Course : FINC6001

Effective Period : September2019

Dividend, Dividend Policy

Session 17
Sub Title Template (Optional)
 Acknowledgement

If you are using PowerPoint from textbook, please use this

slide to give information about the source of the slides.

Example:

These slides have been adapted from:

Gitman, (2019), Principle of Managerial Finance, ISBN978-1-
292-26151-5, chapter 14, page 652-690

Leach, J Chris. (2018). Entrepreneurial FInance, Cengage.

USA. ISBN: 978-9-814-83456-8

Chapter
Dear Lecturers and Students: please use Gitman
chapter 14 for exercise

Dear Lecturers: Due to a lot of materials for this

session, please use materials in this pptx accordingly
 Principles of Managerial Finance
Fifteenth Edition, Global Edition

Chapter 14
Payout Policy

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

 Learning Goals (1 of 2)

LG 1 Understand cash payout procedures, their tax treatment, and

the role of dividend reinvestment plans.
LG 2 Describe the residual theory of dividends and the key
arguments with regard to dividend irrelevance and
relevance.
LG 3 Discuss the key factors involved in establishing a dividend
policy.
LG 4 Review and evaluate the three basic types of dividend policies.
LG 5 Evaluate stock dividends from accounting, shareholder, and
company points Learning
of view. Goals (2 of 2)
LG 6 Explain stock splits and the firm’s motivation for undertaking
them.
 14.1 The Basics of Payout Policy (1 of 4)

• Elements of Payout Policy

– Payout Policy
• 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
– Elements of Payout Policy
• When we observe the decisions that companies make regarding payouts to
shareholders, some common patterns emerge:
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. Firms can make cash payouts through dividends or share
repurchase
4. When business conditions are weak, firms are more willing to
reduce share buybacks than to cut dividends
 14.1 The Basics of Payout Policy (2 of 4)

• Trends in Earnings and Dividends

– Over the long term the earnings and dividends
lines tend to move together
– Earnings are much more volatile than dividends
– The effect of the most recent recession on both
corporate earnings and dividends was large by
historical standards
Figure 14.1 Per-Share Earnings and
Dividends of the S&P 500 Index
P&G’s Dividend History
Few companies have Matter of Fact
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 through 2017.
 14.1 The Basics of Payout Policy (3 of 4)

• Trends in Dividends and Share Repurchases

– In the 1980s, share repurchases began to grow
rapidly and then slowed again in the early 1990s
• The value of aggregate share repurchases first
eclipsed total dividend payments in 2006
– Whereas aggregate dividends have risen smoothly
over time, share repurchases display much more
volatility
 14.1 The Basics of Payout Policy (4 of 4)

• Trends in Dividends and Share Repurchases

– Conclusions
• Firms exhibit a strong desire to maintain modest,
steady growth in dividends that is roughly
consistent with the long-run growth in earnings
• Share repurchases have accounted for a growing
fraction of total cash payouts over time
• When earnings fluctuate, firms adjust their short-
term payouts primarily by adjusting share
repurchases (rather than dividends), cutting
buybacks during recessions, and increasing them
rapidly during economic expansions
 Figure 14.2 Aggregate Dividends and
Repurchases for All U.S. Publicly Listed Companies
 Matter of Fact

Share Repurchases Gain Worldwide Popularity

The growing importance of share repurchases in
corporate payout policy is not confined to the
United States. 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 study of payout policy at firms from 25 different
countries found that share repurchases rose at an
annual rate of 19% from 1999 through 2008.
 14.2 The Mechanics of Payout Policy
(1 of 9)

• 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
Figure 14.3 U.S. Publicly Listed Companies
Maintaining, Increasing, or Decreasing
Dividends
 14.2 The Mechanics of Payout Policy
(2 of 9)

• Cash Dividend Payment Procedures

– Date of Record (Dividends)
• 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
– Ex Dividend
• A period usually beginning 2 business days
prior to the date of record, during which a stock
is sold without the right to receive the current
dividend
– Payment Date
• Set by the firm’s directors, the actual date on
which the firm mails the dividend payment to
the holders of record
 14.2 The Mechanics of Payout Policy
(3 of 9)

• Cash Dividend Payment Procedures

– Holders of Record
• All persons whose names are recorded as
stockholders on the date of record
 Example 14.1 (1 of 3)

On April 17, 2017, the board of directors of Whirlpool

announced that the firm’s next quarterly cash dividend would
be $1.10 per share, payable on June 15, 2017, to shareholders
of record on Friday, May 19, 2017. Whirlpool shares would
begin trading ex dividend on the previous Wednesday, May 17.
At the time of the announcement, Whirlpool had about 74
million shares of common stock outstanding, so the total
dividend payment would be $81.4 million. Figure 14.4 shows a
timeline depicting the key dates relative to the Whirlpool
dividend.
 Example 14.1 (2 of 3)

Before the dividend was declared, the key accounts of the firm were
as follows (dollar values quoted in thousands):
Cash $951,000 Dividends payable $0
Blank Blank Retained earnings $7,394,000

When the dividend was announced by the directors, $81.4 million of

the retained earnings ($1.10 per share × 74 million shares) was
transferred to the dividends payable account. The key accounts
thus became

Cash $951,000 Dividends payable $81,400

Blank Blank Retained earnings $7,312,600
 Example 14.1 (3 of 3)

When Whirlpool actually paid the dividend on June 15, this

produced the following balances in the key accounts of the
firm:
Cash $869,600 Dividends payable $0
Blank Blank Retained earnings $7,312,600

The net effect of declaring and paying the dividend was to

reduce the firm’s total assets (and stockholders’ equity) by
almost $81.4 million.
Figure 14.4 Dividend Payment
Timeline
 14.2 The Mechanics of Payout Policy
(4 of 9)

• Share Purchase Procedures

– Open-market Share Repurchase
• A share repurchase program in which firms simply
buy back some of their outstanding shares on the
open market
– Tender Offer Share Repurchase
• 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
 14.2 The Mechanics of Payout Policy
(5 of 9)

• Share Purchase Procedures

– Dutch Auction Share Repurchase
• 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
 Example 14.2 (1 of 2)

In June 2017, Lifeway Foods announced a Dutch auction

repurchase for 6 million common shares at prices ranging from
$8.50 to $9.50 per share. Lifeway shareholders were instructed
to contact the company to indicate how many shares they would
be willing to sell at different prices in this range. Suppose that
after accumulating this information from investors, Lifeway
constructed the following demand schedule:

Offer price Shares tendered Cumulative total

$8.50 1,000,000 1,000,000
8.75 1,500,000 2,500,000
9.00 3,500,000 6,000,000
9.25 4,000,000 10,000,000
9.50 4,500,000 14,500,000
 Example 14.2 (2 of 2)

At a price of $9, shareholders are willing to tender a total of 6

million shares, exactly the amount that Lifeway wants to
repurchase. Each shareholder who expressed a willingness to
tender shares at a price of $9 or less receives $9, and Lifeway
repurchases all 6 million shares at a cost of roughly $54
million.
 14.2 The Mechanics of Payout Policy
(6 of 9)

• 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
– When firms repurchased shares, the taxes triggered by that
type of payout were generally much lower
– The Jobs and Growth Tax Relief Reconciliation Act of 2003
significantly changed the tax treatment of corporate
dividends for most taxpayers
 14.2 The Mechanics of Payout Policy
(7 of 9)

• Tax Treatment of Dividends and Repurchases

– The 2003 act reduced the tax rate on corporate dividends for
most taxpayers to the tax rate applicable to capital gains,
which was a maximum rate of 15%
– Under current tax law, stockholders face tax rates on
dividends and capital gains as low as 0% or as high as 23.8%,
depending on their income level
 Personal Finance Example 14.3 (1 of 2

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 26, with 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.
 Personal Finance Example 14.3 (2 of 2)

Given the Friday, October 26, date of record, the stock

would begin selling ex dividend 2 business days earlier
on Wednesday, October 24. Purchasers of the stock on
or before Tuesday, October 23, 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.
 14.2 The Mechanics of Payout Policy
(8 of 9)

• Dividend Reinvestment Plans (DRIPs)

– 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
 14.2 The Mechanics of Payout Policy
(9 of 9)

• 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
 14.3 Relevance of Payout Policy (1 of 5)

• Residual Theory of Dividends

– A school of thought suggesting that the dividend
paid by a firm should be viewed as a residual, that
is, the amount left over after all acceptable
investment opportunities have been undertaken
 14.3 Relevance of Payout Policy (2 of 5)
• Residual Theory of Dividends
– Using this residual approach, the firm would treat the
dividend decision in three steps, as follows:
• Step 1: Determine its optimal level of capital expenditures, which
would be the level that exploits all a firm’s positive NPV projects
• Step 2: Using the optimal capital structure proportions, estimate
the total amount of equity financing needed to support the
expenditures generated in Step 1
• Step 3: 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
 14.3 Relevance of Payout Policy (3 of 5)

• The Dividend Irrelevance Theory

– 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
– Clientele Effect
• The argument that different payout policies attract
different types of investors but still do not change the
value of the firm
 14.3 Relevance of Payout Policy (4 of 5)

• Arguments for Dividend Relevance

– Dividend Relevance Theory
• The theory, advanced by Gordon and Lintner, that
there is a direct relationship between a firm’s dividend
policy and its market value
– Bird-in-the-Hand Argument
• The belief, in support of dividend relevance theory,
that investors see current dividends as less risky than
future dividends or capital gains
– Information Content
• 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
 14.3 Relevance of Payout Policy (5 of 5)

• Arguments for Dividend Relevance

– Agency Cost Theory
• The agency cost theory says that a firm that
commits to paying dividends is reassuring
shareholders that managers will not waste their
money
• Given this reassurance, investors will pay higher
prices for firms promising regular dividend
payments
 14.4 Factors Affecting Dividend Policy
(1 of 6)

• Dividend Policy
– The plan of action to be followed whenever the firm
makes a dividend decision
• 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
– Excess Earnings Accumulation Tax
• 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
 Example 14.4

The stockholders’ equity account of Miller Flour Company, a

large grain processor, is presented in the following table.
Miller Flour Company Blank
Stockholders’ Equity Blank
Common stock at par $100,000
Paid-in capital in excess of par 200,000
Retained earnings 140,000
Total stockholders’ equity $440,000

In states where the firm’s legal capital is defined as the par value of its
common stock, the firm could pay out $340,000 ($200,000 + $140,000) in
cash dividends without impairing its capital. In states where the firm’s legal
capital includes all paid-in capital, the firm could pay out only $140,000 in
cash dividends.
 Example 14.5

Assume that Miller Flour Company, from the

preceding example, in the year just ended has $30,000
in earnings available for common stock dividends. As
the table in Example 14.4 indicates, the firm has past
retained earnings of $140,000. Thus, it can legally pay
dividends of up to $170,000.
 14.4 Factors Affecting Dividend Policy
(2 of 6)

• 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
 14.4 Factors Affecting Dividend Policy
(3 of 6)

• Growth Prospects
– The firm’s financial requirements are directly related to how
much it expects to grow and what assets it will need to
acquire
– A growth firm likely has 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
 14.4 Factors Affecting Dividend Policy
(4 of 6)

• Owner Considerations
– The firm must establish a policy that has a favorable effect on
the wealth of its owners
– One consideration is the 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
– A second consideration is the owners’ investment
opportunities
• A firm should not retain funds for investment in projects
yielding lower returns than the owners could obtain from
external investments of equal risk
 14.4 Factors Affecting Dividend Policy
(5 of 6)

• Owner Considerations
– A final consideration is the potential dilution of
ownership
• If a firm pays out a high percentage of earnings,
new equity capital will have to be raised with
common stock
• The result of a new stock issue may be dilution
of both control and earnings for the existing
owners
 14.4 Factors Affecting Dividend Policy
(6 of 6)

• Market Considerations
– Catering Theory
• 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
 14.5 Types of Dividend Policies (1 of 3)

• 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
• Constant-Payout-Dividend Policy
– A dividend policy based on the payment of a
certain percentage of earnings to owners in
each dividend period
 Example 14.6 (1 of 2)

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. Data on
Peachtree’s earnings, dividends, and average stock prices for the
past 6 years follow.
Year Earnings/share Dividends/share Average price/share
2019 −$0.50 $0.00 $42.00
2018 3.00 1.20 52.00
2017 1.75 0.70 48.00
2016 −1.50 0.00 38.00
2015 2.00 0.80 46.00
2014 4.50 1.80 50.00
 Example 14.6 (2 of 2)

Dividends increased in 2017 and in 2018 but decreased in the

other years. In years of decreasing dividends, the firm’s stock
price dropped; when dividends increased, the price of the
stock increased. Peachtree’s sporadic dividend payments
appear to make its owners uncertain about the returns they
can expect.
 14.5 Types of Dividend Policies (2 of 3)

• Regular Dividend Policy

– A dividend policy based on the payment of a fixed-dollar
dividend in each period
– Firms that use this policy increase the regular dividend
once a sustainable increase in earnings has occurred
– Under this policy, dividends are almost never decreased
• Target Dividend-Payout Ratio
– 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
 Example 14.7 (1 of 3)

The dividend policy of Woodward Laboratories, a

producer of a popular artificial sweetener, is to pay
annual 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. The
firm does not anticipate decreasing its dividend unless
its liquidity is in jeopardy. Data for Woodward’s
earnings, dividends, and average stock prices for the
past 12 years follow.
 Example 14.7 (2 of 3)

Year Earnings/share Dividends/share Average price/share

2019 $4.50 $1.50 $47.50
2018 3.90 1.50 46.50
2017 4.60 1.50 45.00
2016 4.20 1.00 43.00
2015 5.00 1.00 42.00
2014 2.00 1.00 38.50
2013 6.00 1.00 38.00
2012 3.00 1.00 36.00
2011 0.75 1.00 33.00
2010 0.50 1.00 33.00
2009 2.70 1.00 33.50
2008 2.85 1.00 35.00
 Example 14.7 (3 of 3)

Whatever the level of earnings, Woodward Laboratories paid

dividends of $1.00 per share through 2016. In 2017, the dividend
increased to $1.50 per share because earnings in excess of $4.00
per share had been achieved for 3 years. In 2017, the firm also had
to establish a new earnings plateau for further dividend increases.
Woodward Laboratories’ average price per share exhibited a stable,
increasing behavior in spite of a somewhat volatile pattern of
earnings.
 14.5 Types of Dividend Policies (3 of 3)

• Low-Regular-and-Extra Dividend Policy

– 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
– Extra Dividend
• An additional dividend optionally paid by the firm when
earnings are higher than normal in a given period
 14.6 Other Forms of Dividend (1 of 4)

• Stock Dividends
– The payment, to existing owners, of a dividend in the form of
stock
– Accounting Aspects
• Small (Ordinary) Stock Dividend
– A stock dividend representing less than 20% to 25% of
the common stock outstanding when the dividend is
declared
The current stockholders’ equity on the balance sheet of Garrison
Corporation, a distributorExample 14.8
of prefabricated cabinets,
(1 of 3)is as shown in
the following accounts:

Preferred stock $ 300,000

Common stock (100,000 shares at $4 par) $ 400,000

Paid-in capital in excess of par $ 600,000

Retained earnings $ 700,000

Total stockholders’ equity $2,000,000

 Example 14.8 (2 of 3)

Garrison, which has 100,000 shares of common stock outstanding,

declares a 10% stock dividend when the market price of its stock is
$15 per share. When Garrison issues 10,000 new shares (10% of
100,000) at the prevailing market price of $15 per share, it shifts
$150,000 ($15 per share × 10,000 shares) from retained earnings to
the common stock and paid-in capital accounts. Garrison adds a
total of $40,000 ($4 par × 10,000 shares) to common stock, and it
adds the remaining $110,000 [($15 − $4) × 10,000 shares] to the
paid-in capital in excess of par.
 Example 14.8 (3 of 3)

The resulting account balances are as follows:

Preferred stock $ 300,000

Common stock (110,000 shares at $4 par) $ 440,000

Paid-in capital in excess of par $ 710,000

Retained earnings $ 550,000

Total stockholders’ equity $2,000,000

The firm’s total stockholders’ equity has not changed; the company
has merely shifted funds among stockholders’ equity accounts.
 14.6 Other Forms of Dividend (2 of 4)

• Stock Dividends
– Shareholder’s Viewpoint
• The shareholder receiving a stock dividend typically
receives nothing of value
• After the firm pays the dividend, the per-share value of
the shareholder’s stock decreases in proportion to the
dividend in such a way that the market value of his or her
total holdings in the firm remains unchanged
• Therefore, stock dividends are usually nontaxable
• The shareholder’s proportion of ownership in the firm
also remains the same, and as long as the firm’s earnings
remain unchanged, so does the dollar value of his or her
share of total earning
 Example 14.9 (1 of 2)

Ms. Xu owned 10,000 shares of Garrison Corporation’s stock. The

company’s recent earnings were $220,000, and they are not expected
to change in the near future. Before the stock dividend, Ms. Xu
owned 10% (10,000 shares ÷ 100,000 shares) of the firm’s stock,
which was selling for $15 per share. Earnings per share were $2.20
($220,000 ÷ 100,000 shares). Because Ms. Xu owned 10,000 shares,
her stock represented a claim against Garrison’s earnings of $22,000
($2.20 per share × 10,000 shares). After receiving the 10% stock
dividend, Ms. Xu has 11,000 shares, which again is 10% of the
ownership (11,000 shares ÷ 110,000 shares).
 Example 14.9 (2 of 2)

The market price of the stock should drop to $14.64 per

share [$15 × (1.00 ÷ 1.10)], which means that the market
value of Ms. Xu’s holdings is $150,000 (11,000 shares ×
$14.64 per share). This is the same as the initial value of
her holdings (10,000 shares × $15 per share). The future
earnings per share drops to $2 ($220,000 ÷ 110,000
shares) because the same $220,000 in earnings must
now be divided among 110,000 shares. Because Ms. Xu
still owns 10% of the stock, her share of total earnings is
still $22,000 ($2 per share × 11,000 shares).
 14.6 Other Forms of Dividend (3 of 4)
• Stock Dividends
– The Company’s Viewpoint
• Stock dividends are more costly to issue than cash
dividends, but certain advantages may outweigh these
costs
• Firms find the stock dividend to be a way to give owners
something without having to use cash
• Generally, when a firm needs to preserve cash to finance
rapid growth, it uses a stock dividend
• When the stockholders recognize that the firm is
reinvesting the cash flow to maximize future earnings, the
market value of the firm should at least remain unchanged
• However, if the stock dividend is paid to retain cash for
satisfying past-due bills, a decline in market value may
result
 14.6 Other Forms of Dividend (4 of 4)

• Stock Splits
– A method commonly used to lower the market price of a
firm’s stock by increasing the number of shares belonging to
each shareholder
– Reverse Stock Split
• 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
 Example 14.10

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 at a high market price, the firm has declared a 2-for-
1 stock split. The total before-and after-split stockholders’ equity is
shown in the following table.

Blank

Before split After 2-for-1 split

Common stock Blank Common stock Blank
(200,000 shares at $2 par) $ 400,000 (400,000 shares at $1 par) $ 400,000
Paid-in capital in excess of par 4,000,000 Paid-in capital in excess of par 4,000,000
Retained earnings 2,000,000 Retained earnings 2,000,000
Total stockholders’ equity $6,400,000 Total stockholders’ equity $6,400,000

The insignificant effect of the stock split on the firm’s books is

obvious.
 Personal Finance Example 14.11 (1 of
2)

Shakira Washington, a single investor in the 24% 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.
 Personal Finance Example 14.11 (2 of
2)

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. Even if there were a
gain or loss attributable to the split, Shakira would not have
any tax liability unless she actually sold the stock and realized
that (or any other) gain or loss.
 Review of Learning Goals (1 of 7)
• LG 1
– 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 tax-law changes, investors pay taxes on
corporate dividends at a maximum rate of 23.8%
• Some firms offer dividend reinvestment plans that allow
stockholders to acquire shares in lieu of cash dividends
 Review of Learning Goals (2 of 7)

• LG 2
– 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 in which market imperfections such as
transaction costs and taxes do not 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
 Review of Learning Goals (3 of 7)

• LG 3
– 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
• Legal constraints prohibit corporations from paying out as
cash dividends any portion of the firm’s “legal capital,” nor
can firms with overdue liabilities and legally insolvent or
bankrupt firms pay cash dividends
• Contractual constraints result from restrictive provisions in
the firm’s loan agreements
 Review of Learning Goals (4 of 7)

• LG 3 (Cont.)
– Discuss the key factors involved in establishing a dividend
policy.
• 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
 Review of Learning Goals (5 of 7)

• LG 4
– 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
 Review of Learning Goals (6 of 7)

• LG 5
– 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
 Review of Learning Goals (7 of 7)
• LG 6
– Explain stock splits and the firm’s motivation 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
Thank you,