Chapter 13

Payout Policy

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All rights reserved.

Objectives

Understand cash payout procedures, their tax treatment, and the role of
dividend reinvestment plans.

Describe the residual theory of dividends and the key arguments with
regard to dividend irrelevance and relevance.

Discuss the key factors involved in establishing a dividend policy.

Review and evaluate the three basic types of dividend policies.

Evaluate stock dividends from accounting, shareholder, and company

points of view.

Explain stock splits and the firms motivation for undertaking them.

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The Basics of Payout Policy:

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

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The Mechanics of Payout Policy: Cash

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

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Dividend Payment Time Line

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The Mechanics of Payout Policy: Cash

Dividend Payment Procedures (cont.)
On June 24, 2010, the board of directors of Best Buy announced that
the firms next quarterly cash dividend would be $0.15 per share,
payable October 26 to shareholders of record on October 5. At the
time, Best Buy had 420,061,666 shares of common stock
outstanding. Before the dividend was declared, the key accounts of
the firm were as follows (dollar values quoted in thousands):
Cash: $1,826,000
Dividends payable: $0
Retained earnings: $5,797,000

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The Mechanics of Payout Policy: Cash

Dividend Payment Procedures (cont.)
When the dividend was announced by the directors, $63 million of the
retained earnings ($0.15 per share 420 million shares) was
transferred to the dividends payable account. The key accounts thus
became:
Cash: $1,826,000
Dividends payable: $63,000
Retained earnings: $5,734,000

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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: $1,763,000
Dividends payable: $0
Retained earnings: $5,734,000

The net effect of declaring and paying the dividend was to reduce the
firms total assets (and stockholders equity) by $63 million.

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13-8

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:

Dividend Reinvestment Plans
Dividend reinvestment plans (DRIPs) are plans that
enable stockholders to use dividends received on the firms
stock to acquire additional shareseven fractional shares
at little or no transaction cost.
Some companies even allow investors to make their initial
purchases of the firms stock directly from the company without
going through a broker.
With DRIPs, plan participants typically can acquire shares at
about 5 percent below the prevailing market price.
Firms can issue new shares to participants more economically
and avoid the under-pricing and flotation costs of a public sale.
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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 residualthe
amount left over after all acceptable investment opportunities have
been undertaken. Dividend decisions should involve 3 steps:
1. Determine its optimal level of capital expenditures, which would be the
level that exploits all of a firms positive NPV projects.
2. Using the optimal capital structure proportions, estimate the total amount
of equity financing needed to support the expenditures generated in Step 1.
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 amountthe residualas dividends.
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Relevance of Payout Policy:

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

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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 firms 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 firms
dividend policy and its market value.
The bird-in-the-hand argument is the belief, in support of
dividend relevance theory, that investors see current dividends as
less risky than future dividends or capital gains.
In essence, the payment of a dividend is considered a sure thing
by investors and reduces uncertainty about their return. This
results in a lower required rate by investors which has the effect
of increasing the stock price.

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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 firms stock.
The agency cost theory says that a firm that commits to paying dividends is
reassuring shareholders that managers will not waste their money.
Although many other arguments related to dividend relevance have been put
forward, empirical studies have not provided evidence that conclusively
settles the debate about whether and how payout policy affects firm value.

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Factors Affecting Dividend

Policy
Dividend policy represents the firms plan of action to be
followed whenever it makes a dividend decision.
First consider five factors in establishing a dividend policy:
1. legal constraints imposed by some state laws prohibit payment
from equity such as legal capital or par value stock.
2. contractual constraints imposed by banks on payment due to
outstanding loans.
3. the firms growth prospects affect whether earnings are paid
4. owner considerations such as tax bracket and preference
5. market considerations such as demand for stock dividends
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Types of Dividend Policies:

Payout-Ratio Dividend Policies
A firms dividend payout ratio indicates the percentage of each
dollar earned that a firm distributes to the owners in the form of
cash. It is calculated by dividing the firms cash dividend per share
by its earnings per share.

A constant-payout-ratio dividend policy is a dividend policy based on the

payment of a certain percentage of earnings to owners in each dividend period.
The amount paid will fluctuate with earnings since its a percent.

Regular dividend policy is a dividend policy based on the payment of a fixeddollar dividend in each period. An example is $1.00 per share.
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:

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

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Other Forms of Dividends

(cont.)
Delphi Company, a forest products concern, had 200,000 shares of $2par-value common stock and no preferred stock outstanding. Because
the stock is selling at a high market price, the firm has declared a 2for-1 stock split. The total before and after-split stockholders equity is
shown in the following table.

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Chapter Summary

The board of directors makes the cash payout decision and, for dividends,
establishes the record and payment dates. Some firms offer dividend reinvestment
plans that allow stockholders to acquire shares in lieu of cash dividends.

The residual theory suggests that dividends should be viewed as the earnings left
after all acceptable NPV investment opportunities have been undertaken. 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.

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

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Chapter Summary (cont.)

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
firms earnings are higher than normal.

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.

Stock splits are used to enhance trading activity of a firms shares by lowering or
raising their market price. A stock split merely involves accounting adjustments; it
has no effect on the firms cash or on its capital structure and is usually nontaxable.

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