Chapter 13

Learning Goals
Chapter 13
Dividend Policy 1. Understand cash dividend payment procedures
2. Describe the residual theory of dividends and
the key arguments with regard to dividend
irrelevance and relevance.
3. Discuss the key factors involved in
establishing a dividend policy.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-2
Learning Goals (cont.) Dividend Fundamentals
4. Review and evaluate the three basic types of • A dividend is a redistribution from earnings.
dividend policies. • Most companies maintain a dividend policy whereby they pay a
regular dividend on a quarterly basis.
5. Evaluate stock dividends from accounting,
• Some companies pay an extra dividend to reward shareholders
shareholder, and company points of view. if they’ve had a particularly good year. Many companies pay
6. Explain stock splits and stock repurchases and dividends according to a preset payout ratio, which measures
the proportion of dividends to earnings.
the firm’s motivation for undertaking each of
• Many companies have paid regular dividends for over a hundred
them. years.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-3 Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-4
Dividend Fundamentals:
Dividend Fundamentals (cont.)
Cash Dividend Payment Procedures
• Dividend growth tends to lag behind earnings growth • Date of Record: The date on which investors must own shares in
for most corporations (see next slide). order to receive the dividend payment.
• Since dividend policy is one of the factors that drives • Ex Dividend Date: Four days prior to the date of record. The
day on which a stock trades ex dividend (exclusive of dividends).
an investor’s decision to purchase a stock, most
companies announce their dividend policy and
telegraph any expected changes in policy to the public. In the financial press. Transactions in the stock on the
• Therefore, it can be seen that many companies use their ex dividend date are indicated by an “x” next to the
dividend policy to provide information not otherwise volume of transactions. In general, stock prices fall by
available to investors. an amount equal to the quarterly dividend on the ex
dividend date.
Dividend Fundamentals: Cash Dividend Dividend Fundamentals: Cash Dividend
Payment Procedures (cont.) Payment Procedures (cont.)
• Date of Record: The date on which investors must own Example

shares in order to receive the dividend payment.
At the quarterly dividend meeting on June 10th, the Rudolf
• Ex Dividend Date: Four days prior to the date of
Company board of directors declared an $0.80 cash
record. The day on which a stock trades ex dividend
dividend for holders of record on Friday, July 2 nd. The firm
(exclusive of dividends).
had 100,000 shares of stock outstanding. The payment
• Distribution Date: The day on which a dividend is (distribution) date was Monday, August 2 nd. Before the
paid (payment date) to stockholders. It is usually two meeting, the relevant accounts showed the following.
or more weeks before stockholders who owned shares
on the date of record receive their dividends.
Cash $200,000 Dividends Payable $ 0
Retained Earnings 1,000,000

When the dividend was announced by the directors, Rudolf Company’s stock began selling ex dividend 2
business days prior to the date of record, which was
$80,000 of the retained earnings ($.80/share x 100,000
Wednesday, June 30th. This date was found by subtracting
shares) was transferred to the dividends payable account. 2 days from the July 2nd date of record. Purchasers of
As a result, the key accounts changed as follows: Rudolf’s stock on Tuesday, June 29th or earlier received the
rights to the dividends; those who purchased the stock on or
Cash $200,000 Dividends Payable $ 80,000 after June 30th did not. Assuming a stable market, Rudolf’s
stock price was expected to drop by about $0.80 per share
Retained Earnings 920,000
when it began selling ex dividend on June 30th.

On August 2nd, the firm mailed dividend checks to Figure 13.1 Dividend Payment Time Line
shareholders of record as of July 20th. This produced the
following balances in the key accounts of the firm.
Cash $120,000 Dividends Payable $ 0

Retained Earnings 920,000
The net effect of the dividend payment is a reduction of the

firm’s assets (through a reduction in cash) and equity
(through a reduction in retained earnings) by a total of
$80,000 (the dividend payment).
The Relevance of Dividend Policy: The Relevance of Dividend Policy:
The Residual Theory of Dividends The Residual Theory of Dividends (cont.)
• The residual theory of dividends suggests that dividend Step 2: Using the optimal capital structure proportions,
payments should be viewed as residual—the amount left over
after all acceptable investment opportunities have been estimate the total amount of equity financing needed to
undertaken.
support the expenditures estimated in Step 1.
• Using this approach, the firm would treat the dividend decision
in three steps as follows:
Step 3: Because the cost of retained earnings is less than
Step 1: Determine the optimal level of capital new equity, use retained earnings to meet the equity
expenditures which is given by the point of intersection requirement in Step 2. If inadequate, sell new stock. If there
of the investment opportunities schedule (IOS) and is an excess of retained earnings, distribute the surplus
weighted marginal cost of capital schedule (WMCC). amount—the residual—as dividends.

The Residual Theory of Dividends (cont.) The Residual Theory of Dividends (cont.)
• In sum, this theory suggests that no cash Overbrook Industries, a manufacturer of canoes and other
dividend is paid as long as the firm’s equity small watercraft, has available from the current period’s
need is in excess of the amount of retained operations $1.8 million that can be retained or paid out in
earnings. dividends. The firm’s optimal capital structure is 30% debt
and 70% equity. Figure 13.2 depicts the firm’s WMCC
• Furthermore, it suggests that the required return
schedule along with three investment opportunity
demanded by stockholders is not influenced by
schedules (IOSs). For each IOS, the level of total new
the firm’s dividend policy—a premise that in
financing or investment determined by the point of
turn suggests that dividend policy is irrelevant. intersection of the IOS and the WMCC has been noted.

The Residual Theory of Dividends (cont.) The Residual Theory of Dividends (cont.)
Figure 13.2 WMCC and IOSs

Table 13.1 shows that if IOS1 exists, the firm will pay out
$750,000 in dividends because only $1,050,000 of the
$1,800,000 of available earnings is needed. The table
also shows the dividend payouts associated with IOS2 and
IOS3. Depending on which IOS exists, the firm’s dividend
would in effect be the residual, if any, remaining after all
acceptable investments have been financed.
The Residual Theory of Dividends (cont.) Arguments for Dividend Irrelevance
Table 13.1 Applying the Residual Theory of Dividends to • Merton Miller and Franco Modigliani (MM) developed
Overbrook Industries for Each of Three IOSs (Shown in a theory that shows that in perfect financial markets
Figure 13.2) (certainty, no taxes, no transactions costs or other
market imperfections), the value of a firm is unaffected
by the distribution of dividends.
• They argue that value is driven only by the future
earnings and risk of its investments.
• Retaining earnings or paying them in dividends does
not affect this value.

Arguments for Dividend Irrelevance (cont.) Arguments for Dividend Irrelevance (cont.)
• Some studies suggested that large dividend changes • In summary, MM and other dividend irrelevance proponents
affect stock price behavior. argue that—all else being equal—an investor’s required return,
• MM argued, however, that these effects are the result of and therefore the value of the firm, is unaffected by dividend
the information conveyed by these dividend changes, policy because:
not to the dividend itself. 1. The firm’s value is determined solely by the earning power and
• Furthermore, MM argue for the existence of a ―clientele risk of its asset investments.
effect.‖ 2. If dividends do affect value, they do so because of the
• Investors preferring dividends will purchase high information content, which signals management’s future
dividend stocks, while those preferring capital gains expectations.
will purchase low dividend paying stocks. 3. A clientele effect exists that causes shareholders to receive the
level of dividends they expect.
The Relevance of Dividend Policy: Factors Affecting Dividend Policy:

Arguments for Dividend Irrelevance (cont.) Legal Constraints
• Contrary to dividend irrelevance proponents, Gordon and • Most state securities regulations prevent firms from paying out
Lintner suggested stockholders prefer current dividends ant that dividends from any portion of the company’s ―legal capital‖
a positive relationship exists between dividends and market which is measured by the par value of common stock—or par
value. value plus paid-in-capital.
• Fundamental to this theory is the ―bird-in-the-hand‖ argument
which suggests that investors are generally risk-averse and attach • Dividends are also sometimes limited to the sum of the firm’s
less risk to current as opposed to future dividends or capital most recent and past retained earnings—although payments in
gains. excess of current earnings is usually permitted.
• Because current dividends are less risky, investors will lower • Most states also prohibit dividends when firm’s have overdue
their required return—thus boosting stock prices. liabilities, is legally insolvent, or bankrupt.
Factors Affecting Dividend Policy: Factors Affecting Dividend Policy:
Legal Constraints (cont.) Contractual Constraints
• Even the IRS has ruled in the area of dividend policy. • In many cases, companies are constrained in the extent
• Specifically, the IRS prohibits firms from acquiring earnings to to which they can pay dividends by restrictive
reduce stockholders’ taxes. provisions in loan agreements and bond indentures.
• I the IRS can determine that a firm has accumulated an excess of • Generally, these constraints prohibit the payment of
earnings to allow owners to delay paying ordinary income taxes cash dividends until a certain level of earnings are
(on dividends), it may levy an excess earnings accumulation achieved or to a certain dollar amount or percentage of
tax on any retained earnings above $250,000 for most earnings.
businesses.
• Any violation of these constraints generally trigger the
• It should be noted, however, that this ruling is seldom applied. demand for immediate payment.

Internal Constraints Growth Prospects
• A company’s ability to pay dividends is usually • Newer, rapidly-growing firms generally pay little or no
constrained by the amount of available cash rather dividends.
than the level of retained earnings against which to
• Because these firms are growing so quickly, they must
charge them.
use most of their internally generated funds to support
• Although it is possible to borrow to pay dividends, operations or finance expansion.
lenders are usually reluctant to grant them because
• On the other hand, large, mature firms generally pay
using the funds for this purpose produces not operating
cash dividends since they have access to adequate
benefits that help to repay them.
capital and may have limited investment opportunities.

Owner Considerations Owner Considerations (cont.)
• The firm must establish a policy that has a favorable • A second consideration is the owner’s investment
effect on the wealth of the majority of its owners. opportunities.
• If a firm has a large percentage of wealthy • A firm should not retain funds for investment projects yielding
shareholders, it may decide to pay out a lower lower returns that the owners could obtain from external
percentage of its earnings to allow them to delay the investments of equal risk.
payment of taxes until they sell the stock.
• A final consideration is the potential dilution of ownership.
• Because cash dividends are taxed at the same rate as
capital gains, this strategy benefits owners through tax • If a firm pays out a high percentage of earnings, new equity
deferral rather than as a result of a lower tax rate. capital will have to be raised with common stock.
Factors Affecting Dividend Policy: Types of Dividend Policies:
Market Considerations Constant-Payout-Ratio Policy
• Perhaps the most important aspect of dividend policy is that the • With a constant-payout-ratio dividend policy, the firm
firm maintain a level of predictability. establishes that a specific percentage of earnings is paid
• Stockholders that prefer dividend-paying stocks prefer a to shareholders each period.
continuous stream of fixed or increasing dividends. • A major shortcoming of this approach is that if the
• Shareholders also view the firm’s dividend payment as a firm’s earnings drop or are volatile, so too will be the
―signal‖ of the firm’s future prospects. dividend payments.
• Fixed or increasing dividends are often considered a ―positive‖ • As mentioned earlier, investors view volatile dividends
signal, while erratic dividend payments are viewed as ―negative‖ as negative and risky—which can lead to lower share
signals. prices.
Types of Dividend Policies: Types of Dividend Policies:

Constant-Payout-Ratio Policy (cont.) Regular Dividend Policy
Peachtree Industries, a miner of potassium, has a • A regular dividend policy is based on the
policy of paying out 40% of earnings in cash
payment of a fixed-dollar dividend each period.
dividends. In the periods when a loss occurs, the
firm’s policy is to pay no cash dividends. • It provides stockholders with positive
information indicating that the firm is doing well
and it minimizes uncertainty.
• Generally, firms using this policy will increase
the regular dividend once earnings are proven to
be reliable.
Types of Dividend Policies: Types of Dividend Policies:

Regular Dividend Policy (cont.) Regular Dividend Policy (cont.)
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 exceeded $4.00
for three 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.
Types of Dividend Policies: Other Forms of Dividends:
Low-Regular-and-Extra Dividend Policy Stock Dividends
• Using this policy, firms pay a low regular dividend, • A stock dividend is paid in stock rather than in cash.
supplemented by additional dividends when earnings • Many investors believe that stock dividends increase the value of
can support it. their holdings.
• When earnings are higher than normal, the firm will • In fact, from a market value standpoint, stock dividends function
pay this additional dividend, often called an extra much like stock splits. The investor ends up owning more
dividend, without the obligation to maintain it during shares, but the value of their shares is less.
subsequent periods.
• From a book value standpoint, funds are transferred from
• This type of policy is often used by firms whose sales retained earnings to common stock and additional paid-in-
and earnings are susceptible to swings in the business capital.
cycle.
Other Forms of Dividends: Other Forms of Dividends:

Stock Dividends (cont) Stock Dividends (cont)
• Accounting Aspects • Accounting Aspects

The current stockholder’s equity on the balance sheet If Garrison declares a 10% stock dividend and the
of Garrison Corporation, a distributor of prefabricated current market price of the stock is $15/share, $150,000
cabinets, is as shown in the following accounts. of retained earnings (10% x 100,000 shares x
$15/share) will be capitalized.
The $150,000 will be distributed between the common

stock (par) account and paid-in-capital in excess of par
account based on the par value of the common stock.
The resulting balances are as follows

Stock Dividends (cont) Stock Dividends (cont)
• Accounting Aspects • The Shareholder’s Viewpoint

– From a shareholder’s perspective, stock dividends result in
a dilution of shares owned.
– For example, assume a stockholder owned 100 shares at
$20/share ($2,000 total) before a stock dividend.
– If the firm declares a 10% stock dividend, the shareholder
Because 10,000 new shares (10% x 100,000) have will have 110 shares of stock. However, the total value of her
been issued at the current price of $15/share, shares will still be $2,000.
$150,000 ($15/share x 10,000 shares) is shifted – Therefore, the value of her share must have fallen to
from retained earnings to the common stock and $18.18/share ($2,000/110).
paid-in-capital accounts.
Stock Dividends (cont) Stock Splits
• The Company’s Viewpoint • A stock split is a recapitalization that affects the

– Disadvantages of stock dividends include: number of shares outstanding, par value, earnings per
• The cost of issuing the new shares share, and market price.
• Taxes and listing fees on the new shares • The rationale for a stock split is that it lowers the price
• Other recording costs
of the stock and makes it more attractive to individual
– Advantages of stock dividends include: investors
• The company conserves needed cash
• Signaling effect to the shareholders that the firm is retaining cash Delphi Company, a forest products concern, had
because of lucrative investment opportunities 200,000 shares of $2-par value common stock
outstanding and declares a 2-for-1 split. The total
before and after split impact on stockholders equity is:

Stock Splits (cont.) Stock Splits (cont.)
• A reverse stock split reduces the number of shares outstanding

and raises stock price—the opposite of a stock split.
• The rationale for a reverse stock split is to add respectability to
the stock and convey the meaning that it isn’t a junk stock.
Research on both stock splits and stock dividends

generally supports the theory that they do not affect the
value of shares. They are often used, however, to send
a signal to investors that good things are going to
happen.

Stock Repurchases Stock Repurchases (cont.)
• A stock repurchase is the purchasing and • Alternative reasons for stock repurchases:
retiring of stock by the issuing corporation. – To use the shares for another purpose
• A repurchase is a partial liquidation since it – To alter the firm’s capital structure
decreases the number of shares outstanding.
– To increase EPS and ROE resulting in a higher
• It may also be thought of as an alternative to market price
cash dividends. – To reduce the chance of a hostile takeover
Other Forms of Dividends: Stock Repurchases
Viewed as a Cash Dividend
• The repurchase of stock results in a type of reverse

dilution.
• The net effect of the repurchase is similar to the
payment of a cash dividend.
• However, if the firm pays the dividend, the owner
would have to pay tax on the income.
• The gain on the increase in share price as a result of the
repurchase, however, would not be taxed until sold.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-49

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Learning Goals

Learning Goals (cont.) Dividend Fundamentals

• Date of Record: The date on which investors must own Example

Dividend Fundamentals: Cash Dividend Dividend Fundamentals: Cash Dividend

Dividend Fundamentals: Cash Dividend Dividend Fundamentals: Cash Dividend

Cash $120,000 Dividends Payable $ 0

The net effect of the dividend payment is a reduction of the

The Relevance of Dividend Policy: The Relevance of Dividend Policy:

The Relevance of Dividend Policy: The Relevance of Dividend Policy:

Figure 13.2 WMCC and IOSs

The Relevance of Dividend Policy: The Relevance of Dividend Policy:

The Relevance of Dividend Policy: Factors Affecting Dividend Policy:

Factors Affecting Dividend Policy: Factors Affecting Dividend Policy:

Factors Affecting Dividend Policy: Factors Affecting Dividend Policy:

Types of Dividend Policies: Types of Dividend Policies:

Types of Dividend Policies: Types of Dividend Policies:

The dividend policy of Woodward Laboratories, a producer

Other Forms of Dividends: Other Forms of Dividends:

• Accounting Aspects • Accounting Aspects

The $150,000 will be distributed between the common

Other Forms of Dividends: Other Forms of Dividends:

• Accounting Aspects • The Shareholder’s Viewpoint

• The Company’s Viewpoint • A stock split is a recapitalization that affects the

Other Forms of Dividends: Other Forms of Dividends:

• A reverse stock split reduces the number of shares outstanding

Research on both stock splits and stock dividends

Other Forms of Dividends: Other Forms of Dividends:

• The repurchase of stock results in a type of reverse

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-49

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