978-1259277160 Case Case 28

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Montgomery Corporation Case 28

Dividend Policy

Purpose: The key issue is whether the firm’s cash dividend should be considered an active or residual

variable in setting the actual payment. There is enough bickering between directors and officers of the

firm to give the student plenty of insight into this issue. Though Montgomery Corporation is a fictitious

firm in the retail industry, the student is given enough information to compare its dividend policy to

Dillard’s, J.C. Penney, Wal-Mart, and others. The student is also asked to use the dividend valuation

model, to consider capital structure issues, and also evaluate the suitability of a stock dividend versus a

cash dividend.

Relation to Text: The case should follow Chapter 18. It is also assumed that the student is familiar with

capital structure considerations (Chapter 11) and common stock (Chapter 17).

Complexity: The case is moderately complex. It should require 1 hour.

Solutions

1. a. From Figure 1, we note that dividends per share for the years 2009-2015 were:

The firm is following a constant dividend policy with increases as the company grows. Note that

b. In Figure 2, we see that all of Montgomery’s competitors are either following the same policy that

Montgomery is, or they are striving to increase the dividend every year. Dollar General held to a

$.20 dividend in 2014 even though EPS decreased over 75%! In 2013 Dollar General actually

2. a. Given that D1 = $2.10, g = 7.1%, and P0 = $35, Ke, the expected return to the common

stockholder is:

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%1.13

%1.7%6

%1.7

35$

10.2$





b. If Don’s proposal is adopted, and next year’s dividend is zero, but g rises to 14%, the expected

return to the stockholders is:

%14

%140

%14

35$





It appears that if Montgomery adopted Don’s suggestion, the stockholders would realize a 0.9%

increase in their expected return. By this calculation alone, then, we might conclude that Don’s

idea is a good one; the firm should adopt a residual dividend policy. However, note that the

stockholders would only realize Don’s 14% gain if they sell their shares, while the firm’s current

3. Don’s argument rests on the principle that the capital budget, as well as the dividend, must be paid for

solely out of net income for the current year, and, of course, this is not so. It is the amount of cash

available that is the limiting factor. Referring to Figure 1, we see that Montgomery’s cash balance for

4. a. The cost of internal equity financing is, of course, 13.1%, which was computed in question 2a,

c. This might throw the debt-equity mix out of proportion. Excessive use of debt might not only

5. Mr. Autry’s comments strike at the heart of the residual dividend policy. That policy presumes that

the stockholders have no preferences about the form of repayment they receive from their investment

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whether or not the stockholders have a preference, or how strong it might be. Strong cases can be

6. The firm could pay a stock dividend in place of the cash dividend, and some stockholders might be

satisfied with that. However, the majority would probably recognize that they had not received

7. As we mentioned in question 5, there is no universal agreement on this question. Some would argue

that dividends do not matter and some would argue that they do. Most would agree, however, that if

the firm does pay taxes, and if there are flotation costs associated with outside equity financing, and if

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