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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
Chapter Concepts
LO1. The board of directors and corporate management must decide what to do with the firm’s
annual earnings: pay them out in dividends or retain them for reinvestment in future projects.
LO3. Many other factors also influence dividend policy, such as legal rules, the cash position of
the firm, and the tax position of shareholders.
LO5. Some firms decide to repurchase their shares in the market rather than increase dividends.
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Annotated Outline and Strategy
I. The Marginal Principle of Retained Earnings
A. Life cycle growth and dividends
1. The corporate growth rate in sales and earnings is a major influence on
dividends.
2 A firm’s dividend policy will usually reflect the firm’s stage of development.
a. Stage I—small firm, initial stage of development—no dividends.
b. Stage II—successful firm, growing demand for products and
increasing sales, earnings, and assets—stock dividends followed later
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.
B. Dividends as a passive variable—according to the passive residual theory of
C. An incomplete theory—the residual dividend theory assumes a lack of preference for
dividends by investors.
D. 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:
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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
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 WWII has been 40 to 50 percent of
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
A. Legal rules—most states have enacted laws protecting corporate creditors by
forbidding distribution of the firm’s capital in the form of dividends.
PPT Dividend Policy Considerations (Table 18-2)
B. Cash position of 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
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D. Desire for control
2. Established firms may feel pressure to pay dividends to avoid stockholders’
E. Tax position of shareholders
1. High tax-bracket stockholders may prefer retention of earnings because they
2. Lower tax-bracket individuals, corporations receiving dividends, and tax-free
3. See Table 18-3 for the new tax rates on dividends and capital gains under the
PPT Tax Cuts and Jobs Act of 2017 (2018 Tax Rates) (Table 18-3)
IV. Dividend Payment Procedures
A. Dividends are usually paid quarterly.
1. Dividend Yield = Annual dividend per share ÷ Current stock price.
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. If an
V. Stock Dividend—An additional distribution of stock shares, typically about 10 percent of
outstanding amount.
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PPT XYZ Corporation’s Financial Position before Stock Dividend
(Table 18-4)
PPT XYZ Corporation’s Financial Position before Stock Dividend
(Table 18-5)
A. An accounting transfer is required at fair market from retained earnings. The par
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
VI. Stock Split—A distribution of stock that increases the total shares outstanding by 20 to 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.
VII. Repurchase of Stock as an Alternative to Dividends
A. Alternative to payment of dividends
1. Most often used when the firm has excess cash and inadequate investment
opportunities.
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1. Management may deem that stock is selling at a very low price and is the
best investment available.
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
PPT Billion Dollar Stock Repurchases (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
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.
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Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 28, Montgomery Corporation (Dividend Policy)