14 Zutter Smart MFBrief 15e Ch14 Rev

Principles of Managerial Finance
Fifteenth Edition
Chapter 14
Payout Policy
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Learning Goals (1 of 2)
LG 1 Understand cash payout procedures, their tax
treatment, and the role of dividend reinvestment plans.
LG 2 Describe the residual theory of dividends and the key
arguments with regard to dividend irrelevance and
relevance.
LG 3 Discuss the key factors involved in establishing a
dividend policy.
LG 4 Review and evaluate the three basic types of dividend
policies.
Learning Goals (2 of 2)
LG 5 Evaluate stock dividends from accounting, shareholder,
and company points of view.
LG 6 Explain stock splits and the firm’s motivation for
undertaking them.
4
1. Introduction
A payout policy is a set of principles regarding a
corporation’s distributions to shareholders.
– May be established with regard to a dividend payout, a
dividend per share, a growth in dividend per share, or
any other metric.
– May include stock splits and stock dividends.
– May include stock repurchases.
Copyright © 2013 CFA Institute

14.1 The Basics of Payout Policy (1 of 4)
• Elements of Payout Policy
– Payout Policy
 Decisions that a firm makes regarding whether to distribute cash to
shareholders, how much cash to distribute, and the means by which cash
should be distributed
– Elements of Payout Policy
 When we observe the decisions that companies make regarding payouts to
shareholders, some common patterns emerge:
1. Rapidly growing firms generally do not pay out cash to shareholders
2. Slowing growth, positive cash flow generation, and favorable tax
conditions can prompt firms to initiate cash payouts to investors
3. Firms can make cash payouts through dividends or share
repurchase
4. When business conditions are weak, firms are more willing to
reduce share buybacks than to cut dividends
What is “payout policy”?
• The payout policy defines:
– The level of cash distributions to shareholders
– The form of the distribution (dividend vs. stock
repurchase)
– The stability of the distribution
Free Cash Flow: Distributions to Shareholders
Sales revenues
− Operating costs and taxes
− Required investments in operating capital
Free cash flow

= Sources
(FCF)
Uses
Interest Purchase of
Principal Stock
payments Dividends short-term
(after tax)
repayments repurchases investments
7
Dividend Fundamentals
• A dividend is a redistribution from earnings.
• Most companies maintain a dividend policy whereby they pay a
regular dividend on a quarterly basis.
• Some companies pay an extra dividend to reward shareholders
if they’ve had a particularly good year. Many companies pay
dividends according to a preset payout ratio, which measures
the proportion of dividends to earnings.
• Many companies have paid regular dividends for over a hundred
years.
Dividend Fundamentals (cont.)
• Dividend growth tends to lag behind earnings growth
for most corporations (see next slide).
• Since dividend policy is one of the factors that drives
an investor’s decision to purchase a stock, most
companies announce their dividend policy and
telegraph any expected changes in policy to the public.
• Therefore, it can be seen that many companies use their
dividend policy to provide information not otherwise
available to investors.
• Trends in Earnings and Dividends
– Over the long term the earnings and dividends lines tend to
move together
– Earnings are much more volatile than dividends
– The effect of the most recent recession on both corporate
earnings and dividends was large by historical standards
Figure 14.1 Per-Share Earnings and
Dividends of the S&P 500 Index
Distributions Patterns Over Time
• The percent of total payouts as a percentage of net income
has been stable at around 26%-28%.
– Dividend payout rates have fallen, stock repurchases have
increased.
– Repurchases now total more dollars in distributions than
dividends.
• A smaller percentage of companies now pay dividends.
When young companies first begin making distributions, it
is usually in the form of repurchases.
• Dividend payouts have become more concentrated in a
smaller number of large, mature firms.
Dividend Yields for Selected Industries
Industry Div. Yield %
Recreational Products 0.3
Lumber, Wood Products 1.9
Application Software 1.6
Banks 2.2
Housewares & Accessaries 2.5
Food-Major Diversified 3.7
Electric Utilities 3.8
Tobacco 3.9
Source: Yahoo Industry Data, June 2011
Life cycle growth and dividend
policy
Development Growth Expansion Maturity
Stage I Stage II Stage III Stage IV
No cash dividends Stock dividends Stock dividends Moderate to high

Low cash dividends Low to moderate cash dividends
cash dividends
Sales ($) Stock splits
Maturity
Expansion
Decline
Growth
Development
Time
Life Cycle Growth and Dividend Policy
Dividend policy is reflected in 4 stages:
Stage I - Development
no cash dividends
Stage II - Growth
stock dividends, low cash dividends
Stage III - Expansion
stock dividends, low to moderate cash dividends, stock splits
Stage IV - Maturity
moderate to high cash dividends
Matter of Fact
P&G’s Dividend History
Few companies have
replicated the dividend
achievements of the
consumer products giant
Procter & Gamble
(P&G). P&G has paid
dividends every year for
more than a century, and
it increased its dividend
in every year from 1956
through 2017.
• Trends in Dividends and Share Repurchases
– In the 1980s, share repurchases began to grow rapidly and
then slowed again in the early 1990s
 The value of aggregate share repurchases first eclipsed total
dividend payments in 2006
– Whereas aggregate dividends have risen smoothly over
time, share repurchases display much more volatility
• Trends in Dividends and Share Repurchases
– Conclusions
 Firms exhibit a strong desire to maintain modest, steady
growth in dividends that is roughly consistent with the long-run
growth in earnings
 Share repurchases have accounted for a growing fraction of
total cash payouts over time
 When earnings fluctuate, firms adjust their short-term payouts
primarily by adjusting share repurchases (rather than
dividends), cutting buybacks during recessions, and increasing
them rapidly during economic expansions
Figure 14.2 Aggregate Dividends and Repurchases
for All U.S. Publicly Listed Companies
Matter of Fact
Share Repurchases Gain Worldwide Popularity
The growing importance of share repurchases in corporate
payout policy is not confined to the United States. In most of
the world’s largest economies, repurchases have been on
the rise in recent years, eclipsing dividend payments at least
some of the time in countries as diverse as Belgium,
Denmark, Finland, Hungary, Ireland, Japan, Netherlands,
South Korea, and Switzerland. A study of payout policy at
firms from 25 different countries found that share
repurchases rose at an annual rate of 19% from 1999
through 2008.
14.2 The Mechanics of Payout Policy
(1 of 9)
• At quarterly or semiannual meetings, a firm’s board of

directors decides whether and in what amount to pay cash
dividends
• If the firm has already established a precedent of paying
dividends, the decision facing the board is usually whether
to maintain or increase the dividend, and that decision is
based primarily on the firm’s recent performance and its
ability to generate cash flow in the future
• Boards rarely cut dividends unless they believe that the
firm’s ability to generate cash is in serious jeopardy
Figure 14.3 U.S. Publicly Listed Companies
Maintaining, Increasing, or Decreasing
Dividends
(2 of 9)
• Cash Dividend Payment Procedures

– Date of Record (Dividends)
 Set by the firm’s directors, the date on which all persons
whose names are recorded as stockholders receive a declared
dividend at a specified future time
– Ex Dividend
 A period usually beginning 2 business days prior to the date of
record, during which a stock is sold without the right to receive
the current dividend
– Payment Date
 Set by the firm’s directors, the actual date on which the firm
mails the dividend payment to the holders of record
(3 of 9)
• Cash Dividend Payment Procedures

– Holders of Record
 All persons whose names are recorded as stockholders on the
date of record
Example 14.1 (1 of 3)
On April 17, 2017, the board of directors of Whirlpool
announced that the firm’s next quarterly cash dividend would
be $1.10 per share, payable on June 15, 2017, to
shareholders of record on Friday, May 19, 2017. Whirlpool
shares would begin trading ex dividend on the previous
Wednesday, May 17. At the time of the announcement,
Whirlpool had about 74 million shares of common stock
outstanding, so the total dividend payment would be $81.4
million. Figure 14.4 shows a timeline depicting the key dates
relative to the Whirlpool dividend.
Before the dividend was declared, the key accounts of the
firm were as follows (dollar values quoted in thousands):
Cash $951,000 Dividends payable $0
Blank Blank Retained earnings $7,394,000
When the dividend was announced by the directors, $81.4

million of the retained earnings ($1.10 per share × 74 million
shares) was transferred to the dividends payable account.
The key accounts thus became
Cash $951,000 Dividends payable $81,400
When Whirlpool actually paid the dividend on June 15, this
produced the following balances in the key accounts of the
firm:
Cash $869,600 Dividends payable $0

The net effect of declaring and paying the dividend was to

reduce the firm’s total assets (and stockholders’ equity) by
almost $81.4 million.
The Procedures of a Dividend Payment:
An Example
• November 11: Board declares a quarterly dividend of $0.50
per share to holders of record as of December 10.
• December 7: Dividend goes with stock.
• December 8: Ex-dividend date.
• December 10: Holder of record date.
• December 31: Payment date to holders of record.
Figure 14.4 Dividend Payment Timeline
The Mechanics of Payout Policy: Share
Repurchase
• A stock repurchase is the purchasing and retiring of
stock by the issuing corporation.
• A repurchase is a partial liquidation since it decreases
the number of shares outstanding.
• It may also be thought of as an alternative to cash
dividends.
Purposes of Stock Repurchases
Alternative reasons for stock repurchases:
• To use the shares for another purpose
• To alter the firm’s capital structure
• To increase EPS and ROE resulting in a higher
market price
• To reduce the chance of a hostile takeover
Stock Repurchases Viewed as a
Cash Dividend
• The repurchase of stock results in a type of reverse
dilution.
• The net effect of the repurchase is similar to the
payment of a cash dividend.
• However, if the firm pays the dividend, the owner
would have to pay tax on the income.
• The gain on the increase in share price as a result of the
repurchase, however, would not be taxed until sold.
33
Cash Dividends vs. Repurchasing Stock
• Reasons for preferring repurchasing stock over paying a

cash dividend
– Potential tax advantages
– Signaling
– Managerial flexibility
– Offset dilution from executive stock options
– Increase financial leverage
• A stock repurchase may be a good alternative to an
increase in cash dividends.

Advantages of Repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be maintained.
• Repurchased stock can be used in takeovers or resold to raise
cash as needed.
• Income received is capital gains rather than higher-taxed
dividends.
• Stockholders may take as a positive signal--management thinks
stock is undervalued.
Disadvantages of Repurchases
• May be viewed as a negative signal (firm has poor
investment opportunities).
• IRS could impose penalties if repurchases were
primarily to avoid taxes on dividends.
• Selling stockholders may not be well informed, hence
be treated unfairly.
• Firm may have to bid up price to complete purchase,
thus paying too much for its own stock.
14-35
The Procedures of a Repurchase
• Firm announces intent to repurchase stock.
• Three ways to purchase:
– Have broker/trustee purchase on open market over
period of time.
– Make a tender offer to shareholders.
– Make a block (targeted) repurchase.
• Firm doesn’t have to complete its announced
intent to repurchase.
(4 of 9)
• Share Purchase Procedures

– Open-market Share Repurchase
 A share repurchase program in which firms simply buy back
some of their outstanding shares on the open market
– Tender Offer Share Repurchase
 A repurchase program in which a firm offers to repurchase a
fixed number of shares, usually at a premium relative to the
market value, and shareholders decide whether or not they
want to sell back their shares at that price
(5 of 9)
• Share Purchase Procedures

– Dutch Auction Share Repurchase
 A repurchase method in which the firm specifies how many
shares it wants to buy back and a range of prices at which it is
willing to repurchase shares
 Investors specify how many shares they will sell at each price
in the range, and the firm determines the minimum price
required to repurchase its target number of shares
 All investors who tender receive the same price
In June 2017, Lifeway Foods announced a Dutch auction
repurchase for 6 million common shares at prices ranging
from $8.50 to $9.50 per share. Lifeway shareholders were
instructed to contact the company to indicate how many
shares they would be willing to sell at different prices in this
range. Suppose that after accumulating this information from
investors, Lifeway constructed the following demand schedule:
Offer price Shares tendered Cumulative total
$8.50 1,000,000 1,000,000
8.75 1,500,000 2,500,000
9.00 3,500,000 6,000,000
9.25 4,000,000 10,000,000
9.50 4,500,000 14,500,000
At a price of $9, shareholders are willing to tender a total of
6 million shares, exactly the amount that Lifeway wants to
repurchase. Each shareholder who expressed a willingness
to tender shares at a price of $9 or less receives $9, and
Lifeway repurchases all 6 million shares at a cost of roughly
$54 million.
(6 of 9)
• Tax Treatment of Dividends and Repurchases

– For many years, dividends and share repurchases had very
different tax consequences
– The dividends that investors received were generally taxed
at ordinary income tax rates
– When firms repurchased shares, the taxes triggered by that
type of payout were generally much lower
– The Jobs and Growth Tax Relief Reconciliation Act of 2003
significantly changed the tax treatment of corporate
dividends for most taxpayers
(7 of 9)
• Tax Treatment of Dividends and Repurchases

– The 2003 act reduced the tax rate on corporate dividends
for most taxpayers to the tax rate applicable to capital gains,
which was a maximum rate of 15%
– Under current tax law, stockholders face tax rates on
dividends and capital gains as low as 0% or as high as
23.8%, depending on their income level
Personal Finance Example 14.3 (1 of 2)
The board of directors of Espinoza Industries Inc., on
October 4 of the current year, declared a quarterly dividend
of $0.46 per share payable to all holders of record on Friday,
October 26, with a payment date of November 19. Rob and
Kate Heckman, who purchased 500 shares of Espinoza’s
common stock on Thursday, October 15, wish to determine
whether they will receive the recently declared dividend and,
if so, when and how much they would net after taxes from
the dividend given that the dividends would be subject to a
15% federal income tax.
Given the Friday, October 26, date of record, the stock would
begin selling ex dividend 2 business days earlier on
Wednesday, October 24. Purchasers of the stock on or
before Tuesday, October 23, would receive the right to the
dividend. Because the Heckmans purchased the stock on
October 15, they would be eligible to receive the dividend of
$0.46 per share. Thus, the Heckmans will receive $230 in
dividends ($0.46 per share × 500 shares), which will be
mailed to them on the November 19 payment date. Because
they are subject to a 15% federal income tax on the
dividends, the Heckmans will net $195.50 [(1 − 0.15) × $230]
after taxes from the Espinoza Industries dividend.
(8 of 9)
• Dividend Reinvestment Plans (DRIPs)

– Plans that enable stockholders to use dividends received on
the firm’s stock to acquire additional shares—even fractional
shares—at little or no transaction cost
What’s a “dividend reinvestment plan
(DRIP)”?
• Shareholders can automatically reinvest their dividends in
shares of the company’s common stock. Get more stock
than cash.
• There are two types of plans:
– Open market
o purchase additional shares in huge blocks to reduce per share commission
– New stock
o Company-direct DRIP
o Brokerage-direct DRIP
Advantages of DRIPS
• For Stockholders:
– substantial reduction in commission costs
– they provide investors with an automatic savings
mechanism.
• For Companies:
– goodwill
– reduction in cost of delivering dividend checks.
– An inexpensive means of raising equity capital for firms
company-directed plans.
What is dividend policy?
• The decision to pay out earnings versus retaining and reinvesting
them.
• Dividend policy includes
– High or low dividend payout?
– Stable or irregular dividends?
– How frequent to pay dividends?
– Announce the policy?
Relevance of Payout Policy
• The financial literature has reported numerous theories and
empirical findings concerning payout policy.
• Although this research provides some interesting insights about
payout policy, capital budgeting and capital structure decisions are
generally considered far more important than payout decisions.
• In other words, firms should not sacrifice good investment and
financing decisions for a payout policy of questionable
importance.
• The most important question about payout policy is this: Does
payout policy have a significant effect on the value of a firm?
(9 of 9)
• Stock Price Reactions to Corporate Payouts

– What happens to the stock price when a firm pays a
dividend or repurchases shares?
 In theory, when a stock begins trading ex dividend, the stock
price should fall by exactly the amount of the dividend
 In theory, when a firm buys back shares at the going market
price, the market price of the stock should remain the same
 In practice, taxes and a variety of other market imperfections
may cause the actual change in share price in response to a
dividend payment or share repurchase to deviate from what we
expect in theory
14.3 Relevance of Payout Policy (1 of 5)
• Residual Theory of Dividends
– A school of thought suggesting that the dividend paid by a
firm should be viewed as a residual, that is, the amount left
over after all acceptable investment opportunities have
been undertaken
• Residual Theory of Dividends
– Using this residual approach, the firm would treat the dividend
decision in three steps, as follows:
 Step 1: Determine its optimal level of capital expenditures, which
would be the level that exploits all a firm’s positive NPV projects
 Step 2: Using the optimal capital structure proportions, estimate the
total amount of equity financing needed to support the expenditures
generated in Step 1
 Step 3: Because the cost of retained earnings, rr, is less than the cost
of new common stock, rn, use retained earnings to meet the equity
requirement determined in Step 2
– If retained earnings are inadequate to meet this need, sell new
common stock. If the available retained earnings are in excess of
this need, distribute the surplus amount—the residual—as
dividends
Residual dividend model
 Target   Total 
   
Dividends  Net Income -  equity    capital 
 ratio   budget 
  

• Capital budget – $800,000
• Target capital structure – 40% debt, 60% equity
• Forecasted net income – $600,000
• How much of the forecasted net income should be
paid out as dividends?
Residual dividend model:
Calculating dividends paid
• Calculate portion of capital budget to be funded by equity.
– Of the $800,000 capital budget, 0.6($800,000) = $480,000
will be funded with equity.
• Calculate excess or need for equity capital.
– With net income of $600,000, there is more than enough
equity to fund the capital budget. There will be $600,000 -
$480,000 = $120,000 left over to pay as dividends.
• Calculate dividend payout ratio
– $120,000 / $600,000 = 0.20 = 20%
Residual dividend model: What if net income
drops to $400,000? Rises to $800,000?
• If NI = $400,000 …
– Dividends = $400,000 – (0.6)($800,000) = -$80,000.
– Since the dividend results in a negative number, the firm
must use all of its net income to fund its budget, and
probably should issue equity to maintain its target capital
structure.
– Payout = $0 / $400,000 = 0%
• If NI = $800,000 …
– Dividends = $800,000 – (0.6)($800,000) = $320,000.
– Payout = $320,000 / $800,000 = 40%
The Relevance of Dividend Policy:
The Residual Theory of Dividends (cont.)
• In sum, this theory suggests that no cash dividend is paid as long
as the firm’s equity need is in excess of the amount of retained
earnings.
• Furthermore, it suggests that the required return demanded by
stockholders is not influenced by the firm’s dividend policy—a
premise that in turn suggests that dividend policy is irrelevant.
• The Dividend Irrelevance Theory
– Miller and Modigliani’s theory that, in a perfect world, the
firm’s value is determined solely by the earning power and
risk of its assets (investments) and that the manner in which
it splits its earnings stream between dividends and internally
retained (and reinvested) funds does not affect this value
– Clientele Effect
 The argument that different payout policies attract different
types of investors but still do not change the value of the firm
• Arguments for Dividend Relevance
– Dividend Relevance Theory
 The theory, advanced by Gordon and Lintner, that there is a
direct relationship between a firm’s dividend policy and its
market value
– Bird-in-the-Hand Argument
 The belief, in support of dividend relevance theory, that
investors see current dividends as less risky than future
dividends or capital gains
– Information Content
 The information provided by the dividends of a firm with
respect to future earnings, which causes owners to bid up or
down the price of the firm’s stock
• Arguments for Dividend Relevance
– Agency Cost Theory
 The agency cost theory says that a firm that commits to paying
dividends is reassuring shareholders that managers will not
waste their money
 Given this reassurance, investors will pay higher prices for
firms promising regular dividend payments
14.4 Factors Affecting Dividend Policy
(1 of 6)
• Dividend Policy
– The plan of action to be followed whenever the firm makes a
dividend decision
• Legal Constraints
– Most states prohibit corporations from paying out as cash
dividends any portion of the firm’s “legal capital,” which is typically
measured by the par value of common stock
– Other states define legal capital to include not only the par value of
the common stock but also any paid-in capital in excess of par
– Excess Earnings Accumulation Tax
 The tax the IRS levies on retained earnings above $250,000 for most
businesses when it determines that the firm has accumulated an
excess of earnings to allow owners to delay paying ordinary income
taxes on dividends received
Example 14.4
The stockholders’ equity account of Miller Flour Company, a large
grain processor, is presented in the following table.
Miller Flour Company Blank
Stockholders’ Equity Blank
Common stock at par $100,000
Paid-in capital in excess of par 200,000
Retained earnings 140,000
Total stockholders’ equity $440,000
In states where the firm’s legal capital is defined as the par value
of its common stock, the firm could pay out $340,000 ($200,000 +
$140,000) in cash dividends without impairing its capital. In states
where the firm’s legal capital includes all paid-in capital, the firm
could pay out only $140,000 in cash dividends.
Example 14.5
Assume that Miller Flour Company, from the preceding
example, in the year just ended has $30,000 in earnings
available for common stock dividends. As the table in
Example 14.4 indicates, the firm has past retained earnings
of $140,000. Thus, it can legally pay dividends of up to
$170,000.
(2 of 6)
• Contractual Constraints
– Often, the firm’s ability to pay cash dividends is constrained
by restrictive provisions in a loan agreement
– Generally, these constraints prohibit the payment of cash
dividends until the firm achieves a certain level of earnings,
or they may limit dividends to a certain dollar amount or
percentage of earnings
(3 of 6)
• Growth Prospects
– The firm’s financial requirements are directly related to how
much it expects to grow and what assets it will need to
acquire
– A growth firm likely has to depend heavily on internal
financing through retained earnings, so it is likely to pay out
only a very small percentage of its earnings as dividends
– A more established firm is in a better position to pay out a
large proportion of its earnings, particularly if it has ready
sources of financing
(4 of 6)
• Owner Considerations
– The firm must establish a policy that has a favorable effect
on the wealth of its owners
– One consideration is the tax status of a firm’s owners
 If a firm has a large percentage of wealthy stockholders who
have sizable incomes, it may decide to pay out a lower
percentage of its earnings to allow the owners to delay the
payment of taxes until they sell the stock
– A second consideration is the owners’ investment
opportunities
 A firm should not retain funds for investment in projects
yielding lower returns than the owners could obtain from
external investments of equal risk
(5 of 6)
• Owner Considerations
– A final consideration is the potential dilution of ownership
 If a firm pays out a high percentage of earnings, new equity
capital will have to be raised with common stock
 The result of a new stock issue may be dilution of both control
and earnings for the existing owners
(6 of 6)
• Market Considerations
– Catering Theory
 A theory that says firms cater to the preferences of
investors, initiating or increasing dividend payments during
periods in which high-dividend stocks are particularly
appealing to investors
68
Tax Systems and Dividend Policy

Consider a company that has earnings before tax of $100 million
and pays all its earnings as dividends. The company’s tax rate is
35%, and individual shareholders have a marginal tax rate of
25%. In countries with a split-rate system, dividends are taxed at
28% at the corporate level.
Earnings taxed at
Double Effective tax on
corporate level and
dividends =
Taxation dividends taxed at
51.25%
shareholder level
Earnings taxed at
Dividend corporate level and Effective tax on
Imputation tax credit at dividends = 25%
shareholder level
Earnings distributed
Split-Rate are taxed at a lower Effective tax on
System rate than retained dividends = 46%
Copyright © 2013 CFA Institute earnings
69
4. Payout Policies
•

14.5 Types of Dividend Policies (1 of 3)
• Dividend Payout Ratio
– Indicates the percentage of each dollar earned that a firm
distributes to the owners in the form of cash; it is calculated
by dividing the firm’s cash dividend per share by its earnings
per share
• Constant-Payout-Dividend Policy
– A dividend policy based on the payment of a certain
percentage of earnings to owners in each dividend period
Peachtree Industries, a miner of potassium, has a policy of
paying out 40% of earnings in cash dividends. In periods
when a loss occurs, the firm’s policy is to pay no cash
dividends. Data on Peachtree’s earnings, dividends, and
average stock prices for the past 6 years follow.
Year Earnings/share Dividends/share Average price/share
2019 −$0.50 $0.00 $42.00
2018 3.00 1.20 52.00
2017 1.75 0.70 48.00
2016 −1.50 0.00 38.00
2015 2.00 0.80 46.00
2014 4.50 1.80 50.00
Dividends increased in 2017 and in 2018 but decreased in
the other years. In years of decreasing dividends, the firm’s
stock price dropped; when dividends increased, the price of
the stock increased. Peachtree’s sporadic dividend
payments appear to make its owners uncertain about the
returns they can expect.
73
Example: Payout Policies

Consider the financial information for Apple, Inc. (AAPL)
Fiscal Year Ending 9/29/2012 9/24/2011 9/25/2010
Net income (millions) $41,773 $25,922 $14,014
1. What are dividends for FY2011 and FY2012 if the

company followed a stable dividend policy, with a target
dividend payout of 10% and an adjustment factor of 0.3?
Fiscal Year Ending 9/29/2012 9/24/2011
Increase in earnings $15,851 $11,900
Multiply by target 0.10 0.10
Multiply by adjustment factor 0.30 0.30
Dividends $475.53 $357.24

74
Example: Payout Policies

company followed a constant dividend payout at 6%?

Net income (millions) $41,773 $25,922
Multiply by 6% 0.06 0.06
Dividends $2,506 $1,555.32

company followed the residual payout policy?
Net income (millions) $41,773 $25,922
Less: capital expenditures 9,402 7,452
Dividends $32,371 $18,470
• Regular Dividend Policy
– A dividend policy based on the payment of a fixed-dollar
dividend in each period
– Firms that use this policy increase the regular dividend once
a sustainable increase in earnings has occurred
– Under this policy, dividends are almost never decreased
• Target Dividend-Payout Ratio
– A dividend policy under which the firm attempts to pay out a
certain percentage of earnings as a stated dollar dividend
and adjusts that dividend toward a target payout as proven
earnings increases occur
The dividend policy of Woodward Laboratories, a producer
of a popular artificial sweetener, is to pay annual dividends of
$1.00 per share until per-share earnings have exceeded
$4.00 for 3 consecutive years. At that point, the annual
dividend is raised to $1.50 per share, and a new earnings
plateau is established. The firm does not anticipate
decreasing its dividend unless its liquidity is in jeopardy.
Data for Woodward’s earnings, dividends, and average stock
prices for the past 12 years follow.
Year Earnings/share Dividends/share Average price/share
2019 $4.50 $1.50 $47.50
2018 3.90 1.50 46.50
2017 4.60 1.50 45.00
2016 4.20 1.00 43.00
2015 5.00 1.00 42.00
2014 2.00 1.00 38.50
2013 6.00 1.00 38.00
2012 3.00 1.00 36.00
2011 0.75 1.00 33.00
2010 0.50 1.00 33.00
2009 2.70 1.00 33.50
2008 2.85 1.00 35.00
Whatever the level of earnings, Woodward Laboratories paid
dividends of $1.00 per share through 2016. In 2017, the
dividend increased to $1.50 per share because earnings in
excess of $4.00 per share had been achieved for 3 years. In
2017, the firm also had to establish a new earnings plateau
for further dividend increases. Woodward Laboratories’
average price per share exhibited a stable, increasing
behavior in spite of a somewhat volatile pattern of earnings.
• Low-Regular-and-Extra Dividend Policy
– A dividend policy based on paying a low regular dividend,
supplemented by an additional (“extra”) dividend when
earnings are higher than normal in a given period
– Extra Dividend
 An additional dividend optionally paid by the firm when
earnings are higher than normal in a given period
Example: Dividend Policy
Starjump’s Coffee has had the following earnings per
share over the 2008-2016 period:
Year EPS
2008 1.50
2009 1.00
2010 .80
2011 1.20
2012 1.30
2013 1.60
2014 1.10
2015 .90
2016 1.60
a. If the firm’s dividend policy is based on a constant
payout ratio of 50 percent for all years with positive
earnings, determine the annual dividend paid in each
year.
Solution:
a. If the firm paid out 50 percent of each year’s

earnings in years with positive earnings, the
dividends paid per share (DPS) would be as
follows:
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016
DPS $0.75 $0.50 $0.40 $0.60 $0.65 $0.80 $0.55 $0.45 $0.80
a. If the firm’s dividend policy is based on a constant payout
ratio of 50 percent for all years with positive earnings,
determine the annual dividend paid in each year.
b. If the firm has a regular dividend policy of paying $.60 per

share per year, regardless of the per-share earnings, until the
per-share earnings remain above $1.20 for two periods, at
which time the dividend would be increased to $.80 per
share, determine the annual dividend paid in each year.
Solution:
b. If the firm paid out a fixed $.60 per share until

earnings were above $1.20 for two years, at
which time they raised the dividend to $0.80 per
share, the dividend paid would be as follows:
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016
DPS $0.60 $0.60 $0.60 $0.60 $0.60 $0.80 $0.80 $0.80 $0.80
a. If the firm’s dividend policy is based on a constant payout
ratio of 50 percent for all years with positive earnings,
determine the annual dividend paid in each year.
b. If the firm has a regular dividend policy of paying $.60
per share per year, regardless of the per-share earnings,
until the per-share earnings remain above $1.20 for two
periods, at which time the dividend would be increased to
$.80 per share, determine the annual dividend paid in each
year.
c. If the firm’s policy is to pay out $.20 per share each
period, except in those periods when earnings are above
$1.00, when they pay out an extra dividend equal to 30
percent of the earnings above $1.00, determine the
amount of regular and extra dividends paid each year.
Solution:
c. If the firm pays a regular dividend plus an

extra dividend the payout would be as follows:
Year 2008 2009 2010 2011 2012 2013 2014 2015 2016
RDPS $0.20 $0.20 $0.20 $0.20 $0.20 $0.20 $0.20 $0.20 $0.20
EDPS $0.15 $0.00 $0.00 $0.06 $0.09 $0.18 $0.03 $0.00 $0.18
TDPS $0.35 $0.20 $0.20 $0.26 $0.29 $0.38 $0.23 $0.20 $0.38
14.6 Other Forms of Dividend (1 of 4)
• Stock Dividends
– The payment, to existing owners, of a dividend in the form of
stock
– Accounting Aspects
 Small (Ordinary) Stock Dividend
– A stock dividend representing less than 20% to 25% of the
common stock outstanding when the dividend is declared
The current stockholders’ equity on the balance sheet of
Garrison Corporation, a distributor of prefabricated cabinets,
is as shown in the following accounts:
Preferred stock $ 300,000
Common stock (100,000 shares at $4 par) $ 400,000
Paid-in capital in excess of par $ 600,000
Retained earnings $ 700,000
Total stockholders’ equity $2,000,000
Garrison, which has 100,000 shares of common stock
outstanding, declares a 10% stock dividend when the market
price of its stock is $15 per share. When Garrison issues
10,000 new shares (10% of 100,000) at the prevailing
market price of $15 per share, it shifts $150,000 ($15 per
share × 10,000 shares) from retained earnings to the
common stock and paid-in capital accounts. Garrison adds a
total of $40,000 ($4 par × 10,000 shares) to common stock,
and it adds the remaining $110,000 [($15 − $4) × 10,000
shares] to the paid-in capital in excess of par.
The resulting account balances are as follows:
Preferred stock $ 300,000
Common stock (110,000 shares at $4 par) $ 440,000
Paid-in capital in excess of par $ 710,000
Retained earnings $ 550,000
Total stockholders’ equity $2,000,000
The firm’s total stockholders’ equity has not changed; the

company has merely shifted funds among stockholders’
equity accounts.
• Stock Dividends
– Shareholder’s Viewpoint
 The shareholder receiving a stock dividend typically receives
nothing of value
 After the firm pays the dividend, the per-share value of the
shareholder’s stock decreases in proportion to the dividend in
such a way that the market value of his or her total holdings in
the firm remains unchanged
 Therefore, stock dividends are usually nontaxable
 The shareholder’s proportion of ownership in the firm also
remains the same, and as long as the firm’s earnings remain
unchanged, so does the dollar value of his or her share of total
earning
Ms. Xu owned 10,000 shares of Garrison Corporation’s stock.
The company’s recent earnings were $220,000, and they are
not expected to change in the near future. Before the stock
dividend, Ms. Xu owned 10% (10,000 shares ÷ 100,000
shares) of the firm’s stock, which was selling for $15 per
share. Earnings per share were $2.20 ($220,000 ÷ 100,000
shares). Because Ms. Xu owned 10,000 shares, her stock
represented a claim against Garrison’s earnings of $22,000
($2.20 per share × 10,000 shares). After receiving the 10%
stock dividend, Ms. Xu has 11,000 shares, which again is
10% of the ownership (11,000 shares ÷ 110,000 shares).
The market price of the stock should drop to $14.64 per
share [$15 × (1.00 ÷ 1.10)], which means that the
market value of Ms. Xu’s holdings is $150,000 (11,000
shares × $14.64 per share). This is the same as the
initial value of her holdings (10,000 shares × $15 per
share). The future earnings per share drops to $2
($220,000 ÷ 110,000 shares) because the same
$220,000 in earnings must now be divided among
110,000 shares. Because Ms. Xu still owns 10% of the
stock, her share of total earnings is still $22,000 ($2 per
share × 11,000 shares).
• Stock Dividends
– The Company’s Viewpoint
 Stock dividends are more costly to issue than cash dividends,
but certain advantages may outweigh these costs
 Firms find the stock dividend to be a way to give owners
something without having to use cash
 Generally, when a firm needs to preserve cash to finance rapid
growth, it uses a stock dividend
 When the stockholders recognize that the firm is reinvesting
the cash flow to maximize future earnings, the market value of
the firm should at least remain unchanged
 However, if the stock dividend is paid to retain cash for
satisfying past-due bills, a decline in market value may result
• Stock Splits
– A method commonly used to lower the market price of a
firm’s stock by increasing the number of shares belonging to
each shareholder
– Reverse Stock Split
 A method used to raise the market price of a firm’s stock by
exchanging a certain number of outstanding shares for one
new share
Example 14.10
Delphi Company, a forest products concern, had 200,000
shares of $2-par-value common stock and no preferred stock
outstanding. Because the stock is selling at a high market price,
the firm has declared a 2-for-1 stock split. The total before-and
after-split stockholders’ equity is shown in the following table.
Blank
Before split After 2-for-1 split

Common stock Blank Common stock Blank
(200,000 shares at $2 par) $ 400,000 (400,000 shares at $1 par) $ 400,000
Paid-in capital in excess of par 4,000,000 Paid-in capital in excess of par 4,000,000
Retained earnings 2,000,000 Retained earnings 2,000,000
Total stockholders’ equity $6,400,000 Total stockholders’ equity $6,400,000
The insignificant effect of the stock split on the firm’s books

is obvious.
Shakira Washington, a single investor in the 24% federal
income tax bracket, owns 260 shares of Advanced
Technology Inc., common stock. She originally bought the
stock 2 years ago at its initial public offering (IPO) price of $9
per share. The stock of this fast-growing technology
company is currently trading for $60 per share, so the
current value of her Advanced Technology stock is $15,600
(260 shares × $60 per share). Because the firm’s board
believes that the stock would trade more actively in the $20
to $30 price range, it just announced a 3-for-1 stock split.
Shakira wishes to determine the impact of the stock split on
her holdings and taxes.
Because the stock will split 3 for 1, after the split Shakira will
own 780 shares (3 × 260 shares). She should expect the
market price of the stock to drop to $20 (1/3 × $60)
immediately after the split; the value of her after-split holding
will be $15,600 (780 shares × $20 per share). Because the
$15,600 value of her after-split holdings in Advanced
Technology stock exactly equals the before-split value of
$15,600, Shakira has experienced neither a gain nor a loss
on the stock as a result of the 3-for-1 split. Even if there were
a gain or loss attributable to the split, Shakira would not have
any tax liability unless she actually sold the stock and
realized that (or any other) gain or loss.
Review of Learning Goals (1 of 7)
• LG 1
– Understand cash payout procedures, their tax treatment,
and the role of dividend reinvestment plans.
 The board of directors makes the cash payout decision and,
for dividends, establishes the record and payment dates
 As a result of tax-law changes, investors pay taxes on
corporate dividends at a maximum rate of 23.8%
 Some firms offer dividend reinvestment plans that allow
stockholders to acquire shares in lieu of cash dividends
• LG 2
– Describe the residual theory of dividends and the key arguments
with regard to dividend irrelevance and relevance.
 The residual theory suggests that dividends should be viewed as the
earnings left after all acceptable investment opportunities have been
undertaken
 Miller and Modigliani argue in favor of dividend irrelevance, using a
perfect world in which market imperfections such as transaction costs
and taxes do not exist
 Gordon and Lintner advance the theory of dividend relevance, basing
their argument on the uncertainty-reducing effect of dividends,
supported by their bird-in-the-hand argument
 Empirical studies fail to provide clear support of dividend relevance
 Even so, the actions of financial managers and stockholders tend to
support the belief that dividend policy does affect stock value
• LG 3
– Discuss the key factors involved in establishing a dividend
policy.
 A firm’s dividend policy should provide for sufficient financing
and maximize stockholders’ wealth
 Dividend policy is affected by legal and contractual constraints,
by growth prospects, and by owner and market considerations
 Legal constraints prohibit corporations from paying out as cash
dividends any portion of the firm’s “legal capital,” nor can firms
with overdue liabilities and legally insolvent or bankrupt firms
pay cash dividends
 Contractual constraints result from restrictive provisions in the
firm’s loan agreements
• LG 3 (Cont.)
– Discuss the key factors involved in establishing a dividend
policy.
 Growth prospects affect the relative importance of retaining
earnings rather than paying them out in dividends
 The tax status of owners, the owners’ investment opportunities,
and the potential dilution of ownership are important owner
considerations
 Finally, market considerations are related to the stockholders’
preference for the continuous payment of fixed or increasing
streams of dividends
• LG 4
– Review and evaluate the three basic types of dividend
policies.
 With a constant-payout-ratio dividend policy, the firm pays a
fixed percentage of earnings to the owners each period;
dividends move up and down with earnings, and no dividend is
paid when a loss occurs
 Under a regular dividend policy, the firm pays a fixed-dollar
dividend each period; it increases the amount of dividends only
after a proven increase in earnings
 The low-regular-and-extra dividend policy is similar to the
regular dividend policy except that it pays an extra dividend
when the firm’s earnings are higher than normal
• LG 5
– Evaluate stock dividends from accounting, shareholder, and
company points of view.
 Firms may pay stock dividends as a replacement for or
supplement to cash dividends
 The payment of stock dividends involves a shifting of funds
between capital accounts rather than an outflow of funds
 Stock dividends do not change the market value of
stockholders’ holdings, proportion of ownership, or share of
total earnings
 Therefore, stock dividends are usually nontaxable
 However, stock dividends may satisfy owners and enable the
firm to preserve its market value without having to use cash
• LG 6
– Explain stock splits and the firm’s motivation for undertaking
them.
 Stock splits are used to enhance trading activity of a firm’s
shares by lowering or raising their market price
 A stock split merely involves accounting adjustments; it has no
effect on the firm’s cash or on its capital structure and is
usually nontaxable
 To retire outstanding shares, firms can repurchase stock in lieu
of paying a cash dividend
 Reducing the number of outstanding shares increases
earnings per share and the market price per share
 Stock repurchases also defer the tax payments of stockholders
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Principles of Managerial Finance

Copyright © 2013 CFA Institute

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

No cash dividends Stock dividends Stock dividends Moderate to high

• At quarterly or semiannual meetings, a firm’s board of

• Cash Dividend Payment Procedures

• Cash Dividend Payment Procedures

When the dividend was announced by the directors, $81.4

Cash $869,600 Dividends payable $0

The net effect of declaring and paying the dividend was to

Cash Dividends vs. Repurchasing Stock

• Reasons for preferring repurchasing stock over paying a

Copyright © 2013 CFA Institute

• Share Purchase Procedures

• Share Purchase Procedures

• Tax Treatment of Dividends and Repurchases

• Tax Treatment of Dividends and Repurchases

• Dividend Reinvestment Plans (DRIPs)

• Stock Price Reactions to Corporate Payouts

Tax Systems and Dividend Policy

Copyright © 2013 CFA Institute

Example: Payout Policies

1. What are dividends for FY2011 and FY2012 if the

Copyright © 2013 CFA Institute

Example: Payout Policies

Fiscal Year Ending 9/29/2012 9/24/2011

3. What are dividends for FY2011 and FY2012 if the

a. If the firm paid out 50 percent of each year’s

b. If the firm has a regular dividend policy of paying $.60 per

b. If the firm paid out a fixed $.60 per share until

c. If the firm pays a regular dividend plus an

Common stock (100,000 shares at $4 par) $ 400,000

Paid-in capital in excess of par $ 600,000

Retained earnings $ 700,000

Total stockholders’ equity $2,000,000

The firm’s total stockholders’ equity has not changed; the

Before split After 2-for-1 split

The insignificant effect of the stock split on the firm’s books

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