Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 14
Payout Policy

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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.

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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.

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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
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14.1 The Basics of Payout Policy (2 of 4)
• 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

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Figure 14.1 Per-Share Earnings and
Dividends of the S&P 500 Index

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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.
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14.1 The Basics of Payout Policy (3 of 4)
• 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

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14.1 The Basics of Payout Policy (4 of 4)
• 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

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Figure 14.2 Aggregate Dividends and Repurchases
for All U.S. Publicly Listed Companies

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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.

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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

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Figure 14.3 U.S. Publicly Listed Companies
Maintaining, Increasing, or Decreasing
Dividends

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14.2 The Mechanics of Payout Policy
(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

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14.2 The Mechanics of Payout Policy
(3 of 9)

• Cash Dividend Payment Procedures

– Holders of Record
 All persons whose names are recorded as stockholders on the
date of record

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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.

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Example 14.1 (2 of 3)
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
Blank Blank Retained earnings $7,312,600

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Example 14.1 (3 of 3)
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

Blank Blank Retained earnings $7,312,600

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.

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Figure 14.4 Dividend Payment Timeline

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14.2 The Mechanics of Payout Policy
(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

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14.2 The Mechanics of Payout Policy
(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

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Example 14.2 (1 of 2)
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

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Example 14.2 (2 of 2)
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.

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14.2 The Mechanics of Payout Policy
(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

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14.2 The Mechanics of Payout Policy
(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

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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.

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Personal Finance Example 14.3 (2 of 2)
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.

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14.2 The Mechanics of Payout Policy
(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

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14.2 The Mechanics of Payout Policy
(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

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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

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14.3 Relevance of Payout Policy (2 of 5)
• 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
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14.3 Relevance of Payout Policy (3 of 5)
• 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

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14.3 Relevance of Payout Policy (4 of 5)
• 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
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14.3 Relevance of Payout Policy (5 of 5)
• 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

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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
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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.
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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.

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14.4 Factors Affecting Dividend Policy
(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

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14.4 Factors Affecting Dividend Policy
(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

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14.4 Factors Affecting Dividend Policy
(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

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14.4 Factors Affecting Dividend Policy
(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

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14.4 Factors Affecting Dividend Policy
(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

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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

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Example 14.6 (1 of 2)
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

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Example 14.6 (2 of 2)
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.

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14.5 Types of Dividend Policies (2 of 3)
• 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

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Example 14.7 (1 of 3)
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.

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Example 14.7 (2 of 3)
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

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Example 14.7 (3 of 3)
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.

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14.5 Types of Dividend Policies (3 of 3)
• 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

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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

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Example 14.8 (1 of 3)
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

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Example 14.8 (2 of 3)
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.

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Example 14.8 (3 of 3)
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.

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14.6 Other Forms of Dividend (2 of 4)
• 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

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Example 14.9 (1 of 2)
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).

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Example 14.9 (2 of 2)
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).

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14.6 Other Forms of Dividend (3 of 4)
• 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

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14.6 Other Forms of Dividend (4 of 4)
• 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

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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 4,000,000
par
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.
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Personal Finance Example 14.11 (1 of 2)
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.

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Personal Finance Example 14.11 (2 of 2)
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.

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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

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Review of Learning Goals (2 of 7)
• 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
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Review of Learning Goals (3 of 7)
• 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

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Review of Learning Goals (4 of 7)
• 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

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Review of Learning Goals (5 of 7)
• 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

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Review of Learning Goals (6 of 7)
• 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

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Review of Learning Goals (7 of 7)
• 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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