Chapter 14
Payout Policy
Instructor’s Resources
Overview
Chapter 14 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.
Suggested Answer to Opener-in-Review Question
The chapter opener described Whirlpool’s decision to dramatically increase its dividend in early 2017 to
$1.10 per share. In the previous quarter, Whirlpool paid a dividend of $1 on March 15 to shareholders of
record on March 3. When do you think the stock began trading ex dividend? The market price of
Whirlpool stock just before the ex dividend date was $178.59. Immediately after the stock went ex dividend,
the market price was $178.14. Is that price change surprising? Calculate the return that an investor might
have earned if she had purchased the stock before the ex dividend date, sold the stock immediately
afterward, and received the dividend a few weeks later.
If the record date was March 3, then the stock would have started trading ex dividend two business days before on
in mind that the investor held the stock for a single day. For perspective, that daily return is on the order of 100
times greater than the average one-day return on the overall stock market.
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
2. Rapidly growing firms may not have sufficient funds available to support all acceptable projects.
do not pay dividends.
3. Dividends are divided by earnings in computation of the dividend payout ratio. Because dividends
are more stable than earnings, the dividend payout ratio increases in a recession. During economic
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
5. The Jobs and Growth Tax Reconciliation Act of 2003 substantially reduced the marginal tax rate on
dividends received by taxpayers. Prior to the 2003 act, dividends were taxed at the ordinary income tax rate,
which could reach as high as 35%. The act reduced the marginal rate to the same 15% rate as capital gains
6. Dividend reinvestment plans enable stockholders to use dividends to acquire full or fractional
shares at little or no transaction cost. These plans can be handled in either of two ways. In one approach, a
7. The residual theory of dividends suggests that a firm’s dividend payment should be the amount left
over (the residual) after all acceptable investment opportunities have been undertaken. Because investment
opportunities would tend to vary year to year, this approach would not lead to a stable dividend. This theory
8. The dividend irrelevance theory proposed by Miller and Modigliani (M & M) states that in a
perfect world the value of a firm is not affected by dividends but is determined solely by the earnings power
investors that management expects future earnings to change in the same direction as the change in
Conversely, Gordon and Lintner’s dividend relevance theory states that there is a direct relationship
between a firm’s dividend policy and its market value. According to their bird-in-the-hand argument,
Although empirical studies of the dividend relevance theory have not provided conclusive evidence
9. a. Legal constraints prohibit the corporation from paying out cash dividends that are considered
b. Contractual constraints limit a firm’s ability to pay dividends according to the restrictive
covenants in a loan agreement.
payout policy.
e. Market considerations are the perceptions of the stockholders and their response to the dividend
policy, which may indirectly affect the stock price.
10. With a constant-payout-ratio dividend policy, a firm pays out a certain percentage of earnings each
high earnings, an “extra” dividend is paid.
The constant-payout-ratio policy results in dividends that fluctuate in sync with earnings, whereas the other
policies tend to lead to more stable dividends over time.
The stockholder’s assumption that he or she will break even in five years with a 20% stock dividend is
incorrect. A stock dividend does not mean an increase in value of holdings; the per-share value decreases in
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
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
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?
It is probably naïve for managers to think that if they hit an EPS target simply by repurchasing shares that
consistently meets EPS targets only by reducing the denominator of that calculation.
Suggested Answer to Focus on Practice Box: Capital Gains and
Dividend Tax Treatment Extended to 2012
How might the expected future reappearance of higher tax rates on individuals receiving dividends affect
corporate dividend payout?
Just as the lowering of the individual tax rates on corporate dividends has stimulated corporate dividend payouts,
an increase in the tax on dividends could reverse the recent increase in dividend payouts.
Answers to Warm-Up Exercises
E14-1. Relevant dividend dates
will begin selling ex dividend on Friday, November 29, which is four days before the date of record.
E14-2. Residual theory of dividend payout
Answer: 1. New investments $2,700,000
2. Retained earnings available 1,200,000
E14-3. Legal constraints on dividend payout
Answer: If legal capital is defined solely as the par value of common stock, Ashkenazi will be able to pay out
paid-in capital in excess of par plus all retained earnings.
Potential dividend per share (divide total available by 350,000 shares) $9.29
If legal capital is defined as both the par value of common stock and paid-in capital in excess of par,
E14-4. Constant dividend payout ratio
Answer: The first step in analyzing the Kopi scenario is to determine the historical payout ratio.
Year EPS Dividend/Share Dividend Payout Ratio
2016 $1.75 $0.95 54.29%
2018 2.05 1.25 60.98
Discussion: Kopi Companies’ historical dividend payout ratio has been fairly consistent and near the
60% constant payout ratio that the board is considering. So in terms of dollar amounts, the new
E14-5. Stock dividend
Answer: After the 10% stock dividend, Hilo’s stockholder’s equity account is as follows:
Common stock (55,000 shares at $3 par) $165,000
Paid-in capital in excess of par 335,000