Dividend Policy
STOCK DIVIDEND STOCK SPLIT
Meaning • Similar to cash dividends (cash dividend payed in
stock).
• Shareholders are given additional shares “freely”
(company uses the amount of money that would
be paid as a cash dividend to purchase additional
common shares for the shareholder  cash does
not leave the company).
Reason • Generally, when a firm needs to preserve cash to
finance rapid growth, it uses a stock dividend.
Effect on price • The stock price declines roughly in line with
the amount of the stock dividend.
Accounting • Transfer from retained earnings to par-value and
treatment additional paid-in capital.
• The equity account is simply increased by the
amount of shares issued to investors and
decreased by the amount of the dividend given
to each shareholder resulting in net zero effect.
Shareholders • No change in the proportional ownership
ownership represented by the shares.
• Division of existing equity shares into multiple shares.
• A stock split occurs when a company feels its stock is
overpriced (this can often occur to rapidly growing
companies)  it uses a stock split to decrease the price
of stock and bring it into a more acceptable price range
to stimulate trading activity/increase liquidity of
shares.
• Stock splits are often made prior to issuing additional
stock to enhance that stock's marketability and
stimulate market activity.
• Is similar to that of stock dividend—reduces in
proportion to the split ratio (holders of the stock will
not be disappointed by this share price drop since they
will each be receiving proportionately more shares).
• Shows as proportional reduction in the par value of the
share only while paid-up capital, retain earnings and
therefore equity share capital accounts remain
unchanged.
• No change in the proportional ownership represented
by the shares.
Problem 1
A firm has $750,000 in paid-in capital, retained earnings of $41,000 (including
the current year's earnings), and 21,000 shares of common 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
stockholder? (Assume that legal capital includes all paid-in capital.)
b. What effect would a cash dividend of $1.18 per share have on the firm's
balance 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
dividend payments?
a. "Legal capital" can be more broadly defined as the par value of common
stock and paid-in capital. Dividends in this situation can only be paid out
of retained earnings using the following formula:

�������� �������� $ 41,000

��������= = =$ 1.95
������ �� ����������� �h���� 21,000

b. A dividend payment will reduce retained earnings and cash by the same
amount. If the firm pays a cash dividend of $1.18 per share, the total
amount of dividend payment is the dividend per share times the
number of common shares outstanding, as shown in the following
formula:
Total amount of dividend payment = $1.18 × 21,000 shares =
= $24,780.
 Thus, a $24,780 decrease in cash and retained earnings is the result of
a $1.18.

c. Cash is the key constraint, because a firm cannot pay out more in
dividends than it has in cash, unless it borrows.
Problem 2
Val-U, the company, which has been earning good profits, has been paying a
dividend of $0.20 per share on its ordinary share capital in each of the last few
years. The same rate of dividend has already been announced for the year just
ended. Company has currently 1,600 million of ordinary shares outstanding
which are now trading at a market price of $6.5 per share.
At a meeting of Val-U’s board:
• the company’s Chairman suggests that, in addition to the normal dividend of
$0.20 per share, the shareholders should be rewarded with an additional
one-time special dividend exactly equal to the normal dividend.
• the CFO suggests that, instead of a special dividend, the company should
offer shareholders a 25% stock dividend (send each shareholder 1 additional
share for each 4 that the shareholder owns). The CFO says that maintaining
the same dividend rate on the increased share capital would provide better
long-term rewards for the shareholders and would have a more favourable
impact on the share price.
• the company Secretary argues that the issue of additional shares would
depress the EPS and have an adverse effect on the share price. In his view the
company should repurchase 3% of the shares at a premium of 10% to the
market price. The Company Secretary says that the receipt of a substantial
premium over the market price of their shares, and the increased EPS
resulting from reduction in the overall number of shares, would create the
best value for shareholders.
• A Non-Executive Director points out that the firm’s major shareholders are
sophisticated investors like investment trusts and, given investor rationality in
an efficient market, none of the three proposals would make any difference
to shareholder value.
With reference to the last remark by the Non-Executive Director, evaluate the
theoretical impact of each of three proposals - i.e. the special dividend, stock
dividend and stock repurchase - on the wealth of a shareholder in Val-U who is
currently owning 1,000 shares. Provide appropriate calculations, and comment
on your results.
Value of the company:
$6.5/share × 1,600 million shares = $10,400 million
Normal dividend:
$0.20/share × 1,600 million shares = $320 million 
One-time special dividend = normal dividend = $320 million

For a shareholder currently holding 1,000 shares:

the value is $6.5/share × 1,000 shares = $6,500
 OPTIONS

Special Stock Stock

dividend dividend repurchase

Current market value of the firm $6.5 × 1,600 mil = $10,400 mil
Less: special dividend paid out (320 mil)
New market capitalization 10,080 mil
Ex-dividend share price $10,080 mil / 1,600 mil = $6.3

For a shareholder who holds 1,000 shares:

New (ex-dividend) value of shares $6.3 × 1,000 = $6,300

Add: special dividend received $0.20 × 1,000 = $200
Total value $6,500
 OPTIONS

Special Stock Stock

dividend dividend repurchase

25% stock dividend:

Current market value of the firm $10,400 mil
Number of outstanding shares 1,600 mil × 1.25 = 2,000 mil
New share price $10,400 mil / 2,000 mil = $5.2

For a shareholder who holds 1,000 shares:

Number of new shares received 1,000 × 0.25 = 250

Total value $5.2 × (1,000 + 250) = $6,500
 OPTIONS

Special Stock Stock

dividend dividend repurchase

Repurchase of 3% of outstanding stock at 10% premium over the current market price
Number of shares repurchased 0.03 × 1,600 mil = 48 mil
Number of outstanding shares 1,600 mil – 48 mil = 1,552 mil
Amount paid for repurchase $6.5 × 1.10 × 48 mil = $343.2 mil

Current market value of the firm $ 10,400 mil

Less: capital paid out ($ 343.2 mil)
New market capitalization: $ 10,056.8 mil
Ex-dividend share price $10,056.8 mil / 1,552 mil = $6.48

For a shareholder who holds 1,000 shares:

Cash received for repurchase 0.03 × 1,000 × $6.5 × 1.10 = $214.5
New (ex-dividend value of shares) (1 – 0.03) × 1,000 × $6.48 = $6,285.6
Total value $6,500
• As the Non-Executive Director, has suggested,
theoretically the shareholder would indeed be
unaffected, whichever of the three proposals the
company chooses.
• But the actual share price in each case would depend on
how the market perceives the company’s announcement
and actions.
• Depending on the market reaction, the actual share
price will vary from the theoretical figures calculated
above, causing the shareholder’s holding to either gain
or lose in value.
Problem 3
A subsidiary of KMS & Co. is considering either a 50% stock dividend or a 1.5-
for-1 stock split. The company has 400,000 shares of stock outstanding selling
for $90 per share. If all other factors affecting the price of the stock remain the
same:
a. Calculate the expected market price of the stock after the stock dividend
and after the stock split.
b. If you owned ten shares of stock in the company before the stock split or
stock dividend, find the total value of your stockholding in the company
after the stock split or stock dividend.
c. What is the impact of the above exercises to your wealth?
[Total: 20 marks]
 Value of the company:
$90/share × 400,000 shares = $36 million.
If all other factors affecting the price of the stock remain the
same after the stock dividend or the stock split the value of
the firm will remain the same.

50% stock dividend:

Current market value of the firm $36 mil
New number of outstanding shares 400,000 + 400,000 × 0.5 = 600,000
New share price $36 mil / 600,000 = $60

1.5-for-1 stock split:

Current market value of the firm $36 mil
New number of outstanding shares 400,000 × 1.5 = 600,000
New share price $36 mil / 600,000 = $60
 Value of the company:
$90/share × 400,000 shares = $36 million.
For a shareholder currently holding 10 shares:
the value is $90/share × 10 shares = $900
50% stock dividend:
Number of new shares received 10 × 0.5 = 5
Total value ex-dividend $60 × (10 + 5) = $900

1.5-for-1 stock split:

Number of new shares received 10 × 0.5 = 5

Total value ex-dividend $60 × (10 + 5) = $900

No impact on the shareholders’ wealth as there is no real

cash movement out of the firm. Rather it is only accounting
cosmetics.
Problem 4
The Kenanga Company has the following shareholders’ equity account:
Common stock ($8 par value) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000

The current market price of the stock is $60 per share.

a. What will happen to this account and to the number of shares outstanding with:
i. 20 percent stock dividend?
ii. a 2-for-1 stock split?
iii. a 1-for-2 reverse stock split?
b.
i. In the absence of an informational or signalling effect, at what share price
should the common sell after the 20 percent stock dividend?
ii. What might happen if there were a signalling effect?
 OPTIONS

1-for-2
20% Stock 2-for-1 stock
reverse stock
dividend split
split

Before 20% stock dividend

Common stock
(250,000 shares at $8 par) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000

After 20% stock dividend

Common stock
(250,000 × 1.2 = 300,000 shares $8 par value) $2,400,000
Additional paid-in capital (1,600,000 + 3,000,000 – 50,000 × $8) 4,200,000
Retained earnings (8,400,000 – 50,000 shares × $60) 5,400,000
Shareholders’ equity $12,000,000
 OPTIONS

1-for-2
20% Stock 2-for-1 stock
reverse stock
dividend split
split

Before 2-for-1 stock split

Common stock
(250,000 shares at $8 par) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000

After 2-for-1 stock split

Common stock
(250,000 × 2 = 500,000 shares $4 par value) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000
 OPTIONS

1-for-2
20% Stock 2-for-1 stock
reverse stock
dividend split
split

Before 1-for-2 stock split

Common stock
(250,000 shares at $8 par) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000

After 1-for-2 stock split

Common stock
(250,000 × 0.5 = 125,000 shares $16 par value) $2,000,000
Additional paid-in capital 1,600,000
Retained earnings 8,400,000
Shareholders’ equity $12,000,000
• Before stock dividend there were 250,000 shares outstanding at
$60/share. Therefore the total value of the company was
$15,000,000 = 250,000 × $60.
• In the absence of signalling effect after the stock dividend the value
of the firm should at least remain unchanged. However, there will
be larger number of shares outstanding: 250,000 × 1.20 = 300,000.
Therefore the new stock price should be $50.
• But the actual share price in each case would depend on how the
market perceives the company’s announcement and actions
(information content/signalling):
• If the stockholders perceive that the firm is reinvesting the cash
flow to maximize future earnings, the market of the firm should
at least remain unchanged  price would be $50 or more.
• However, if the market sense that the stock dividend is paid to
retain cash for satisfying past-due bills, a decline in market
value may result  share price may fall below $50.
Problem 5
Harte Textiles, Inc., a maker of custom upholstery fabrics, is concerned about preserving
the wealth of its stockholders during a cyclic downturn in the home furnishings business.
The company has maintained a constant dividend payout of $4.00 tied to a target payout
ratio of 30%. Management is preparing a share repurchase recommendation to present
to the firm's board of directors. The following data have been gathered from the last two
years: 2018 2019
Earnings available for common stockholders $1,365,000 $1,300,000
Number of shares outstanding 121,875 121,875
Earnings per share $11.20 $10.67
Market price per share $66.08 $56.55
Price/earnings ratio 5.9 5.3

a. How many shares should the company have outstanding in 2019 if its earnings
available for common stockholders in that year are $1,300,000 and it pays a dividend of
$4.00, given that its desired payout ratio is 30%?
b. How many shares would Harte have to repurchase to have the level of shares
outstanding calculated in part a?
 a. The number of shares the firm should have outstanding is calculated using
the following formula:

�������� �������� × ������ �����

�h��������������� ������=
�������� ��� �h���

• The company's earnings available for common stockholders in 2019 are

$1,300,000 and it pays a dividend of $4.00. Given its desired payout ratio of
30%, the number of shares the firm should have outstanding is computed as
follows:
$ 1,300,000 ×0.3 $ 390,000
�h��������������� ������= = =$ 97,500
�������� ��� �h��� 4

b. To find the number of shares to repurchase, subtract the number of shares

outstanding needed from the number of shares currently outstanding:
121,875 − 97,500 = 24,375 shares. Thus, Harte would have to repurchase
24,375 shares in order to have the needed 97,500 shares outstanding.
Problem 6
The board of Wicker Home Health Care, Inc., is exploring ways to expand the number of shares
outstanding in an effort to reduce the market price per share to a level that the firm considers more
appealing to investors. The options under consideration are a 20% stock dividend and, alternatively,
a 5-for-4 stock split. At the present time, the firm's equity account and other per-share information
are given as follows:
Preferred stock $ 0
Common stock (200,000 shares @ $1 par) 200,000
Paid-in capital in excess of par 800,000
Retained earnings 1,420,000
Total Stockholders’ equity $2,420,000

Price per share $28

Earnings per share $3.30
a. Show the effect on the equity accounts and per-share data of a 20% stock dividend.
Dividend per share $1.36
b. Show the effect on the equity accounts and per-share data of a 5-for-4 stock split.
c. Which option will accomplish Wicker's goal of reducing the current stock price while maintaining
a stable level of retained earnings?
d. What legal constraints might encourage the firm to choose a stock split over a stock dividend?
a.

Before 20% stock split

Common stock (200,000 shares @ $1 par) 200,000
Paid-in capital in excess of par 800,000
Retained earnings 1,420,000
Total Stockholders’ equity $2,420,000

After 20% stock dividend

Common stock
(200,000 × 1.2 = 240,000 shares at $1 par value) $240,000
Additional paid-in capital (800,000 + 40,000 × $27) $1,880,000
Retained earnings (1,420,000 – 40,000 shares × $28) 300,000
Shareholders’ equity $2,420,000

$ 28× 200,000
��� ����� ��� �h���= =$ 23.33
240,000
b.

Before 5-for-4 stock split

Common stock (200,000 shares @ $1 par) 200,000
Paid-in capital in excess of par 800,000
Retained earnings 1,420,000
Total Stockholders’ equity $2,420,000

After 5-for-4 stock split

Common stock
(200,000 × 5/4 = 250,000 shares at $0.8 par value) $200,000
Additional paid-in capital $800,000
Retained earnings 1,420,000
Shareholders’ equity $2,420,000

$ 28× 200,000
��� ����� ��� �h���= =$ 22.4
250,000
c. The option in part b, the stock split, will accomplish the goal of reducing the
stock price while maintaining a stable level of retained earnings. A stock split
does not cause any change in retained earnings but reduces the price of the
shares in the same proportion as the split ratio.

d. The firm may be restricted in the amount of retained earnings available for
dividend payments, whether cash or stock dividends. Stock splits do not have
any impact on the firm's retained earnings.
Problem 7
Assume that XCorp has a targeted all-equity capital structure. The company
currently generates after-tax operating income of $70 mil. It is growing at 3%
per year. The reinvestment needs that are currently amount $40 mil are also
growing at the same rate of 3% per year. Company has 100 mil shares
outstanding and its cost of capital is 8%. The pay-out policy is such that XCorp
pays out all the residual cash flows as dividend each year.
Board of directors however currently is considering two scenarios:
I. Increase the current dividend 2 times.
II. Decrease the current dividend 2 times and retain the residual cash flow as
cash balance.
Assume that XCorp can issue new stock with no issuance cost to raise these
funds (i.e. its growth rate and the cost of capital are unaffected). Investigate
and comment on the impact of the above proposed scenarios on XCorp’s
existing shareholders.
���� =���� ( 1 −� ) − ������������ �����=$ 70 ��� − $ 40 ���=$ 30 ���

���� 0 (1+�) 30( 1.0 3)

����� �� �h� ����= = =$ 618 ���
(���� �� ������� − �) (0. 08 − 0.0 3)

$ 618 ���
����� ��� �h���= =$ 6.18
100 ���

$ 30 ���
�������� ��� �h���= =$ 0.3
100 ���

����� ����� ��� �h���=$ 6.18+ $ 0.3=$ 6.48

Scenario 1: XCorp Doubles Dividends Scenario 2: XCorp cuts Dividends 2
times
(It now has to raise $30 million in new
financing to cover its reinvestment needs (retains the residual
through stock issuance as borrowing is $15 million as a cash balance)
fixed)

***Value will remain the same because

the value is determined by the cashflows
generated by the company. The
cashflows would be not affected if XCorp
can issue new stock with no issuance cost
to raise these funds (i.e. its growth rate
and the cost of capital are unaffected)
Problem 8
Persistent Corp. has stable operating income of $15,000 annually. The firm is
all-equity financed, and it pays out its full operating income as dividends every
year. Assume that Persistent’s cost of capital is 15 percent, that markets are
perfect, and that there are no corporate or personal taxes.
A. What is the market value of persistent Corp.?
B. If there are 5,000 shares outstanding, what is the current price per share?
C. Persistent now decides on a one-time-only change in its dividend policy.
During the coming year, it will sell $30,000 worth of new stock and pay
$45,000 in dividends to its current shareholders. Thereafter, Persistent will
issue no more new stock and will pay $15,000 in dividends in all future
years. Assume that Persistent Corp. can issue new stock with no issuance
cost to raise these funds (i.e. its growth rate and the cost of capital are
unaffected). How many shares are to be sold and at what will be their
price?
D. Investigate and comment on the impact of the above one-time change in
dividend policy on Persistent Corp existing shareholders.
 A. $15,000 $15,000 ∞

$ 15,000
� �= =$ 100,000
0.15 *** If Persistent Corp. can issue new stock
with no issuance cost to raise these funds
(i.e. its growth rate and the cost of capital
B. are unaffected)  the value of the company
$ 100,000 will not change. Therefore, once the shares
� ������ �����= =$ 20 are issued the older shareholders value will
5,000 be only $100,000 - $30,000 = $70,000

C.
$ 70,000∗ ∗∗
����� ������� �h����= =$ 14
5,000
$ 30,000
������ �� �h���� �� �� ������= =2,143
$ 14
D.
Under current payout policy: Under one-time dividend change
Price per share $20 Price per share = $70,000/5,000 $14
Dividend = $15,000/5,000 $3 Dividend = 45,000/5,000 $9
Total value per share $23 Total value per share $23