Chapter 14

Payout Policy

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All rights reserved.
 The Basics of Payout Policy

The term payout policy refers to the 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.

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Elements of Payout Policy

Some common patterns in decisions that companies make

regarding payouts:
1. Rapidly growing firms generally do not pay out cash to
shareholders.
2. Slowing growth, positive cash flow generation, and
favorable tax conditions can prompt firms to initiate cash
payouts to investors.
3. Firms can make cash payouts through dividends or share
repurchases.
4. When business conditions are weak, firms are more
willing to reduce share buybacks than to cut dividends.
 Figure 14.1 Per Share Earnings and
Dividends of the S&P500 Index

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 The Mechanics of Payout Policy:
Cash Dividend Payment Procedures
• 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.

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 The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

• The date of record (dividends) is 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.
• A stock is ex dividend for a period, beginning 2 business days
prior to the date of record, during which a stock is sold without
the right to receive the current dividend because of the time
needed to make bookkeeping entries.
• The payment date is set by the firm’s directors, the actual date
on which the firm mails the dividend payment to the holders of
record.

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 Figure 14.4
Dividend Payment Time Line

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 Figure 14.4
Dividend Payment Time Line

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 The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

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. At
the time of the announcement, Whirlpool had about 74
million shares of common stock outstanding. Before the
dividend was declared, the key accounts of the firm were
as follows (dollar values quoted in thousands):
– Cash: $951000
– Dividends payable: $0
– Retained earnings: $7394000

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 The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

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: $951000
– Dividends payable: $81400
– Retained earnings: $7312600

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 The Mechanics of Payout Policy: Cash
Dividend Payment Procedures (cont.)

When Whirlpool actually paid the dividend on June 15,

this produced the following balances in the key accounts of
the firm:
– Cash: $869600
– Dividends payable: $0
– Retained earnings: $7312600
The net effect of declaring and paying the dividend was to
reduce the firm’s total assets (and stockholders’ equity) by
$81.4 million.

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 The Mechanics of Payout Policy:
Share Repurchase Procedures
• Common methods for repurchasing shares include:
– An open-market share repurchase is a share repurchase program in which
firms simply buy back some of their outstanding shares on the open market.
– A tender offer repurchase is 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.
– A Dutch Auction repurchase is 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.

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 The Mechanics of Payout Policy:
Share Repurchase Procedures (cont.)

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.

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 Personal Finance Example on
Tax Treatment
The board of directors of Espinoza Industries, Inc., on
October 4 of the current year, declared a quarterly dividend
of $0.46 per share payable to all holders of record on Friday,
October 30. They set a payment date of November 19. Rob
and Kate Heckman, who purchased 500 shares of Espinoza’s
common stock on Thursday, October 15, wish to determine
whether they will receive the recently declared dividend
and, if so, when and how much they would net after taxes
from the dividend given that the dividends would be subject
to a 15% federal income tax.

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 Personal Finance Example
(cont.)
Given the Friday, October 30 date of record, the stock would begin
selling ex dividend 2 business days earlier on Wednesday, October 28.
Purchasers of the stock on or before Tuesday, October 27, would
receive the right to the dividend. Because the Heckmans purchased the
stock on October 15, they would be eligible to receive the dividend of
$0.46 per share.
Thus, the Heckmans will receive $230 in dividends
($0.46 per share  500 shares), which will be mailed to them
on the November 19 payment date.
Because they are subject to a 15% federal income tax on the
dividends, the Heckmans will net $195.50 [(1 – 0.15)  $230]
after taxes from the Espinoza Industries dividend.

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 The Mechanics of Payout Policy: 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.

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 Relevance of Payout Policy

• The financial literature has reported numerous theories and

empirical findings concerning payout policy.
• Although this research provides some interesting insights about
payout policy, capital budgeting and capital structure decisions are
generally considered far more important than payout decisions.
• In other words, firms should not sacrifice good investment and
financing decisions for a payout policy of questionable importance.
• The most important question about payout policy is this: Does
payout policy have a significant effect on the value of a firm?

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 Relevance of Payout Policy:
Residual Theory of Dividends
The residual theory of dividends is a school of thought that suggests
that the dividend paid by a firm should be viewed as a residual—the
amount left over after all acceptable investment opportunities have
been undertaken.

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 Relevance of Payout Policy: Residual
Theory of Dividends (cont.)

Using the residual theory of dividends, the firm would treat the
dividend decision in three steps, as follows:
– Determine its optimal level of capital expenditures, which would be the level
that exploits all of a firm’s positive NPV projects.
– Using the optimal capital structure proportions, estimate the total amount of
equity financing needed to support the expenditures generated in Step 1.
– Because the cost of retained earnings, r , is less than the cost of new common
r
stock, rn, 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.

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 Relevance of Payout Policy:
The Dividend Irrelevance Theory
The dividend irrelevance theory is 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.
– In a perfect world (certainty, no taxes, no transactions costs, and no other
market imperfections), the value of the firm is unaffected by the distribution
of dividends.
– Of course, real markets do not satisfy the “perfect markets” assumptions of
Modigliani and Miller’s original theory.

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 Relevance of Payout Policy:
The Dividend Irrelevance Theory (cont.)

The clientele effect is the argument that different payout policies

attract different types of investors but still do not change the value of
the firm.
– Tax-exempt investors may invest more heavily in firms that pay dividends
because they are not affected by the typically higher tax rates on dividends.
– Investors who would have to pay higher taxes on dividends may prefer to
invest in firms that retain more earnings rather than paying dividends.
– If a firm changes its payout policy, the value of the firm will not change—
what will change is the type of investor who holds the firm’s shares.

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 Relevance of Payout Policy:
Arguments for Dividend Relevance
• Dividend relevance theory is the theory, advanced by Gordon and
Lintner, that there is a direct relationship between a firm’s dividend
policy and its market value.
• The bird-in-the-hand argument is the belief, in support of
dividend relevance theory, that investors see current dividends as
less risky than future dividends or capital gains.

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 Relevance of Payout Policy: Arguments
for Dividend Relevance (cont.)

Studies have shown that large changes in dividends do

affect share price.
– Informational content is 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.
– Investors view an increase in dividends as a positive signal,
and they bid up the share price. They view a decrease in
dividends as a negative signal that causes investors to sell
their shares, resulting in the share price decreasing.

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 Dividend Policy

Dividend policy represents the firm’s plan of action to be

followed whenever it makes a dividend decision.

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 Types of Dividend Policies: Constant-
Payout-Ratio Dividend Policy

• A firm’s 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.
• A constant-payout-ratio dividend policy is a dividend
policy based on the payment of a certain percentage of
earnings to owners in each dividend period.

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 Types of Dividend Policies: Constant-
Payout-Ratio Dividend Policy (cont.)

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.

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 Types of Dividend Policies:
Regular Dividend Policy
• Regular dividend policy is a dividend policy based on
the payment of a fixed-dollar dividend in each period.
• A regular dividend policy is often build around a target
dividend-payout ratio, which is 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.

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 Types of Dividend Policies:
Regular Dividend Policy (cont.)
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.

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 Types of Dividend Policies:
Low-Regular-and-Extra Dividend Policy

• A low-regular-and-extra dividend policy is 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.
• An extra dividend is an additional dividend optionally
paid by the firm when earnings are higher than normal in
a given period.

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 Other Forms of Dividends

A stock dividend is the payment, to existing owners, of a dividend in

the form of stock.
– In a stock dividend, investors simply receive additional shares in proportion
to the shares they already own.
– No cash is distributed, and no real value is transferred from the firm to
investors.
– Instead, because the number of outstanding shares increases, the stock price
declines roughly in line with the amount of the stock dividend.
– In an accounting sense, the payment of a stock dividend is a shifting of funds
between stockholders’ equity accounts rather than an outflow of funds.

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 Other Forms of Dividends
(cont.)
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 @ $4 par) 400,000
Paid-in capital in excess of par 600,000
Retained earnings 700,000
Total stockholders’ equity $2,000,000

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 Other Forms of Dividends
(cont.)
Garrison declares a 10% stock dividend when the market
price of its stock is $15 per share. The resulting account
balances are as follows:
Preferred stock $300,000
Common stock (110,000 shares @ $4 par) 440,000
Paid-in capital in excess of par 710,000
Retained earnings 550,000
Total stockholders’ equity $2,000,000

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 Other Forms of Dividends
(cont.)
Ms. X owned 10,000 shares of Garrison Corporation’s stock.
– The company’s most recent earnings were $220,000, and earnings are not
expected to change in the near future.
– Before the stock dividend, Ms. X owned 10% of the firm’s stock, which was
selling for $15 per share.
– Because Ms. X owned 10,000 shares, her earnings were $22,000
($2.20 per share  10,000 shares).
– After receiving the 10% stock dividend, Ms. X has 11,000 shares, which
again is 10% of the ownership (11,000 shares ÷ 110,000 shares).
– The market price of the stock can be expected to drop to $13.64 per share
[$15  (1.00 ÷ 1.10)], which means that the market value of Ms. X’s holdings
is $150,000 (11,000 shares  $13.64 per share).
– The future earnings per share drops to $2.

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 Other Forms of Dividends
(cont.)
A stock split is a method commonly used to lower the
market price of a firm’s stock by increasing the number of
shares belonging to each shareholder.
– Stock splits are often made prior to issuing additional stock to
enhance that stock’s marketability and stimulate market activity.
– It is not unusual for a stock split to cause a slight increase in the
market value of the stock, attributable to its informational
content and to the fact that total dividends paid commonly
increases slightly after a split.
– A reverse stock split is 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.

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 Other Forms of Dividends
(cont.)
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.

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 Personal Finance Example

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.

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 Personal Finance Example
(cont.)
• 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.

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The End