978-0134476308 Chapter 13

Chapter 13

Payout Policy

 Instructor’s Resources

Overview

Chapter 13 concentrates on the payout decision from the viewpoint of both the firm and the investors. The types of

payout policies, forms of dividends, and their possible effects on the value of the firm are included in this chapter.

The arguments for the relevancy and irrelevancy of dividends are presented. The legal, contractual, and internal

constraints affecting dividend policy are discussed. An introduction to dividend reinvestment plans is included.

The chapter notes that dividend cash outflows reduce corporate assets while enhancing personal wealth and,

therefore, have implications for both the student’s professional life and personal life.

Note to instructors: After the initial print run of this text, Congress passed the Tax Cuts and Jobs Act.

Subsequently, we made some minor changes to this chapter to reflect the new tax law. These changes affected

problem 14 and the integrative case. Following, we include solutions for the original tax rates as well as the

revised ones.

 Answers to Review Questions

1. The two primary ways in which a firm can distribute cash to shareholders is through a dividend payment and

share repurchases. Many companies use both techniques to return money to investors. In recent years, firms

2. Rapidly growing firms may not have sufficient funds available to support all acceptable projects. Such firms

3. Dividends are divided by earnings in computation of the dividend payout ratio. Because dividends are more

4. All holders of a firm’s stock in the firm’s stock ledger on the date of record, which is set by the directors, will

receive a declared dividend. These stockholders are referred to as holders of record. Due to the time needed

10. With a constant-payout-ratio dividend policy, a firm pays out a certain percentage of earnings each period. A

regular dividend policy is a fixed dollar dividend payment each period. The amount of this payment may be

11. A stock dividend is a dividend paid in the form of stock made to existing owners. Although stock dividends

are more costly to issue than cash dividends, stock dividends are a means of giving the owners something

12. A stock split is a method of increasing the number of shares belonging to each shareholder. A stock split

reduces the par value of stock outstanding and increases the number of shares outstanding. A stock split also

reduces the price per share roughly in the same proportion as the split, so the total value of shares remains

more or less the same. For example, in a 2-for-1 split, the price of the stock should fall by half. A reverse

stock split is exactly the opposite of a stock split. The par value is increased and the number of shares

outstanding is reduced. Neither type of split has any effect on a firm’s financial structure but can be viewed as

a change in accounting values. Normally, (reverse) stock splits are made when the firm believes its stock

price is too (low) high to be actively traded. A stock dividend works the same as a stock split except that the

ratio of new shares to old shares is lower. For example, a common stock split is 2 for 1. A stock dividend may

be a 10% dividend, having the same effect as a 1.1 for 1 split.

 Suggested Answer to Focus on Ethics Box: Buyback Mountain

Given the market generally punishes firms that miss their EPS forecast, do you believe it is ethical to use

stock repurchases just to hit the target?

E13-1. Relevant dividend dates

P13-1. Dividend payment procedures

LG 1; Basic

a. Debit Credit

P13-2. Personal finance: Dividend payment

LG 1; Intermediate

P13-3. Residual dividend policy

LG 2; Intermediate

a. Residual dividend policy means that the firm will consider its investment opportunities first. If after

meeting these requirements there are funds left, the firm will pay the residual out in the form of

2013 0.50 2017 0.62

2015 0.53 2019 0.74

d. 2012 $0.50 2016 $0.50

2014 0.50 2018 0.60

2015 0.50 2019 0.84

e. Part a uses a constant-payout-ratio dividend policy, which will yield low or no dividends if earnings

P13-9. Stock dividend—firm

LG 5; Intermediate

(a) 5%

Stock Dividend

(b) (1) 10%

Stock Dividend

(b) (2) 20%

Stock Dividend

Chapter 13 Payout Policy 299

a. The company has experienced positive and increasing earnings since it went public. Management believes

that EPS should remain stable over the next three years (±10%). This stable earning pattern is conducive to

b. The

low-regular-and-extra dividend policy should be adopted for two reasons. First, this approach provides

c. There are six factors the board should consider before setting an initial dividend policy:

1. Legal constraints—Are there legal restrictions that come into play that will prohibit the firm from paying a

dividend? A common constraint in most states is the firm cannot pay dividends out of “legal capital,”

2. Contractual constraints—Loan covenants may be in place that put some prohibitions on the ability of the

firm to pay dividends.

3. Internal constraints—This factor addresses whether or not the firm has the available funds to make the

4. Growth prospects—If the firm needs the funds to invest in new or ongoing projects, it may wish to retain

5. Owner considerations—Although it is impossible to maximize the wealth of every single owner,

6. Market consideration—How will market participants view the dividend decision? This factor is

concerned with the information content of the decision to institute a dividend payout where none

previously existed.

d. Ms. McNeely will want to set a dividend that is high enough to inform stockholders of the financial strength

of the firm. She needs to be cautious of not setting it too high and forcing the firm into a dividend cut

e. The initial dividend should be approximately $0.72 per share per year ($0.18 per quarter). General Access has

had EPS in excess of $0.72 since the year after it went public. This amount is a payout ratio of about 20%

based on 2012 EPS. This is a substantial initial dividend, which is probably what is needed by the market