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Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Dividend Policy and Retained Earnings 18.

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Presentation on theme: "Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Dividend Policy and Retained Earnings 18."— Presentation transcript:

1 Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Dividend Policy and Retained Earnings 18

2 18-2 Chapter Outline Decisions on use of firm’s annual earnings. Dividends and the dividend policy. Factors influencing the dividend policy. Stock dividends and stock splits. Repurchase of the firm’s shares.

3 18-3 The Marginal Principle of Retained Earnings Benefits to stockholders analyzed by comparing: –Rate of return on retained earnings. –Earnings that may be generated by offering dividends. Project financed by internally generated funds must provide a higher rate of return: –Compared to what stockholders can achieve on other investments.

4 18-4 Life Cycle Growth and Dividends

5 18-5 Dividends as a Passive Variable Dividends are paid out only if the corporation cannot make better use of the funds for the benefit of stockholders. –Active decision variable is the retained earnings. –Residual after taking care of internal corporate needs is paid to stockholders. Cash dividends.

6 18-6 An Incomplete Theory Residual theory of earnings does not consider the stockholders opinion on dividends. –It is considered acceptable, if the stockholders only concerns are corporate retained earnings: Remaining in the business. Paid out as current dividends. –If however, the stockholder prefers one over the other option, then this theory is incomplete.

7 18-7 Arguments for the Relevance of Dividends Dividends resolve uncertainty in the minds of investors. –It can be hypothesized that stockholders might: Apply a higher discount rate (K e ). Assign a lower valuation of funds that are retained in the business. –Because of the information content of dividends – it may be more favorable to the stockholders. –Stockholder’s needs and preferences go beyond the marginal principle of retained funds.

8 18-8 Arguments for the Relevance of Dividends (cont’d) In practice, it appears that most corporations adhere to the following logic: –Investment opportunities relative to a required return (marginal analysis) are determined. –For mature firms: An analysis of both investment opportunities and stockholder preferences may indicate that a higher rate of payout is required.

9 18-9 Corporate Dividend Policy

10 18-10 Dividend Stability Maintenance of stability is a primary factor in considering stockholder desire in dividend policy. –Dollar amount of cash dividends tends to be more stable. Increases in value takes place when new permanent levels of income are achieved. –Management hopes to lower the discount rate applied to future dividends, thus raising the value of the firm.

11 18-11 Corporate Profits and Dividends for Non-Financial Firms

12 18-12 Legal Rules Most states forbid payment of dividends that might impair the initial capital contributions to the firm. –They may thus be distributed only from past and current earnings. –Aim is to protect creditors. –If the firm chooses to pay dividends equal to the retained earnings, the operation of the firm may be jeopardized.

13 18-13 Raiding the Capital Assume a company has the following statement of net worth, the maximum dividend payment would be $20 million. Common stock (1 million shares at $10 par value)*………………………………………..$10,000,000 Retained earnings……………………………………………….$20,000,000 Net worth…………………………………………………………$30,000,000 *If there is a paid-in capital in excess of par” account, some states will allow additional dividend payment while others will not. To simplify the problem now, paid-in capital in excess of par is not considered.

14 18-14 Cash Position of the Firm There are limitations to the use of current earnings as an indicator of liquidity. –A growth firm producing the greatest gains in earnings may be in the poorest cash position. –There is a buildup in receivables and inventory, with a rapid expansion in sales and earnings. This may far exceed cash flow generated through earnings.

15 18-15 Access to Capital Markets A medium-to-large size company may be willing to pay dividends. –It can sell new common stock or binds in the future if and when funds are necessary. Some may issue debt or stock and use part of the proceeds to guarantee the maintenance of current dividends. –Justifying this action on the basis of maintaining stable dividends.

16 18-16 Desire for Control Directors and officers of a small, closely held firms may hold back paying dividends. –To avoid diluting the cash position. Larger firms face a different kind of threat: –Stockholders, in the light of previously offered healthy dividends, may demand the removal of management if dividends are withheld for some reason.

17 18-17 Tax Position of Shareholders Growth Tax Relief Act of 2003 –Requires a maximum of 15%, on long-term capital gains only, for high income tax payers. –Short-term capital gains are taxed up to a maximum of 30%. –Those in the lower tax bracket are now taxed at 5% on both types of income. High dividend paying stock is attractive now that tax rate differential has been eliminated by the legislation.

18 18-18 Dividend Payment Procedures Cash dividends are usually paid quarterly – though quoted on an annual basis. Dividend yield (%): –Annual dividend per share / current stock price.

19 18-19 Dates Associated with Declaration of Quarterly Dividends Holder-of-Record Date –Date on which the firm examines its books to determine who is entitled to cash dividends. –Possible if investor has bought or owned the stock before ex-dividend date. Ex-Dividend Date –Is two-business dates before the holder-of- record date. –Value of the stock will go down by the value of the quarterly dividend on the ex-dividend date.

20 18-20 Dates Associated with Declaration of Quarterly Dividends (cont’d) Dividend Payment Date –The date, or about the time, the checks will be sent to the entitled stockholders.

21 18-21 Stock Dividend Represents a distribution of additional shares to common stockholders. –Typically, is in the 10% range. –Larger distributions of 20-25% or more are usually considered to have the characteristics of a stock split

22 18-22 XYZ Corporation’s Financial Position Before Stock Dividend

23 18-23 XYZ Corporation’s Financial Position after Stock Dividend

24 18-24 Value to an Investor Assumption: 1 million shares were outstanding before the stock dividend and 1.1 million shares afterward. Assuming that a firm has an after-tax earnings of 46.6 million. Without a stock dividend, earnings per share would be: Earnings per share = Earnings after taxes Shares outstanding Without stock dividend: = $6.6 million = $ million shares With stock dividend: = $6.6 million = %6.00 (10% decline) 1.1 million shares Earnings per share have decreased by exactly the same percentage that shares outstanding increased.

25 18-25 Value to an Investor (cont’d) Assuming that Stockholder A had 10 shares before the stock dividend and 11 afterward, his total claims to earnings would be: Claim to earnings = Share X Earnings per share Without stock dividend = 10 X $6.60 = $66 With stock dividend = 11 X $6.00 = $66 Assuming that the stock sold 20 times earnings before and after the stock dividend, the total market value of the portfolio in each case would be: Total market value = Shares X (P/E ratio X Earnings per share) Without stock dividend = 10 X (20 X $6.60) = 10 X $132 = $1,320 With stock dividend = 11 X (20 X $6.00) = 11 X $120 = $1,320

26 18-26 Possible Value of Stock Dividends If at the time a stock dividend is declared, the cash dividend per share remains constant, the stockholder will receive greater total cash dividends.

27 18-27 Use of Stock Dividends Most frequently used by growth companies as a form of ‘informational content.’ –Explains the retentions of funds for reinvestment purposes. –Market reaction may be neutral or slightly positive. May also be used to: –Camouflage inability of firm to pay dividends. –Cover up ineffectiveness in generating a cash flow. –Informed investors may react very negatively.

28 18-28 Stock Splits Similar to a stock dividend, only more numbers of shares are distributed. –The NYSE and the FASB encourage distribution in excess of 20-25% to be handled as stock splits. The accounting for a stock split involves: –No transfer of funds from retained earnings to the capital accounts. –Reduction in par value. –Proportionate increase in the number of outstanding shares.

29 18-29 Stock Splits (cont’d) The market price of the stock drop proportionately to the split. –The benefit is almost impossible to capture after the split has been announced. Primary purpose of a stock split is to: –Lower the price into a more popular trading range. –So companies with a substantial growth can participate.

30 18-30 XYZ Corporation Before and After Stock Split

31 18-31 Reverse Stock Splits A firm exchanges fewer shares for existing shares with the intent of increasing the stock price. –Stock price does not always increase by a commensurate amount. –Main purpose - to attempt to place a stock’s value at a level acceptable to: The NYSE. The American Stock Exchange. The NASDAQ.

32 18-32 Repurchase of Stock as an Alternative to Dividends A corporate stock repurchase may be undertaken by a firm with excess cash. –The overall benefit to the stockholders is that earnings per share will go up as the number of shares outstanding is decreased.

33 18-33 Financial Data of Morgan Corporation

34 18-34 Other Reasons for Repurchase Acquired if the selling price is low. –Thereby maintaining a constant demand for its own securities. Use for employee stock options or as part of a tender offer in a merger. As a protected device against being taken over as a merger candidate.

35 18-35 Recent Examples of Share Repurchase Announcements

36 18-36 Dividend Reinvestment Plans Provides the investor with an opportunity to buy additional shares of stock with the cash dividend paid by the company. –The company is the beneficiary of increased cash flow. Company’s transfer agent, buys shares of stock in the market for the stockholder. –Benefits the shareholders.

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