You are on page 1of 70

Chapter 14

Payout Policy

Learning Goals
LG1

Understand cash payout procedures, their tax


treatment, and the role of dividend
reinvestment plans.

LG2

Describe the residual theory of dividends and


the key arguments with regard to dividend
irrelevance and relevance.

LG3

Discuss the key factors involved in establishing


a dividend policy.

Pearson Education Limited, 2015.

14-2

Learning Goals (cont.)


LG4

Review and evaluate the three basic types of


dividend policies.

LG5

Evaluate stock dividends from accounting,


shareholder, and company points of view.

LG6

Explain stock splits and the firms motivation for


undertaking them.

Pearson Education Limited, 2015.

14-3

The Basics of Payout Policy:


Elements of Payout Policy
The term payout policy refers to the decisions that
a firm makes regarding whether to distribute cash
to shareholders, how much cash to distribute, and
the means by which cash should be distributed.
Cash can be distributed as a dividend or through
stock repurchase plans.

Pearson Education Limited, 2015.

14-4

The Basics of Payout Policy:


General Lessons
1. Rapidly growing firms generally do not pay out
cash to shareholders.
2. Slowing growth, positive cash flow generation, and
favorable tax conditions can prompt firms to
initiate cash payouts to investors.
3. Cash payouts can be made through dividends or
share repurchases.
4. When business conditions are weak, firms are
more willing to reduce share buybacks than to cut
dividends.

Pearson Education Limited, 2015.

14-5

Figure 14.1 Per Share Earnings and


Dividends of the S&P 500 Index

Pearson Education Limited, 2015.

14-6

Matter of Fact
P&Gs Dividend History
Few companies have
replicated the
dividend
achievements of the
consumer products
giant, Procter &
Gamble (P&G). P&G
has paid dividends
every year for more
than a century, and it
increased its dividend
in every year from
19562010.
Pearson Education Limited, 2015.

14-7

Figure 14.2 Aggregate Dividends and


Repurchases for All U.S.-Listed
Companies

Pearson Education Limited, 2015.

14-8

Matter of Fact
Share Repurchases Gain Worldwide Popularity
In most of the worlds largest economies, repurchases
have been on the rise in recent years, eclipsing dividend
payments at least some of the time in countries as diverse
as Belgium, Denmark, Finland, Hungary, Ireland, Japan,
Netherlands, South Korea, and Switzerland.
A recent study of payout policy at firms from 25 different
countries found that share repurchases rose at an annual
rate of 19% from 19992008.

Pearson Education Limited, 2015.

14-9

Focus on Ethics
Are Buybacks Really a Bargain?
In addition to simply returning cash to shareholders,
companies also typically say they repurchase stock
because they believe their stock is undervalued.
Yet new research shows that companies often use creative
financial reporting to push earnings downward before
buybacks, making the stock seem undervalued and
causing its price to bounce higher after the buyback.
Do you agree that corporate managers would manipulate
their stocks value prior to a buyback, or do you believe
that corporations are more likely to initiate a buyback to
enhance shareholder value?

Pearson Education Limited, 2015.

14-10

The Mechanics of Payout Policy:


Cash Dividend Payment Procedures
At quarterly or semiannual meetings, a firms board
of directors decides whether and in what amount to
pay cash dividends.
If the firm has already established a precedent of
paying dividends, the decision facing the board is
usually whether to maintain or increase the
dividend, and that decision is based primarily on
the firms recent performance and its ability to
generate cash flow in the future.
Boards rarely cut dividends unless they believe that
the firms ability to generate cash is in serious
jeopardy.
Pearson Education Limited, 2015.

14-11

Figure 14.3 U.S. Public Industrial


Firms Increasing, Decreasing, or
Maintaining Dividends

Pearson Education Limited, 2015.

14-12

The Mechanics of Payout Policy: Cash


Dividend Payment Procedures (cont.)
The date of record (dividends) is set by the
firms directors, the date on which all persons
whose names are recorded as stockholders receive
a declared dividend at a specified future time.
A stock is ex dividend for a period, beginning 2
business days prior to the date of record, during
which a stock is sold without the right to receive the
current dividend.
The payment date is set by the firms directors,
the actual date on which the firm mails the dividend
payment to the holders of record.

Pearson Education Limited, 2015.

14-13

Figure 14.4
Dividend Payment Time Line

Pearson Education Limited, 2015.

14-14

The Mechanics of Payout Policy: Cash


Dividend Payment Procedures (cont.)
On August 21, 2013, the board of directors of Best Buy
announced that the firms next quarterly cash dividend
would be $0.17 per share, payable October 1, 2013 to
shareholders of record on Tuesday, September 10,
2013.The stock would begin trading ex-dividend on
Friday, September 6, 2013. At the time, Best Buy had
340,967,179 shares of common stock outstanding, so
the total dividend would be $57,964,420. Before the
dividend was declared, the key accounts of the firm
were as follows (dollar values quoted in thousands):
Cash: $680,000
Dividends payable: $0
Retained earnings: $3,395,000
Pearson Education Limited, 2015.

14-15

The Mechanics of Payout Policy: Cash


Dividend Payment Procedures (cont.)
When the dividend was announced by the directors,
almost $58 million of the retained earnings ($0.17 per
share 341 million shares) was transferred to the
dividends payable account. The key accounts thus
became:
Cash: $680,000
Dividends payable: $57,964
Retained earnings: $3,337,036

Pearson Education Limited, 2015.

14-16

The Mechanics of Payout Policy: Cash


Dividend Payment Procedures (cont.)
When Best Buy actually paid the dividend on October
26, this produced the following balances in the key
accounts of the firm:
Cash: $622,036
Dividends payable: $0
Retained earnings: $3,337,036

The net effect of declaring and paying the dividend


was to reduce the firms total assets (and
stockholders equity) by almost $58 million.

Pearson Education Limited, 2015.

14-17

The Mechanics of Payout Policy: Share


Repurchase Procedures
Common methods for repurchasing shares include:
An open-market share repurchase is a share repurchase
program in which firms simply buy back some of their
outstanding shares on the open market.
A tender offer repurchase is a repurchase program in which a
firm offers to repurchase a fixed number of shares, usually at a
premium relative to the market value, and shareholders decide
whether or not they want to sell back their shares at that price.
A Dutch Auction repurchase is a repurchase method in which
the firm specifies how many shares it wants to buy back and a
range of prices at which it is willing to repurchase shares.
Investors specify how many shares they will sell at each price in
the range, and the firm determines the minimum price required
to repurchase its target number of shares. All investors who
tender receive the same price.

Pearson Education Limited, 2015.

14-18

The Mechanics of Payout Policy:


Share Repurchase Procedures (cont.)
In July 2013, Fidelity National Information Services announced a
Dutch auction repurchase for 86 million common shares at
prices ranging from $29 to $31.50 per share.

At a price of $31.25, shareholders are willing to tender a total of


86 million shares, exactly the amount that Fidelity wants to
repurchase.
Pearson Education Limited, 2015.

14-19

The Mechanics of Payout Policy: Tax


Treatment of Dividends and Repurchases
For many years, dividends and share repurchases had
very different tax consequences.
The dividends that investors received were generally taxed
at ordinary income tax rates.
On the other hand, when firms repurchased shares, the
taxes triggered by that type of payout were generally
much lower.
Shareholders who did not participate did not owe any taxes.
Shareholders who did participate in the repurchase program
might not owe any taxes on the funds they received if they
were tax-exempt institutions, or if they sold their shares at a
loss.
Shareholders who participated in the repurchase program and
sold their shares for a profit only paid taxes at the (usually
lower) capital gains tax rate, and even that tax only applied to
the gain, not to the entire value of the shares repurchased.
Pearson Education Limited, 2015.

14-20

The Mechanics of Payout Policy: Tax


Treatment of Dividends and Repurchases
The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly
changed the tax treatment of corporate dividends for most taxpayers.
The act reduced the tax rate on corporate dividends for most
taxpayers to the tax rate applicable to capital gains, which is a
maximum rate of 5 percent to 15 percent, depending on the
taxpayers tax bracket.
This change significantly diminishes the degree of double taxation of
dividends, which results when the corporation is first taxed on its
income and then when the investor who receives the dividend is also
taxed on it.
After-tax cash flow to dividend recipients is much greater at the lower
applicable tax rate; the result is noticeably higher dividend payouts
by corporations today than prior to passage of the 2003 legislation.
The American Taxpayer Relief Act of 2012, extended the 15% rate on
capital gains and dividends for taxpayers in all but the highest tax
bracket.

Pearson Education Limited, 2015.

14-21

Focus on Practice
Capital Gains and Dividend Tax Treatment Extended to 2012
and Beyond for Some
Prior to 2003, dividends were taxed once as part of corporate
earnings, and again as the personal income of the investor, in both
cases with a potential top rate of 35%. The result was an effective
tax rate of 57.75% on some dividends.
Though the 2003 tax law did not completely eliminate the double
taxation of dividends, it reduced the maximum possible effect of the
double taxation of dividends to 44.75%. For taxpayers in the lower
tax brackets, the combined effect was a maximum of 38.25%.
The American Taxpayer Relief Act of 2012 extended the 15% rate
for taxpayers in the 25, 28, 33, and 35% income tax brackets.
However, individuals making more than $400,000 and couples
earning more than $450,000 will now pay 20% on capital gain and
dividends.
How might the expected future reappearance of higher tax rates on
individuals receiving dividends affect corporate dividend payout
policies?

Pearson Education Limited, 2015.

14-22

Personal Finance Example


The board of directors of Espinoza Industries, Inc., on
October 4 of the current year, declared a quarterly
dividend of $0.46 per share payable to all holders of
record on Friday, October 30. They set a payment
date of November 19. Rob and Kate Heckman, who
purchased 500 shares of Espinozas common stock on
Thursday, October 15, wish to determine whether
they will receive the recently declared dividend and, if
so, when and how much they would net after taxes
from the dividend given that the dividends would be
subject to a 15% federal income tax.

Pearson Education Limited, 2015.

14-23

Personal Finance Example (cont.)


Given the Friday, October 30 date of record, the stock would
begin selling ex dividend 2 business days earlier on Wednesday,
October 28. Purchasers of the stock on or before Tuesday,
October 27, would receive the right to the dividend. Because the
Heckmans purchased the stock on October 15, they would be
eligible to receive the dividend of $0.46 per share.
Thus, the Heckmans will receive $230 in dividends
($0.46 per share 500 shares), which will be mailed to them
on the November 19 payment date.
Because they are subject to a 15% federal income tax on the
dividends, the Heckmans will net $195.50 [(1 0.15) $230]
after taxes from the Espinoza Industries dividend.

Pearson Education Limited, 2015.

14-24

The Mechanics of Payout Policy: Dividend


Reinvestment Plans
Dividend reinvestment plans (DRIPs) are plans
that enable stockholders to use dividends received on
the firms stock to acquire additional shareseven
fractional sharesat little or no transaction cost.
Some companies even allow investors to make their initial
purchases of the firms stock directly from the company
without going through a broker.
With DRIPs, plan participants typically can acquire shares
at about 5 percent below the prevailing market price.

Pearson Education Limited, 2015.

14-25

The Mechanics of Payout Policy: Stock


Price Reactions to Corporate Payouts
What happens to the stock price when a firm pays a
dividend or repurchases shares?
In theory, when a stock begins trading ex dividend, the
stock price should fall by exactly the amount of the
dividend.
In theory, when a firm buys back shares at the going
market price, the market price of the stock should remain
the same.
In practice, taxes and a variety of other market
imperfections may cause the actual change in share price
in response to a dividend payment or share repurchase to
deviate from what we expect in theory.

Pearson Education Limited, 2015.

14-26

Relevance of Payout Policy


The financial literature has reported numerous theories
and empirical findings concerning payout policy.
Although this research provides some interesting
insights about payout policy, capital budgeting and
capital structure decisions are generally considered far
more important than payout decisions.
In other words, firms should not sacrifice good
investment and financing decisions for a payout policy
of questionable importance.
The most important question about payout policy is
this: Does payout policy have a significant effect on
the value of a firm?

Pearson Education Limited, 2015.

14-27

Relevance of Payout Policy:


Residual Theory of Dividends
The residual theory of dividends is a school of
thought that suggests that the dividend paid by a firm
should be viewed as a residualthe amount left over
after all acceptable investment opportunities have
been undertaken.

Pearson Education Limited, 2015.

14-28

Relevance of Payout Policy: Residual


Theory of Dividends (cont.)
Using the residual theory of dividends, the firm would
treat the dividend decision in three steps, as follows:
Determine its optimal level of capital expenditures, which
would be the level that exploits all of a firms positive NPV
projects.
Using the optimal capital structure proportions, estimate the
total amount of equity financing needed to support the
expenditures generated in Step 1.
Because the cost of retained earnings, rr, is less than the cost
of new common stock, rn, use retained earnings to meet the
equity requirement determined 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 amountthe residualas dividends.

Pearson Education Limited, 2015.

14-29

Relevance of Payout Policy:


The Dividend Irrelevance Theory
The dividend irrelevance theory is Miller and
Modiglianis theory that in a perfect world, the firms
value is determined solely by the earning power and
risk of its assets (investments) and that the manner
in which it splits its earnings stream between
dividends and internally retained (and reinvested)
funds does not affect this value.
In a perfect world (certainty, no taxes, no transactions
costs, and no other market imperfections), the value of the
firm is unaffected by the distribution of dividends.
Of course, real markets do not satisfy the perfect
markets assumptions of Modigliani and Millers original
theory.
Pearson Education Limited, 2015.

14-30

Relevance of Payout Policy:


The Dividend Irrelevance Theory (cont.)
The clientele effect is the argument that different
payout policies attract different types of investors but
still do not change the value of the firm.
Tax-exempt investors may invest more heavily in firms that
pay dividends because they are not affected by the
typically higher tax rates on dividends.
Investors who would have to pay higher taxes on dividends
may prefer to invest in firms that retain more earnings
rather than paying dividends.
If a firm changes its payout policy, the value of the firm
will not changewhat will change is the type of investor
who holds the firms shares.

Pearson Education Limited, 2015.

14-31

Relevance of Payout Policy:


Arguments for Dividend Relevance
Dividend relevance theory is the theory,
advanced by Gordon and Lintner, that there is a
direct relationship between a firms dividend policy
and its market value.
The bird-in-the-hand argument is the belief, in
support of dividend relevance theory, that investors
see current dividends as less risky than future
dividends or capital gains.

Pearson Education Limited, 2015.

14-32

Relevance of Payout Policy: Arguments


for Dividend Relevance (cont.)
Studies have shown that large changes in dividends
do affect share price.
Informational content is the information provided by the
dividends of a firm with respect to future earnings, which
causes owners to bid up or down the price of the firms
stock.
The agency cost theory says that a firm that commits to
paying dividends is reassuring shareholders that managers
will not waste their money.
Although many other arguments related to dividend
relevance have been put forward, empirical studies have
not provided evidence that conclusively settles the debate
about whether and how payout policy affects firm value.

Pearson Education Limited, 2015.

14-33

Factors Affecting Dividend Policy


Dividend policy represents the firms plan of action
to be followed whenever it makes a dividend decision.
First consider five factors in establishing a dividend
policy:
1.
2.
3.
4.
5.

legal constraints
contractual constraints
the firms growth prospects
owner considerations
market considerations

Pearson Education Limited, 2015.

14-34

Factors Affecting Dividend Policy: Legal


Constraints
Most states prohibit corporations from paying out as
cash dividends any portion of the firms 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 common 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.

Pearson Education Limited, 2015.

14-35

Factors Affecting Dividend Policy:


Legal Constraints (cont.)
In states where the firms legal capital is defined as the par
value of its common stock, Miller Flour Company could pay out
$340,000 ($200,000 + $140,000) in cash dividends without
impairing its capital. In states where the firms legal capital
includes all paid-in capital, the firm could pay out only
$140,000 in dividends.

Pearson Education Limited, 2015.

14-36

Factors Affecting Dividend Policy: Legal


Constraints (cont.)
If a firm has overdue liabilities or is legally insolvent
or bankrupt, most states prohibit its payment of
cash dividends.
In addition, the Internal Revenue Service prohibits
firms from accumulating earnings to reduce the
owners taxes.
The excess earnings accumulation tax is the tax the
IRS levies on retained earnings above $250,000 for most
businesses when it determines that the firm has
accumulated an excess of earnings to allow owners to
delay paying ordinary income taxes on dividends received.

Pearson Education Limited, 2015.

14-37

Factors Affecting Dividend Policy:


Contractual Constraints
Often the firms ability to pay cash dividends is
constrained by restrictive provisions in a loan
agreement.
Generally, these constraints prohibit the payment of
cash dividends until the firm achieves a certain level
of earnings, 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 firms insolvency.

Pearson Education Limited, 2015.

14-38

Factors Affecting Dividend Policy: Growth


Prospects
A growth firm is likely to have to depend heavily on
internal financing through retained earnings, so it is
likely to pay out only a very small percentage 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.

Pearson Education Limited, 2015.

14-39

Factors Affecting Dividend Policy: Owner


Considerations
Tax status of a firms owners:
If a firm has a large percentage of wealthy stockholders who
have sizable incomes, 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.

Owners investment opportunities:


If it appears that the owners have better opportunities
externally, the firm should pay out a higher percentage of its
earnings.

Potential dilution of ownership:


If a firm pays out a high percentage of earnings, new equity
capital will have to be raised with common stock. The result
of a new stock issue may be dilution of both control and
earnings for the existing owners.
Pearson Education Limited, 2015.

14-40

Factors Affecting Dividend Policy: Market


Considerations
Catering theory is a theory that says firms cater to
the preferences of investors, initiating or increasing
dividend payments during periods in which highdividend stocks are particularly appealing to investors.

Pearson Education Limited, 2015.

14-41

Types of Dividend Policies: ConstantPayout-Ratio Dividend Policy


A firms dividend payout ratio indicates the
percentage of each dollar earned that a firm
distributes to the owners in the form of cash. It is
calculated by dividing the firms cash dividend per
share by its earnings per share.
A constant-payout-ratio dividend policy is a
dividend policy based on the payment of a certain
percentage of earnings to owners in each dividend
period.

Pearson Education Limited, 2015.

14-42

Types of Dividend Policies: ConstantPayout-Ratio Dividend Policy (cont.)


Peachtree Industries, a miner of potassium, has a
policy of paying out 40% of earnings in cash dividends.
In periods when a loss occurs, the firms policy is to
pay no cash dividends.

Pearson Education Limited, 2015.

14-43

Types of Dividend Policies:


Regular Dividend Policy
Regular dividend policy is a dividend policy based
on the payment of a fixed-dollar dividend in each
period.
A regular dividend policy is often build around a
target dividend-payout ratio, which is a dividend
policy under which the firm attempts to pay out a
certain percentage of earnings as a stated dollar
dividend and adjusts that dividend toward a target
payout as proven earnings increases occur.

Pearson Education Limited, 2015.

14-44

Types of Dividend Policies:


Regular Dividend Policy (cont.)
The dividend policy
of Woodward
Laboratories, a
producer of a popular
artificial sweetener,
is to pay dividends of
$1.00 per share until
per-share earnings
have exceeded $4.00
for 3 consecutive
years. At that point,
the annual dividend
is raised to $1.50 per
share, and a new
earnings plateau is
established.
Pearson Education Limited, 2015.

14-45

Types of Dividend Policies:


Low-Regular-and-Extra Dividend Policy
A low-regular-and-extra dividend policy is a
dividend policy based on paying a low regular
dividend, supplemented by an additional (extra)
dividend when earnings are higher than normal in a
given period.
An extra dividend is an additional dividend
optionally paid by the firm when earnings are
higher than normal in a given period.

Pearson Education Limited, 2015.

14-46

Other Forms of Dividends


A stock dividend is the payment, to existing owners,
of a dividend in the form of stock.
In a stock dividend, investors simply receive additional
shares in proportion to the shares they already own.
No cash is distributed, and no real value is transferred
from the firm to investors.
Instead, because the number of outstanding shares
increases, the stock price declines roughly in line with the
amount of the stock dividend.
In an accounting sense, the payment of a stock dividend is
a shifting of funds between stockholders equity accounts
rather than an outflow of funds.

Pearson Education Limited, 2015.

14-47

Other Forms of Dividends (cont.)


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

Pearson Education Limited, 2015.

14-48

Other Forms of Dividends (cont.)


Garrison declares a 10% stock dividend when the
market price of its stock is $15 per share. The
resulting account balances are as follows:
Preferred stock
$300,000
Common stock (110,000 shares @ $4 par) 440,000
Paid-in capital in excess of par
710,000
Retained earnings
550,000
Total stockholders equity
$2,000,000

Pearson Education Limited, 2015.

14-49

Other Forms of Dividends (cont.)


Ms. X owned 10,000 shares of Garrison Corporations stock.
The companys 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% of the firms stock,
which was selling for $15 per share.
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. Xs holdings is $150,000 (11,000 shares $13.64 per
share).
The future earnings per share drops to $2.

Pearson Education Limited, 2015.

14-50

Other Forms of Dividends (cont.)


A stock split is a method commonly used to lower
the market price of a firms stock by increasing the
number of shares belonging to each shareholder.
Stock splits are often made prior to issuing additional stock
to enhance that stocks marketability and stimulate market
activity.
It is not unusual for a stock split to cause a slight increase
in the market value of the stock, attributable to its
informational content and to the fact that total dividends
paid commonly increases slightly after a split.
A reverse stock split is a method used to raise the
market price of a firms stock by exchanging a certain
number of outstanding shares for one new share.

Pearson Education Limited, 2015.

14-51

Other Forms of Dividends (cont.)


Delphi Company, a forest products concern, had
200,000 shares of $2-par-value common stock and no
preferred stock outstanding. Because the stock is
selling for a high market price, the firm declared a 2for-1 stock split.

Pearson Education Limited, 2015.

14-52

Personal Finance Example


Shakira Washington, a single investor in the 25%
federal income tax bracket, owns 260 shares of
Advanced Technology, Inc., common stock. She
originally bought the stock 2 years ago at its initial
public offering (IPO) price of $9 per share. The stock of
this fast-growing technology company is currently
trading for $60 per share, so the current value of her
Advanced Technology stock is $15,600
(260 shares $60 per share). Because the firms board
believes that the stock would trade more actively in the
$20 to $30 price range, it just announced a 3-for-1
stock split. Shakira wishes to determine the impact of
the stock split on her holdings and taxes.

Pearson Education Limited, 2015.

14-53

Personal Finance Example (cont.)


Because the stock will split 3 for 1, after the split
Shakira will own 780 shares (3 260 shares).
She should expect the market price of the stock to
drop to $20 (1/3 $60) immediately after the split;
the value of her after-split holding will be $15,600
(780 shares $20 per share).
Because the $15,600 value of her after-split
holdings in Advanced Technology stock exactly
equals the before-split value of $15,600, Shakira
has experienced neither a gain nor a loss on the
stock as a result of the 3-for-1 split.
Shakira has experienced neither a gain nor a loss
on the stock as a result of the 3-for-1 split.
Pearson Education Limited, 2015.

14-54

Review of Learning Goals


LG1

Understand cash payout procedures, their tax


treatment, and the role of dividend
reinvestment plans.
The board of directors makes the cash payout decision
and, for dividends, establishes the record and
payment dates. As a result of a tax-law change in
2003, most taxpayers pay taxes on corporate
dividends at a maximum rate of 5 percent to 15
percent, depending on the taxpayers tax bracket.
Some firms offer dividend reinvestment plans that
allow stockholders to acquire shares in lieu of cash
dividends.

Pearson Education Limited, 2015.

14-55

Review of Learning Goals (cont.)


LG2

Describe the residual theory of dividends and the


key arguments with regard to dividend irrelevance
and relevance.
The residual theory suggests that dividends should be
viewed as the earnings left after all acceptable investment
opportunities have been undertaken. Miller and Modigliani
argue in favor of dividend irrelevance, using a perfect
world wherein information content and clientele effects
exist. Gordon and Lintner advance the theory of dividend
relevance, basing their argument on the uncertaintyreducing effect of dividends, supported by their bird-inthe-hand argument. Empirical studies fail to provide clear
support of dividend relevance. Even so, the actions of
financial managers and stockholders tend to support the
belief that dividend policy does affect stock value.

Pearson Education Limited, 2015.

14-56

Review of Learning Goals (cont.)


LG3

Discuss the key factors involved in establishing a


dividend policy.
A firms dividend policy should provide for sufficient
financing and maximize stockholders wealth. Dividend
policy is affected by legal and contractual constraints,
by growth prospects, and by owner and market
considerations. Growth prospects affect the relative
importance of retaining earnings rather than paying
them out in dividends. The tax status of owners, the
owners investment opportunities, and the potential
dilution of ownership are important owner
considerations. Finally, market considerations are
related to the stockholders preference for the
continuous payment of fixed or increasing streams of
dividends.

Pearson Education Limited, 2015.

14-57

Review of Learning Goals (cont.)


LG4

Review and evaluate the three basic types of


dividend policies.
With a constant-payout-ratio dividend policy, the firm
pays a fixed percentage of earnings to the owners
each period; dividends move up and down with
earnings, and no dividend is paid when a loss occurs.
Under a regular dividend policy, the firm pays a fixeddollar dividend each period; it increases the amount of
dividends only after a proven increase in earnings.
The low-regular-and-extra dividend policy is similar to
the regular dividend policy, except that it pays an
extra dividend when the firms earnings are higher
than normal.

Pearson Education Limited, 2015.

14-58

Review of Learning Goals (cont.)


LG5

Evaluate stock dividends from accounting,


shareholder, and company points of view.
Firms may pay stock dividends as a replacement for
or supplement to cash dividends. The payment of
stock dividends involves a shifting of funds between
capital accounts rather than an outflow of funds.
Stock dividends do not change the market value of
stockholders holdings, proportion of ownership, or
share of total earnings. Therefore stock dividends are
usually nontaxable. However, stock dividends may
satisfy owners and enable the firm to preserve its
market value without having to use cash.

Pearson Education Limited, 2015.

14-59

Review of Learning Goals (cont.)


LG6

Explain stock splits and the firms motivation for


undertaking them.
Stock splits are used to enhance trading activity of a
firms shares by lowering or raising their market price.
A stock split merely involves accounting adjustments;
it has no effect on the firms cash or on its capital
structure and is usually nontaxable.
To retire outstanding shares, firms can repurchase
stock in lieu of paying a cash dividend. Reducing the
number of outstanding shares increases earnings per
share and the market price per share. Stock
repurchases also defer the tax payments of
stockholders.

Pearson Education Limited, 2015.

14-60

Chapter Resources on MyFinanceLab


Chapter Cases
Group Exercises
Critical Thinking Problems

Pearson Education Limited, 2015.

14-61

Integrative Case:
OGrady Apparel Company
OGrady Apparel Company is a small manufacturer of fabrics and
clothing. In 2015, the LA based company experienced sharp
increases in domestic and European sales. European sales
represented 3% in 2010 and increased to 29% in 2015.
Management expects sales and earnings per share to continue to
increase in 2016.

Pearson Education Limited, 2015.

14-62

Integrative Case:
OGrady Apparel Company (cont.)
The corporate
treasurer, Margaret
Jennings, has been
presented with
several competing
investment
opportunities by
division and product
managers. However,
funds are limited
and Jennings must
choose among the
investments.

Pearson Education Limited, 2015.

14-63

Integrative Case:
OGrady Apparel Company (cont.)
Management has set a policy of maintaining the current capital
structure proportions of 25% long-term debt, 10% preferred
stock, and 65% common stock equity for at least the next 3
years. In addition, it plans to keep paying out 40% of its
earnings as dividends.

Pearson Education Limited, 2015.

14-64

Integrative Case:
OGrady Apparel Company (cont.)
a.

Over the relevant ranges noted in the following


table, calculate the after-tax cost of each source
of financing needed to complete the table.

Pearson Education Limited, 2015.

14-65

Integrative Case:
OGrady Apparel Company (cont.)
b.

(1) Determine the break point associated with common equity. A


break point represents the total amount of financing that a firm can
raise before it triggers an increase in the cost of a particular
financing source. For example, OGrady plans to use 25% long-term
debt in its capital structure. So, for every $1 in debt that the firm
uses, it will use $3 from other financing sources (total financing is
then $4, and because $1 comes from long-term debt, its share in
the total is the desired 25%). From Table 3, we can see that after
the firm raises $700,000 in long-term debt, the cost of this
financing source begins to rise. Therefore, the firm can raise total
capital of $2,8 million before the cost of debt will rise ($700,000 in
debt plus $2.1 million in other sources to maintain the 25%
proportion for the debt), and $2.8 is the break point for debt. If the
firm wants to maintain a capital structure with 25% long-term debt
and it also wants to raise more than $2.8 million in total financing,
it will require more than $700,000 in long-term debt, and it will
trigger the higher cost of the additional debt beyond $700,000.

Pearson Education Limited, 2015.

14-66

Integrative Case:
OGrady Apparel Company (cont.)
b.

(2) Using the break points developed in part (1), determine


each of the ranges of total new financing over which the
firms weighted average cost of capital (WACC) remains
constant.
(3) Calculate the weighted average cost of capital for each
range of total new financing. Draw a graph with the WACC
on the vertical axis and total money raised on the horizontal
axis, and show how the firms WACC increases in steps as
the amount of money raised increases.

Pearson Education Limited, 2015.

14-67

Integrative Case:
OGrady Apparel Company (cont.)
c.

(1) Sort the investment opportunities described in Table 2


from highest to lowest return, and plot a line on the graph
you drew in part (3) above showing how much money is
required to fund the investments, starting with the highest
return and going to the lowest. In the words, this line will
plot the relationship between the IRR on the firms
investments and the total financing required to undertake
those investments.
(2) Which, if any, of the available investments would you
recommend that the firm accept? Explain your answer.

Pearson Education Limited, 2015.

14-68

Integrative Case:
OGrady Apparel Company (cont.)
d.

(1) Assuming that the specific financing costs do not


change, what effect would a shift to a more highly
leveraged capital structure consisting of 50% long-term
debt, 10% preferred stock, and 40% common stock have
on your previous findings? (Note: Rework parts b and c
using these capital structure weights.)
(2) Which capital structurethe original one or this one
seems better? Why?

Pearson Education Limited, 2015.

14-69

Integrative Case:
OGrady Apparel Company (cont.)
e. (1) What type of dividend policy does the firm appear to
employ? Does it seem appropriate given the firms recent
growth in sales and profits and given its current investment
opportunities?
(2) Would you recommend an alternative dividend policy? Explain.
How would this policy affect the investments recommended in part
c(2)?

Pearson Education Limited, 2015.

14-70