Part 8 Dividend policy, accounting for DBA.pptx

Dividend policy, accounting for DBA

1. Principles of Managerial Finance Fifteenth Edition, Global Edition Chapter 14 Payout Policy

2. 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.

3. 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.

4. 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: Rapidly growing firms generally do not pay out cash to shareholders Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms to initiate cash payouts to investors Firms can make cash payouts through dividends or share repurchase When business conditions are weak, firms are more willing to reduce share buybacks than to cut dividends

5. 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

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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.

12. Figure 14.4 Dividend Payment Timeline

13. 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

14. 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

15. 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

16. 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.

17. 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

18. 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

19. 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, r r , is less than the cost of new common stock, r n , 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

20. 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

21. 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

22. 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

23. 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 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

24. 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.

25. 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.

26. 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. Owner Considerations The firm must establish a policy that has a favorable effect on the wealth of its owners 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

27. 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

28. 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

29. 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.

30. 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

31. 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.

32. 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

33. 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.

34. 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

35. 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

36. 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

37. 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.

38. 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.

39. 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

40. 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).

41. 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).

42. 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

43. 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

44. 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. Before split Blank 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 par 4,000,000 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.

45. 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.

46. 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.

47. 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

48. 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

49. 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

50. 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

51. 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

52. 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

53. 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