Chapter
Dividend Policy and
Retained Earnings
PPT 18-2
Chapter 18 - Outline
Dividends vs. Retained Earnings
Factors Influencing Dividend Policy
Life Cycle Growth and Dividends
Cash and Stock Dividends
Stock Splits
Repurchase of Stock
Summary and Conclusions
PPT 18-3
Dividends vs. Retained Earnings
‹A
company has a choice or decision regarding what
to do with its profits:
Pay them out to shareholders as dividends
OR
‹ Retain the earnings in the business
‹
‹ There
is disagreement as to whether investors prefer
dividends or reinvestment
PPT 18-7
Factors Influencing Dividend Policy
‹ Investment
opportunities and growth prospects
within company
‹ Company’s stage in corporate life cycle
‹ Cash position of the firm
‹ Access to capital markets
‹ Desire for control
‹ Legal and lender restrictions
‹ Tax position of shareholders
‹ Pressure to maintain stability in dividends
‹ Improve company’s image by increasing dividends
PPT 18-10
Figure 18-3
Life cycle growth and dividend policy
Sales ($)
Maturity
Expansion
Decline
Growth
Development
Time
Development
Development
StageII
Stage
Growth
Growth
StageIIII
Stage
Expansion
Expansion
StageIII
III
Stage
Maturity
Maturity
StageIV
IV
Stage
No cash dividends
Stock dividends
Low cash dividends
Stock dividends
Low to moderate
cash dividends
Stock splits
Moderate to high
cash dividends
PPT 18-9
Life Cycle Growth and Dividend Policy
Dividend policy is reflected in 4 stages:
Stage I - Development
‹
no cash dividends
Stage II - Growth
‹
stock dividends, low cash dividends
Stage III - Expansion
‹
stock dividends, moderate cash dividends, stock splits
Stage IV - Maturity
‹
moderate to high cash dividends
Residual theory of dividends
A.
According to the passive residual theory of dividends,
earnings should be retained as long as the rate earned is
expected to exceed a shareholder’s rate of return on the
distributed dividend.
B. The residual dividend theory assumes a lack of preference
for dividends by investors.
1, Much disagreement exists as to investors’ preference
for dividends or retention of earnings.
2, The homemade dividend argument suggests dividend
policy is irrelevant to firm valuation
Figure 18-1
Homemade dividends
PPT 18-4
Relevance of dividends arguments
1.
Resolves uncertainty ( Bird in hand theory )
2.
Information content
( signaling theory )
3. Payout ratios suggest firms view dividends as relevant
PPT 18-5
Table 18-1
Earnings and dividends of selected
Canadian corporations
Bank of Montreal
Earnings
Dividends
Payout ratio
Canadian Tire
Earnings
Dividends
Payout ratio
Dofasco
Earnings
Dividends
Payout ratio
Inco
Earnings
Dividends
Payout ratio
Noranda
Earnings
Dividends
Payout ratio
BCE Inc
Earnings
Dividends
Payout ratio
Cognos
Earnings
Dividends
Payout ratio
Ten Year
Average
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
$20.45
$7.85
38%
$2.66
$1.12
42%
$3.25
$1.00
31%
$2.34
$0.94
40%
$2.29
$0.88
38%
$2.28
$0.82
36%
$2.06
$0.74
36%
$1.62
$0.66
41%
$1.49
0.60
40%
$1.28
$0.56
44%
$1.18
$0.53
45%
$16.17
$4.00
25%
$2.25
$0.40
18%
$1.89
$0.40
21%
$1.89
$0.40
21%
$2.09
$0.40
19%
$1.79
$0.40
22%
$1.51
$0.40
26%
$1.38
$0.40
29%
$1.30
$0.40
31%
$1.11
$0.40
36%
$0.96
$0.40
42%
$14.99
$5.67
38%
$0.35
$1.06
303%
$2.46
$1.06
43%
$3.16
$1.00
32%
$2.02
$1.00
50%
$2.12
$0.80
38%
$2.12
$0.30
14%
$1.98
$0.00
0%
$2.33
$0.30
13%
$1.41
$0.00
0%.
($2.96)
$0.15
n.a.
$6.43
$2.95
46%
$1.52
$0.00
0%
$2.06
$0.00
0%
$0.08
$0.00
0%
($0.63)
$0.10
n.a.
$0.25
$0.40
160%
$1.17
$0.40
34%
$1.82
$0.40
22%
$0.15
$0.40
267%
$0.22
$0.40
182%
($0.21)
$0.85
n.a.
$9.47
$9.40
99%
($0.47)
$0.80
n.a.
$1.14
$0.80
70%
$0.70
$0.80
114%
$2.68
$1.00
37%
$1.00
$1.00
100%
$1.02
$1.00
98%
$2.26
$1.00
44%
$1.45
$1.00
69%
($0.41)
$1.00
-244%
$0.10
$1.00
1000%
$28.06
$13.21
47%
$0.56
$1.20
214%
$7.43
$1.24
17%
$8.35
$1.36
16%
$2.50
1.36
54%
2.00
$1.36
68%
$1.54
$1.36
88%
$1.12
$1.36
121%
$1.43
$1.34
94%
$1.03
$1.33
129%
$2.10
$1.30
62%
$3.17
$0.00
0%
$0.70
$0.00
0%
$0.67
$0.00
0%
$0.66
$0.00
0%
$0.36
$0.00
0%
$0.40
$0.00
0%
$0.20
$0.00
0%
$0.10
$0.00
0%
$0.04
$0.00
0%
($0.08)
$0.00
0%
$0.04
$0.00
0%
Figure 18-2
Corporate earnings and dividends (all
industries)
PPT 18-6
Dividend yields on selected common
shares, April 1995
Edper Group A ……………………7.1%
TransAlta Utilities………………….6.7%
Hees International Bankcorp……...6.6%
Trilon Financial A………………….6.1%
Cdn Utilities A………………………5.8%
BCE………………………………….5.6%
Comparison of dividend policy
Year
1
EPS
$1.5
Reinvest of EPS
0.40
Dividend per share
1) Pure residual
dividend policy 1.10
2) Smoothed residual
dividend policy 0.90
3) Stable payout
ratio policy
0.75
2
$2.1
0.80
3
$1.2
1.30
4
$2.8
1.35
5
$2.4
1.15
Total
$10.00
5.00
1.25
5.00
1.30
-0.10
1.45
0.90
1.00
1.10
1.05
0.60
1.40
1.10
1.20
5.00
5.00
Other factors influencing dividend policy
‹
Legal rules:
Laws have been enacted protecting corporate
creditors by forbidding distribution of the firm’s
capital in the form of dividends. Dividends are also
prohibited if the firm will become insolvent as a
result.
Other factors influencing dividend policy
( cont’ )
‹
Cash position:
The firm must have cash available regardless of
the level of past or current earnings in order to pay
dividends.
Other factors influencing dividend policy
( cont’ )
‹
Access to capital markets
The easier the access to capital markets, the
more able the firm is to pay dividends rather than
retain earnings. Some large firms have borrowed to
maintain dividend payments.
Other factors influencing dividend policy
( cont’ )
Desire for control:
‹
1.
Small, closely-held firms may limit dividends
to avoid restrictive borrowing provisions or the need
to sell new stock.
2.
Established firms may feel pressure to pay
dividends to avoid shareholders’ demand for
change of management.
Other factors influencing dividend policy
( cont’ )
‹
Tax position of shareholders ( clientele effect )
1. High tax-bracket shareholders may prefer retention of
earnings.
2. Lower tax-bracket individuals, institutional investors,
and corporations receiving dividends prefer higher dividend
payouts.
3. Shareholder preferences for dividends or capital gains
fosters investor behavior called the clientele effect. High tax
bracket investors often invest in growth-oriented firms that
pay no or lowdividends. Low tax bracket investors often
purchase stocks withhigh dividend payouts.
4. The dividend tax credit lowers the effective tax rate on
dividend income.
PPT 18-8
Sample calculation of tax* on individual
dividend receipt
Dividend received . . . . . . . . . . . . . . . . . . . . .
Gross-up . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Taxable amount. . . . . . . . . . . . . . . . . . . . . . .
$1,000
250
1,250
Federal tax (at 29%) . . . . . . . . . . . . . . . . . . .
363
Federal tax credit (13 1/3% of $1,250) . . . .
167
Federal tax payable . . . . . . . . . . . . . . . . . . . .
196
Provincial tax payable (10% of $1,250) . . . .
125
Provincial tax credit (32% of $250) . . . . .
80
Provincial tax payable . . . . . . . . . . . .
45
Total taxes payable . . . . . . . . . . . . . . . . . . . .
241
Net dividend ($1,000 - $241) . . . . . . . . . . . . .
$759
*based upon an Alberta resident in the top tax bracket for 2001
Dividend payment procedures
‹
Three key dividend dates:
1. Dividend record date : the date the corporation
examines its books to determine who is entitled to a cash
dividend.
2. Ex-dividend date : two business days prior to the
holder of record date. If an investor buys a share of stock
after the second day prior to the holder of record date, the
investor’ name would not appear on the firm’s books.
3. Payment date : approximate date of mailing of
dividend checks.
PPT 18-11
Cash and Stock Dividends
‹ Cash
dividends are usually paid quarterly
‹ Dividend
Yield (%):=
annual dividend per share / current stock price
‹A
stock dividend is a distribution of additional
shares of stock
‹ There
is no benefit from a stock dividend unless
total cash dividends increase
PPT 18-12
Table 18-4
XYZ Corporation’s financial position
before stock dividend
Capital
accounts
{
Common stock (1 million shares issued) $15,000,000
Retained earnings . . . . . . . . . . . 15,000,000
Net worth. . . . . . . . . . . . . . . $30,000,000
PPT 18-13
Table 18-5
XYZ Corporation’s financial position after
stock dividend
Capital
accounts
{
Common stock (1.1 million shares issued)
. $16,500,000
Retained earnings . . . . . . . . . . . . 13,500,000
Net worth. . . . . . . . . . . . . . . . $30,000,000
PPT 18-14
Stock Splits
‹ Similar
to a stock dividend: increases the total
shares of stock outstanding
‹ Market value of stock is unchanged initially
‹
ex, a 2-for-1 split will double the number of shares
outstanding (with each share worth half as much as
before)
‹ Primary
purpose of a stock split is to lower the price
into a more popular trading range
‹ Stock splits are used if the stock price gets too high
PPT 18-15
Table 18-6
XYZ Corporation before and after stock
split
Before
Common stock (1 million shares issued)
Retained earnings
After
Common stock (2 million shares issued)
Retained earnings
$15,000,000
15,000,000
$30,000,000
$15,000,000
15,000,000
$30,000,000
PPT 18-16
Repurchase of Stock
‹ May
be used as an alternative to paying a cash
dividend
‹ Often utilized when a firm has excess cash
‹ Benefits to the shareholder are the same (in theory)
‹ Other reasons for repurchase:
belief that the stock is selling at a low price
‹ may be used for employee stock options
‹ reduces the possibility of being taken over by another
firm
‹
PPT 18-8
Table 18-8
Stock repurchases announced in 1997
Shares
Shares
Company
Originally Bid
Inco
Bought
11.5 million
nil
Toronto Dominion Bank
Nova
million
24 million
nil
25
22.5 million
Seagram
24 million
19.2 million
Source: Merrill Lynch & Co.
Dividend reinvestment plans
A.
Begun during the 1970s, plans provide investors with an
opportunity to buy additional shares of stock with the cash
dividend paid by the company.
B. Types of plans
1. The company sells authorized but unissued shares.
The stock is often sold at a discount since no investment or
underwriting fees have to be paid. This plan provides a cash
flow to the company.
2. The company’s transfer agent buys shares of stock in
the market for the shareholder. This plan does not provide a
cash flow to the firm but is the service to the shareholder.
PPT 18-17
Summary and Conclusions
LET’S
REVIEW . . .
‹A
profitable company must decide
whether to retain (reinvest) the
earnings in the business, or pay a
dividend
‹Factors influencing dividend
policy include the cash position of
the company, its growth prospects,
its access to capital markets, legal
and lender restrictions, and
considerations of corporate image.
‹Stock dividends and stock splits
lower the stock price into a more
acceptable trading range
‹A share repurchase may reflect
management’s opinion that the
shares are trading too low.