Dividends

Periodic distributions of cash to the stockholders of a firm.

Dividend policy
The firm’s plan of action to be followed whenever it makes a dividend decision.

Factors Affecting Dividend Policy

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. These capital impairment restrictions are generally established to
provide a sufficient equity base to protect creditors’ claims. An example will clarify the differing
definitions of capital.

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. Constraints on dividends help to protect creditors from losses due to the
firm’s insolvency.

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. It must evaluate its profitability and risk to develop insight into its
ability to raise capital externally. In addition, the firm must determine the cost and speed with
which it can obtain financing. Generally, a large, mature firm has adequate access to new capital,
whereas a rapidly growing firm may not have sufficient funds available to support its acceptable
projects. A growth firm is likely to have 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.

OWNER CONSIDERATIONS
The firm must establish a policy that has a favorable effect on the wealth of the majority of
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. Because cash dividends are taxed at the same rate as capital gains (as a
 result of the 2003 Tax Act), this strategy benefits owners through the tax deferral rather
than as a result of a lower tax rate. Lower-income shareholders, however, who need
dividend income, will prefer a higher payout of earnings.
 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. If it appears that the owners have better
opportunities externally, the firm should pay out a higher percentage of its earnings. If the
firm’s investment opportunities are at least as good as similar-risk external investments, a
lower payout is justifiable.

 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. By paying out a low percentage of its earnings, the firm can minimize the
possibility of such dilution.

MARKET CONSIDERATIONS
One of the more recent theories proposed to explain firms’ payout decisions is called the catering
theory. According to the catering theory, investors’ demands for dividends fluctuate over time.
For example, during an economic boom accompanied by a rising stock market, investors may be
more attracted to stocks that offer prospects of large capital gains. When the economy is in
recession and the stock market is falling, investors may prefer the security of a dividend. The
catering theory suggests that firms are more likely to initiate dividend payments or to increase
existing payouts when investors exhibit a strong preference for dividends. Firms cater to the
preferences of investors.

Types of Dividend Policies

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-ratio dividend policy
A dividend policy based on the payment of a certain percentage of earnings to owners in each
dividend period.
Regular dividend policy
A dividend policy based on the payment of a fixed-dollar dividend in each period.
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.
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.

Other Forms of Dividends

Stock dividend
The payment, to existing owners, of a dividend in the form of stock.

Small (ordinary) stock dividend

A stock dividend representing less than 20 percent to 25 percent of the common stock
outstanding when the dividend is declared.

Stock split
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.
 Practice Questions
1. The Howe Company’s stockholders’ equity account follows:

Common stock (400,000 shares at $4 par) $1,600,000

Paid-in capital in excess of par 1,000,000
Retained earnings 1,900,000
Total stockholders’ equity $4,500,000

The earnings available for common stockholders from this period’s operations are $100,000,
which have been included as part of the $1.9 million retained earnings.
a) What is the maximum dividend per share that the firm can pay? (Assume that legal
capital includes all paid-in capital.)
b) If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without
borrowing?
c) Indicate the accounts and changes, if any, that will result if the firm pays the dividends
indicated in parts a and b.
d) Indicate the effects of an $80,000 cash dividend on stockholders’ equity.

2. A firm has $800,000 in paid-in capital, retained earnings of $40,000 (including the current
year’s earnings), and 25,000 shares of common stock outstanding. In the current year, it has
$29,000 of earnings available for the common stockholders.
a) What is the most the firm can pay in cash dividends to each common stockholder?
(Assume that legal capital includes all paid-in capital.)
b) What effect would a cash dividend of $0.80 per share have on the firm’s balance sheet
entries?
c) If the firm cannot raise any new funds from external sources, what do you consider the
key constraint with respect to the magnitude of the firm’s dividend payments? Why?
3. Bennett Farm Equipment Sales, Inc., is in a highly cyclic business. Although the firm has a
target payout ratio of 25%, its board realizes that strict adherence to that ratio would result in
a fluctuating dividend and create uncertainty for the firm’s stockholders. Therefore, the firm
has declared a regular dividend of $0.50 per share per year with extra cash dividends to be
paid when earnings justify them. Earnings per share for the last several years are as follows:
Year EPS
2014 1.97
2015 2.15
2016 2.80
2017 2.20
2018 2.40
2019 3.00

a) Calculate the payout ratio for each year on the basis of the regular $0.50 dividend and the
cited EPS.
b) Calculate the difference between the regular $0.50 dividend and a 25% payout for each
year.
c) Bennett has established a policy of paying an extra dividend of $0.25 only when the
difference between the regular dividend and a 25% payout amounts to $1.00 or more.
Show the regular and extra dividends in those years when an extra dividend would be
paid. What would be done with the “extra” earnings that are not paid out?
4. Over the last 10 years, a firm has had the earnings per share shown in the following table.
Year EPS
2010 0.25
2011 -0.50
2012 1.80
2013 1.20
2014 2.40
2015 3.20
2016 2.80
2017 3.20
2018 3.80
2019 4.00

a) If the firm’s dividend policy were based on a constant payout ratio of 40% for all
years with positive earnings and 0% otherwise, what would be the annual dividend
for each year?
b) If the firm had a dividend payout of $1.00 per share, increasing by $0.10 per share
whenever the dividend payout increase by 50%, what annual dividend would the firm
pay each year?
c) If the firm’s policy were to pay $0.50 per share each period except when earnings per
share exceed $3.00, when an extra dividend equal to 80% of earnings beyond $3.00
would be paid, what annual dividend would the firm pay each year?
d) Discuss the pros and cons of each dividend policy described in parts a through c.
5. Columbia Paper has the following stockholders’ equity account. The firm’s common stock
has a current market price of $30 per share.

Preferred stock $100,000

Common stock (10,000 shares at $2 par) 20,000
Paid-in capital in excess of par 280,000
Retained earnings 100,000
Total stockholders’ equity $500,000

a. Show the effects on Columbia of a 5% stock dividend.

b. Show the effects of (1) a 10% and (2) a 20% stock dividend.
c. In light of your answers to parts a and b, discuss the effects of stock dividends on
stockholders’ equity.
6. Milwaukee Tool has the following stockholders’ equity account. The firm’s common stock
currently sells for $4 per share.

Preferred stock $ 100,000

Common stock (400,000 shares at $1 par) 400,000
Paid-in capital in excess of par 200,000
Retained earnings 320,000
Total stockholders’ equity $ 1,020,000

a) Show the effects on the firm of a cash dividend of $0.01, $0.05, $0.10, and $0.20 per
share.
b) Show the effects on the firm of a 1%, 5%, 10%, and 20% stock dividend.
c) Compare the effects in parts a and b. What are the significant differences between the two
methods of paying dividends?

7. Growth Industries’ current stockholders’ equity account is as follows:

Preferred stock $ 400,000

Common stock (600,000 shares at $3 par) 1,800,000
Paid-in capital in excess of par 200,000
Retained earnings 800,000
Total stockholders’ equity $3,200,000

a) Indicate the change, if any, expected if the firm declares a 2-for-1 stock split.
1
b) Indicate the change, if any, expected if the firm declares a 1-for-1 reverse stock split.
2
c) Indicate the change, if any, expected if the firm declares a 3-for-1 stock split.
d) Indicate the change, if any, expected if the firm declares a 6-for-1 stock split.
e) Indicate the change, if any, expected if the firm declares a 1-for-4 reverse stock split.