loan.

Miller Flour Company’s stockholders’ equity account presented earlier indicates
EXAMPLE
that if the firm’s legal capital is defined as all paid-in capital, the firm can pay
$140,000 in dividends. If the firm has total liquid assets of $50,000 ($20,000 in
cash plus marketable securities worth $30,000) and $35,000 of this is needed for
operations, the maximum cash dividend the firm can pay is $15,000 ($50,000
$35,000).


4. A firm that has an operating loss in the current period can still pay cash dividends as long as sufficient retained
earnings against which to charge the dividend are available and, of course, as long as it has the cash with which to
make the payments.
471
CHAPTER 12 Dividend Policy


Growth Prospects
The firm’s financial requirements are directly related to how much it expects to
grow and what assets it will need to acquire. It must evaluate its profitability and
risk to develop insight into its ability to raise capital externally. In addition, the
firm must determine the cost and speed with which it can obtain financing. Gen-
erally, a large, mature firm has adequate access to new capital, whereas a rapidly
growing firm may not have sufficient funds available to support its acceptable
projects. A growth firm is likely to have to depend heavily on internal financing
through retained earnings, and so it is likely to pay out only a very small percent-
age of its earnings as dividends. A more established firm is in a better position to
pay out a large proportion of its earnings, particularly if it has ready sources of
financing.


Owner Considerations
The firm must establish a policy that has a favorable effect on the wealth of the
majority of owners. One consideration is the tax status of a firm’s owners. If a
firm has a large percentage of wealthy stockholders who are in a high tax
bracket, it may decide to pay out a lower percentage of its earnings to allow the
owners to delay the payment of taxes until they sell the stock. Of course, when
the stock is sold, if the proceeds are in excess of the original purchase price, the
capital gain will be taxed, possibly at a more favorable rate than the one applied
to ordinary income. Lower-income shareholders, however, who need dividend
income, will prefer a higher payout of earnings.
A second consideration is the owners’ investment opportunities. A firm
should not retain funds for investment in projects yielding lower returns than the
owners could obtain from external investments of equal risk. If it appears that the
owners have better opportunities externally, the firm should pay out a higher per-
centage of its earnings. If the firm’s investment opportunities are at least as good
as similar-risk external investments, a lower payout is justifiable.
A final consideration is the potential dilution of ownership. If a firm pays out
a high percentage of earnings, new equity capital will have to be raised with com-
mon stock. The result of a new stock issue may be dilution of both control and
earnings for the existing owners. By paying out a low percentage of its earnings,
the firm can minimize the possibility of such dilution.


Market Considerations
An awareness of the market’s probable response to certain types of policies is also
helpful in formulating dividend policy. Stockholders are believed to value a fixed
or increasing level of dividends as opposed to a fluctuating pattern of dividends.
This belief is supported by the research of John Lintner5, who found that corpo-
rate managers are averse to changing the dollar amount of dividends in response


5. John Lintner, “Distribution of Income of Corporations Among Dividends, Retained Earnings, and Taxes,”
American Economic Review 46 (May 1956), pp. 97–113.
472 PART 4 Long-Term Financial Decisions



In Practice
FOCUS ON ETHICS Were Ford Managers Hoarding Cash?
When managers don’t pay divi- Chrysler and Ford have come was now in a “cash crisis.” The
dends or pay only minimal divi- under fire for investing too much in Wall Street Journal stated that in
dends, they open themselves up to cash and short-term securities. hindsight, Ford management was
the charge that they are hoarding Investor Kirk Kerkorian success- wise to hoard cash against hard
cash unnecessarily. Shareholders fully forced Chrysler to make a times, and investors were unwise
may believe this is unethical if they one-time $1 billion payout to stock- to clamor for bigger payouts of
are convinced that managers are holders in 1996. Ford held the cash to shareholders.
simply playing it too safe in order largest cash and security balances Caution and prudence are
to protect their jobs and (by reduc- in corporate America: In 1999, virtues—and these virtues provide
ing the number of new stock or when Jacques Nasser became ethical justification for managers
bond issues) to keep from having CEO, its cash and securities accused of putting self-interest
to answer to external funding totaled $14 billion more than its ahead of shareholder interests.
sources. Some of these companies entire debt. Nasser invested “Virtue theory” focuses on the
sell products in slow-growth mar- chunks of that cash when acquir- character of the decision maker,
kets and cannot point to future ing Volvo and Land Rover, and he over and above merely doing one’s
asset-funding requirements to jus- also initiated a combined $5.7 bil- duty. This area of ethics is now
tify their cash buildup. “Empire- lion cash dividend and share getting more attention, thanks to
building” behavior, whether repurchase. But maybe he went business guru Steven Covey and to
investing in negative-NPV projects too far—or maybe his timing was ethicists such as Scott Rae, Ken-
or hoarding cash, reminds us once bad. (Did you hear about the $3.5- man Wong, and Thomas Whet-
again that shareholder wealth billion tire replacement project?) In stone. In cases such as Ford’s, it is
maximization has to be ethically 2001, not only did Ford have to cut probably wisest to give managers
constrained. its normal quarterly dividend, but the benefit of the doubt.
But this lesson can be taken its debt was downgraded because
too far. Automakers such as investment bankers decided Ford




to changes in earnings, particularly when earnings decline. In addition, stock-
holders are believed to value a policy of continuous dividend payment. Because
regularly paying a fixed or increasing dividend eliminates uncertainty about the
frequency and magnitude of dividends, the returns of the firm are likely to be dis-
counted at a lower rate. This should result in an increase in the market value of
the stock and therefore an increase in the owners’ wealth.
A final market consideration is informational content. As noted earlier,
shareholders often view a dividend payment as a signal of the firm’s future suc-
cess. A stable and continuous dividend is a positive signal, conveying the firm’s
good financial health. Shareholders are likely to interpret a passed dividend pay-
ment due to a loss or to very low earnings as a negative signal. The nonpayment
of the dividend creates uncertainty about the future, which is likely to result in
lower stock value. Owners and investors generally construe a dividend payment
during a period of losses as an indication that the loss is merely temporary.


Review Question

12–5 What are the six factors that affect dividend policy? Briefly describe each
of them.
473
CHAPTER 12 Dividend Policy


Types of Dividend Policies
LG4

The firm’s dividend policy must be formulated with two basic objectives in mind:
providing for sufficient financing and maximizing the wealth of the firm’s own-
ers. Three of the more commonly used dividend policies are described in the
following sections. A particular firm’s cash dividend policy may incorporate ele-
ments of each.


Constant-Payout-Ratio Dividend Policy
dividend payout ratio
Indicates the percentage of each
One type of dividend policy involves use of a constant payout ratio. The dividend
dollar earned that is distributed
payout ratio indicates the percentage of each dollar earned that is distributed to
to the owners in the form of cash.
It is calculated by dividing the the owners in the form of cash. It is calculated by dividing the firm’s cash divi-
firm’s cash dividend per share by
dend per share by its earnings per share. With a constant-payout-ratio dividend
its earnings per share.
policy, the firm establishes that a certain percentage of earnings is paid to owners
constant-payout-ratio in each dividend period.
dividend policy The problem with this policy is that if the firm’s earnings drop or if a loss
A dividend policy based on the
occurs in a given period, the dividends may be low or even nonexistent. Because
payment of a certain percentage
dividends are often considered an indicator of the firm’s future condition and sta-
of earnings to owners in each
tus, the firm’s stock price may thus be adversely affected.
dividend period.

Peachtree Industries, a miner of potassium, has a policy of paying out 40% of
EXAMPLE
earnings in cash dividends. In periods when a loss occurs, the firm’s policy is to
pay no cash dividends. Data on Peachtree’s earnings, dividends, and average
stock prices for the past 6 years follow.


Year Earnings/share Dividends/share Average price/share

2003 $0.50 $0.00 $42.00
2002 3.00 1.20 52.00
2001 1.75 0.70 48.00
2000 1.50 0.00 38.00
1999 2.00 0.80 46.00
1998 4.50 1.80 50.00



Dividends increased in 2001 and in 2002 but decreased in the other years. In
years of decreasing dividends, the firm’s stock price dropped; when dividends
increased, the price of the stock increased. Peachtree’s sporadic dividend pay-
ments appear to make its owners uncertain about the returns they can expect.

Although some firms use a constant-payout-ratio dividend policy, it is not
recommended.


Regular Dividend Policy
regular dividend policy
The regular dividend policy is based on the payment of a fixed-dollar dividend in
A dividend policy based on the
each period. This policy provides the owners with generally positive information,
payment of a fixed-dollar
thereby minimizing their uncertainty. Often, firms that use this policy increase
dividend in each period.
474 PART 4 Long-Term Financial Decisions


the regular dividend once a proven increase in earnings has occurred. Under this
policy, dividends are almost never decreased.

The dividend policy of Woodward Laboratories, a producer of a popular artifi-
EXAMPLE
cial sweetener, is to pay annual dividends of $1.00 per share until per-share earn-
ings have exceeded $4.00 for three consecutive years. At that point, the annual
dividend is raised to $1.50 per share, and a new earnings plateau is established.
The firm does not anticipate decreasing its dividend unless its liquidity is in jeop-
ardy. Data for Woodward’s earnings, dividends, and average stock prices for the
past 12 years follow.

Year Earnings/share Dividends/share Average price/share

2003 $4.50 $1.50 $47.50
2002 3.90 1.50 46.50
2001 4.60 1.50 45.00
2000 4.20 1.00 43.00
1999 5.00 1.00 42.00
1998 2.00 1.00 38.50
1997 6.00 1.00 38.00
1996 3.00 1.00 36.00
1995 0.75 1.00 33.00
1994 0.50 1.00 33.00
1993 2.70 1.00 33.50
1992 2.85 1.00 35.00


Whatever the level of earnings, Woodward Laboratories paid dividends of
$1.00 per share through 2000. In 2001, the dividend increased to $1.50 per share
because earnings in excess of $4.00 per share had been achieved for 3 years. In
2001, the firm also had to establish a new earnings plateau for further dividend
increases. Woodward Laboratories’ average price per share exhibited a stable,
target dividend-payout
ratio increasing behavior in spite of a somewhat volatile pattern of earnings.
A dividend policy under
which the firm attempts to Often a regular dividend policy is built around a target dividend-payout
pay out a certain percentage
ratio. Under this policy, the firm attempts to pay out a certain percentage of earn-
of earnings as a stated dollar
ings, but rather than let dividends fluctuate, it pays a stated dollar dividend and
dividend and adjusts that divi-
adjusts that dividend toward the target payout as proven earnings increases
dend toward a target payout as
occur. For instance, Woodward Laboratories appears to have a target payout
proven earnings increases occur.
ratio of around 35 percent. The payout was about 35 percent ($1.00 $2.85)
low-regular-and-extra
when the dividend policy was set in 1992, and when the dividend was raised to
dividend policy
$1.50 in 2001, the payout ratio was about 33 percent ($1.50 $4.60).
A dividend policy based on
paying a low regular dividend,
supplemented by an additional
dividend when earnings are
Low-Regular-and-Extra Dividend Policy
higher than normal in a given
period.
Some firms establish a low-regular-and-extra dividend policy, paying a low regu-
extra dividend lar dividend, supplemented by an additional dividend when earnings are higher
An additional dividend optionally
than normal in a given period. By calling the additional dividend an extra divi-
paid by the firm if earnings are
dend, the firm avoids giving shareholders false hopes. This policy is especially
higher than normal in a given
common among companies that experience cyclical shifts in earnings.
period.
475
CHAPTER 12 Dividend Policy


By establishing a low regular dividend that is paid each period, the firm gives
investors the stable income necessary to build confidence in the firm, and the extra
dividend permits them to share in the earnings from an especially good period.
Firms using this policy must raise the level of the regular dividend once proven
increases in earnings have been achieved. The extra dividend should not be a regu-
lar event; otherwise, it becomes meaningless. The use of a target dividend-payout
ratio in establishing the regular dividend level is advisable.


Review Question

12–6 Describe a constant-payout-ratio dividend policy, a regular dividend pol-
icy, and a low-regular-and-extra dividend policy. What are the effects of
these policies?



Other Forms of Dividends
LG5 LG6


Dividends can be paid in forms other than cash. Here we discuss two other meth-
ods of paying dividends—stock dividends and stock repurchases—as well as a
closely related topic, stock splits.


Stock Dividends
A stock dividend is the payment, to existing owners, of a dividend in the form of
stock dividend
The payment, to existing owners, stock. Often firms pay stock dividends as a replacement for or a supplement to
of a dividend in the form of stock. cash dividends. Although stock dividends do not have a real value, stockholders
may perceive them to represent something they did not have before.

Accounting Aspects
In an accounting sense, the payment of a stock dividend is a shifting of funds
between stockholders’ equity accounts rather than a use of funds. When a firm
declares a stock dividend, the procedures for announcement and distribution are
the same as those described earlier for a cash dividend. The accounting entries
small (ordinary) stock dividend associated with the payment of a stock dividend vary depending on its size. A
A stock dividend representing
small (ordinary) stock dividend is a stock dividend that represents less than 20 to
less than 20 to 25 percent of the
25 percent of the common stock outstanding when the dividend is declared.
common stock outstanding when
Small stock dividends are most common.
the dividend is declared.

The current stockholders’ equity on the balance sheet of Garrison Corporation, a
EXAMPLE
distributor of prefabricated cabinets, is as shown in the following accounts.
Preferred stock $ 300,000
Common stock (100,000 shares at $4 par) 400,000
Paid-in capital in excess of par 600,000
Retained earnings 700,000
Total stockholders’ equity $2,000,000
476 PART 4 Long-Term Financial Decisions


Garrison, which has 100,000 shares outstanding, declares a 10% stock divi-
dend when the market price of its stock is $15 per share. Because 10,000 new
shares (10% of 100,000) are issued at the prevailing market price of $15 per
share, $150,000 ($15 per share 10,000 shares) is shifted from retained earnings
to the common stock and paid-in capital accounts. A total of $40,000 ($4 par
10,000 shares) is added to common stock, and the remaining $110,000 [($15
$4) 10,000 shares] is added to the paid-in capital in excess of par. The resulting
account balances are as follows:

Preferred stock $ 300,000
Common stock (110,000 shares at $4 par) 440,000
Paid-in capital in excess of par 710,000
Retained earnings 550,000
Total stockholders’ equity $2,000,000

The firm’s total stockholders’ equity has not changed; funds have merely been
shifted among stockholders’ equity accounts.


The Shareholder’s Viewpoint
The shareholder receiving a stock dividend typically receives nothing of value.
After the dividend is paid, the per-share value of the shareholder’s stock decreases
in proportion to the dividend in such a way that the market value of his or her
total holdings in the firm remains unchanged. The shareholder’s proportion of
ownership in the firm also remains the same, and as long as the firm’s earnings
remain unchanged, so does his or her share of total earnings. (However, if the
firm’s earnings and cash dividends increase when the stock dividend is issued, an
increase in share value is likely to result.)

Ms. X owned 10,000 shares of Garrison Corporation’s stock. The company’s
EXAMPLE
most recent earnings were $220,000, and earnings are not expected to change in
the near future. Before the stock dividend, Ms. X owned 10% (10,000 shares
100,000 shares) of the firm’s stock, which was selling for $15 per share. Earnings
per share were $2.20 ($220,000 100,000 shares). Because Ms. X owned
10,000 shares, her earnings were $22,000 ($2.20 per share 10,000 shares).
After receiving the 10% stock dividend, Ms. X has 11,000 shares, which again is
10% of the ownership (11,000 shares 110,000 shares). The market price of the
stock can be expected to drop to $13.64 per share [$15 (1.00 1.10)], which
means that the market value of Ms. X’s holdings is $150,000 (11,000 shares
$13.64 per share). This is the same as the initial value of her holdings (10,000
shares $15 per share). The future earnings per share drops to $2 ($220,000
110,000 shares) because the same $220,000 in earnings must now be divided
among 110,000 shares. Because Ms. X still owns 10% of the stock, her share of
total earnings is still $22,000 ($2 per share 11,000 shares).

In summary, if the firm’s earnings remain constant and total cash dividends do
not increase, a stock dividend results in a lower per-share market value for the
firm’s stock.
477
CHAPTER 12 Dividend Policy


The Company’s Viewpoint
Stock dividends are more costly to issue than cash dividends, but certain advan-
tages may outweigh these costs. Firms find the stock dividend a way to give owners
something without having to use cash. Generally, when a firm needs to preserve
cash to finance rapid growth, a stock dividend is used. When the stockholders rec-
ognize that the firm is reinvesting the cash flow so as to maximize future earnings,
the market value of the firm should at least remain unchanged. However, if the
stock dividend is paid so that cash can be retained to satisfy past-due bills, a
decline in market value may result.


Stock Splits
Although not a type of dividend, stock splits have an effect on a firm’s share price
similar to that of stock dividends. A stock split is a method commonly used to
stock split
A method commonly used to lower the market price of a firm’s stock by increasing the number of shares
lower the market price of a firm’s
belonging to each shareholder. In a 2-for-1 split, for example, two new shares are
stock by increasing the number
exchanged for each old share, with each new share worth half the value of each
of shares belonging to each
old share. A stock split has no effect on the firm’s capital structure.
shareholder.
Quite often, a firm believes that its stock is priced too high and that lowering
the market price will enhance trading activity. Stock splits are often made prior to
issuing additional stock to enhance that stock’s marketability and stimulate mar-
ket activity. It is not unusual for a stock split to cause a slight increase in the mar-
ket value of the stock, attributable to its informational content and to the fact
that total dividends paid commonly increase slightly after a split.

Delphi Company, a forest products concern, had 200,000 shares of $2-par-value
EXAMPLE
common stock and no preferred stock outstanding. Because the stock is selling at
a high market price, the firm has declared a 2-for-1 stock split. The total before-
and after-split stockholders’ equity is shown in the following table.

Before split

Common stock (200,000 shares at $2 par) $ 400,000
Paid-in capital in excess of par 4,000,000
Retained earnings 2,000,000
Total stockholders’ equity $6,400,000

After 2-for-1 split

Common stock (400,000 shares at $1 par) $1,400,000
Paid-in capital in excess of par 4,000,000
Retained earnings 2,000,000
Total stockholders’ equity $6,400,000

reverse stock split
A method used to raise the The insignificant effect of the stock split on the firm’s books is obvious.
market price of a firm’s
stock by exchanging a certain
Stock can be split in any way desired. Sometimes a reverse stock split is
number of outstanding shares
made: A certain number of outstanding shares are exchanged for one new share.
for one new share.
478 PART 4 Long-Term Financial Decisions


For example, in a 1-for-3 split, one new share is exchanged for three old shares.
Reverse stock splits are initiated to raise the market price of a firm’s stock when it
is selling at too low a price to appear respectable.6


Stock Repurchases
In recent years, firms have increased their repurchasing of outstanding common
stock in the marketplace. The practical motives for stock repurchases include
stock repurchase
The repurchase by the firm of obtaining shares to be used in acquisitions, having shares available for employee
outstanding common stock in the stock option plans, and retiring shares. The recent increase in frequency and
marketplace; desired effects of
importance of stock repurchases is due to the fact that they either enhance
stock repurchases are that they
shareholder value or help to discourage an unfriendly takeover. Stock repur-
either enhance shareholder
chases enhance shareholder value by (1) reducing the number of shares out-
value or help to discourage an
unfriendly takeover. standing and thereby raising earnings per share, (2) sending a positive signal to
investors in the marketplace that management believes that the stock is under-
valued, and (3) providing a temporary floor for the stock price, which may have
been declining. The use of repurchases to discourage unfriendly takeovers is
predicated on the belief that a corporate raider is less likely to gain control of
the firm if there are fewer publicly traded shares available. Here we focus on
retiring shares through repurchase, because this motive for repurchase is similar
to the payment of cash dividends.

Stock Repurchases Viewed as a Cash Dividend
When common stock is repurchased for retirement, the underlying motive is to
distribute excess cash to the owners. Generally, as long as earnings remain con-
stant, the repurchase reduces the number of outstanding shares, raising the
earnings per share and therefore the market price per share. In addition, certain
owner tax benefits may result. The repurchase of common stock results in a type
of reverse dilution, because the EPS and the market price of stock are increased
by reducing the number of shares outstanding. The net effect of the repurchase is
similar to the payment of a cash dividend.

Benton Company, a national sportswear chain, has released the following finan-
EXAMPLE
cial data:
Earnings available for common stockholders $1,000,000
Number of shares of common stock outstanding 400,000
Earnings per share ($1,000,000 400,000) $2.50
Market price per share $50
Price/earnings (P/E) ratio ($50 $2.50) 20
The firm wants to use $800,000 of its earnings either to pay cash dividends or to
repurchase shares. If the firm paid cash dividends, the amount of the dividend
would be $2 per share ($800,000 400,000 shares). If the firm paid $52 per


6. If a firm’s stock is selling at a low price—possibly less than a few dollars—many investors are hesitant to purchase
it because they believe it is “cheap.” These somewhat unsophisticated investors correlate cheapness and quality, and
they feel that a low-priced stock is a low-quality investment. A reverse stock split raises the stock price and increases
per-share earnings.
479
CHAPTER 12 Dividend Policy


share to repurchase stock, it could repurchase approximately 15,385 shares
($800,000 $52 per share). As a result of this repurchase, 384,615 shares
(400,000 shares 15,385 shares) of common stock would remain outstanding.
Earnings per share (EPS) would rise to $2.60 ($1,000,000 384,615). If the
stock still sold at 20 times earnings (P/E 20), its market price could be estimated
by multiplying the new EPS by this P/E ratio (the price/earnings multiple
approach presented in Chapter 7). The price would therefore rise to $52 per
share ($2.60 20). In both cases, the stockholders would receive $2 per share: a
$2 cash dividend in the dividend case or a $2 increase in share price ($50 per
share to $52 per share) in the repurchase case.

Besides the advantage of an increase in per-share earnings, certain owner tax
benefits also result. If the cash dividend were paid, the owners would have to pay
ordinary income taxes on it, whereas the $2 increase in the market value of the
stock that resulted from the repurchase would not be taxed until the owner sold
the stock. Of course, when the stock is sold, the capital gain is taxed, but possibly
at a more favorable rate than the one applied to ordinary income. The IRS is
alleged to monitor firms that regularly repurchase stock and levies a penalty when
it believes repurchases have been made to delay the payment of taxes by
stockholders.


Accounting Entries
The accounting entries that result when common stock is repurchased are a
reduction in cash and the establishment of a contra capital account called “trea-
sury stock,” which is shown as a deduction from stockholders’ equity. The label
treasury stock is used on the balance sheet to indicate the presence of repur-
chased shares.


The Repurchase Process
When a company intends to repurchase a block of outstanding shares, it should
make shareholders aware of its intentions. Specifically, it should advise them of
the purpose of the repurchase (acquisition, stock options, retirement) and the dis-
position (if any) planned for the repurchased shares (traded for shares of another
firm, distribution to executives, or held in the treasury).
Three basic methods of repurchase are commonly used. One is to purchase
shares on the open market. This places upward pressure on the price of shares if
the number of shares being repurchased is reasonably large in comparison with
the total number outstanding. The second method is through tender offers. A
tender offer is a formal offer to purchase a given number of shares of a firm’s
tender offer
A formal offer to purchase a stock at a specified price. The price at which a tender offer is made is set above
given number of shares of a
the current market price to attract sellers. If the number of shares desired cannot
firm’s stock at a specified price.
be repurchased through the tender offer, open-market purchases can be used to
obtain the additional shares. Tender offers are preferred when large numbers of
shares are repurchased, because the company’s intentions are clearly stated and
each stockholder has an opportunity to sell shares at the tendered price. A third
method that is sometimes used involves the purchase, on a negotiated basis, of a
large block of shares from one or more major stockholders. Again, in this case,
the firm has to state its intentions and make certain that the purchase price is
480 PART 4 Long-Term Financial Decisions


fair and equitable in view of the interests and opportunities of the remaining
shareholders.


Review Questions

12–7 Why do firms issue stock dividends? Comment on the following state-
ment: “I have a stock that promises to pay a 20 percent stock dividend
every year, and therefore it guarantees that I will break even in 5 years.”
12–8 Compare a stock split with a stock dividend.
12–9 What is the logic behind repurchasing shares of common stock to distri-
bute excess cash to the firm’s owners?




SUMMARY
FOCUS ON VALUE
Cash dividends are the cash flows that a firm distributes to its common stockholders. As noted in
Chapter 7, a share of common stock gives its owner the right to receive all future dividends. The
present value of all those future dividends expected over a firm’s assumed infinite life determines
the firm’s stock value.
Dividends not only represent cash flows to shareholders but also contain useful information
with regard to the firm’s current and future performance. Such information affects the shareholders’
perception of the firm’s risk. A firm can also pay stock dividends, initiate stock splits, or repurchase
stock. Each of these dividend-related actions can affect the firm’s risk, return, and value as a result
of their cash flows and informational content.
Although the theory with regard to the relevance of dividends is still evolving, the behavior of
most firms and stockholders suggests that dividend policy affects share prices. It is therefore
believed to be important for the financial manager to develop and implement a dividend policy that
is consistent with the firm’s goal of maximizing stock price.



REVIEW OF LEARNING GOALS
Describe the residual theory of dividends and
Understand cash dividend payment procedures LG2
LG1
the key arguments with regard to dividend irrel-
and the role of dividend reinvestment plans.
evance and relevance. The residual theory suggests
The cash dividend decision is normally made by the
that dividends should be viewed as the earnings left
board of directors, which establishes the record and
after all acceptable investment opportunities have
payment dates. Generally, the larger the dividend
been undertaken. Miller and Modigliani argue in
charged to retained earnings and paid in cash, the
favor of dividend irrelevance, using a perfect world
greater the amount of financing that must be raised
wherein information content and clientele effects
externally. Some firms offer dividend reinvestment
exist. Gordon and Lintner advance the theory of
plans that allow stockholders to acquire shares in
dividend relevance, basing their argument on the
lieu of cash dividends.
481
CHAPTER 12 Dividend Policy


uncertainty-reducing effect of dividends, supported when a loss occurs. Under a regular dividend policy,
by their bird-in-the-hand argument. Although the the firm pays a fixed-dollar dividend each period; it
idea is intuitively appealing, empirical studies fail to increases the amount of dividends only after a
provide clear support of dividend relevance. Even proven increase in earnings has occurred. The low-
so, the actions of financial managers and stockhold- regular-and-extra dividend policy is similar to the
ers tend to support the belief that dividend policy regular dividend policy, except that it pays an
does affect stock value. “extra dividend” in periods when the firm’s earn-
ings are higher than normal. The regular and the
Discuss the key factors involved in formulating low-regular-and-extra dividend policies are gener-
LG3
a dividend policy. A firm’s dividend policy ally preferred because their stable patterns of divi-
should provide for sufficient financing and maxi- dends reduce uncertainty.
mize the wealth of the firm’s owners. Dividend pol-
icy is affected by certain legal, contractual, and Evaluate stock dividends from accounting,
LG5
internal constraints, as well as by growth prospects, shareholder, and company points of view.
owner considerations, and market considerations. Occasionally, firms pay stock dividends as a
Legal constraints prohibit corporations from paying replacement for or supplement to cash dividends.
out as cash dividends any portion of the firm’s The payment of stock dividends involves a shifting
“legal capital”; they also constrain firms with over- of funds between capital accounts rather than a use
due liabilities and legally insolvent or bankrupt of funds. Shareholders receiving stock dividends
firms from paying cash dividends. Contractual con- receive nothing of value; the market value of their
straints result from restrictive provisions in the holdings, their proportion of ownership, and their
firm’s loan agreements. Internal constraints tend to share of total earnings remain unchanged. How-
result from a firm’s limited availability of excess ever, the firm may use stock dividends to satisfy
cash. Growth prospects affect the relative impor- owners and preserve its market value without hav-
tance of retaining earnings rather than paying them ing to use cash.
out in dividends. The tax status of owners, the own-
ers’ investment opportunities, and the potential dilu- Explain stock splits and stock repurchases and
LG6
tion of ownership are important owner considera- the firm’s motivation for undertaking each of
tions. Finally, market considerations are related to them. Stock splits are used to enhance trading activ-
the stockholders’ preference for the continuous pay- ity of a firm’s shares by lowering or raising their
ment of fixed or increasing streams of dividends and market price. A stock split merely involves account-
the perceived informational content of dividends. ing adjustments; it has no effect on the firm’s cash
or on its capital structure. Stock repurchases can be
Review and evaluate the three basic types of made in lieu of cash dividend payments to retire
LG4
dividend policies. With a constant-payout-ratio outstanding shares. They reduce the number of out-
dividend policy, the firm pays a fixed percentage of standing shares and thereby increase earnings per
earnings to the owners each period; dividends move share and the market price per share. They also
up and down with earnings, and no dividend is paid delay the tax burden of shareholders.




SELF-TEST PROBLEM (Solution in Appendix B)
ST 12–1 Stock repurchase The Off-Shore Steel Company has earnings available for
LG6
common stockholders of $2 million and has 500,000 shares of common stock
outstanding at $60 per share. The firm is currently contemplating the payment
of $2 per share in cash dividends.
a. Calculate the firm’s current earnings per share (EPS) and price/earnings (P/E)
ratio.
482 PART 4 Long-Term Financial Decisions


b. If the firm can repurchase stock at $62 per share, how many shares can be
purchased in lieu of making the proposed cash dividend payment?
c. How much will the EPS be after the proposed repurchase? Why?
d. If the stock sells at the old P/E ratio, what will the market price be after
repurchase?
e. Compare and contrast the earnings per share before and after the proposed
repurchase.
f. Compare and contrast the stockholders’ position under the dividend and
repurchase alternatives.


PROBLEMS
12–1 Dividend payment procedures At the quarterly dividend meeting, Wood Shoes
LG1
declared a cash dividend of $1.10 per share for holders of record on Monday,
July 10. The firm has 300,000 shares of common stock outstanding and has set
a payment date of July 31. Prior to the dividend declaration, the firm’s key
accounts were as follows:

Cash $500,000 Dividends payable $ 0
Retained earnings 2,500,000
a. Show the entries after the meeting adjourned.
b. When is the ex dividend date?
c. What values would the key accounts have after the July 31 payment date?
d. What effect, if any, will the dividend have on the firm’s total assets?
e. Ignoring general market fluctuations, what effect, if any, will the dividend
have on the firm’s stock price on the ex dividend date?

12–2 Dividend payment Kathy Snow wishes to purchase shares of Countdown
LG1
Computing, Inc. The company’s board of directors has declared a cash dividend
of $0.80 to be paid to holders of record on Wednesday, May 12.
a. What is the last day that Kathy can purchase the stock (trade date) in order
to receive the dividend?
b. What day does this stock begin trading “ex dividend”?
c. What change, if any, would you expect in the price per share when the stock
begins trading on the ex dividend day?
d. If Kathy held the stock for less than one quarter and then sold it for $39 per
share, would she achieve a higher investment return by (1) buying the stock
prior to the ex dividend date at $35 per share and collecting the $0.80 divi-
dend, or (2) buying it on the ex dividend date at $34.20 per share but not
receiving the dividend?

12–3 Residual dividend policy As president of Young’s of California, a large cloth-
LG2
ing chain, you have just received a letter from a major stockholder. The stock-
holder asks about the company’s dividend policy. In fact, the stockholder has
asked you to estimate the amount of the dividend that you are likely to pay next
year. You have not yet collected all the information about the expected dividend
payment, but you do know the following:
483
CHAPTER 12 Dividend Policy


(1) The company follows a residual dividend policy.
(2) The total capital budget for next year is likely to be one of three amounts,
depending on the results of capital budgeting studies that are currently under
way. The capital expenditure amounts are $2 million, $3 million, and $4
million.
(3) The forecasted level of potential retained earnings next year is
$2 million.
(4) The target or optimal capital structure is a debt ratio of 40%.

You have decided to respond by sending the stockholder the best information
available to you.
a. Describe a residual dividend policy.
b. Compute the amount of the dividend (or the amount of new common stock
needed) and the dividend payout ratio for each of the three capital expendi-
ture amounts.
c. Compare, contrast, and discuss the amount of dividends (calculated in part b)
associated with each of the three capital expenditure amounts.

12–4 Dividend constraints The Howe Company’s stockholders’ equity account is as
LG3
follows:

Common stock (400,000 shares at $4 par) $1,600,000
Paid-in capital in excess of par 1,000,000
Retained earnings 1,900,000
Total stockholders’ equity $4,500,000

The earnings available for common stockholders from this period’s operations
are $100,000, which have been included as part of the $1.9 million retained
earnings.
a. What is the maximum dividend per share that the firm can pay? (Assume that
legal capital includes all paid-in capital.)
b. If the firm has $160,000 in cash, what is the largest per-share dividend it can
pay without borrowing?
c. Indicate the accounts and changes, if any, that will result if the firm pays the
dividends indicated in parts a and b.
d. Indicate the effects of an $80,000 cash dividend on stockholders’ equity.

12–5 Dividend constraints A firm has $800,000 in paid-in capital, retained earnings
LG3
of $40,000 (including the current year’s earnings), and 25,000 shares of com-
mon stock outstanding. In the current year, it has $29,000 of earnings available
for the common stockholders.
a. What is the most the firm can pay in cash dividends to each common stock-
holder? (Assume that legal capital includes all paid-in capital.)
b. What effect would a cash dividend of $0.80 per share have on the firm’s bal-
ance sheet entries?
c. If the firm cannot raise any new funds from external sources, what do you
consider the key constraint with respect to the magnitude of the firm’s divi-
dend payments? Why?
484 PART 4 Long-Term Financial Decisions


12–6 Alternative dividend policies Over the last 10 years, a firm has had the earn-
LG4
ings per share shown in the following table.


Year Earnings per share

2003 $4.00
2002 3.80
2001 3.20
2000 2.80
1999 3.20
1998 2.40
1997 1.20
1996 1.80
1995 0.50
1994 0.25



a. If the firm’s dividend policy were based on a constant payout ratio of 40%
for all years with positive earnings and 0% otherwise, what would be the
annual dividend for each year?
b. If the firm had a dividend payout of $1.00 per share, increasing by $0.10 per
share whenever the dividend payout fell below 50% for two consecutive
years, what annual dividend would the firm pay each year?
c. If the firm’s policy were to pay $0.50 per share each period except when
earnings per share exceed $3.00, when an extra dividend equal to 80% of
earnings beyond $3.00 would be paid, what annual dividend would the firm
pay each year?
d. Discuss the pros and cons of each dividend policy described in parts a
through c.

12–7 Alternative dividend policies Given the earnings per share over the period
LG4
1996–2003 shown in the following table, determine the annual dividend per
share under each of the policies set forth in parts a through d.


Year Earnings per share

2003 $1.40
2002 1.56
2001 1.20
2000 0.85
1999 1.05
1998 0.60
1997 1.00
1996 0.44



a. Pay out 50% of earnings in all years with positive earnings.
485
CHAPTER 12 Dividend Policy


b. Pay $0.50 per share and increase to $0.60 per share whenever earnings per
share rise above $0.90 per share for two consecutive years.
c. Pay $0.50 per share except when earnings exceed $1.00 per share, in which
case pay an extra dividend of 60% of earnings above $1.00 per share.
d. Combine policies in parts b and c. When the dividend is raised (in part b),
raise the excess dividend base (in part c) from $1.00 to $1.10 per share.
e. Compare and contrast each of the dividend policies described in parts a
through d.

12–8 Stock dividend—Firm Columbia Paper has the following stockholders’
LG5
equity account. The firm’s common stock has a current market price of $30
per share.

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