978-1259277160 Chapter 18 Lecture Note

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Dividend Policy and Retained Earnings

Author’s Overview

The key initial question to be asked is: How does a corporation determine the amount of

dividends to be paid? The discussion should move to the marginal principle of retained

earnings with the associated emphasis on dividends as a passive variable in the decision-making

process. The corporate life-cycle curve is included to relate growth to dividend policy.

Because few students would accept the theory that a corporation sets its dividend payment

entirely on the basis of whether the corporation or stockholder can make a higher return on the

funds, the passive approach to dividends is seen as a good but incomplete theory that must be

supplemented with further considerations. The instructor can then cover other relevant

functions of dividends such as resolution of uncertainty and information content, and integrate

the marginal principle of retained earnings with considerations of investor preferences. Other

influences on dividend policy such as legal requirements, cash position of the firm, access to

capital markets, and the like are presented.

Additional material is also provided on dividend payment procedures and dividend reinvestment

plans. Tax rates on dividends and capital gains are also presented with the Taxpayer Relief Act

of 2013 and modified in 2014 for the Affordable Care Act. Additionally stock repurchase as an

alternative to the cash dividend has received increasing attention in the literature and in the

popular press and makes a good ending discussion point.

Chapter Concepts

LO1. The board of directors and corporate management must decide what to do with the

firm’s annual earnings: pay them out as dividends or retain them for reinvestment in

future projects.

LO2. Dividends may have positive or negative information content for shareholders.

Dividend policy can also provide information about where the firm is on its life cycle

curve.

LO3. Many other factors also influence dividend policy such as legal rules, the cash position

of the firm, and the tax position of shareholders.

LO4. Stock dividends and stock splits provide common stockholders with new shares, but

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their value must be carefully assessed.

LO5. Some firms make a decision to repurchase their shares in the market rather than increase

dividends.

Annotated Outline and Strategy

I. The Marginal Principle of Retained Earnings

A. Life cycle growth and dividends

B. The corporate growth rate in sales and earnings is a major influence on

dividends.

CA firm’s dividend policy will usually reflect the firm’s stage of development.

1. Stage I — small firm, initial stage of development — no dividends.

2. Stage II — successful firm, growing demand for products and increasing

sales, earnings and assets — stock dividends followed later by small cash

dividends.

3. Stage III — cash dividends rise as asset expansion slows and external

funds are more readily available — stock dividends and stock splits also

common.

4. Stage IV — the firm reaches maturity and maintains a stable sales growth

rate and cash dividends tend to be 40-60 percent of earnings depending

on the industry.

PPT Life Cycle Growth and Dividend Policy (Figure 18-1)

Perspective 18-1: The life cycle curve is important. The impact of growth on cash flow ties

back to cash forecasting in Chapter 4, and external and internal funds in Chapter 14. Be sure to

emphasize the accelerating, decelerating, and constant growth areas.

D. Dividends as a Passive Variable – According to the passive residual theory of

dividends, earnings should be retained as long as the rate earned is expected to

exceed a stockholder’s rate of return on the distributed dividend.

E. An Incomplete Theory – The residual dividend theory assumes a lack of

preference for dividends by investors.

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F. Arguments for the Relevance of Dividends – Much disagreement exists as to

investors’ preference for dividends or retention of earnings. Arguments for the

relevance of dividends ignore investor preferences but include:

1. Resolves investor uncertainty about receiving dividends.

2. Information content: “The firm must be doing well because it paid a

dividend.”

3. A bird in the hand is worth two in the bush. In other words a known

dividend is better than an unknown capital gain.

PPT Corporate Dividend Policy (Table 18-1)

Finance in Action: Being an Aristocrat is Pretty Good

This box highlights companies that have been able to raise their dividends over 25 consecutive

years and these companies are referred to as Dividend Aristocrats because there are not many

companies that can make that claim. We include a box of companies like 3M Co., Coca-Cola,

Johnson and Johnson and a few others who have managed this feat for 51 years in a row.

II. Dividend Stability

A. Firms with high growth rates usually pay relatively low dividends. See Table

18-1.

B. Mature firms follow a relatively high payout policy.

C. The average payout of U.S. corporations since WW II has been 40 to 50 percent

of aftertax earnings.

D. The stable dividend policy followed by U.S. corporations indicates that

corporate management feels that stockholders have a preference for dividends.

Perspective 18-2: Figure 18-2 highlights the nature of retained earnings for the economy as a

whole as companies divide their total profits between dividends and retained earnings.

PPT Corporate Profits, Dividends, and Retained Earnings (Figure 18-2)

III. Other Factors Influencing Dividend Policy

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A. Legal rules — most states have enacted laws protecting corporate creditors by

forbidding distribution of the firm’s capital in the form of dividends.

B. Cash position- the firm – must have cash available regardless of the level of past

or current earnings in order to pay dividends.

C. Access to capital markets– the easier the access to capital markets, the more able

the firm is to pay dividends rather than retain earnings.

D. Desire for control

1. Small, closely-held firms may limit dividends to avoid restrictive

borrowing provisions or the need to sell new stock.

2. Established firms may feel pressure to pay dividends to avoid

stockholders’ demand for change of management.

E. Tax position of shareholders

1. High tax-bracket stockholders may prefer retention of earnings because

they can choose when to sell and pay taxes on their capital gain. They

may also prefer retention of earnings over dividends when tax rates on

dividends are higher than long-term capital gains taxes.

2. Lower tax-bracket individuals, corporations receiving dividends, and

tax-free institutional investors such as pension funds may prefer higher

dividend payout ratios.

3. See Table 18-3 for the new tax rates on dividends and capital gains under

the American Taxpayer Relief Act of 2013 and modified for 2014. Notice

that the table distinguishes between ordinary dividends and qualified

dividends.

IV. Dividend Payment Procedures

A. Dividends are usually paid quarterly.

1. Dividend Yield = Annual dividend per share ÷ Current stock price.

2. Dividend Payout Ratio = Annual dividend per share ÷ Earnings per share

B. Three key dividend dates:

1. Holder of record date – the date the corporation examines its books to

determine who is entitled to a cash dividend.

2. Ex-dividend date – two business days prior to the holder of record date.

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If an investor buys a share of stock after the third day prior to the holder

of record date, the investor’s name would not appear on the firm’s books.

3. Payment date – approximate date of mailing of dividend checks.

V. Stock Dividends – – An additional distribution of stock shares, typically about 10

percent of outstanding amount.

PPT XYZ Corporation’s Financial Position before Stock Dividend

(Table 18-4)

PPT XYZ Corporation’s Financial Position after Stock Dividend

(Table 18-5)

A. An accounting transfer is required at fair market from retained earnings. The par

value of the stock dividend is transferred to the common stock account and the

remainder (if any) is added to the capital in excess of par account.

B. Unless total cash dividends increase, the stockholder does not benefit from a

stock dividend.

C. Use of stock dividends

1. Informational content-retention of earnings for reinvestment

2. Camouflage inability to pay cash dividends

D. Reverse stock splits have an opposite impact: to lower the number of shares

outstanding (as well as earnings per share) but to increase stock price.

VI. Stock Split –– A distribution of stock that increases the total shares outstanding by

20-25 percent or more.

PPT XYZ Corporation Before and After Stock Split (Table 18-6)

A. Accounting transfer from retained earnings is not required. Par value of stock is

reduced and the number of shares increases proportionately.

B. Benefits to stockholders, if any, are difficult to identify.

C. Primary purpose is to lower stock price into a more popular trading range.

VII. Repurchase of Stock as an Alternative to Dividends

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A. Alternative to payment of dividends

1. Most often used when the firm has excess cash and inadequate

investment opportunities.

2. With the exception of a lower capital gains tax (preferential tax treatment

of capital gains was eliminated by the tax Reform Act of 1986) the

stockholder would be as well off with a cash dividend.

B. Other reasons for repurchase

1. Management may deem that stock is selling at a very low price and is the

best investment available.

2. Use for stock options or as part of a tender offer in a merger or

acquisition.

3. To reduce the possibility of being “taken over.”

PPT Financial Data of Morgan Corporation (Table 18-7)

Finance in Action: IBM Repurchases Common Stock Worth Billions of Dollars.

This article discusses IBM’s policy to repurchase common stock instead of paying large

dividends. It also presents other reasons why other firms may follow this policy.

PPT Recent Examples of Share Repurchase Announcements (Table 18-8)

VIII. Dividend Reinvestment Plans

A. Begun during the 1970s, plans provide investors with an opportunity to buy

additional shares of stock with the cash dividend paid by the company.

B. Types of plans

1. The company sells treasury stock or authorized but unissued shares. The

stock is often sold at a discount since no investment banking or

underwriting fees have to be paid. This plan provides a cash flow to the

company.

2. The company’s transfer agent buys shares of stock in the market for the

stockholder. This plan does not provide a cash flow to the firm but is a

service to the stockholder.

C. Plans usually allow stockholders to supplement dividends with cash payments up

to $1,000 per month in order to increase purchase of stock

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Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 28, Montgomery Corporation (Dividend Policy)

Case 29, Orbit Chemical Co. (Dividend Policy; This case also considers stock repurchases and

stock options)

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