Chapter 13 - Dividend Policy

Residual Dividend Policy

According to this policy, the amount of the firm's dividends paid is based on the earnings left over after the funding of the firm's optimal capital budget. That is, the firm's annual dividend is calculated as the difference between the firm's net income and the retained earnings needed to finance the firm's optimal capital budget.

Stock Split

Effectively a bookkeeping adjustment undertaken by a firm that increases the number of shares outstanding and immediately causes a proportional decrease in the price of the firm's stock. For example, a firm with 100,000 shares of outstanding stock, each trading for $44 per share, announces a 2-for-1 stock split. This doubles the number of shares outstanding and causes the per-share market value of the shares to decrease to $22.

Dividend Irrelevance Theory

This theory contends that a firm's dividend policy will not impact either the value of the firm or its cost of capital. It is argued that an investor is only concerned with the total return generated by an investment, and is indifferent whether this return is derived from dividend income or capital gains. As a result, neither the form nor the magnitude of the dividends paid by a firm will affect the investor's required return, the price of the stock, or the firm's cost of equity capital, or weighted average cost of capital.

Low-regular-dividend-plus-extra dividend policy

A low-regular-dividend-plus-extra dividend policy would have the firm set a conservatively low dividend most years and reserve excess earnings. Periodically, the firm would pay out this excess cash as an extra dividend.

residual dividend policy

A residual dividend policy would have the firm use earnings to pay the equity portion of required investment in the capital budget (thus keeping the target capital structure intact); the earnings left over (the residual) would be paid as dividends. The goal of a residual dividend policy is to reinvest earnings into the firm if the rate of return the firm can earn on reinvested earnings exceeds the rate that investors, on average, can earn on other investments of comparable risk. The problem with this dividend policy is that its dividends tend to dramatically fluctuate from year to year, even though investors prefer dividends to be stable and predictable.

Stable, predictable dividend policy

A stable, predictable dividend policy would have the firm pay out the same dollar amount in dividends every year or periodically increase the dividend at a constant rate or by a constant amount. Investors tend to like this sort of dividend policy because a stable, predictable dividend policy implies more certainty than the variable dividend policies.

optimal dividend policy

This dividend policy maximizes the price of a firm's common stock and the value of the firm.

bond indenture

often stipulates that no dividends can be paid unless the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums.

Preferred Stock Restriction

states that common dividends cannot be paid if the company has not paid its preferred stock dividends.

Impairment of capital rule

states that dividend payments cannot exceed the balance sheet item "retained earnings. This legal restriction is designed to protect creditors. Without this rule, a company in financial trouble could distribute most of its assets to stockholders and leave debt holders with nothing.

Purple Turtle Group currently has 30,000 shares of common stock outstanding. Its management believes that its current stock price of $100 per share is too high. The company is planning to conduct a 4-for-1 stock split. If Purple Turtle Group declares a 4-for-1 stock split, what will be the price of the company's stock after the split—assuming that the total value of the firm's stock remains the same before and after the split—should be ___________ per share.

$25.00 When a firm declares a 4-for-1 stock split, it quadruples the number of shares outstanding. This causes the earnings and dividends per share to be cut to one-fourth of their value before the stock split, thereby reducing the stock price to one-fourth of its original value. Each shareholder will own four times as many shares, but each share will be worth only one-fourth of its value before the stock split. Post-split stock price = $100 per share/4 new shares = $25.00 per share

Dividend distribution decisions are complicated and involve the understanding of critical strategic factors that affect the policy and value of a firm. Thus, the management of any firm has to consider the constraints on dividend payments, the availability and cost of alternative sources of capital, and other external factors when they create and implement their distribution policy.

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Which of the following statements would be considered advantages of a stock repurchase? - At times, the company will repurchase its stock at a price higher than the true value of the stock. - The market generally perceives a stock repurchase as a sign that management believes that the firm's stock is undervalued. - Stock repurchases allow a firm to distribute earnings to investors without changing the amount of the regular cash dividend.

- The market generally perceives a stock repurchase as a sign that management believes that the firm's stock is undervalued. - Stock repurchases allow a firm to distribute earnings to investors without changing the amount of the regular cash dividend. Firms are generally reluctant to increase their annual dividend payments unless they are confident that future operations can sustain the increase. An advantage of stock repurchases is that they are not expected to continue into the future, so they are an effective way to distribute additional free cash flows to stockholders without increasing the regular dividend. Another advantage of a stock repurchase is that many investors perceive it as a sign that the company's management thinks that the firm's stock is undervalued. This generally increases the demand for the company's stock, which will increase the stock's value. A disadvantage of a stock repurchase is that there will be times when the company will pay too much for the stock that is repurchased. When this happens, the stock price will fall after the repurchase program ends.

______________ dividend reinvestment program invests the dividends in newly issued stock. This type of plan raises new capital for the firm.

A new stock Under an old stock dividend reinvestment plan, the company gives any cash dividends that investors would have received to a bank, which acts as a trustee. The bank then uses the money to repurchase the company's stock on the open stock market and allocates the shares purchased to the participating stockholders' accounts on a pro rata basis.

stock dividend

A dividend that is paid in the form of additional shares of the paying firm's stock rather than in cash. This form of dividend does not enrich a shareholder because the increase in the number of shares owned is accompanied by a proportional decrease in the firm's per-share earnings and dividends and the market value of each share owned. Since a shareholder's percentage ownership of the firm is not changed by the payment of a stock dividend, then their payment does not affect the ownership structure of the firm.

stock repurchase

An earnings distribution activity used to adjust the firm's capital structure, acquire additional shares for its employee option or compensation plans, prevent a possible takeover attempt, or increase the market value of the firm's stock by reducing the number of shares outstanding.

constant payout ratio

If a firm's net income varies from year to year, this dividend policy exposes a shareholder to uncertainty regarding the amount of dividends to be received each year. Under a constant payout ratio dividend policy, a firm pays a constant proportion of its net earnings as dividends each year.

Dividend Reinvestment Plan (DRIP)

If a shareholder opts to participate in this program, their dividends are automatically used to purchase additional shares of the firm's outstanding or newly issued stock. Dividend reinvestment plans (DRIPs) are voluntary dividend programs that allow investors to have their dividends automatically invested to purchase additional shares, either newly issued or outstanding shares, depending upon the purpose of the paying firm's DRIP.

Holder-of-record date

If a shareholder owns a firm's shares on this date, he or she will receive the firm's next declared dividend. The holder-of-record date is the date on which a firm closes its stock transfer, or stock ownership, book, and the shareholders recorded in it will receive the firm's next declared dividend. If shares are sold but the company receives notification of the sale after the holder-of-record, or date-of-record, date, then the seller of the shares, not the buyer, will receive the next dividend paid.

On the ________________ date, the dividend to be paid is recorded as a _________________ , and retained earnings are _______________ by the same amount. If the company lists a stockholder as an owner on the _________________________ , the stockholder receives the dividend for that period.

- declaration - current liability - decreased - holder-of-record date The dividend process begins with the declaration date, when the firm announces when it will pay a dividend and how much it will be. The firm also will announce the holder-of-record date, which says that the owner of a stock on that specific date in the future is entitled to receive the dividend. However, the ex-dividend date usually is set two days before the holder-of-record date to avoid conflicts of dividends rights for shares transacted immediately before the holder-of-record date. As of the ex-dividend date, stocks that are traded do not transfer the right to the current dividend from the seller of the stock to the buyer. The payment date is the day the dividend is actually sent to the shareholders. The announced dividend will be paid within the next 12 months. Therefore, on the declaration date, the firm should record a current liability equal to the total dividends expected to be paid. Remember that dividends are paid out of earnings, so the firm also should reduce its retained earnings balance. The expected dividend remains on the balance sheet until the payment date, when the liability is retired.

Identify which factors, in general, tend to favor high or low payout ratios. 1. A firm has limited investment opportunities. 2. A firm has several investment opportunities and limited internal cash flow generation. 3. Due to an inflationary environment, a firm has to increase cash balances to meet the rising prices of accounts payable and other short-term liabilities.

1. Favors a High Payout 2. Favors a Low Payout 3. Favors a Low Payout A firm with several investment opportunities and limited internal cash flow will likely favor a low payout ratio. The cash flow available to the firm will be used for investments instead of dividend distribution. A firm with limited investment and growth prospects is less likely to use its cash flow for investment and is thus more likely to favor a high payout ratio. In an inflationary environment where a firm has to increase cash balances to meet rising prices of its short-term liabilities, the firm is likely to retain more earnings and favor a lower dividend payout.

In general, firms' dividend practices fit into the categories listed in the following table (constant payout ratio, low-regular-dividend-plus-extras, residual dividend policy, and stable, predictable dividend policies). Identify the category that each practice corresponds in the table. 1. ABCDE Telecom Inc. uses a policy that allows it to pay a small, consistent dividend in years when earnings are low or large capital investments are required. In some years, the firm pays an extra dividend when excess funds are available. 2. Omni Consumer Products Co. pays out a set percentage of its income each year in the form of dividends. This causes the firm's dividends to fluctuate from year to year. 3. St. Mildred's Brewing Co.'s dividends represent the portion of earnings left after it has made all profitable investments. 4. Universal Drugmakers Inc.'s annual dividends increase by the same amount, or percentage, every year.

1. Low-Regular-Dividend-Plus-Extras 2. Constant Payout Ratio 3. Residual Dividend 4. Stable, Predictable Dividend

Indicate which type of firms they are most likely to be attracted to. Potential Investors 1. Stockholders in their peak earning years 2. Investors who have a preference for current investment income 3. Retired individuals, pension funds, and university endowment funds

1. Low-dividend-payout firms 2. High-dividend-payout firms 3. High-dividend-payout firms Investors who have a preference for current investment income should own shares in high-dividend-payout firms, but investors who have no need for current investment income should own shares in low-dividend-payout firms. Stockholders in their peak earning years prefer reinvestment because they do not have a need for current investment income. When the firm directly reinvests its income instead of paying dividends, investors do not have to pay the income taxes and brokerage costs that would be associated with receiving and reinvesting dividend income. Since retired individuals, pension fund managers, and university endowment fund managers generally prefer cash income, they look to invest in high-dividend-payout firms.

Happy Frog Inc. is one of Purple Turtle's leading competitors. Happy Frog's market intelligence research team has learned of Purple Turtle's stock split plans, and is considering paying a stock dividend in response. As a result, executives at Happy Frog decide to pay stock dividends to its shareholders. A stock dividend is another way of keeping the stock price from going too high. Happy Frog Inc. currently has 3,300,000 shares of common stock outstanding. If Happy Frog pays a 8% stock dividend, how many new shares will the firm issue to its existing shareholders?

264,000 shares Stock dividends reward existing shareholders with new shares of stock. The magnitude of the stock dividend indicates how many new shares the investor will receive. Multiply the current number of shares outstanding by the stock dividend to determine the number of new shares that will be issued. The calculation is: New shares issued = Pre-stock- dividend shares outstanding×Number of new shares issued in stock dividend = 3,300,000 shares×8% = 264,000 shares

Blime Inc. has generated earnings of $1,400,000. Its target capital structure consists of 60% equity and 40% debt. It plans to spend $87,000 on capital projects over the next year and expects to finance this investment in the same proportion as its capital structure. The company makes distributions in the form of dividends. Blime's dividend payout ratio will be ____________ if it follows a residual dividend policy.

96.27% When a firm follows a residual dividend policy, it means that the distribution (dividend paid) is equal to net income minus the amount of retained earnings necessary to finance the firm's optimal capital budget. The first step to solving this problem is computing Blime's expected dividend distribution. This can be calculated using the following formulas: Dividends = Net income−Retained earnings needed to finance new investments = Net income−(Target equity ratio×Total Capital Budget) Dividends = $1,400,000−(0.60×$87,000) = $1,347,800 Next, use the following equation to solve for the firm's dividend payout ratio: Dividend payout ratio = Dividends/Net income Dividend payout ratio = $1,347,800/$1,400,000 =0.9627 = 96.27%

constant-payout-ratio dividend policy

A constant payout ratio dividend policy would have the firm pay out the same percentage of its earnings as dividends every year. If a firm uses a constant payout ratio dividend policy and its earnings fluctuate from year to year, this creates a great deal of uncertainty about the expected dividends each year. Because investors have a strong preference for dividend policies that pay stable, predictable dividends, many investors do not like this kind of dividend policy.

Residual Dividend Policy Approach

Based on the theory that a company's optimal distribution policy is a function of its target capital structure, the investment opportunities available to the firm, and the availability and cost of its external capital. The firm makes distributions to its shareholders based on its residual earnings.

InOutOil Company is an oil drilling company and has some free cash flow that is not expected to be used for growth or investment projects. The company plans to distribute to its shareholders but is still deciding whether they should conduct a stock repurchase or distribute dividends. Which of the following is a characteristic of a firm's optimal dividend policy? -It maximizes the firm's total assets. -It maximizes the firm's earnings per share. -It maximizes the firm's stock price. -It maximizes the firm's return on equity.

It maximizes the firm's stock price. A firm's optimal dividend policy maximizes the firm's stock price by striking a balance between current dividends and future growth. Remember that maximizing shareholder wealth is the primary goal in financial management. Optimal decisions regarding dividends, capital structure, and other issues should reflect the desire to maximize shareholder wealth by maximizing the firm's stock price.

When a firm has a large number of profitable investment opportunities, it will usually have a __________ target payout ratio.

Low If a firm has a large number of profitable investment opportunities, it will usually want to retain a large portion of its income to invest in these projects. This will cause the firm to have a low target payout ratio.

_________ levels of participation in a dividend reinvestment program suggest that stockholders are content with the amount of cash dividends that the firm is paying out

Low If a small percentage of stockholders are participating in a dividend reinvestment program, it is generally a signal that stockholders are content with the amount of cash dividends that the firm is paying out.

If management is concerned with keeping control of the company, it will be likely to retain ________ earnings than it otherwise would to avoid diluting control by issuing new stock to raise capital.

More If management is concerned about maintaining control of the company, it may be reluctant to sell new stock. This means that it will retain more of its earnings than it otherwise would.

Clientele Effect

Refers to the tendency of firms to attract investors who like their dividend policies. Three potential investors are described in the table.

There are a number of reasons why a firm might want to repurchase its own stock. Read the statement and then answer the corresponding question about the company's motivation for the stock repurchase: Parrot Transport Corp. is a high-tech company that recently repurchased a number of shares so that it will be able to meet obligations to employees without having to issue any new shares. What is the company's motivation for the stock repurchase? - To adjust the firm's capital structure - To protect against a takeover attempt - To acquire shares needed for employee options or compensation - To distribute excess funds to stockholders

To acquire shares needed for employee options or compensation In this example, Parrot is repurchasing shares so that the company can reissue those shares when employees exercise their stock options. This allows the company to avoid having to issue new shares, which would dilute earnings per share.

Modigliani and Miller argued that each shareholder can construct his or her own dividend policy. This statement is: (True/False) Modigliani and Miller also pointed out that many institutional investors do not pay taxes and can buy and sell stocks with very low transaction costs. For these investors, dividend policy is ________ relevant than it is for an individual investor.

True less True: When using a strict set of assumptions, Modigliani and Miller were able to show that dividend policy has no effect on either a firm's stock price or its cost of capital. They proved that a firm's value is determined only by its basic earning power and its business risk. In addition, they argued that each shareholder has the ability to construct his or her own dividend policy. If a firm does not pay dividends, a shareholder could create his or her own dividends by selling shares of stock. If a firm pays a higher dividend than an investor wants, the investor can use the unwanted dividends to buy additional shares of the company's stock. In defense of dividend irrelevance theory, Modigliani and Miller pointed out that many stocks are owned by institutional investors who pay no taxes and who can buy and sell stocks with low transaction costs. They pointed out that for these investors, dividend policy could be irrelevant.

Information Content Hypothesis

Under this theory, management is reluctant to increase their stock's annual dividend unless they have expectations of increased sustainable future earnings from which to pay the dividends. The information content, or signalling, hypothesis of dividend policy management contends that management uses its dividend payments to send signals regarding the firm's future earnings forecasts. An announced dividend payment that exceeds investors' expectations is interpreted to be "good" news and should be expected to increase the price of the firm's common stock, whereas an announced dividend that is less than investors' expectations is construed as "bad" news and should be expected to decrease the firm's share price. Under this theory, management is reluctant to increase their stock's annual dividend unless they have expectations of increased sustainable future earnings from which to pay the dividends.