Solution manual financial management 10e by keown chapter 17

In this regard, the financialmanager should consider the investment opportunities available to the firm and anypreference that the company's investors have for dividend income or capital

CHAPTER 17

Dividend Policy and Internal Financing

CHAPTER ORIENTATION

In determining the firm's dividend policy, two issues are important: the dividend payoutratio and the stability of the dividend payment over time In this regard, the financialmanager should consider the investment opportunities available to the firm and anypreference that the company's investors have for dividend income or capital gains Also,stock dividends, stock splits, or stock repurchases can be used to supplement or replacecash dividends

CHAPTER OUTLINE

I The trade-offs in setting a firm's dividend policy

A If a company pays a large dividend, it will therefore:

1 Have a low retention of profits within the firm

2 Need to rely heavily on a new common stock issue for equity

financing

B If a company pays a small dividend, it will therefore:

1 Have a high retention of profits within the firm

2 Will not need to rely heavily on a new common stock issue for

equity financing The profits retained for reinvestment will providethe needed equity financing

II Impact of Dividend Policy on Stock Price

A The importance of a firm's dividend policy depends on the impact of the

dividend decision on the firm's stock price That is, given a firm's capitalbudgeting and borrowing decisions, what is the impact of the firm's dividendpolicies on the stock price?

B Three views about the importance of a firm's dividend policy.

1 View 1: Dividends do not matter

a Assumes that the dividend decision does not change the firm's

capital budgeting and financing decisions

b Assumes perfect capitals markets, which means:

(1) There are no brokerage commissions when investors

buy and sell stocks

(2) New securities can be issued without incurring any

flotation costs

(3) There are no personal or corporate income taxes.(4) Complete information about the firm is free and

equally readily available to all investors

(5) There are no conflicts of interest between

management and stockholders

(6) Financial distress and bankruptcy costs are

nonexistent

c Under the foregoing assumptions, it may be shown that the

market price of a corporation's common stock is unchangedunder different dividend policies If the firm increases thedividend to its stockholders, it has to offset this increase byissuing new common stock in order to finance the availableinvestment opportunities If on the other hand, the firmreduces its dividend payment, it has more funds availableinternally to finance future investment projects In eitherpolicy, the present value of the resulting cash flows to beaccrued to the current investors is independent of thedividend policy By varying the dividend policy, only the type

of return is affected (capital gains versus dividend income),not the total return

2 View 2: High dividends increase stock value

a Dividends are more predictable than capital gains because

management can control dividends, while they cannot dictatethe price of the stock Thus, investors are less certain ofreceiving income from capital gains than from dividendincome The incremental risk associated with capital gainsrelative to dividend income should therefore cause us to use ahigher required rate in discounting a dollar of capital gainsthan the rate used for discounting a dollar of dividends In sodoing, we would give a higher value to the dividend incomethan we would the capital gains

b Criticisms of view 2.

(1) Since the dividend policy has no impact on the

volatility of the company's overall cash flows, it has

no impact on the riskiness of the firm

(2) Increasing a firm's dividend does not reduce the basic

riskiness of the stock; rather, if dividend paymentrequires management to issue new stock, it onlytransfers risk and ownership from the current owners

to the new owners

3 View 3: Low dividends increase value

Stocks that allow us to defer taxes (low dividends-highcapital gains) will possibly sell at a premium relative tostocks that require us to pay taxes currently (high dividends-low capital gains) Only then will the two stocks providecomparable after-tax returns, which suggests that a policy topay low dividends, will result in a higher stock price That is,high dividends hurt investors, while low dividends-highretention help the firm's investors

But wait, then came 2003 and Congress again felt the need tochange the tax code as it pertained to both dividend incomeand capital gains income On May 28 President Bush signedinto law the “Jobs and Growth Tax Relief Reconciliation Act

of 2003.” Recall that part of the impetus for this Act was therecession 2001

In a nutshell this 2003 Act lowered the top tax rate ondividend income to 15 percent from a previous top rate of38.6 percent, and also lowered the top rate paid on realizedlong-term capital gains to the same 15 percent from aprevious 20 percent Thus, you can see that the so-calledinvestment playing field was (mostly) leveled for dividendincome relative to qualifying capital gains This ratherdramatic change in the tax code will immediately remind you

of Principle 8: Taxes Bias Business Decisions In effect,

a major portion of the previous bias against paying cashdividends to investors was mitigated But, not all of it

C Additional thoughts about the importance of a firm's dividend policy

1 Residual dividend theory: Because of flotation costs incurred in

issuing new stock, firms must issue a larger amount of securities inorder to receive the amount of capital required for investments As aresult, new equity capital will be more expensive than capital raised

through retained earnings Therefore, financing investmentsinternally (and decreasing dividends) instead of issuing new stockmay be favored This is embodied in the residual dividend theory,where a dividend would be paid only when any internally generatedfunds remain after financing the equity portion of the firm'sinvestments.

2 The clientele effect: If investors do in fact have a preference between

dividends and capital gains, we could expect them to seek out firmsthat have a dividend policy consistent with these preferences Theywould in essence "sort themselves out" by buying stocks whichsatisfy their preferences for dividends and/or capital gains In otherwords, there would be a "clientele effect," where firms draw a givenclientele based on their stated dividend policy However, unless there

is a greater aggregate demand for a particular policy than is beingsatisfied in the market, dividend policy is still unimportant, in thatone policy is as good as the other The clientele effect only tells us toavoid making capricious changes in a company's dividend policy

3 Information effect

a We know from experience that a large, unexpected change in

dividends can have significant impact on the stock price.Despite such "evidence," it is not unreasonable to hypothesizethat dividend policy only appears to be important, because weare not looking at the real cause and effect It may be thatinvestors use a change in dividend policy as a signal aboutthe firm's "true" financial condition, especially its earningpower

b Some would argue that management frequently has inside

information about the firm that it cannot make available tothe investors This difference in accessibility to informationbetween management and investors, called informationasymmetry, may result in a lower stock price than would berealized if we had conditions of certainty Dividends become

a means in a risky marketplace to minimize any "drag" on thestock price that might come from differences in the level ofinformation available to managers and investors

4 Agency costs: Conflicts between management and stockholders may

exist, and the stock price of a company owned by investors who areseparate from management may be less than the stock value of aclosely-held firm The difference in price is the cost of the conflict tothe owners, which has come to be called agency costs A firm'sdividend policy may be perceived by owners as a tool to minimizeagency costs Assuming the payment of a dividend requiresmanagement to issue stock to finance new investments, then newinvestors will be attracted to the company only if management

provides convincing information that the capital will be usedprofitably Thus, the payment of dividends indirectly results in acloser monitoring of management's investment activities In this case,dividends may provide a meaningful contribution to the value of thefirm.

5 Expectations theory: As the time approaches for management to

announce the amount of the next dividend, investors formexpectations as to how much the dividend will be When the actualdividend decision is announced, the investor compares the actualdecision with the expected decision If the amount of the dividend is

as expected, even if it represents an increase from prior years, themarket price of the stock will remain unchanged However, if thedividend is higher or lower than expected, the investors will reassesstheir perceptions about the firm and the value of the stock

D The empirical evidence about the importance of dividend policy

1 Statistical tests To test the relationship between dividend payments

and security prices, we could compare a firm's dividend yield(dividend/stock price) and the stock's total return, the question being,

"Do stocks that pay high dividends provide higher or lower returns tothe investors?" Such tests have been conducted using a variety of themost sophisticated statistical techniques available Despite the use ofthese extremely powerful analytical tools involving intricate andcomplicated procedures, the results have been mixed However, overlong periods of time, the results have given a slight advantage to thelow-dividend stocks; that is, stocks that pay lower dividends appear

to have higher prices The findings are far from conclusive, however,owing to the relatively large standard errors of the estimates

2 Reasons for inconclusive results from the statistical tests

a To be accurate, we would need to know the amount of

dividends investors expect to receive Since theseexpectations cannot be observed, we can only use historicaldata, which may or may not relate to expectations

b Most empirical studies have assumed a linear relationship

between dividend payments and stock prices The actualrelationship may be nonlinear, possibly even withdiscontinuities in the relationship

3 Since our statistical prowess does not provide us with any

conclusive evidence, researchers have surveyed financial managersabout their perceptions of the relevance of dividend policy In suchsurveys, the evidence favors the relevance of dividend policy, but notjust overwhelming so For the most part, managers are dividedbetween believing that dividends are important and having noopinion in the matter

E Conclusions about the importance of dividend policy

1 As a firm's investment opportunities increase, the dividend payout

ratio should decrease

2 The firm's dividend policy appears to be important; however,

appearances may be deceptive The real issue may be the firm'sexpected earnings power and the riskiness of these earnings

3 If dividends influence stock price, it probably comes from the

investor's desire to minimize and/or defer taxes and from the role ofdividends in minimizing agency costs

4 If the expectations theory has merit, which we believe it does, it

behooves management to avoid surprising the investors when itcomes to the firm's dividend decision

III Dividend policy decisions

A Other practical considerations

1 Legal restrictions

a A corporation may not pay a dividend

(l) if the firm's liabilities exceed its assets(2) if the amount of the dividend exceeds the accumulated

profits (retained earnings)(3) if the dividend is being paid from capital invested in

the firm

b Debtholders and preferred stockholders may impose

restrictive provisions on management, such as commondividends not being paid from earnings prior to the payment

of interest or preferred dividends

2 Liquidity position: The amount of a firm's retained earnings and its

cash position are seldom the same Thus, the company must haveadequate cash available as well as retained earnings to paydividends

3 Absence or lack of other sources of financing: All firms do not have

equal access to the capital markets Consequently, companies withlimited financial resources may rely more heavily on internallygenerated funds

4 Earnings predictability: A firm that has a stable earnings trend will

generally pay a larger portion of its earnings in dividends If earningsfluctuate significantly, a larger amount of the profits may be retained

to ensure that enough money is available for investment projectswhen needed

5 Ownership control: For many small firms, and certain large ones,

maintaining the controlling vote of common stock is very important

These owners would prefer the use of debt and retained profits tofinance new investments rather than to issue new stock.

6 Inflation: Because of inflation, the cost of replacing equipment has

increased substantially Depreciation funds tend to becomeinsufficient Hence, greater profit retention may be required

B Alternative dividend policies

1 Constant dividend payout ratio: The percentage of earnings paid out

in dividends is held constant Therefore, the dollar amount of thedividend fluctuates from year to year

2 Stable dollar dividend per share: Relatively stable dollar dividend is

maintained The dividend per share is increased or decreased onlyafter careful investigation by the management

3 Small, regular dividend plus a year-end extra: Extra dividend is paid

out in prosperous years Management's objective is to avoid theconnotation of a permanent dividend increase

C Basis for stable dividends

1 Stable dividend policy is most common of the three options

2 Managers were found to be reluctant to change the amount of the

dividend, especially when it came to decreasing the amount

3 Increasing-stream hypothesis of dividend policy states that dividend

stability is a smoothing of the dividend stream to minimize the effect

of other types of company reversals.

a Corporate managers attempt to have a gradually increasing

dividend over the long-term

b If dividend reduction is necessary, it should be large enough

to reduce the probability of future cuts

D Dividend policy and corporate strategy: Things will change—even dividend

policy

1 The recessions of 1990 to 1991 and 2001 induced a large number of

American corporations to revisit their broadest corporate strategies,including adjusting dividend policies

2 One firm that altered its dividend policy in response to new

strategies was the W.R Grace & Co., headquartered in Columbia,Maryland

3 Table 17-5 in the text reviews W.R Grace’s actual dividend policies

over the 1992 to 1996 time frame The firm’s payout ratio and theabsolute amount of the cash dividend paid per share declined in asignificant fashion over this period

IV Dividend payment procedures

A Dividends are generally paid quarterly

B The declaration date is the date on which the firm's board of directors

announces the forthcoming dividends

C The date of record designates when the stock transfer books are to be

closed Investors who own stock on this date are entitled to the dividend

D Brokerage firms terminate the right of ownership to the dividend two

working days prior to the date of record This date is called the ex-dividenddate

E Dividend checks are mailed on the payment date

V Stock dividends and stock splits

A Both a stock dividend and a stock split involve issuing new shares of stock

to current stockholders

B The investor’s percentage ownership in the firm remains unchanged The

investor is neither better nor worse off than before the stock split/dividend

C On an economic basis there is no difference between a stock dividend and a

stock split

D For accounting purposes, the stock split has been defined as a stock

dividend exceeding 25 percent of the number of shares currentlyoutstanding

E Accounting treatment

1 For a stock dividend, the dollar amount of the dividend is transferred

from retained earnings to the capital accounts (par and paid-incapital)

2 In the case of a split, the dollar amounts of the capital accounts do

not change Only the number of shares is increased while the parvalue of each share is decreased proportionately

F Rationale for a stock dividend or split

1 Shareholders benefit because the price of stock may not fall precisely

in proportion to the share increase; thus, the stockholders' value isincreased

2 If a company is encountering cash problems, it can substitute a stock

dividend for a cash dividend Investors will probably look beyond thestock dividend to determine the underlying reasons for conservingcash

VI Stock repurchases

A A number of benefits exist justifying stock repurchases instead of dividend

payments Included in these are:

1 to provide an internal investment opportunity

2 to modify the firm's capital structure

3 to impact earnings per share, thus increasing stock price

B Share repurchase as a dividend decision

1 A firm may decide to repurchase its shares, increasing the earnings

per share, which should be reflected in a higher stock price

2 The investor's choice

a For tax purposes, the investor may prefer the firm to

repurchase stock in lieu of a dividend Dividends formerlywere taxed as ordinary income, whereas any priceappreciation resulting from the stock repurchase would betaxed as a capital gain, and can be deferred until the gain isrealized

b The investor may prefer dividend payment because

(l) Dividends are viewed as being more dependable than

stock repurchases

(2) The price the firm must pay for its stock may be too

high

(3) Riskiness of the firm's capital structure may increase,

lowering the P/E ratio and thus the stock price

C Financing or investment decision

1 A stock repurchase effectively increases the debt-equity ratio

towards higher debt, thus repurchase is viewed as a financingdecision

2 When buying its own stock at depressed prices, a firm may consider

the repurchase as an investment decision However, this action is not

a true investment opportunity; buying its own stock does not providethe expected returns as other investments do

D The repurchase procedure

1 A public announcement should be made detailing the amount,

purpose and procedure for the stock repurchase

2 Open market purchase – stock is bought at the current market price

3 Tender offer - more formal offer where offer for stock is at a

specified price, usually above current market price

4 Negotiated basis - repurchasing from specific, major shareholders at

a negotiated price

VII The Multinational firm: The Case of Low Dividend Payments

A During economic prosperity, multinational firms look to international

markets for high net present value projects

1 This provides diversification of country-related economic risks

2 Firm can achieve cost advantages over its competitors

B U.S multinational firms favor the UK and Canada for direct investments

C U.S multinational firms concentrate investments in manufacturing

industries when investing internationally

1 Firms can achieve lower labor costs by employing workers in a

foreign country

2 Lower labor costs improve a firm’s competitive position.

VIII How Financial Managers Use This Material

A In the text, actual examples of dividend policy in action are presented that

deal with Coca-Cola and the Walt Disney Company

B And we are reminded that the differential tax treatment of cash dividends as

opposed to capital gains can give investors a preferential tax advantage when shares are repurchased, as the capital gains can be deferred This is not possible with the receipt of cash dividends The income tax has to be paid in the year that the dividends are actually received by the investor

ANSWERS TO END-OF-CHAPTER QUESTIONS

17-1 The dividend payout ratio indicates the amount of dividends paid relative to the

earnings available to common stockholders, or dividend-per-share divided byearnings-per-share

17-2 A firm's net profits are used to pay dividends and/or to finance new investments

As larger dividends are paid, the retained earnings available for reinvestment arereduced Conversely, as a larger amount of profits is reinvested, the capitalavailable for common stockholders' dividends is reduced

17-3 (a) In a perfect market, there are no brokerage commissions, no flotation costs,

no taxes, no information content assigned to a particular dividend policy,complete information about a firm is available to every investor, no conflicts

of interest between management and stockholders and financial distress andbankruptcy costs are nonexistent

(b) A firm's dividend policy is irrelevant in a perfect market Management may

choose between retaining profits and paying dividends without affecting thevalue of the firm's security Therefore, the only wealth-creating activities in

a perfect market are management's investment and financing decisions.17-4 The existence of flotation costs eliminates the indifference between financing by

internal capital and new stock Financing investments through retained earningswill be preferred to avoid flotation costs and capital leakage If no other perfectmarket assumptions have been relaxed, new stock would be issued only afterinternally generated funds have been exhausted

17-5 (a) According to the residual dividend theory, dividends are paid only if

retained earnings are available after financing all acceptable investments.(b) This theory may not be feasible in the short term because the year-to-year

variability in dividend payments is undesirable The theory can be used inthe long term if management projects financing needs for several years Atarget dividend payout ratio for this planning horizon can be established thatwill distribute the residual capital smoothly over the period