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

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter 13

Payout Policy

© 2012 Pearson Prentice Hall. All rights reserved. 13-2

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 firm’s motivation for undertaking them.


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 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.


The Mechanics of Payout Policy: Cash Dividend Payment Procedures

• 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.


Dividend Payment Time Line


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



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



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


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



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.


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.

– Firms can issue new shares to participants more economically and avoid the under-pricing and flotation costs of a public sale.


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.


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?


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. Dividend decisions should involve 3 steps:

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.


Relevance of Payout Policy: The Dividend Irrelevance Theory

The dividend irrelevance theory is Miller and Modigliani’s theory that in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value.

– In a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends.

– Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani and Miller’s original theory.


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.


Relevance of Payout Policy: Arguments for Dividend Relevance

• Dividend relevance theory is the theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value.

• The bird-in-the-hand argument is the belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.

• 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.


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.


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 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 firm’s 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


Types of Dividend Policies: Payout-Ratio Dividend Policies

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. The amount paid will fluctuate with earnings since it’s a percent.

• Regular dividend policy is a dividend policy based on the payment of a fixed-dollar 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.


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.


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.


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 $300,000Common stock (100,000 shares @ $4 par) 400,000Paid-in capital in excess of par 600,000Retained earnings 700,000Total stockholders’ equity $2,000,000



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 $300,000Common stock (110,000 shares @ $4 par) 440,000Paid-in capital in excess of par 710,000Retained earnings 550,000Total stockholders’ equity $2,000,000



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.



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.


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 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.


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 firm’s 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 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.

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

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