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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.

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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 firm’s motivation


for undertaking them.

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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.

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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.

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Figure 14.1 Per Share Earnings and
Dividends of the S&P 500 Index

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Matter of Fact
P&G’s 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
1956–2010.

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Figure 14.2 Aggregate Dividends and
Repurchases for All U.S.-Listed
Companies

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Matter of Fact

Share Repurchases Gain Worldwide Popularity


– In most of the world’s 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 1999–2008.

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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 stock’s value prior to a buyback, or do you believe
that corporations are more likely to initiate a buyback to
enhance shareholder value?

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The Mechanics of Payout Policy:
Cash Dividend Payment Procedures

• At quarterly or semiannual meetings, a firm’s


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 firm’s recent performance and its ability to
generate cash flow in the future.
• Boards rarely cut dividends unless they believe that
the firm’s ability to generate cash is in serious
jeopardy.

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Figure 14.3 U.S. Public Industrial
Firms Increasing, Decreasing, or
Maintaining Dividends

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The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

• The date of record (dividends) is set by the


firm’s 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 firm’s directors,
the actual date on which the firm mails the dividend
payment to the holders of record.

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Figure 14.4
Dividend Payment Time Line

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The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

On August 21, 2013, the board of directors of Best


Buy announced that the firm’ s 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
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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

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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 firm’s total assets (and
stockholders’ equity) by almost $58 million.

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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.

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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.
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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.

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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
taxpayer’s 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.
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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?

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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 Espinoza’s 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.

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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.

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The Mechanics of Payout Policy: Dividend
Reinvestment Plans

Dividend reinvestment plans (DRIPs) are plans


that enable stockholders to use dividends received on
the firm’ s stock to acquire additional shares—even
fractional shares—at little or no transaction cost.
– Some companies even allow investors to make their initial
purchases of the firm’s 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.

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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.

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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?
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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 residual—the amount left over
after all acceptable investment opportunities have
been undertaken.

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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 firm’s 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 amount—the
residual—as dividends.
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Relevance of Payout Policy:
The Dividend Irrelevance Theory

The dividend irrelevance theory is Miller and


Modigliani’ s theory that in a perfect world, the firm’ s
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 Miller’s original theory.

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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 change—what will change is the type of investor
who holds the firm’s shares.

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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 firm’s 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.

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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 firm’s
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.

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Factors Affecting Dividend Policy

Dividend policy represents the firm’ s plan of action


to be followed whenever it makes a dividend decision.
First consider five factors in establishing a dividend
policy:
1. legal constraints
2. contractual constraints
3. the firm’s growth prospects
4. owner considerations
5. market considerations

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Factors Affecting Dividend Policy: 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 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.

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Factors Affecting Dividend Policy:
Legal Constraints (cont.)
In states where the firm’s 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 firm’s legal capital
includes all paid-in capital, the firm could pay out only
$140,000 in dividends.

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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.

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Factors Affecting Dividend Policy:
Contractual Constraints

• Often the firm’s 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 firm’s insolvency.

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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.

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Factors Affecting Dividend Policy: Owner
Considerations

Tax status of a firm’ s 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.
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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 high-
dividend stocks are particularly appealing to
investors.

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Types of Dividend Policies: Constant-
Payout-Ratio Dividend Policy

• A firm’s 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 firm’s 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.

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Types of Dividend Policies: Constant-
Payout-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 firm’s
policy is to pay no cash dividends.

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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.

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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.

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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.

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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.

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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

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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

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Other Forms of Dividends (cont.)
Ms. X owned 10,000 shares of Garrison Corporation’ s
stock.
– The company’s 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 firm’s
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. X’s holdings is $150,000 (11,000
shares  $13.64 per share).
– The future earnings per share drops to $2.
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Other Forms of Dividends (cont.)

A stock split is a method commonly used to lower


the market price of a firm’ s stock by increasing the
number of shares belonging to each shareholder.
– Stock splits are often made prior to issuing additional stock
to enhance that stock’s 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 firm’s stock by exchanging a certain
number of outstanding shares for one new share.

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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 2-
for-1 stock split.

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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 firm’s
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.
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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.

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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 taxpayer’s tax bracket.
Some firms offer dividend reinvestment plans that
allow stockholders to acquire shares in lieu of cash
dividends.

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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 uncertainty-reducing effect of dividends,
supported by their bird-in-the-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.
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Review of Learning Goals (cont.)

LG3 Discuss the key factors involved in establishing


a dividend policy.
A firm’s 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.

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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 fixed-
dollar 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 firm’s earnings are higher
than normal.

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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.

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Review of Learning Goals (cont.)

LG6 Explain stock splits and the firm’ s motivation for


for undertaking them.
Stock splits are used to enhance trading activity of a
firm’s shares by lowering or raising their market price.
A stock split merely involves accounting adjustments;
it has no effect on the firm’s 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.

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Chapter Resources on MyFinanceLab

• Chapter Cases
• Group Exercises
• Critical Thinking Problems

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Integrative Case:
O’Grady Apparel Company
O’Grady 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.

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Integrative Case:
O’Grady 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.

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Integrative Case:
O’Grady 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.

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Integrative Case:
O’Grady 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.

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Integrative Case:
O’Grady 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, O’Grady 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.

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Integrative Case:
O’ Grady 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
firm’ s 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 firm’s WACC increases in “steps” as
the amount of money raised increases.

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Integrative Case:
O’Grady 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 firm’s
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.

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Integrative Case:
O’ Grady 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 structure—the original one or this one—
seems better? Why?

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Integrative Case:
O’ Grady Apparel Company (cont.)

e. (1) What type of dividend policy does the firm appear to


employ? Does it seem appropriate given the firm’s 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)?

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