Chapter 16

Introduction
When a firm generates cash from
operations, what can the firm do with the
cash?
1. Use the cash to fund new investments,
2. Use the cash to pay off some of its debt,
and/or
3. Distribute the cash back to the firms
shareholders either as
a cash dividend, or
as stock repurchases.
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How Do Firms Distribute Cash to

their Shareholders? (cont.)
With cash dividend, cash is paid directly
to the shareholders.
With a share repurchase, a company
uses cash to buy back its own shares from
the market place, thereby reducing the
number of outstanding shares.

Cash Dividends
A firms dividend policy determines how
much cash it will distribute to its
shareholders and when these distributions
will be made.
Dividends are generally described in terms
of dividend payout ratio, which indicates
the amount of dividends paid relative to
the companys earnings.
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Cash Dividend Policies

1. Constant Dividend Payout Ratio
If directors declare a constant payout ratio
of, for example, 30%, then for every peso of
earnings available to stockholders, 30 cents
would be paid out as dividends.
The ratio remains constant over time, but
the peso value of dividends changes as
earnings change.

Cash Dividend Policies

With a constant-payout-ratio dividend
policy, the firm establishes that a specific
percentage of earnings is paid to
shareholders each period.
A major shortcoming of this approach is that
if the firms earnings drop or are volatile, so
too will be the dividend payments.
Investors view volatile dividends as negative
and riskywhich can lead to lower share
prices.
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Cash Dividend Policies

Peachtree Industries, a miner of potassium, has a
policy of paying out 40% of earnings in cash
dividends. In the periods when a loss occurs, the
firms policy is to pay no cash dividends.

Cash Dividend Policies

2. Stable peso/Regular Dividend Policy:
The firm tries to pay a fixed peso dividend
each period.
Firms and stockholders prefer stable
dividends.
Decreasing the dividend sends a negative
signal.

Cash Dividend Policies

It provides stockholders with positive
information indicating that the firm is doing
well and it minimizes uncertainty.
Generally, firms using this policy will increase
the regular dividend once earnings are
proven to be reliable.

Cash Dividend Policies

The dividend policy of Woodward Laboratories, a producer
of a popular artificial sweetener, is to pay annual dividends
of P1.00 per share until per-share earnings exceeded
P4.00 for three consecutive years. At that point, the annual
dividend is raised to P1.50 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 Woodwards earnings, dividends, and average
stock prices for the past 12 years follow.
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Cash Dividend Policies

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Cash Dividend Policies

3. Small Regular Dividend plus Year-End
Extras
The firm pays a stable dividend regularly and
includes an extra dividend in prosperous
years.
By identifying the additional dividend as
extra, directors hope to avoid signaling that
this is a permanent dividend.

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Cash Dividend Policies

4. Residual Dividend Policy
The firm first finances its investments
using its own earnings. Dividends are paid
out of the residual earnings that are not
needed to finance new investment
opportunities.
While this policy minimizes the cost of
financing, it can lead to unstable dividends
for shareholders.
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Other Factors Playing a Role in

How Much to Distribute
Liquidity Position
Because dividend payments and stock
repurchases are made with cash, and
not with retained earnings, the firm
must have cash available for payouts to
be made.

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Other Factors Playing a Role in How

Much to Distribute (cont.)
Lack of Other Sources of Financing
Many small or new companies may not
have access to the capital markets, and
must depend upon internally generated
funds to fund their investment
opportunities. As a result, the dividend
pay out ratio for such firms is generally
lower.
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Other Factors Playing a Role in How

Much to Distribute (cont.)
Earnings Predictability
A companys payout ratio depends to
some extent on the predictability of a
firms profits over time. Firms with
stable earnings will typically pay out a
larger portion of its earnings.

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Dividend Payment Procedures

Important dates with regard to
dividend payment:
Announcement date: It is the date on which
dividend is formally declared by the board of
directors.
Date of record: Investors who own stock on this
date receive the dividend.
Ex-dividend date: This is three days before the date
of record and any investor who buys shares after
the ex-dividend date is not entitled to dividend.
Payment date: This is the date on which dividend
checks are mailed to the investors.
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18

Stock Repurchases (Stock Buyback)

Stock repurchase is when a firm uses its cash to
repurchase some of its own stock.
This results in reduction in the firms cash balance
as well as the number of shares of stock
outstanding (reverse dilution)
Increase EPS and ROE resulting in a higher market
price
Increases leverage; alters the firms capital
structure

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Stock Repurchases (Stock Buyback)

If the firm pays the dividend, all stockholders
would have to pay tax on the dividend income
If the firm repurchases some of its stock in the
stock market, current stockholders benefit from
an increased market price and would not be taxed
until they sell their shares at a later time.

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Stock Repurchases (Stock Buyback)

Firms use one of three methods to
purchase the shares:
open market repurchase
tender offer
direct purchase

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How do Firms Repurchase Their

Shares?
Open Market Repurchase
The firm acquires the stock on the market,
often buying a relatively small number of
shares everyday. This will put upward pressure
on share prices. This is the most widely used
method for stock repurchase.

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How do Firms Repurchase Their

Shares? (cont.)
Tender Offer
A company uses this method when it wants to
buy a relatively large number of shares very
quickly.
The company makes a formal offer to buy a
specified number of shares at a stated price.
The price is set above the market price to
attract sellers.

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How do Firms Repurchase Their

Shares? (cont.)
Direct Purchase from a large investor
Here the firm purchases the stock from one or
more major stockholders on a negotiated basis.
This method is not used frequently.

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Non-Cash Distributions:
Stock Dividends and Stock Splits
A stock dividend is a pro-rata distribution of
additional shares of stock to the firms
current stockholders. These distributions are
generally defined in terms of a fraction paid
per share.
Example: Citizens Corporation announces a
5% stock dividend to all shareholders of
record. For each 100 shares held,
shareholders receive another five shares.
Does the shareholders wealth increase?
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Stock Dividends
From a market value standpoint, stock
dividends function much like stock splits.
The investor ends up owning more shares,
but the value of their shares is less.
From a book value standpoint, funds are
transferred from retained earnings to
common stock and additional paid-incapital.

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Stock Dividends
Accounting Aspects
The current stockholders equity on the balance sheet
of Garrison Corporation, a distributor of prefabricated
cabinets, is as shown in the following accounts.

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Stock Dividends
Accounting Aspects
If Garrison declares a 10% stock dividend and the
current market price of the stock is P15/share,
P150,000 of retained earnings (10% x 100,000 shares x
P15/share) will be capitalized.
The P150,000 will be distributed between the common
stock (par) account and paid-in-capital in excess of par
account based on the par value of the common stock.
The resulting balances are as follows:
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Stock Dividends
Accounting Aspects

Because 10,000 new shares (10% x 100,000) have been

issued at the current price of P15/share, P150,000
(P15/share x 10,000 shares) is shifted from retained
earnings to the common stock and paid-in-capital
accounts.
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Stock Dividends
The Companys Viewpoint
Disadvantages of stock dividends include:
The cost of issuing the new shares
Taxes and listing fees on the new shares
Other recording and clerical costs
Advantages of stock dividends include:
The company conserves needed cash

Signaling effect to the shareholders that

the firm is retaining cash because of
lucrative investment opportunities
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Stock Splits
Stock Split: The firm increases the number
of shares outstanding and reduces the par
value of each share.
Example: Jolly, Inc. announces a
3-for-2 stock split. For each 100 shares
held, shareholders receive another 50
shares
Does this increase shareholder wealth?
Are a stock dividend and a stock split the
same?
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Stock Splits
A stock split is a recapitalization that affects the
number of shares outstanding, par value, earnings
per share, and market price.
The rationale for a stock split is that it lowers the
price of the stock and makes it more attractive to
individual investors
Delphi Company, a forest products concern, had
200,000 shares of P2-par value common stock
outstanding and declares a 2-for-1 split. The total
before and after split impact on stockholders equity is:
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Stock Splits

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Stock Splits
A reverse stock split reduces the number
of shares outstanding and raises the par
valuethe opposite of a stock split.
The rationale for a reverse stock split is to
add respectability to the stock and convey
the message that it is not a junk stock.

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Stock Dividends and Stock Splits

Stock Splits and Stock Dividends are
economically the same: The number of
shares outstanding increases and the
price of each share drops. The value of
the firm does not change.
Example: To the stockholder, a 3-for-2
stock split is the same as a 50% stock
dividend. For each 100 shares held,
shareholders receive another 50 shares.
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Stock Dividend Example

An investor has 120 shares of PNB. Assume the
following:
Shares outstanding: 1,000,000
Net income = P5,000,000
EPS = P5
P/E ratio = 20
Value of 120 shares:
(20 x P5) x 120 shares = P12,000
After a 25% stock dividend does the value of the
investors shares change?
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Stock Dividend Example

After the 25% stock dividend:
Shares outstanding = 1,000,000 x 1.25 = 1,250,000
EPS = 5,000,000/1,250,000 = P4
If P/E ratio = 20, Price = P80 per share
Investor now has 120 x 1.25 = 150 shares
Value = P80 x 150 shares = P12,000

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GAAP vs. IFRS

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