Chapter 13 Payout Policy Copyright 2012 Pearson Prentice

Chapter 13 Payout Policy Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Learning Goals 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. © 2012 Pearson Prentice Hall. All rights reserved. 2

Learning Goals LG 4 Review and evaluate three basic types of dividend policies. LG 5 Evaluate stock dividends from accounting, shareholder, and company points of view. LG 6 Explain stock splits and the firm’s motivation for undertaking them. © 2012 Pearson Prentice Hall. All rights reserved. 3

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. © 2012 Pearson Prentice Hall. All rights reserved. 4

Figure 13. 1 Per Share Earnings and Dividends of the S&P 500 Index © 2012 Pearson Prentice Hall. All rights reserved. 5

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. © 2012 Pearson Prentice Hall. All rights reserved. 6

Figure 13. 2 Aggregate Dividends and Repurchases for All U. S. -Listed Companies © 2012 Pearson Prentice Hall. All rights reserved. 7

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. © 2012 Pearson Prentice Hall. All rights reserved. 8

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. © 2012 Pearson Prentice Hall. All rights reserved. 9

Figure 13. 3 U. S. Firms Increasing or Decreasing Dividends © 2012 Pearson Prentice Hall. All rights reserved. 10

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. © 2012 Pearson Prentice Hall. All rights reserved. 11

Figure 13. 4 Dividend Payment Time Line © 2012 Pearson Prentice Hall. All rights reserved. 12

The Mechanics of Payout Policy: Cash Dividend Payment Procedures (cont. ) On June 24, 2010, the board of directors of Best Buy announced that the firm’s 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 © 2012 Pearson Prentice Hall. All rights reserved. 13

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 © 2012 Pearson Prentice Hall. All rights reserved. 14

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 firm’s total assets (and stockholders’ equity) by $63 million. © 2012 Pearson Prentice Hall. All rights reserved. 15

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. © 2012 Pearson Prentice Hall. All rights reserved. 16

The Mechanics of Payout Policy: Share Repurchase Procedures (cont. ) In July 2010, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31. 50 per share. Fidelity 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, Fidelity constructed the following demand schedule: © 2012 Pearson Prentice Hall. All rights reserved. 17

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. © 2012 Pearson Prentice Hall. All rights reserved. 18

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. © 2012 Pearson Prentice Hall. All rights reserved. 19

Focus on Practice Capital Gains and Dividend Tax Treatment Extended to 2010 – In May 2003, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). – Prior to that new law, 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 percent. The result was an effective tax rate of 57. 75 percent 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 percent. For taxpayers in the lower tax brackets, the combined effect was a maximum of 38. 25 percent. – How might the expected future reappearance of higher tax rates on individuals receiving dividends affect corporate dividend payout policies? © 2012 Pearson Prentice Hall. All rights reserved. 20

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. © 2012 Pearson Prentice Hall. All rights reserved. 21

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. © 2012 Pearson Prentice Hall. All rights reserved. 22

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. © 2012 Pearson Prentice Hall. All rights reserved. 23

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. © 2012 Pearson Prentice Hall. All rights reserved. 24

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? © 2012 Pearson Prentice Hall. All rights reserved. 25

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. © 2012 Pearson Prentice Hall. All rights reserved. 26

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: 1. Determine its optimal level of capital expenditures, which would be the level that exploits all of a firm’s 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 amount—the residual—as dividends. © 2012 Pearson Prentice Hall. All rights reserved. 27

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 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. © 2012 Pearson Prentice Hall. All rights reserved. 28

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. © 2012 Pearson Prentice Hall. All rights reserved. 29

Relevance of Payout Policy: Arguments for Dividend Relevance • Dividend relevance theory is 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. © 2012 Pearson Prentice Hall. All rights reserved. 30

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. © 2012 Pearson Prentice Hall. All rights reserved. 31

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 © 2012 Pearson Prentice Hall. All rights reserved. 32

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. © 2012 Pearson Prentice Hall. All rights reserved. 33

Factors Affecting Dividend Policy: Legal Constraints (cont. ) • The stockholders’ equity account of Miller Flour Company, a large grain processor, is presented in the following table. • 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. © 2012 Pearson Prentice Hall. All rights reserved. 34

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. © 2012 Pearson Prentice Hall. All rights reserved. 35

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. © 2012 Pearson Prentice Hall. All rights reserved. 36

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. © 2012 Pearson Prentice Hall. All rights reserved. 37

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. © 2012 Pearson Prentice Hall. All rights reserved. 38

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. © 2012 Pearson Prentice Hall. All rights reserved. 39

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. © 2012 Pearson Prentice Hall. All rights reserved. 40

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. Data on Peachtree’s earnings, dividends, and average stock prices for the past 6 years follow. © 2012 Pearson Prentice Hall. All rights reserved. 41

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 dividendpayout ratio, which is a dividend policy under which the firm attempts to pay out a certain percentage of earnings as a stated dollar dividend adjusts that dividend toward a target payout as proven earnings increases occur. © 2012 Pearson Prentice Hall. All rights reserved. 42

Types of Dividend Policies: 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 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. © 2012 Pearson Prentice Hall. All rights reserved. 43

Types of Dividend Policies: Regular Dividend Policy (cont. ) © 2012 Pearson Prentice Hall. All rights reserved. 44

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. © 2012 Pearson Prentice Hall. All rights reserved. 45

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. © 2012 Pearson Prentice Hall. All rights reserved. 46

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 © 2012 Pearson Prentice Hall. All rights reserved. 47

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) Paid-in capital in excess of par 710, 000 Retained earnings 550, 000 Total stockholders’ equity $2, 000 © 2012 Pearson Prentice Hall. All rights reserved. 440, 000 48

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. © 2012 Pearson Prentice Hall. All rights reserved. 49

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. © 2012 Pearson Prentice Hall. All rights reserved. 50

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 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. © 2012 Pearson Prentice Hall. All rights reserved. 51

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. © 2012 Pearson Prentice Hall. All rights reserved. 52

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. © 2012 Pearson Prentice Hall. All rights reserved. 53

Review of Learning Goals 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 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. © 2012 Pearson Prentice Hall. All rights reserved. 54

Review of Learning Goals (cont. ) 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 wherein information content and clientele effects exist. Gordon and Lintner advance 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. © 2012 Pearson Prentice Hall. All rights reserved. 55

Review of Learning Goals (cont. ) 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. 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. © 2012 Pearson Prentice Hall. All rights reserved. 56

Review of Learning Goals (cont. ) LG 4 Review and evaluate 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. © 2012 Pearson Prentice Hall. All rights reserved. 57

Review of Learning Goals (cont. ) 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. © 2012 Pearson Prentice Hall. All rights reserved. 58

Review of Learning Goals (cont. ) 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. – Firms can repurchase stock in lieu of paying a cash dividend, to retire outstanding shares. 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. © 2012 Pearson Prentice Hall. All rights reserved. 59

Chapter Resources on My. Finance. Lab • Chapter Cases • Group Exercises • Critical Thinking Problems © 2012 Pearson Prentice Hall. All rights reserved. 60