CHAPTER 14/DIVIDEND POLICY 211

CHAPTER 14
DIVIDEND POLICY
ANSWERS TO QUESTIONS:
1. Legal constraints:

Capital cannot be impaired as a result of dividend payments.

Dividends must be paid out of present and past net earnings.

Dividends may not be paid when the firm is insolvent.

2. a. The IRS code prohibits corporations from retaining an excessive amount of profits in an
attempt to avoid the payment of taxes on dividends received by shareholders.

b. Prior to the 1986 Tax Reform Act, personal (marginal) tax rates were higher on dividend
income than on capital gains income. This encouraged corporations to keep dividends low so
that shareholders could receive a larger proportion of their pretax returns in the form of capital
gains income and thus increase their after-tax returns. The 1986 Tax Reform Act eliminated the
differential between tax rates on dividend and capital gains income. The Revenue
Reconciliation Act of 1993 restored some tax rate advantage to capital gains income by
retaining a 28% capital gains tax rate while raising marginal tax rates on ordinary income for
many investors. More recently, the Taxpayer Relief Act of 1997 lowered the maximum long-
term capital gains rate for individuals to 20 percent. Also, there is a tax advantage to capital
gains income due to the fact that taxes on capital gains income can be deferred into the future
when the asset is sold, whereas taxes on dividend income must be paid immediately.

3. Other external factors limiting cash dividends include restrictive covenants in loan agreements,
the borrowing capacity of the firm, the firm's liquidity, the stability of a firm's earnings, and the
firm's capital expansion needs.

4. In an inflationary environment, a firm may find that funds generated by the depreciation tax
shield are not sufficient to replace or rehabilitate assets as they become obsolete. Also, with
rising prices, the actual dollars invested in inventories and accounts receivable will tend to
increase in order to support the same physical volume of business. For a growing firm, this
inflationary impact on dividend policy will be even greater, forcing greater retention and lower
dividend payouts.

5. The "clientele effect," as originally developed by Modigliani-Miller, suggests that investors

will tend to be attracted to firms that have dividend policies consistent with the investors'
objectives. High dividend payout companies will attract investors who want high dividend
yields. Growth-oriented companies, with low (or zero) dividend payouts, will attract investors
who prefer earnings retention and possible price appreciation.
212 CHAPTER 14/DIVIDEND POLICY

6. The "informational content" of dividend policy indicates that, for a firm following a stable
dividend policy, changes in dividends convey important information to investors. An increase
in dividends means that management expects future earnings to be higher. Similarly, a cut in
dividends is viewed as conveying unfavorable information about the firm's earnings prospects.

7. a. change in dividend policy represents an unambiguous signal to investors concerning

managements assessment of the future prospects (i.e., earnings and cash flows) of the
company. As insiders, management is perceived as having access to more complete
information about the future profitability of the firm than is available to investors outside
the company.

8. In the world of Miller and Modigliani the value of a firm is determined solely by the firm's
investments. Dividend payouts are a mere detail to the firm given an investment policy and do
not directly influence the firm's value. M and M do recognize that dividends may provide
"information content" to investors, indicating to investors what management feels the future
earnings prospects are likely to be.

9. Most practitioners believe that dividends are important because they help to resolve
uncertainty for investors. Furthermore, in the "real" world where the transactions costs
associated with raising new external funds are significant, a policy of retaining a greater
proportion of earnings when the firm has a large number of attractive investment opportunities
is likely to be a wealth maximizing strategy.

10. There is evidence that although many firms follow a "passive residual" dividend policy, these
firms still strive to maintain a stable dividend record. For example, a firm with growing
earnings might retain a larger proportion of earnings during years when there are large
financing needs. This may be done without cutting the dollar amount of dividends.

11. a. policy of paying out stable dividends is usually preferred to a policy of paying out a
constant percentage of earnings as dividends for a number of reasons. First, many
investors look to changes in a firm's dividend rate as an indicator of the firm's future
expected profits. The constant percentage payout would lead to frequent dividend changes
and hence undermine the "informational content" of dividends. A second reason is the
preference of some investors for relatively certain levels of dividend income for their cash
income requirements. Finally, many institutional investors prefer (or are required) to invest
only in firms having a history of stable and secure dividend payments.

12. a. firm faced with an unusually large number of attractive investment opportunities or a firm
facing temporary adversity might be willing to borrow in order to maintain its record of
continuous dividend payments.

13. Investors who rely on dividend payments for their current income needs prefer that the firm
make cash dividend payments and then raise new funds externally if needed. For these
investors the receipt of dividends reduces the necessity of selling some shares, (and the
payment of transactions costs) perhaps in odd-lots, in order to maintain their spendable
income levels. If the number of these investors is significant, it may justify the practice of
paying dividends and selling new shares at the same time.
 CHAPTER 14/DIVIDEND POLICY 213

14. Shareholders of a firm with a dividend reinvestment plan can automatically have their
dividends reinvested in additional shares of the company's common stock. A dividend
reinvestment plan, in which the dividends are used to purchase newly issued shares of stock,
enables the firm to raise new equity capital over time as well as reduce its cash outflows
required for dividend payments. A dividend reinvestment plan is a convenient method for
shareholders to purchase additional shares and, at the same time, save money on brokerage
commissions.

15. Stock dividends, by increasing the number of shares outstanding, tend to reduce the price of
each share outstanding. A firm may pursue a policy of paying regular stock dividends in order
to maintain its stock price in an "optimal" price trading range. Stock dividends may also have
the effect of broadening the ownership of the firm's stock, and thereby increasing investor
interest in the stock. This last benefit will only occur to the extent that investors tend to sell
their stock dividends, rather than retain them.

16. The IRS does not permit a firm to follow a policy of regular stock repurchases as an
alternative to cash dividends because repurchase plans convert cash dividends to capital gains
that are not taxed until the stock is sold. The IRS considers regular repurchases to be
equivalent to cash dividends and requires that they be taxed accordingly.

17. Ignoring taxes, transaction costs, and other market imperfections, the value of the firm should
not be affected by an equivalent amount of returns from cash dividends or share repurchases.
However, empirical evidence suggests that share repurchases do increase the value of the firm
(stock price). This could be due to (1) Tax advantages of share repurchases - taxes on capital
gains (from share repurchases) can be deferred into the future when the stock is sold whereas
taxes on an equivalent amount of dividend income must be paid in the year that the dividends
are received; (2) Share repurchases give the firm greater flexibility in timing the payment of
returns to shareholders; and (3) Signaling effects of share repurchases - share repurchase may
represent a signal to investors that management expects the firm to have higher earnings and
cash flows in the future.

18. It is impossible to tell from the information provided. The answer depends on additional
factors, such as:

Current shareholders, who are accustomed to a high dividend payout, may be unhappy with
the change in dividend policy and sell their shares, thus depressing the stock price. Having to
sell shares periodically to obtain current income may not be viewed as an acceptable substitute
for regular cash dividends to these investors.

Other investors, who prefer earnings retention and no cash dividends, may be attracted to the
firm's new dividend policy, thus raising the stock price. The net effects on the firm's stock price
of those preferring the current dividend policy and those preferring the new policy are
impossible to determine. The rate of return that the firm earns on the funds released from the
elimination of cash dividends will also affect the stock price. According to the passive residual
dividend policy, a firm should reinvest its earnings as long as it has investment opportunities
that offer rates of return in excess of the required rate.

19. a. firm that is facing financial distress might be tempted to pay out a portion of its remaining
214 CHAPTER 14/DIVIDEND POLICY

assets as dividends to common stockholders, thereby undermining the position of the

firms creditors. Penn Central paid dividends up until the quarter before it declared
bankruptcy. Also, in a closely held firm, the controlling owners may establish dividend
policy without giving consideration to the cash flow distribution preferences of minority
owners.
 CHAPTER 14/DIVIDEND POLICY 215

SOLUTIONS TO PROBLEMS:
1. a. EPS = 2,000,000/1,600,000 = $1.25

b. DPS = $1.25(0.4) = $0.50

2. a. Ex-dividend day is Wednesday, February 20.

b. Stock price should decline by $0.50 to $21.50 per share. Other occurrences in the financial

markets might cause this not to happen, such as changing interest and inflation rate

expectations, a changing economic outlook, or some other firm-specific event (e.g. a new

competitor).

c. Dividends = ($0.50)(200,000) = $100,000

Cash declines by $100,000 as does the retained earnings account and total assets.

3. Pre-split dividend equivalent:

2 x $1.40 = $2.80

Increase in cash dividend rate = (2.80 - 2.40)/2.40 = .167 or 16.7% increase

4. Retention for coming year:

$6.25 - $3.00 = $3.25/share

300,000 shares x $3.25/share = $975,000 total retained equity for year

Equity portion of capital budget requirements:

0.60($4,000,000) = $2,400,000

External equity needed: $2,400,000

- 975,000

$1,425,000

5. Equivalent (pre-stock dividend) dividend per share:

216 CHAPTER 14/DIVIDEND POLICY

$2.65(1 + .03) = $2.73

Dividend rate increase = (2.73 - 2.50)/2.50 = 0.092 or 9.2%

6. a. (i) Maximum dividends = $7,500,000 (retained earnings plus capital in excess of par)

(ii) Maximum dividends = $6,000,000 of retained earnings.

b. Restrictive covenants in the firm's loan agreements, the need for liquidity, limited access to the

capital markets, an unstable earnings pattern, rapid growth requiring new capital for expansion,

and inflation may impair a firm's ability to pay dividends. Shareholders in high marginal tax

brackets may prefer lower dividend payouts. Also, shareholders might prefer retention to a

policy of paying out dividends and then raising new equity by way of the sale of new shares, in

order to prevent dilution of ownership.

7. a. $200,000 EBIT

-80,000 Interest

$120,000 Earnings before tax

-48,000 Tax

$72,000 Earnings after tax

+80,000 Depreciation

$152,000 Cash flow before dividends and sinking fund.

Dividends, Interest + Sinking Fund = 2.00 x 20,000 + 80,000 + 40,000 = $160,000

The proposed dividend cannot be paid.

b. Maximum total dividend = 152,000 - interest - sinking fund

= 152,000 - 80,000 - 40,000 = $32,000

Dividends per share = $32,000/20,000 = $1.60

 CHAPTER 14/DIVIDEND POLICY 217

8. a. Total dividend payment = $10 million earnings

- $6 million of investment projects

= $4 million dividends

b. The firm should pay no dividends and raise $2 million externally to finance the entire $12

million in projects.

c. Lenberg should consider shareholder preferences for dividends. The decision to raise an

additional $2 million means that some potential dilution of ownership of existing stockholders

will occur. Lenberg should also consider the informational content" of the decision to pay no

dividends. Shareholders should be told that the dividend cut is being made to finance growth,

and not as a result of unfavorable future earnings expectations. Note that this problem assumes

that all internally generated funds come from net income. Some students may correctly note

that the firm's cash flow normally is greater than net income after tax by an amount equal to

depreciation charges for the current period. If depreciation is considered, it is likely that the

firm could finance all $12 million of projects internally and perhaps still pay a small dividend.

9. a. Investors in Denver's stock obviously prefer the more predictable pattern of dividends that

Denver maintains to the erratic dividend record of Phoenix. Hence, when all other factors

are held constant, the price of Denver's stock is greater than that of Phoenix.

b. Neither firm appears to be a growth company. In fact, the record of earnings for both firms

suggests the opposite. Hence, a policy of paying out a greater proportion of projected long run

earnings might be desirable, if it can be coupled with a stable dividend policy, such as that

maintained by Denver. This policy might cause periodic liquidity crises during business

downturns when earnings are low or negative, such as 19X5 and 19X6.
218 CHAPTER 14/DIVIDEND POLICY

10. a. If the firm currently has a mix of debt and equity in its capital structure, financing the

project entirely with external equity will reduce the firm's financial leverage. If the current

capital structure is considered optimal, such a financing plan would lead to a relative

decline in the firm's share prices.

b. The same arguments apply to this alternative as apply to all the external equity alternative

discussed in a, above. In addition, it seems unwise to cut dividends for this "one shot" growth

opportunity. The current investor "clientele" of the company may become dissatisfied and sell

their shares.

c. This alternative seems the best because it permits the firm to maintain its stable dividend record

and to maintain its current (and presumably desired) capital structure.

11. a. Capital accounts after 10% stock dividend:

Common stock ($1 par, 550,000 shares) $ 550,000

Contributed capital in excess of par 4,450,000

Retained earnings 10,500,000

Total common stockholders equity $15,500,000

b. a. stock dividend by itself has no impact on the wealth position of shareholders.

c. This is the same as a 10 percent cash dividend increase. To the extent that investors have a

preference for dividends over retention, the wealth position of investors may increase.

12. a. Ignoring taxes, the wealth position of the stockholders remains unchanged, regardless of

the alternative chosen. If the repurchase alternative is used, the stock price after

repurchase will be $42, and the cash dividend alternative is used, the wealth position of all
 CHAPTER 14/DIVIDEND POLICY 219

stockholders will be $42, consisting of a $40 share price plus $2 in cash.

b. The share repurchase will be preferred by high tax bracket stockholders. Dividends are taxed

immediately at ordinary tax rates whereas the $2 gain in the stock price is taxed only when the

stock is sold.

c. The Internal Revenue Service views regular repurchases as an alternative to cash dividends

merely as a scheme to defer taxes. Hence, the regular repurchase of stock may result in taxes

being paid immediately rather than being postponed.

13. a. EBIT $3,000,000

Interest 500,000

EBT $2,500,000

Taxes @ 40% 1,000,000

EAT $1,500,000

EPS = $1,500,000/300,000 shares = $5.00

b. DPS = $600,000/300,000 shares = $2.00

Dividend payout ratio = $2.00/$5.00 = 40%

c. P/E = 12 = P/$5.00

P = $60

Dividend/Price = $2.00/$60.00 = 0.033 or 3.33%

14. The ex-dividend date is Friday, August 20, which is 2 business days prior to the record day.

You must purchase the stock prior to this date to be eligible to receive the dividend.
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15. a. Capital outlays = debt funds raised plus equity retained

= $10 million + $1.3(10 million shares)

= $23 million

b. Assuming that Clynnes capital structure equaled its target before the start of this year,

Clynnes target capital structure consists of approximately 43.5% debt ($10 million/$23

million) and 56.5% common equity.

16. No recommended solution