18

Dividend Policy and Retained

Earnings

Block, Hirt, and Danielsen

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Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Decisions on use of firm’s annual earnings

• Dividends and dividend policy
• Factors influencing dividend policy
• Stock dividends and stock splits
• Repurchase of shares

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 Dividends

• Dividend is a share of profit distributed to the

stockholders
• Dividends paid out only if corporation cannot
make better use of funds for benefit of
stockholders
• Active decision variable is retained earnings
• Residual (after fulfilling internal corporate
expenses) paid to stockholders

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 Corporate Dividend Policy

• Dividend policy depends on corporate growth

rate in sales and the subsequent return on
assets.

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 Life Cycle Growth and Dividends

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 Corporate Dividend Policy
Dividend Payment as a
Historical Growth In Estimated Growth in Percentage of Aftertax
Name EPS (2007-2011) EPS (2012-2016) Earnings (2012)
Category 1--Rapid Growth
Netflix Inc. 22.1 22.7 0
Jack in the Box Inc. 89.9 13.6 0
United Therapeutics Corp. 69.6 40.0 0
Under Armour Inc. 21.9 22.4 0
Baidu Inc. 76.0 34.4 0
Apple Inc. 61.1 20.2 6

Category 2--Slow Growth

Sonoco Products Co. 0.5 6.5 53

Waste Management Inc. -2.1 2.8 66
Exelon Corp. -15.9 0.5 70
Southern Co. 2.2 5.1 73
New York Community Bancorp Inc. 3.4 5.5 91
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 Factors Influencing Dividend Policy

• Legal rules
• Firm’s cash flow position
• Access to capital markets
• Management’s desire for control
• Shareholders’ tax position

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 Legal Rules

• Most states forbid payment of dividends that

might damage firm’s initial capital
contributions
• May be distributed only from past and current
earnings
• Protects creditors
• Payment of dividends equal to retained earnings
may jeopardize firm’s operation

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 Cash Position of the Firm

• Limitations to use of current earnings as

liquidity indicator
• Growth firm with greatest earnings gains may be
in poorest cash position
• Buildup in receivables and inventory, with rapid
expansion in sales and earnings
• May far exceed cash flow generated through earnings
• Complete funds-flow analysis required before
establishing dividend policy

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 Access to Capital Markets

• Dividend-paying medium-to-large size

company will have easy access to financial
markets
• Can sell new common stock or bonds in future if
and when funds necessary
• Some may issue debt or stock to guarantee
maintenance of current dividends

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 Desire for Control

• Directors and officers of small, closely held

firms may hold back paying dividends
• Avoids diluting cash position
• Larger firms face different kind of threat
• Stockholders may demand removal of
management if dividends withheld for any reason

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 Tax Position of Shareholders

• When taxes on qualified dividends higher than

capital gains tax, companies often repurchase
stock rather than raise dividend
• Theoretically pushes up stock price
• Creates gains for shareholders who can sell at
lower tax rate

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 Stock Dividend

• Represents distribution of additional shares to

common stockholders
• Typically in 10% range
• Larger distributions of 20-25% or more usually
considered to have characteristics of stock split

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 XYZ Corporation’s Financial Position Before
and After Stock Dividend

• Before stock dividend

• After 10% stock dividend when MV is $15

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 Value to Investor
• Assume 1 million shares outstanding before stock dividend and 1.1 million
shares afterward, firm has after-tax earnings of $6.6 million

Earnings per share = Earnings after taxes

Shares outstanding
• Without stock dividend
= $6.6 million = $6.60
1 million shares
• With stock dividend
=
$6.6 million = $6.00 (10% decline)
1.1 million shares
• Earnings per share decrease by same percentage shares outstanding
increase

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 Value to Investor (cont’d)
• Assume Stockholder A had 10 shares before stock dividend and 11
afterward
Claim to earnings = Shares × Earnings per share

• Without stock dividend = 10 × $6.60 = $66

• With stock dividend = 11 × $6.00 = $66

• Assume stock sold at 20 times earnings before and after stock dividend
Total market value = Shares × (P/E ratio × Earnings per share)

• Without stock dividend = 10 × (20 × $6.60) = 10 × $132 = $1,320

• With stock dividend = 11 × (20 × $6.00) = 11 × $120 = $1,320
• Total market value unchanged

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 Use of Stock Dividends

• Most frequently used by growth companies as

form of ‘informational content’
• Explains fund retention for reinvestment purposes
• Market reaction may be neutral or slightly positive
• May also be used to
• Camouflage inability of firm to pay dividends
• Cover up ineffectiveness in generating cash flow
• Informed investors may react negatively

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 Stock Splits

• Similar to stock dividend — more shares

distributed
• NYSE and FASB encourage distribution in excess of
20-25% to be handled as stock splits
• Accounting for stock split
• No transfer of funds from retained earnings to
capital accounts
• Reduction in par value
• Proportionate increase in number of outstanding
shares
• Market price of stock drops proportional to split.

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 XYZ Corporation (2-for-1 stock split)
Before and After Stock Split

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 Repurchase of Stock
as Alternative to Dividends
• Firm with excess cash may choose to
repurchase own shares
• Stock repurchase is alternative to cash dividend
payouts
• Theoretically, benefits to stockholder equal under
either alternative
• Overall benefit to stockholders — earnings per
share may increase as number of outstanding
shares decreases

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 Recent Examples of
Share Repurchase Announcements
Company Date Announced Amount ($ millions)

American International 9/6/2012 $5,000

Apple Inc. 3/19/2012 $10,000

AT&T Inc. 7/27/2012 $300

AutoZone Inc. 9/28/2012 $750

CVS Caremark Corp. 9/19/2012 $6,000

Jabil Circuit 9/25/2012 $100

Lorillard Inc. 8/21/2012 $500

Pentair Ltd.-Reg. 9/28/2012 $1,200

PetSmart Inc. 10/15/2012 $525

Ralph Lauren Corp. 8/9/2012 $500

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 Dividend Reinvestment Plans

• Provides investor with opportunity to buy additional

shares of stock with cash dividend paid by company
• Company is beneficiary of increased cash flow
• Company’s transfer agent buys shares of stock in
market for stockholder
• Shareholders benefited by
• Low transaction costs
• Right to own fractional shares
• Flexibility between cash and common stock

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