1. Dividend Policy and Retained Earnings
Chapter 18
Dividend Policy and Retained Earnings

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. 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. Life Cycle Growth and Dividends

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 fulfilling internal corporate expenses) is paid to stockholders
Cash dividends

6. An Incomplete Theory
Residual theory of earnings does not consider the stockholders’ opinion on dividends
It is considered acceptable, if the stockholders’ only concern is achieving highest returns :
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. 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 (Ke), and
Assign a lower valuation of funds that are retained in the business
Because of the information content of dividends –viewed more favorably than retained earnings to the stockholders
Stockholder’s needs and preferences go beyond the marginal principle of retained funds

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
Then, it is tempered by subjective notion of stockholders’ desires
For mature firms:
An analysis of both investment opportunities and stockholder preferences may indicate that a higher rate of payout is required

9. Corporate Dividend Policy

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 (Ke), applied to future dividends, thus raising the value of the firm

11. Corporate Profits and Dividends for Non-Financial Firms

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. 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. 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. Access to Capital Markets
A medium-to-large size company having relatively easy access to financial markets may be willing to pay dividends
It can sell new common stock or bonds 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. 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 light of previously offered healthy dividends, may demand the removal of management if dividends are withheld for any reason

17. Tax Position of Shareholders
Jobs and Growth Tax Relief Act of 2003
Dividends and long-term capital gains only, for high income tax payers, are taxed up to a maximum of 15%
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 the tax rate differential has been eliminated by the legislation

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. 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. Dates Associated with Declaration of Quarterly Dividends (cont’d)
Dividend Payment Date
The date when checks will be sent to the entitled stockholders

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. XYZ Corporation’s Financial Position Before Stock Dividend

23. XYZ Corporation’s Financial Position after Stock Dividend

24. Value to the 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 $6.6 million. Without a stock dividend, earnings per share would be:
Earnings per share = Earnings after taxes
Shares outstanding
Without stock dividend:
= $6.6 million = $6.60
1 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. Value to the 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
The total market value is unchanged

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. 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 negatively

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. Stock Splits (cont’d)
The market price of the stock drops 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 in market price can participate

30. XYZ Corporation Before and After Stock Split

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
May represent evidence that the firm is in trouble
Main purpose - to attempt to place a stock’s value at a level acceptable to:
The NYSE
The American Stock Exchange
The NASDAQ

32. Repurchase of Stock as an Alternative to Dividends
A firm with excess cash may choose to repurchase corporate stock
Stock repurchase can be thought as an alternative to cash dividend payouts
Theoretically, the benefits to the stockholder are equal under either alternative
The overall benefit to stockholders is that earnings per share may increase as the number of outstanding shares is decreased

33. Financial Data of Morgan Corporation

34. Other Reasons for Repurchase
Acquired if the selling price is low
Thereby maintaining a constant demand for its own securities
Used 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. Recent Examples of Share Repurchase Announcements

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
Shareholders benefited by:
Low transaction costs
Right to own fractional shares
Flexibility between cash and common stock

37. End q

38. Q & A

39. Thank You.