Chapter 14 Payout Policy
Chapter Overview
The What Companies Do opener feature examines Starbucks first dividend payment. Many
companies paid dividends in 2010 and these payouts were attributed to the large cash build–up
relative to the market values of many firms. Starbucks was an example of this phenomenon. After
Opening Focus Discussion Questions
1. What is Starbucks share repurchase and enhanced dividend saying about its future prospects?
2. If Starbucks was making new investments at about the same time of the buyback. What could
we observe these as complementary strategies?
This chapter relates the dividend decision to the overall capital structure/financing decision
through:
1-1. Payout Policy Fundamentals
1-2. Factors Affecting Dividend and Share Repurchase Decisions
1-5. Payout Policy: Key Lessons
Technology
1. Smart Practices Video. Andy Bryant, CFO for Intel, explains that dividends are an effective
way to return cash to shareholders.
3. Smart Ideas Video. Kenneth Eades of the University of Virginia notes that it is the earnings
that support dividends that are important.
5. Smart Practices Video. Frank Popoff, retired chairman of the board of Dow Chemical,
discusses the role of the board of directors in determining dividends.
6. Smart Ideas Video. John Graham of Duke University talks about firms’ initiating dividends
and increasing already-existing dividends.
Chapter 14 Payout Policy 389
Lecture Guide
Dividend policy is an important part of the firm’s financing decision. If a firm chooses to pay out a
higher percentage of its net income as dividends, then it may need to raise more money in the
external markets in order to fund its investment projects.
14-1 Payout Policy Fundamentals
This section explains basic dividend terminology and concepts.
14-1a Cash Dividend Payment Procedures
Note that laws do not prohibit firms from paying more in dividends than their current
earnings. If bondholders want to protect themselves, they must write such restrictions into bond
Figure 14.1 Payout Through 2009, Dividends, Repurchases, Earnings
Figure 14.2 A Timeline Illustrating Important Dates in the Dividend Process
14-1b External Factors Affecting Dividend Policy
There are many factors that affect dividend policy including: legal constraints, contractual
Table 14-1 Calculating the Maximum Amount a Firm Can Pay in Cash Dividends
14-1c Types of Dividend Payout Policies
14-1d Stock Dividends and Stock Splits
Note that stock splits are like large stock dividends. (Or, stock dividends are small stock
splits). While, from an accounting standpoint, stock splits and stock dividends do not impact share
14-1e Share Repurchases
Share repurchases are increasingly popular among U.S. firms. Undervaluation is the most
commonly cited reason for repurchase. A repurchase is an indicator of management confidence in
the stock, and their willingness to support that opinion with an investment in the company’s stock.
390 Instructor’s Manual
Not only does the stock price generally rise on the announcement of a share repurchase, but
earnings forecast by analysts tend to be revised upward. There is also evidence that open market
14-2 Factors Affecting Dividend and Share Repurchase Decisions
14-2a CFO Views on Dividends and Repurchases
The findings from a 2005 survey of 384 CFOs and treasurers along with extensive one-on-
one interviews with two dozen additional CFOs and treasurers yield a great deal of insight into the
Figure 14.3 CFOs’ Views on Dividends and Repurchases
14-2b Further Evidence on Dividend and Share Repurchase Practices
This section discusses the effects of dividends and repurchases on the firm value. For
example, when a firm buys back shares, EPS will lower after a share repurchase. This can be a
major factor in a firm’s decision in repurchasing shares. Dividend effects are also seen in a
different light. Dividends are changed or implemented more cautiously due to the impact to the
Figure 14.4 CFOs’ Views on Why Firms Repurchase Shares
14-3 Dividends in Perfect and Imperfect Worlds
14-3a Payout Policy Irrelevance in a World with Perfect Capital Markets
The process of proving dividend irrelevance is similar to proving capital structure
irrelevance. Note the assumptions to make this work, in particular that dividends are equivalent to
14-3b Miller and Modigliani Meet the (Imperfect) Real World
This section discusses the impact of dividend behavior on Modigliani and Miller’s
Figure 14.5 Dividends and Repurchases in the European Union, 1989-2006
14-4 Real World Influences on Payout Policies
Investors may be attracted to companies that have dividend payouts that suit their personal
preferences. For example, retirees might prefer a portfolio of high dividend paying stocks so they
can spend their dividend income. They might choose to invest in utilities and other companies that
traditionally pay high dividends. While in theory capital gains and dividends are perfect
substitutes, in reality, an individual faces transactions costs in selling stock. On the other hand,
dividends are fully taxed at the individual’s marginal personal income tax rate, while capital gains
are taxed at a lower marginal rate. Companies may develop tax clienteles, based on preferences for
current income vs. capital gains, which are taxed at lower rates. Ask students to fill in the
following grid. Suppose a company has a high dividend payout, and has a high need for
investment funds. What are its options?
Firm Need for
Investment Funds
Shareholder Preferences
Current Income
Capital Gains
392 Instructor’s Manual
14-4a Personal Income Taxes
When the personal income tax rate on dividends is higher than the tax rate on capital gains,
firms should repurchase and not issue dividends.
14-4b Trading and Other Transactions Costs
14-4c The Residual Theory of Dividends
14-4d Paying Dividends as a Means of Communicating Information
14-4e What Type of Information Is Being Communicated?
14-4f Dividend Payments as Solutions to Agency Problems
14-5 Payout Policy: Key Lessons
Ch. 14 Resource Articles
“Cisco Shareholders Strongly Reject Dividend Proposal,” Wall Street Journal, November 20, 2002.
Cisco shareholders, by a wide margin, voted against a dividend. Shareholders said they would
Chapter 14 Payout Policy 393
“Will Stock Dividends Get Back their Respect,” Wall Street Journal, December 10, 2002. This
article looks at the proposed tax cut on dividends, declining yields and companies’ increasing use
of stock buybacks.
“Collect, Reinvest, Repeat for Decades,” Wall Street Journal, September 9, 2011. This article
discusses the view of investors toward dividends during a week economic time period. Investors
tend to flock toward stocks with dividends during economic downturn.
Answers to Concept Review Questions
1. A firm’s payout policy refers to its choice of whether to pay out cash to shareholders, in what
fashion, and in what amount. The most obvious and important aspect of this policy is the firm’s
decision whether to pay a cash dividend, how large the cash dividend should be, and how
2. The firm has removed an amount of cash equal to the amount of the dividend from the firm. Its
3. A stock dividend is an issue of stock to all shareholders as a dividend (possibly instead of or In
conjunction with a cash dividend). The stock price will decrease to maintain the same market
4. Share repurchases are an alternative to cash dividends because both have the same effect on the
shareholders as a whole. With a cash dividend, the stock price decreases by the amount of the
per share dividend making all shares in total reduce in value by the entire amount paid in
dividends. With a share repurchase, the stock price does not decrease, but the number of shares
owned by shareholders as a whole decreases by the amount of the shares repurchased. Shares
394 Instructor’s Manual
6. It is certainly possible that some investors value a steady dividend stream. However, investors
who desire steady cash flow from their stock portfolio can achieve that objective by selling a
7. From 1950 through 1983, firms generally paid 1/3 of their earnings in dividends and generally
adjusted dividends within three years if dividend payouts deviated from the desired target.
8. Shareholders could unwind the firm’s dividend policy in two ways. First, suppose
shareholders preferred that the company reinvest dividends rather than paying them out.
9. These firms could also conduct a share repurchase, which would give a similar signal to the
market if done with cash.
10. As long as the firm accepts all positive NPV investment opportunities and has “costless” access
to capital markets, then it can pay whatever dividends it desires. But if a firm pays out its
11. High punitive tax rates led investors to “de–capitalize” the corporate sector by paying out large
12. The signaling and agency theories both support the empirical evidence because the market
interprets the decline in dividends that (a) the firm is not doing well and must not be worth its
13. Cash dividend payments have an inherent credibility that words do not have. Therefore,
investors will be more willing to believe managers who say that their firms have great
prospects when the managers back these statements up with high cash dividend payments than
Chapter 14 Payout Policy 395
14. A firm with weaker cash flows may temporarily be able to mimic a dividend increase
undertaken by a firm with stronger cash flows, but in the long run its lesser cash position would
15. According to the residual theory of dividends, the actual dividend amount paid out by a firm to
shareholders each quarter would be the amount of cash “left over” after the firm’s fixed
Answers to Self-Test Questions
ST14-1. What do date of record, ex–dividend date, and payment date mean, related to dividends?
Why would you expect the price of a stock to drop by the amount of the dividend on the
ex-dividend date? What rationale has been offered for why this does not actually occur?
A: When corporations announce dividend payments, they state that the dividend will be paid
to shareholders of record on a certain date, with payment to be made several days later.
ST14-2. What has happened to the total volume of share repurchases announced by U.S. public
companies since 1982? Why did that year mark such an important milestone in the
history of share repurchase programs in the United States?
396 Instructor’s Manual
A: The total value of share repurchases in the United States increased dramatically after
ST14-3. What has happened to the average cash dividend payout ratio of U.S. corporations over
time? What explains this trend? How would your answer change if share repurchases
were included in calculating U.S. dividend payout ratios?
A: Not only has the fraction of U.S. firms that pay dividends been declining steadily for the
past 50 years, those companies that do pay regular cash dividends tend to pay out lower
fractions of their earnings today than in the past. A relative handful of 200 or so NYSE
ST14-4. What does it mean to say that corporate managers “smooth” cash dividend payments?
Why do managers do this?
A: Most firms will maintain a constant nominal dividend payment until the company’s
managers are convinced that corporate earnings have permanently changed. If the firm’s
ST14-5. What are the key assumptions and predictions of the signaling model of dividends? Are
these predictions supported by empirical research findings?
A: The signaling model of dividends predicts that managers will begin paying dividends in
Chapter 14 Payout Policy 397
ST14-6. What is the expected relationship between dividend payout levels and the growth rate
and availability of positive-NPV projects, under the agency cost model of dividends?
What about the expected relationship between dividend payout and the diverseness of the
firm’s shareholders? Consider a firm such as Microsoft, awash in excess cash flow and
available positive-NPV projects, and having a relatively diverse shareholder base in an
industry with increasing competition. Does either the agency model or the signaling
model adequately predict the dividend policy of Microsoft? Which does the better job?
A: The agency cost model predicts that firms with many positive-NPV investment projects
will have less need to pay out cash as dividends in order to overcome agency costs than
Answers to End-of-Chapter Questions
Q14-1. What fraction of U.S. public companies pays regular cash dividends today? How has this
changed over the past 50 years?
A14-1. Less than 20% of publicly traded U.S. companies pay regular cash dividends today.
Q14-2. What is a firm’s dividend yield? How does it compare to that firm’s dividend payout
ratio?
A14-2. Dividend yield is computed by dividing the annual dividend per share by stock price,
Q14-3. Compare and contrast the following dividend policies: constant payout ratio dividend
policy and the constant dollar payout dividend policy. Which policy do most public
companies actually follow? Why?
A14-3. A firm pursuing a constant payout dividend policy would pay a set fraction of its
398 Instructor’s Manual
Q14-4. What is a low-regular-and-extra-dividend payout policy? Why do firms pursuing this
policy explicitly label some cash dividend payments as “extra”?
A14-4. Firms with volatile earnings, or those that have received a one-time cash windfall
Q14-5. What is a stock dividend? How does this differ from a stock split?
A14-5. A stock dividend is a distribution of new stock to existing investors, usually instead of a
cash dividend. Shareholders who originally owned say, 100 shares, might receive an
extra five shares as a stock dividend, giving them 105 shares in total. Since everyone
receives the same proportional distribution, however, this “dividend” has no real value
Q14-6. What factors have contributed to the growth in share repurchase programs by U.S. public
companies? What effect did the Jobs and Growth Tax Relief Reconciliation Act of 2003
have on share repurchase programs?
A14-6. Prior to the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, most
Chapter 14 Payout Policy 399
stock from the market each year. Shareholders could also choose whether or not to
participate in repurchase programs. Those who chose to sell their shares were liable for
for the rise in repurchase programs. This body of research indicates that managers
implemented repurchase programs primarily to offset the enormous increase in shares
outstanding that resulted from their own share option compensation programs. In other
words, these option distributions were so large that managers had to repurchase shares in
order to prevent a dramatic and dilutive increase in the number of shares outstanding.
Q14-7. What is the average stock market reaction to: (a) a dividend initiation; (b) a dividend
increase; (c) a dividend termination; and (d) a dividend decrease? Are these reactions
logically consistent?
A14-7. The average stock market reaction to a dividend initiation or increase is a 1-3% rise in
stock price on the announcement date. When firms announce dividend cuts or
Q14-8. What are the key assumptions and predictions of the agency cost/contracting model of
dividend payments? Are these predictions supported by research findings?
A14-8. The agency cost contracting model of dividend payments predicts that managers initiate
dividend payments primarily to overcome the agency costs that arise once a publicly
traded firm’s ownership structure becomes diffuse. While ownership is tightly
400 Instructor’s Manual
Q14-9. Around the world, utilities generally have the highest dividend payouts of any industry,
yet they also tend to have massive investment programs which they finance using
external sources. How do you reconcile high payouts and large-scale security issuance?
A14-9. Regulated firms have a clear incentive to commit to paying out almost all of their net
income each period, since if they did not regulators would find it easy to transfer wealth
from shareholders to rate-payers by setting allowable rates very low. In this case, utilities
Q14-10. Why do firms with diverse shareholder bases typically pay higher dividends than private
firms or public firms with more-concentrated ownership structures? How are fixed
dividends used as a bonding (commitment) mechanism by managers of firms with
dispersed ownership structures and large amounts of excess cash flow?
A14-10. Firms with more diverse ownership most likely have higher agency costs. If a firm is
closely held—in other words, the people running the firm are also its owners—then
Q14-11 How is the residual theory of dividends used to explain observed dividend payments?
How is this theory in conflict with evidence suggesting that corporate managers smooth
dividends?
A14-11. According to the residual theory of dividends, the actual dividend amount paid out by a
firm to shareholders each quarter would be the amount of cash “left over” after the firm’s
Solutions to End-of-Chapter Problems
Payout Policy Fundamentals
P14-1. Beta Corporation has the following shareholders’ equity accounts
Common stock at par $ 5,000,000
Paid-in capital in excess of par 2,000,000
Chapter 14 Payout Policy 401
Retained earnings 25,000,000
Total stockholders’ equity $32,000,000
a. What is the maximum amount that Beta Corporation can pay in cash dividends,
without impairing its legal capital, if it is headquartered in a U.S. state where capital
is defined as the par value of common stock?
b. What is the maximum amount that Beta Corporation can pay in cash dividends
without impairing its legal capital if it is headquartered in a U.S. state where capital
is defined as the par value of common stock plus paid-in capital in excess of par?
P14-2. What are alternative ways in which investors can receive a cash return from their
investment in the equity of a company? From a tax standpoint, which of these would be
preferred, assuming that investors the same 15% tax rate on income and capital gains?
What are the pros and cons of paying out cash dividends?
A14-2. Investors can receive cash returns from their equity investments from cash dividends or
share repurchases. From a tax standpoint, shareholders would prefer the share repurchase
if dividends are taxed more heavily than capital gains. They must only pay capital gains
P14-3. Delta Corporation earned $2.50 per share during fiscal year 2011 and paid cash
dividends of $1.00 per share. During the fiscal year that just ended on December 31,
2012, Delta earned $3.00 per share, and the firm’s managers expect to earn this amount
per share during fiscal years 2013 and 2014 as well.
a. What was Delta’s payout ratio for fiscal year 2011?
b. If Delta’s managers wish to follow a constant dollar payout dividend policy, what
dividend per share will they declare for fiscal year 2012?
c. If Delta’s managers wish to follow a constant payout ratio dividend policy, what
dividend per share will they declare for fiscal year 2012?
d. If Delta’s managers wish to follow a partial-adjustment strategy, with a target payout
ratio equal to fiscal year 2011’s, how could they change dividend payments during
2012, 2013, and 2014?
402 Instructor’s Manual
A14-3. a. Delta’s payout ratio for 2008 was 40% ($1.00÷$2.50)
P14-4. Advanced Vehicle Enterprises (AVE) follows a policy of paying out 50% of its net
income as cash dividends to its shareholders each year. The company plans to do so
again this year, during which AVE earned $100 million in net profits after tax. The
company has 40 million shares outstanding and pays dividends annually.
a. What is the company’s dollar dividend payment per share each year?
b. Assuming that AVE’s stock price is $54 per share immediately before its ex-
dividend date, what is the expected price of AVE stock on the ex-dividend date if
there are no personal taxes on dividend income received?
P14-5. General Manufacturing Company (GMC) follows a policy of paying out 50% of its net
income as cash dividends to its shareholders each year. The company plans to do so
again this year, during which GMC earned $100 million in net profits after tax. The
company has 40 million shares outstanding and pays dividends annually. Assume that an
investor purchased GMC stock a year ago at $45. The investor, who faces a personal tax
rate of 15% on both dividend income and on capital gains, plans to sell the stock soon.
Transactions costs are negligible.
a. Calculate the after-tax return this investor will earn if she sells GMC stock at the
current $54 stock price prior to the ex-dividend date.
b. Calculate the after-tax return the investor will earn if she sells GMC stock on the ex-
dividend date, assuming that the price of GMC stock falls by the dividend amount on
the ex-dividend date.
c. Calculate the after-tax return the investor will earn if she sells GMC stock on the ex-
dividend date, assuming that the price of GMC stock falls by one-half the dividend
amount on the ex-dividend date.
A14-5. a. If she purchased the stock for $45/share one year ago and sells it for $54/share prior