{"id":6801,"date":"2021-10-10T20:19:53","date_gmt":"2021-10-10T20:19:53","guid":{"rendered":"https:\/\/assignmenttutors.net\/blog\/principles-of-managerial-finance-business-finance-homework-help\/"},"modified":"2021-10-10T20:19:53","modified_gmt":"2021-10-10T20:19:53","slug":"principles-of-managerial-finance-business-finance-homework-help","status":"publish","type":"post","link":"https:\/\/assignmenttutors.net\/blog\/principles-of-managerial-finance-business-finance-homework-help\/","title":{"rendered":"Principles of managerial finance | Business &#038; Finance homework help"},"content":{"rendered":"<div>\n<p><strong>Resource:\u00a0<\/strong><em>Principles of Managerial Finance<\/em>, Ch. 14<\/p>\n<p><strong>Complete\u00a0<\/strong>the Integrative Case 6 O&#8217;Grady Apparel Company.\u00a0<\/p>\n<p>Please after reading the chapter, I have highlighted the questions that you need to answer. ONLY THE HIGHLIGHTED SECTION IS MINE TO ANSWER THIS IS A TEAM ASSIGNMENT.<\/p>\n<p>\u00a0<\/p>\n<p><span><strong>d.<\/strong><\/span><\/p>\n<ul>\n<li><span><span>(1)<\/span>\u00a0<span>Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged\u00a0<em>capital structure<\/em>\u00a0consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings? (<em>Note:<\/em>\u00a0Rework parts\u00a0<strong>b<\/strong>\u00a0and\u00a0<strong>c<\/strong>\u00a0using these capital structure weights.)<\/span><\/span><\/li>\n<li><span><span>(2)<\/span>\u00a0<span>Which capital structure&#8211;the original one or this one&#8211;seems better? Why?<\/span><\/span><\/li>\n<\/ul>\n<p><span><span>\u00a0<\/span><\/span><\/p>\n<p><span><span><span>Below is Chapter 14<\/span><\/span><\/span><\/p>\n<p><span><span><span>\u00a0<\/span><\/span><\/span><\/p>\n<h2><span><strong><br \/>14\u00a0<\/strong><\/span><strong>Payout Policy<\/strong><\/h2>\n<div>\n<h2><strong>Learning Goals<\/strong><\/h2>\n<ul>\n<li><span><strong><span>LG 1<\/span>\u00a0<\/strong><\/span><span>Understand cash payout procedures, their tax treatment, and the role of dividend reinvestment plans.<\/span><\/li>\n<li><span><strong><span>LG 2<\/span>\u00a0<\/strong><\/span><span>Describe the residual theory of dividends and the key arguments with regard to dividend irrelevance and relevance.<\/span><\/li>\n<li><span><strong><span>LG 3<\/span>\u00a0<\/strong><\/span><span>Discuss the key factors involved in establishing a dividend policy.<\/span><\/li>\n<li><span><strong><span>LG 4<\/span>\u00a0<\/strong><\/span><span>Review and evaluate the three basic types of dividend policies.<\/span><\/li>\n<li><span><strong><span>LG 5<\/span>\u00a0<\/strong><\/span><span>Evaluate stock dividends from accounting, shareholder, and company points of view.<\/span><\/li>\n<li><span><strong><span>LG 6<\/span>\u00a0<\/strong><\/span><span>Explain stock splits and the firm\u2019s motivation for undertaking them.<\/span><\/li>\n<\/ul>\n<\/div>\n<div>\n<h2><strong>Why This Chapter Matters to You<\/strong><\/h2>\n<p><big><strong>In your\u00a0<em><span>professional<\/span><\/em>\u00a0life<\/strong><\/big><\/p>\n<p><strong><span>ACCOUNTING<\/span><\/strong>\u00a0You need to understand the types of dividends and payment procedures for them because you will need to record and report the declaration and payment of dividends; you also will provide the financial data that management must have to make dividend decisions.<\/p>\n<p><strong><span>INFORMATION SYSTEMS<\/span><\/strong>\u00a0You need to understand types of dividends, payment procedures, and the financial data that the firm must have to make and implement dividend decisions.<\/p>\n<p><strong><span>MANAGEMENT<\/span><\/strong>\u00a0To make appropriate dividend decisions for the firm, you need to understand types of dividends, arguments about the relevance of dividends, the factors that affect dividend policy, and types of dividend policies.<\/p>\n<p><strong><span>MARKETING<\/span><\/strong>\u00a0You need to understand factors affecting dividend policy because you may want to argue that the firm would be better off retaining funds for use in new marketing programs or products, rather than paying them out as dividends.<\/p>\n<p><strong><span>OPERATIONS<\/span><\/strong>\u00a0You need to understand factors affecting dividend policy because you may find that the firm\u2019s dividend policy imposes limitations on planned expansion, replacement, or renewal projects.<\/p>\n<p><big><strong>In your\u00a0<em><span>personal<\/span><\/em>\u00a0life<\/strong><\/big><\/p>\n<p>Many individual investors buy common stock for the anticipated cash dividends. From a personal finance perspective, you should understand why and how firms pay dividends and the informational and financial implications of receiving them. Such understanding will help you select common stocks that have dividend-paying patterns consistent with your long-term financial goals.<\/p>\n<\/div>\n<div>\n<h2><span><strong>Whirlpool Corporation\u00a0<\/strong><\/span><strong>Increasing Dividends<\/strong><\/h2>\n<div><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0001.jpg\" alt=\"\" width=\"760\" height=\"538\"\/><\/div>\n<p>In another sign of an improving economy, Whirlpool Corporation, the worldwide appliance manufacturer, announced that it would increase the quarterly dividend that it paid to its stockholders by 25 percent, up to 62.5 cents per share from 50 cents in the previous quarter. Whirlpool\u2019s CEO, Jeff Fettig, explained, \u201cOur actions have delivered a strong financial position enabling us to enhance returns to shareholders through a dividend increase. This dividend increase underscores our confidence that our long-term growth and innovation strategy will continue to create value for our shareholders.\u201d Markets reacted to this news by increasing Whirlpool\u2019s stock price by 3.2 percent.<\/p>\n<p>Why does Whirlpool pay dividends? Fettig\u2019s press release suggests two possibilities. One is that by paying dividends the company can \u201cenhance returns\u201d to shareholders. In other words, Whirlpool believes that returns to shareholders will be higher if the firm pays a dividend (and increases it) than if the firm does not pay a dividend. That sounds logical, but consider that when a firm pays a dividend, it is simply taking cash out of its bank account and putting that cash in the hands of shareholders. Presumably, after a firm pays a dividend, its share price will reflect that it no longer holds as much cash as it did prior to the dividend payment. In other words, paying a dividend may simply be just switching money from one pocket (the company\u2019s) to another (the shareholder\u2019s).<\/p>\n<p>Another reason that Whirlpool may pay a dividend is revealed in the second part of Fettig\u2019s statement. Whirlpool increased its dividend to \u201cunderscore our confidence.\u201d In other words, Whirlpool executives are telling the market that the firm\u2019s financial position is strong enough and its prospects bright enough that managers are confident that they can afford to increase the dividend by 25 percent and still run the company effectively. Indeed, Whirlpool\u2019s history suggests that managers use caution when increasing dividends. From 1995 to 2013, Whirlpool increased its dividend on just three occasions. Compare that record with the dividend history of Emerson Electric Co., a company that as of 2013 had increased its dividend for 54 consecutive years. Apparently Emerson and Whirlpool adopt different policies with respect to dividend increases.<\/p>\n<\/div>\n<div>\n<h2><span><strong>14.1\u00a0<\/strong><\/span><strong>The Basics of Payout Policy<\/strong><\/h2>\n<p><strong><span>LG 1<\/span><\/strong><\/p>\n<p>The term\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_420\">payout policy<\/a><\/strong>\u00a0refers to the decisions that firms make about whether to distribute cash to shareholders, how much cash to distribute, and by what means the cash should be distributed. Although these decisions are probably less important than the investment decisions covered in<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch10\">Chapters 10<\/a>\u00a0through\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch12\">12<\/a>\u00a0and the financing choices discussed in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch13\">Chapter 13<\/a>, they are nonetheless decisions that managers and boards of directors face routinely. Investors monitor firms\u2019 payout policies carefully, and unexpected changes in those policies can have significant effects on firms\u2019 stock prices. The recent history of Whirlpool Corporation, briefly outlined in the chapter opener, demonstrates many of the important dimensions of payout policy.<\/p>\n<div>\n<p><strong><span>payout policy<\/span><\/strong><\/p>\n<p>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.<\/p>\n<\/div>\n<div>\n<h2><strong>ELEMENTS OF PAYOUT POLICY<\/strong><\/h2>\n<p>Dividends are not the only means by which firms can distribute cash to shareholders. Firms can also conduct share repurchases, in which they typically buy back some of their outstanding common stock through purchases in the open market. Whirlpool Corporation, like many other companies, uses both methods to put cash in the hands of their stockholders. In addition to increasing its dividend payout, Whirlpool also resumed its share repurchase program in 2013, which had been halted during the economic recession. At the time of resuming the share repurchase program, the company\u2019s free cash flow was between $600 million and $650 million and expected to increase to between $650 million and $700 million. Whirlpool\u2019s chief executive officier, Jeff Fettig, stated that \u201csales increased in every region of the world\u201d as the company continued to expand its margins and that as the company continued to execute its \u201clong-term growth strategy . . . [it would] continue to drive actions to further create value for . . . shareholders.\u201d<\/p>\n<p>If we generalize the lessons about payout policy, we may expect the following to be true:<\/p>\n<ul>\n<li><span>1.<\/span>\u00a0<span>Rapidly growing firms generally do not pay out cash to shareholders.<\/span><\/li>\n<li><span>2.<\/span>\u00a0<span>Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms to initiate cash payouts to investors. The ownership base of the company can also be an important factor in the decision to distribute cash.<\/span><\/li>\n<li><span>3.<\/span>\u00a0<span>Cash payouts can be made through dividends or share repurchases. Many companies use both methods. In some years, more cash is paid out via dividends, but sometimes share repurchases are larger than dividend payments.<\/span><\/li>\n<li><span>4.<\/span>\u00a0<span>When business conditions are weak, firms are more willing to reduce share buybacks than to cut dividends.<\/span><\/li>\n<\/ul>\n<\/div>\n<div>\n<h2><strong>TRENDS IN EARNINGS AND DIVIDENDS<\/strong><\/h2>\n<p><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig1\">Figure 14.1<\/a>\u00a0illustrates both long-term trends and cyclical movements in earnings and dividends paid by large U.S. firms that are part of the Standard &amp; Poor\u2019s 500 Stock Composite Index. The figure plots monthly earnings and dividend payments from 1950 through the first quarter of 2013. The top line represents the earnings per share of the S&amp;P 500 index, and the lower line represents dividends\u00a0per share. The vertical bars highlight ten periods during which the U.S. economy was in recession. Several important lessons can be gleaned from the figure. First, observe that over the long term the earnings and dividends lines tend to move together.\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig1\">Figure 14.1<\/a>\u00a0uses a logarithmic scale, so the slope of each line represents the growth rate of earnings or dividends. Over the 60 years shown in the figure, the two lines tend to have about the same slope, meaning that earnings and dividends grow at about the same rate when you take a long-term perspective. It makes perfect sense: Firms pay dividends out of earnings, so for dividends to grow over the long-term, earnings must grow too.<\/p>\n<div>\n<h2><span><strong>FIGURE 14.1\u00a0<\/strong><\/span><strong>Per Share Earnings and Dividends of the S&amp;P 500 Index<\/strong><\/h2>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0002.jpg\" alt=\"\" width=\"760\" height=\"376\"\/><\/p>\n<div>\n<p>Monthly U.S. dollar amount of earnings and dividends per share of the S&amp;P 500 index from 1950 through the first quarter of 2013 (the figure uses a logarithmic vertical scale)<\/p>\n<\/div>\n<\/div>\n<p>Second, the earnings series is much more volatile than the dividends series. That is, the line plotting earnings per share is quite bumpy, but the dividend line is much smoother, which suggests that firms do not adjust their dividend payments each time earnings move up or down. Instead, firms tend to smooth dividends, increasing them slowly when earnings are growing rapidly and maintaining dividend payments, rather than cutting them, when earnings decline.<\/p>\n<p>To see this second point more clearly, look closely at the vertical bars in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig1\">Figure 14.1<\/a>. It is apparent that during recessions corporate earnings usually decline, but dividends either do not decline at all or do not decline as sharply as earnings. In six of the last ten recessions, dividends were actually higher when the recession ended than just before it began, although the last two recessions are notable exceptions to this pattern. Note also that, just after the end of a recession, earnings typically increase quite rapidly. Dividends increase, too, but not as fast.<\/p>\n<p>A third lesson from\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig1\">Figure 14.1<\/a>\u00a0is that the effect of the recent recession on both corporate earnings and dividends was large by historical standards. An\u00a0enormous earnings decline occurred from 2007 to 2009. This decline forced firms to cut dividends more drastically than they had in years; nonetheless, the drop in dividends was slight compared with the earnings decrease.<\/p>\n<div>\n<h2><strong>Matter of fact<\/strong><\/h2>\n<p><strong><span>P&amp;G\u2019s Dividend History<\/span><\/strong><\/p>\n<p>Few companies have replicated the dividend achievements of the consumer products giant Procter &amp; Gamble (P&amp;G). P&amp;G has paid dividends every year for more than a century, and it increased its dividend in every year from 1956 through 2012.<\/p>\n<div><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0003.jpg\" alt=\"\" width=\"705\" height=\"594\"\/><\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>TRENDS IN DIVIDENDS AND SHARE REPURCHASES<\/strong><\/h2>\n<p>When firms want to distribute cash to shareholders, they can either pay dividends or repurchase outstanding shares.\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig2\">Figure 14.2<\/a>\u00a0plots aggregate dividends and share repurchases from 1971 through 2011 for all U.S. firms listed on U.S. stock exchanges (again, the figure uses a logarithmic vertical scale). A quick glance at the figure reveals that share repurchases played a relatively minor role in firms\u2019 payout practices in the 1970s. In 1971, for example, aggregate dividends totaled $21 billion, but share repurchases that year were just $1.1 billion. In the 1980s, share repurchases began to grow rapidly and then slowed again in the early 1990s. The value of aggregate share repurchases first eclipsed total dividend payments in 1998. That year, firms paid $175 billion in dividends, but they repurchased $185 billion worth of stock. Share repurchases continued to outpace dividends for all but three of the next 13 years, peaking at $677 billion in 2007.<\/p>\n<p>Whereas aggregate dividends rise smoothly over time,\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig2\">Figure 14.2<\/a>\u00a0shows that share repurchases display much more volatility. The largest drops in repurchase activity occurred in 1974\u20131975, 1981, 1986, 1989\u20131991, 2000\u20132002, and 2008\u20132010. All these drops correspond to periods when the U.S. economy was mired in or just emerging from a recession. During most of these periods, dividends continued to grow modestly. Only during the recent, severe recession did both share repurchases and dividends fall.<\/p>\n<div>\n<h2><span><strong>FIGURE 14.2\u00a0<\/strong><\/span><strong>Aggregate Dividends and Repurchases for All U.S.\u2013Listed Companies<\/strong><\/h2>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0004.jpg\" alt=\"\" width=\"760\" height=\"459\"\/><\/p>\n<div>\n<p>Aggregate U.S. dollar amount of dividends and share repurchases for all U.S. firms listed on U.S. stock exchanges in each year from 1971 through 2011 (the figure uses a logarithmic vertical scale)<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><span><span>in practice\u00a0<\/span><\/span><strong>focus on ETHICS: Are Buybacks Really a Bargain?<\/strong><\/h2>\n<p>When CBS announced in March 2007 that it would buy back $1.4 billion worth of stock, its sagging share price saw the biggest spike since the media giant parted ways with Viacom in 2005. The 4.5 percent jump may have been an omen of good fortune\u2014at the very least, it showed how much shareholders like buybacks.<\/p>\n<p>Companies have been gobbling up their own shares faster than ever in a world of inexpensive capital and swollen balance sheets. Since 2003, the market for buybacks has boomed, with repurchases nearly on a par with capital expenditures. Some, however, have questioned the moves and motives that lead to a big buyback.<\/p>\n<p>In addition to simply returning cash to shareholders, many companies also repurchase stock because they believe that their stock is undervalued. New research, however, shows that companies often use creative financial reporting to push earnings downward before buybacks, making the stock seem undervalued and causing its price to bounce higher after the buyback. That pleases investors who then amplify the effect by pushing the price even higher.<\/p>\n<p>\u201cManagers who are acting opportunistically can use their reporting discretion to reduce the repurchase price by temporarily deflating earnings,\u201d argue Guojin Gong, Henock Louis, and Amy Sun at Penn State University\u2019s Smeal College of Business. Observing data from 1,720 companies, the authors say companies can easily create an apparent slump by speeding up or slowing down expense recognition, changing inventory accounting, or revising estimates of bad debt, all of which are classic methods of making the numbers look worse without actually breaking accounting rules.<\/p>\n<p>The penalty for being caught deliberately managing earnings in advance of a buyback could be severe. With the variety of accounting scandals that popped up regularly in the early 2000s, executives would no doubt be wary of deflating earnings just to get a boost from a buyback. Still, that\u2019s what Louis believes some are doing. \u201cI don\u2019t think what they\u2019re doing is illegal,\u201d he says. \u201cBut it\u2019s misleading their investors.\u201d<\/p>\n<p><span><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_com_f0002.jpg\" alt=\"\" width=\"22\" height=\"22\"\/><\/span>\u00a0<span>Do you agree that corporate managers would manipulate their stock\u2019s value prior to a buyback, or do you believe that corporations are more likely to initiate a buyback to enhance shareholder value?<\/span><\/p>\n<\/div>\n<p>Combining the lessons from\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig1\">Figures 14.1<\/a>\u00a0and\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig2\">14.2<\/a>, we can draw three broad conclusions about firms\u2019 payout policies. First, firms exhibit a strong desire to maintain modest, steady growth in dividends that is roughly consistent with the long-run growth in earnings. Second, share repurchases have accounted for a growing fraction of total cash payouts over time. Third, when earnings fluctuate, firms adjust their short-term payouts primarily by adjusting share repurchases (rather than dividends), cutting buybacks during recessions, and increasing them rapidly during economic expansions.<\/p>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_com_f0001.jpg\" alt=\"\" width=\"40\" height=\"40\"\/>\u00a0<\/span><strong>Matter of fact<\/strong><\/h2>\n<p><strong><span>Share Repurchases Gain Worldwide Popularity<\/span><\/strong><\/p>\n<p>The growing importance of share repurchases in corporate payout policy is not confined to the United States. In most of the world\u2019s largest economies, repurchases have been on the rise in recent years, eclipsing dividend payments at least some of the time in countries as diverse as Belgium, Denmark, Finland, Hungary, Ireland, Japan, Netherlands, South Korea, and Switzerland. A study of payout policy at firms from 25 different countries found that share repurchases rose at an annual rate of 19 percent from 1999 through 2008.<\/p>\n<\/div>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_com_f0007.jpg\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTIONS<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u20131<\/span><\/strong><\/span><\/p>\n<p>What are the two ways that firms can distribute cash to shareholders?<\/p>\n<\/div>\n<div><span><strong><span>14\u20132<\/span><\/strong><\/span><\/p>\n<p>Why do rapidly growing firms generally pay no dividends?<\/p>\n<\/div>\n<div><span><strong><span>14\u20133<\/span><\/strong><\/span><\/p>\n<p>The dividend payout ratio equals dividends paid divided by earnings.<\/p>\n<p>How would you expect this ratio to behave during a recession? What about during an economic boom?<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><span><strong>14.2\u00a0<\/strong><\/span><strong>The Mechanics of Payout Policy<\/strong><\/h2>\n<p><strong><span>LG 1<\/span><\/strong><\/p>\n<p>At quarterly or semiannual meetings, a firm\u2019s 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\u2019s recent performance and its ability to generate cash flow in the future. Boards rarely cut dividends unless they believe that the firm\u2019s ability to generate cash is in serious jeopardy.\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig3\">Figure 14.3<\/a>\u00a0plots the number of U.S. public industrial firms that increased, decreased, or maintained their dividend payment in each year from 1981 through 2011. Clearly, the number of firms increasing their dividends is far greater than the number of companies cutting dividends in most years. When the economy is strong, as it was from 2003 to 2006, the ratio of industrial firms increasing dividends to those cutting dividends may be 10 to 1 or higher. However, a sign of the severity of the most recent recession was that in 2009 this ratio was just 1.5 to 1. That year, 401 U.S. public industrial firms increased their dividend, whereas 266 firms cut dividends.<\/p>\n<div>\n<h2><span><strong>FIGURE 14.3\u00a0<\/strong><\/span><strong>U.S. Public Industrial Firms Increasing, Decreasing, or Maintaining Dividends<\/strong><\/h2>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0005.jpg\" alt=\"\" width=\"760\" height=\"392\"\/><\/p>\n<div>\n<p>Number of U.S. public industrial firms that increased, decreased, or maintained their dividend payment in each year from 1981 through 2011<\/p>\n<\/div>\n<\/div>\n<p><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig3\">Figure 14.3<\/a>\u00a0clearly shows that firms prefer to increase rather than decrease dividends, but what is most evident is that firms prefer to maintain their established dividend levels. In the average year, 79 percent of U.S. industrial firms elect to maintain their previous year\u2019s dividend payout, and 96 percent avoid decreasing their dividend. Although some firms will choose to grow their dividend payout, the main goal of nearly all firms is to do whatever is necessary to avoid cutting dividends.<\/p>\n<div>\n<h2><strong>CASH DIVIDEND PAYMENT PROCEDURES<\/strong><\/h2>\n<p>When a firm\u2019s directors declare a dividend, they issue a statement indicating the dividend amount and setting three important dates: the\u00a0<em>date of record,<\/em>\u00a0the\u00a0<em>ex-dividend date,<\/em>\u00a0and the\u00a0<em>payment date<\/em>. All persons whose names are recorded as stockholders on the\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_152\">date of record<\/a><\/strong>\u00a0receive the dividend. These stockholders are often referred to as\u00a0<em>holders of record<\/em>.<\/p>\n<div>\n<p><strong><span>date of record (dividends)<\/span><\/strong><\/p>\n<p>Set by the firm\u2019s directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time.<\/p>\n<\/div>\n<p>Because of the time needed to make bookkeeping entries when a stock is traded, the stock begins selling\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_213\">ex dividend<\/a><\/strong>\u00a02\u00a0<em>business days<\/em>\u00a0prior to the date of record. Purchasers of a stock selling ex dividend do not receive the current dividend. A simple way to determine the first day on which the stock sells ex dividend is to subtract 2 business days from the date of record.<\/p>\n<div>\n<p><strong><span>ex dividend<\/span><\/strong><\/p>\n<p>A period beginning 2\u00a0<em>business days<\/em>\u00a0prior to the date of record, during which a stock is sold without the right to receive the current dividend.<\/p>\n<\/div>\n<p>The\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_419\">payment date<\/a><\/strong>\u00a0is the actual date on which the firm mails the dividend payment to the holders of record. It is generally a few weeks after the record date. An example will clarify the various dates and the accounting effects.<\/p>\n<div>\n<p><strong><span>payment date<\/span><\/strong><\/p>\n<p>Set by the firm\u2019s directors, the actual date on which the firm mails the dividend payment to the holders of record.<\/p>\n<\/div>\n<div>\n<h2><strong>Example 14.1<\/strong><\/h2>\n<p>On August 21, 2013, the board of directors of Best Buy announced that the firm\u2019s next quarterly cash dividend would be $0.17 per share, payable on October 1, 2013, to shareholders of record on Tuesday, September 10, 2013. Best Buy shares would begin trading ex dividend on the previous Friday, September 6. At the time\u00a0of the announcement, Best Buy had 340,967,179 shares of common stock outstanding, so the total dividend payment would be $57,964,420.\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fig4\">Figure 14.4<\/a>\u00a0shows a time line depicting the key dates relative to the Best Buy dividend. Before the dividend was declared, the key accounts of the firm were as follows (dollar values quoted in thousands):<span><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fn1\">1<\/a><\/span><\/p>\n<div>\n<h2><span><strong>FIGURE 14.4\u00a0<\/strong><\/span><strong>Dividend Payment Time Line<\/strong><\/h2>\n<p><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_14_f0006.jpg\" alt=\"\" width=\"760\" height=\"393\"\/><\/p>\n<div>\n<p>Time line for the announcement and payment of a cash dividend for Best Buy<\/p>\n<\/div>\n<\/div>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Cash<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$680,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividends payable<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03,395,000<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>When the dividend was announced by the directors, almost $58 million of the retained earnings ($0.17 per share \u00d7 341 million shares) was transferred to the dividends payable account. The key accounts thus became<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Cash<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$680,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividends payable<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0\u00a057,964<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03,337,036<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>When Best Buy actually paid the dividend on October 26, this produced the following balances in the key accounts of the firm:<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Cash<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$622,036<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividends payable<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03,337,036<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>The net effect of declaring and paying the dividend was to reduce the firm\u2019s total assets (and stockholders\u2019 equity) by almost $58 million.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>SHARE REPURCHASE PROCEDURES<\/strong><\/h2>\n<p><small>1. The accounting transactions described here reflect only the effects of the dividend. Best Buy\u2019s actual financial statements during this period obviously reflect many other transactions.<\/small><\/p>\n<p>The mechanics of cash dividend payments are virtually the same for every dividend paid by every public company. With share repurchases, firms can use at least two different methods to get cash into the hands of shareholders. The most common method of executing a share repurchase program is called an open-market share repurchase. In an\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_394\">open-market share repurchase<\/a>,<\/strong>\u00a0as the name suggests,\u00a0firms simply buy back some of their outstanding shares on the open market. Firms have a great deal of latitude regarding when and how they execute these open-market purchases. Some firms make purchases in fixed amounts at regular intervals, whereas other firms try to behave more opportunistically, buying back more shares when they think that the share price is relatively low and fewer shares when they think that the price is high.<\/p>\n<div>\n<p><strong><span>open-market share repurchase<\/span><\/strong><\/p>\n<p>A share repurchase program in which firms simply buy back some of their outstanding shares on the open market.<\/p>\n<\/div>\n<p>In contrast, firms sometimes repurchase shares through a\u00a0<em>self-tender offer<\/em>\u00a0or simply a\u00a0<em>tender offer<\/em>. In a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_566\">tender offer share repurchase<\/a>,<\/strong>\u00a0a firm announces the price it is willing to pay to buy back shares and the quantity of shares it wishes to repurchase. The tender offer price is usually set at a significant premium above the current market price. Shareholders who want to participate let the firm know how many shares they would like to sell back to the firm at the stated price. If shareholders do not offer to sell back as many shares as the firm wants to repurchase, the firm may either cancel or extend the offer. If the offer is oversubscribed, meaning that shareholders want to sell more shares than the firms wants to repurchase, the firm typically repurchases shares on a pro rata basis. For example, if the firm wants to buy back 10 million shares, but 20 million shares are tendered by investors, the firm would repurchase exactly half of the shares tendered by each shareholder.<\/p>\n<div>\n<p><strong><span>tender offer share repurchase<\/span><\/strong><\/p>\n<p>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.<\/p>\n<\/div>\n<p>A third method of buying back shares is called a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_187\">Dutch auction share repurchase<\/a>.<\/strong>\u00a0In a Dutch auction, the firm specifies a range of prices at which it is willing to repurchase shares and the quantity of shares that it desires. Investors can tender their shares to the firm at any price in the specified range, which allows the firm to trace out a demand curve for their stock. That is, the demand curve specifies how many shares investors will sell back to the firm at each price in the offer range. This analysis allows the firm to determine the minimum price required to repurchase the desired quantity of shares, and every shareholder receives that price.<\/p>\n<div>\n<p><strong><span>Dutch auction share repurchase<\/span><\/strong><\/p>\n<p>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.<\/p>\n<\/div>\n<div>\n<h2><strong>Example 14.2<\/strong><\/h2>\n<p>In July 2013, Fidelity National Information Services announced a Dutch auction repurchase for 86 million common shares at prices ranging from $29 to $31.50 per share. Fidelity 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, Fidelity constructed the following demand schedule:<\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Offer price<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Shares tendered<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Cumulative total<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$29\u00a0\u00a0\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a05,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a05,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a029.25<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>10,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a015,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a029.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>15,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a030,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a029.75<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>18,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a048,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a030\u00a0\u00a0\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>18,500,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a066,500,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a031.25<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>19,500,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a086,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a031.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>20,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>106,000,000<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>At a price of $31.25, shareholders are willing to tender a total of 86 million shares, exactly the amount that Fidelity wants to repurchase. Each shareholder\u00a0who expressed a willingness to tender their shares at a price of $31.25\u00a0<em>or less<\/em>\u00a0receives $31.25, and Fidelity repurchases all 86 million shares at a cost of roughly $2.7 billion.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>TAX TREATMENT OF DIVIDENDS AND REPURCHASES<\/strong><\/h2>\n<p>For many years, dividends and share repurchases had very different tax consequences. The dividends that investors received were generally taxed at ordinary income tax rates. Therefore, if a firm paid $10 million in dividends, that payout would trigger significant tax liabilities for the firm\u2019s shareholders (at least those subject to personal income taxes). On the other hand, when firms repurchased shares, the taxes triggered by that type of payout were generally much lower. There were several reasons for this difference. Only those shareholders who sold their shares as part of the repurchase program had any immediate tax liability. Shareholders who did not participate did not owe any taxes. Furthermore, some shareholders who did participate in the repurchase program might not owe any taxes on the funds they received if they were tax-exempt institutions or if they sold their shares at a loss. Finally, even those shareholders who participated in the repurchase program and sold their shares for a profit paid taxes only at the (usually lower) capital gains tax rate, (assuming the shares were held for at least one year), and even that tax only applied to the gain, not to the entire value of the shares repurchased. Consequently, investors could generally expect to pay far less in taxes on money that a firm distributed through a share repurchase compared to money paid out as dividends. That differential tax treatment in part explains the growing popularity of share repurchase programs in the 1980s and 1990s.<\/p>\n<p>The\u00a0<em>Jobs and Growth Tax Relief Reconciliation Act of 2003<\/em>\u00a0significantly changed the tax treatment of corporate dividends for most taxpayers. Prior to passage of the 2003 law, dividends received by investors were taxed as ordinary income at rates as high as 35 percent. The 2003 act reduced the tax rate on corporate dividends for most taxpayers to the tax rate applicable to capital gains, which is a maximum rate of 5 percent to 15 percent, depending on the taxpayer\u2019s tax bracket. This change significantly diminishes the degree of \u201cdouble taxation\u201d of dividends, which results when the corporation is first taxed on its income and then shareholders pay taxes on the dividends that they receive. After-tax cash flow to dividend recipients is much greater at the lower applicable tax rate; the result is noticeably higher dividend payouts by corporations today than prior to passage of the 2003 legislation.<\/p>\n<p>In early 2012, Congress passed the American Taxpayer Relief Act of 2012. For eveyone except those individuals in the newly established highest tax bracket, dividends and capital gains continue to be taxed at 15 percent. (For more details on the impact of the 2012 act, see the\u00a0<em><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14box18\">Focus on Practice<\/a><\/em>\u00a0box.)<\/p>\n<div>\n<h2><strong>Personal Finance Example 14.3<\/strong><\/h2>\n<p><strong><span>My<\/span>\u00a0<span>Finance<\/span>\u00a0<span>Lab Solution Video<\/span><\/strong><\/p>\n<p>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, with a payment date of November 19. Rob and Kate Heckman, who purchased 500 shares of Espinoza\u2019s 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.<\/p>\n<div>\n<h2><span><span>in practice\u00a0<\/span><\/span><strong>focus on PRACTICE: Capital Gains and Dividend Tax Treatment Extended to 2012 and Beyond for Some<\/strong><\/h2>\n<p>In 1980, the percentage of firms paying monthly, quarterly, semiannual, or annual dividends stood at 60 percent. By the end of 2002, this number had declined to 20 percent. In May 2003, President George W. Bush signed into law the\u00a0<em>Jobs and Growth Tax Relief Reconciliation Act of 2003<\/em>(JGTRRA). Prior to that new law, dividends were taxed once as part of corporate earnings and again as the personal income of the investor, in both cases with a potential top rate of 35 percent. The result was an effective tax rate of\u00a0<em>57.75<\/em>\u00a0percent on some dividends. Although the 2003 tax law did not completely eliminate the double taxation of dividends, it reduced the maximum possible effect of the double taxation of dividends to 44.75 percent. For taxpayers in the lower tax brackets, the combined effect was a maximum of 38.25 percent. Both the number of companies paying dividends and the amount of dividends spiked following the lowering of tax rates on dividends. For example, total dividends paid rose almost 14 percent in the first quarter after the new tax law was enacted, and the percentage of firms initiating dividends rose by nearly 40 percent the same quarter.<\/p>\n<p>The tax rates under JGTRRA were originally programmed to expire at the end of 2008. However, in May 2006, Congress passed the\u00a0<em>Tax Increase Prevention and Reconciliation Act of 2005<\/em>\u00a0(TIPRA), extending the beneficial tax rates for 2 more years. Taxpayers in tax brackets above 15 percent paid a 15 percent rate on dividends paid before December 31, 2008. For taxpayers with a marginal tax rate of 15 percent or lower, the dividend tax rate was 5 percent until December 31, 2007, and 0 percent from 2008 to 2010. Long-term capital gains tax rates were reduced to the same rates as the new dividend tax rates through 2010. Although JGTRRA expired at the end of 2010, Congress extended the law until 2012 by passing the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.<\/p>\n<p>At the onset of 2012, the pre-JGTRRA taxation of dividends would reappear unless further legislation made the law permanent. Those arguing to make the JGTRRA permanent pointed toward the weak economy and suggested that taxes needed to remain low to stimulate business investment and job creation. Others noted that the U.S. budget deficit was at an all-time high, so some combination of higher taxes and reduced spending was necessary to avoid economic problems associated with too much debt.<\/p>\n<p>In early 2012, Congress passed the American Taxpayer Relief Act of 2012. For individuals in the 25 percent, 28 percent, 33 percent, and 35 percent income tax brackets, qualified dividends as well as capital gains continue to be taxed at 15 percent. However, for individuals with more than $400,000 in taxable income\u2014and couples with more than $450,000\u2014the rate increased to 20 percent. As was the case under JGTRRA, people in the 10 percent and 15 percent brackets, as before, will have a zero tax rate on dividends and capital gains.<\/p>\n<p><span><img loading=\"lazy\" decoding=\"async\" src=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/image\/M29954_com_f0004.jpg\" alt=\"\" width=\"19\" height=\"19\"\/><\/span>\u00a0<span>How might the expected future reappearance of higher tax rates on individuals receiving dividends affect corporate dividend payout policies?<\/span><\/p>\n<\/div>\n<p>Given the Friday, October 30, date of record, the stock would begin selling\u00a0<em>ex dividend<\/em>\u00a02 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 \u00d7 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 \u2212 0.15) \u00d7 $230] after taxes from the Espinoza Industries dividend.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>DIVIDEND REINVESTMENT PLANS<\/strong><\/h2>\n<p>Today, many firms offer\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_181\">dividend reinvestment plans (DRIPs)<\/a>,<\/strong>\u00a0which enable stockholders to use dividends received on the firm\u2019s stock to acquire additional shares\u2014even fractional shares\u2014at little or no transaction cost. Some companies\u00a0even allow investors to make their\u00a0<em>initial purchases<\/em>\u00a0of the firm\u2019s stock directly from the company without going through a broker. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can issue new shares to participants more economically, avoiding the underpricing and flotation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market appeal of a firm\u2019s shares.<\/p>\n<div>\n<p><strong><span>dividend reinvestment plans (DRIPs)<\/span><\/strong><\/p>\n<p>Plans that enable stockholders to use dividends received on the firm\u2019s stock to acquire additional shares\u2014even fractional shares\u2014at little or no transaction cost.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>STOCK PRICE REACTIONS TO CORPORATE PAYOUTS<\/strong><\/h2>\n<p>What happens to the stock price when a firm pays a dividend or repurchases shares? In theory, the answers to those questions are straightforward. Take a dividend payment for example. Suppose that a firm has $1 billion in assets, financed entirely by 10 million shares of common stock. Each share should be worth $100 ($1 billion \u00f7 10,000,000 shares). Now suppose that the firm pays a $1 per share cash dividend, for a total dividend payout of $10 million. The assets of the firm fall to $990 million. Because shares outstanding remain at 10 million, each share should be worth $99. In other words, the stock price should fall by $1, exactly the amount of the dividend. The reduced share price simply reflects that cash formerly held by the firm is now in the hands of investors. To be precise, this reduction in share price should occur not when the dividend checks are mailed but rather when the stock begins trading ex dividend.<\/p>\n<p>For share repurchases, the intuition is that \u201cyou get what you pay for.\u201d In other words, if the firm buys back shares at the going market price, the reduction in cash is exactly offset by the reduction in the number of shares outstanding, so the market price of the stock should remain the same. Once again, consider the firm with $1 billion in assets and 10 million shares outstanding worth $100 each. Let\u2019s say that the firm decides to distribute $10 million in cash by repurchasing 100,000 shares of stock. After the repurchase is completed, the firm\u2019s assets will fall by $10 million to $990 million, but the shares outstanding will fall by 100,000 to 9,900,000. The new share price is therefore $990,000,000 \u00f7 9,900,000, or $100, as before.<\/p>\n<p>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. Furthermore, the stock price reaction to a cash payout may be different than the reaction to an announcement about an upcoming payout. For example, when a firm announces that it will increase its dividend, the share price usually rises on that news, even though the share price will fall when the dividend is actually paid. The next section discusses the impact of payout policy on the value of the firm in greater depth.<\/p>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTIONS<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u20134<\/span><\/strong><\/span><\/p>\n<p>Who are\u00a0<em>holders of record<\/em>? When does a stock sell\u00a0<em>ex dividend<\/em>?<\/p>\n<\/div>\n<div><span><strong><span>14\u20135<\/span><\/strong><\/span><\/p>\n<p>What effect did the\u00a0<em>Jobs and Growth Tax Relief Reconciliation Act of 2003<\/em>\u00a0have on the taxation of corporate dividends? On corporate dividend payouts?<\/p>\n<\/div>\n<div><span><strong><span>14\u20136<\/span><\/strong><\/span><\/p>\n<p>What benefit is available to participants in a\u00a0<em>dividend reinvestment plan<\/em>? How might the firm benefit?<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><span><strong>14.3\u00a0<\/strong><\/span><strong>Relevance of Payout Policy<\/strong><\/h2>\n<p><strong><span>LG 2<\/span><\/strong><\/p>\n<p>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.<\/p>\n<p>The most important question about payout policy is this one: Does payout policy have a significant effect on the value of a firm? A number of theoretical and empirical answers to this question have been proposed, but as yet there is no widely accepted rule to help a firm find its \u201coptimal\u201d payout policy. Most of the theories that have been proposed to explain the consequences of payout policy have focused on dividends. From here on, we will use the terms\u00a0<em>dividend policy<\/em>\u00a0and\u00a0<em>payout policy<\/em>interchangeably, meaning that we make no distinction between dividend payouts and share repurchases in terms of the theories that try to explain whether these policies have an effect on firm value.<\/p>\n<div>\n<h2><strong>RESIDUAL THEORY OF DIVIDENDS<\/strong><\/h2>\n<p>The\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_485\">residual theory of dividends<\/a><\/strong>\u00a0is a school of thought that suggests that the dividend paid by a firm should be viewed as a\u00a0<em>residual<\/em>, that is, the amount left over after all acceptable investment opportunities have been undertaken. Using this approach, the firm would treat the dividend decision in three steps as follows:<\/p>\n<div>\n<p><strong><span>residual theory of dividends<\/span><\/strong><\/p>\n<p>A school of thought that suggests that the dividend paid by a firm should be viewed as a\u00a0<em>residual,<\/em>the amount left over after all acceptable investment opportunities have been undertaken.<\/p>\n<\/div>\n<ul>\n<li><span><strong>Step 1<\/strong>\u00a0<\/span><span>Determine its optimal level of capital expenditures, which would be the level that exploits all a firm\u2019s positive NPV projects.<\/span><\/li>\n<li><span><strong>Step 2<\/strong>\u00a0<\/span><span>Using the optimal capital structure proportions (see\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch13\">Chapter 13<\/a>), estimate the total amount of equity financing needed to support the expenditures generated in Step 1.<\/span><\/li>\n<li><span><strong>Step 3<\/strong>\u00a0<\/span><span>Because the cost of retained earnings,\u00a0<em>r<\/em><span><em>r<\/em><\/span>, is less than the cost of new common stock,\u00a0<em>r<\/em><span><em>n<\/em><\/span>, 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\u2014the residual\u2014as dividends.<\/span><\/li>\n<\/ul>\n<p>According to this approach, as long as the firm\u2019s equity need exceeds the amount of retained earnings, no cash dividend is paid. The argument for this approach is that it is sound management to be certain that the company has the money it needs to compete effectively. This view of dividends suggests that the required return of investors,\u00a0<em>r<\/em><span><em>s<\/em><\/span>, is\u00a0<em>not<\/em>\u00a0influenced by the firm\u2019s dividend policy, a premise that in turn implies that dividend policy is irrelevant in the sense that it does not affect firm value.<\/p>\n<\/div>\n<div>\n<h2><strong>THE DIVIDEND IRRELEVANCE THEORY<\/strong><\/h2>\n<p>The residual theory of dividends implies that if the firm cannot invest its earnings to earn a return that exceeds the cost of capital, it should distribute the earnings by paying dividends to stockholders. This approach suggests that dividends represent an earnings residual rather than an active decision variable that affects the\u00a0firm\u2019s value. Such a view is consistent with the\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_177\">dividend irrelevance theory<\/a><\/strong>\u00a0put forth by Merton H. Miller and Franco Modigliani (M and M).<span><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fn2\">2<\/a><\/span>\u00a0They argue that the firm\u2019s 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. M and M\u2019s theory suggests that 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.<\/p>\n<div>\n<p><strong><span>dividend irrelevance theory<\/span><\/strong><\/p>\n<p>Miller and Modigliani\u2019s theory that, in a perfect world, the firm\u2019s 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.<\/p>\n<\/div>\n<p>Of course, real markets do not satisfy the \u201cperfect markets\u201d assumptions of Modigliani and Miller\u2019s original theory. One market imperfection that may be important is taxation. Historically, dividends have usually been taxed at higher rates than capital gains. A firm that pays out its earnings as dividends may trigger higher tax liabilities for its investors than a firm that retains earnings. As a firm retains earnings, its share price should rise, and investors enjoy capital gains. Investors can defer paying taxes on these gains indefinitely simply by not selling their shares. Even if they do sell their shares, they may pay a relatively low tax rate on the capital gains. In contrast, when a firm pays dividends, investors receive cash immediately and pay taxes at the rates dictated by then-current tax laws.<\/p>\n<p>Even though this discussion makes it seem that retaining profits rather than paying them out as dividends may be better for shareholders on an after-tax basis, Modigliani and Miller argue that this assumption may not be the case. They observe that not all investors are subject to income taxation. Some institutional investors, such as pension funds, do not pay taxes on the dividends and capital gains that they earn. For these investors, the payout policies of different firms have no impact on the taxes that investors have to pay. Therefore, Modigliani and Miller argue, there can be a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_89\">clientele effect<\/a><\/strong>\u00a0in which different types of investors are attracted to firms with different payout policies due to tax effects. 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; instead, what will change is the type of investor who holds the firm\u2019s shares. According to this argument, tax clienteles mean that payout policies cannot affect firm value, but they can affect the ownership base of the company.<\/p>\n<div>\n<p><strong><span>clientele effect<\/span><\/strong><\/p>\n<p>The argument that different payout policies attract different types of investors but still do not change the value of the firm.<\/p>\n<\/div>\n<p>In summary, M and M and other proponents of dividend irrelevance argue that, all else being equal, an investor\u2019s required return\u2014and therefore the value of the firm\u2014is unaffected by dividend policy. In other words, there is no \u201coptimal\u201d dividend policy for a particular firm.<\/p>\n<\/div>\n<div>\n<h2><strong>ARGUMENTS FOR DIVIDEND RELEVANCE<\/strong><\/h2>\n<p><small>2. Merton H. Miller and Franco Modigliani, \u201cDividend Policy, Growth and the Valuation of Shares,\u201d\u00a0<em>Journal of Business<\/em>34 (October 1961), pp. 411\u2013433.<\/small><\/p>\n<p>Modigliani and Miller\u2019s assertion that dividend policy was irrelevant was a radical idea when it was first proposed. The prevailing wisdom at the time was that payout policy could improve the value of the firm and therefore was relevant. The key argument in support of\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_182\">dividend relevance theory<\/a><\/strong>is attributed to Myron J. Gordon\u00a0and John Lintner,<span><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fn3\">3<\/a><\/span>\u00a0who suggest that there is, in fact, a direct relationship between the firm\u2019s dividend policy and its market value. Fundamental to this proposition is their\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_45\">bird-in-the-hand argument<\/a>,<\/strong>\u00a0which suggests that investors see current dividends as less risky than future dividends or capital gains: \u201cA bird in the hand is worth two in the bush.\u201d Gordon and Lintner argue that current dividend payments reduce investor uncertainty, causing investors to discount the firm\u2019s earnings at a lower rate and, all else being equal, to place a higher value on the firm\u2019s stock. Conversely, if dividends are reduced or are not paid, investor uncertainty will increase, raising the required return and lowering the stock\u2019s value.<\/p>\n<div>\n<p><strong><span>dividend relevance theory<\/span><\/strong><\/p>\n<p>The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm\u2019s dividend policy and its market value.<\/p>\n<\/div>\n<div>\n<p><strong><span>bird-in-the-hand argument<\/span><\/strong><\/p>\n<p>The belief, in support of\u00a0<em>dividend relevance theory,<\/em>\u00a0that investors see current dividends as less risky than future dividends or capital gains.<\/p>\n<\/div>\n<p>Modigliani and Miller argued that the bird-in-the-hand theory was a fallacy. They said that investors who want immediate cash flow from a firm that did not pay dividends could simply sell off a portion of their shares. Remember that the stock price of a firm that retains earnings should rise over time as cash builds up inside the firm. By selling a few shares every quarter or every year, investors could, according to Modigliani and Miller, replicate the same cash flow stream that they would have received if the firm had paid dividends rather than retaining earnings.<\/p>\n<p>Studies have shown that large changes in dividends do affect share price. Increases in dividends result in increased share price, and decreases in dividends result in decreased share price. One interpretation of this evidence is that it is not the dividends per se that matter but rather the<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_283\">informational content<\/a><\/strong>\u00a0of dividends with respect to future earnings. In other words, investors view a change in dividends, up or down, as a\u00a0<em>signal<\/em>\u00a0that management expects future earnings to change in the same direction. Investors view an increase in dividends as a\u00a0<em>positive signal,<\/em>\u00a0and they bid up the share price. They view a decrease in dividends as a\u00a0<em>negative signal<\/em>\u00a0that causes investors to sell their shares, resulting in the share price decreasing.<\/p>\n<div>\n<p><strong><span>informational content<\/span><\/strong><\/p>\n<p>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\u2019s stock.<\/p>\n<\/div>\n<p>Another argument in support of the idea that dividends can affect the value of the firm is the<em>agency cost theory<\/em>. Recall that agency costs are costs that arise due to the separation between the firm\u2019s owners and its managers. Managers sometimes have different interests than owners. Managers may want to retain earnings simply to increase the size of the firm\u2019s asset base. There is greater prestige and perhaps higher compensation associated with running a larger firm. Shareholders are aware of the temptations that managers face, and they worry that retained earnings may not be invested wisely. The\u00a0<em>agency cost theory<\/em>\u00a0says 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 that promise regular dividend payments.<\/p>\n<p>Although many other arguments related to dividend relevance have been put forward,\u00a0<em>empirical studies have not provided evidence that conclusively settles the debate about whether and how payout policy affects firm value<\/em>. As we have already said, even if dividend policy really matters, it is almost certainly less important than other decisions that financial mangers make, such as the decision to invest in a large new project or the decision about what combination of debt and equity the firm should use to finance its operations. Still, most financial managers today, especially those running large corporations, believe that payout policy can affect the value of the firm.<\/p>\n<p><small>3. Myron J. Gordon, \u201cOptimal Investment and Financing Policy,\u201d\u00a0<em>Journal of Finance<\/em>\u00a018 (May 1963), pp. 264\u2013272; and John Lintner, \u201cDividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to Corporations,\u201d\u00a0<em>Review of Economics and Statistics<\/em>\u00a044 (August 1962), pp. 243\u2013269.<\/small><\/p>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTIONS<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u20137<\/span><\/strong><\/span><\/p>\n<p>Does following the\u00a0<em>residual theory of dividends<\/em>\u00a0lead to a stable dividend? Is this approach consistent with dividend relevance?<\/p>\n<\/div>\n<div><span><strong><span>14\u20138<\/span><\/strong><\/span><\/p>\n<p>Contrast the basic arguments about dividend policy advanced by Miller and Modigliani (M and M) and by Gordon and Lintner.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><span><strong>14.4\u00a0<\/strong><\/span><strong>Factors Affecting Dividend Policy<\/strong><\/h2>\n<p><strong><span>LG 3<\/span><\/strong><\/p>\n<p>The firm\u2019s\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_180\">dividend policy<\/a><\/strong>\u00a0represents a plan of action to be followed whenever it makes a dividend decision. Firms develop policies consistent with their goals. Before we review some of the popular types of dividend policies, we discuss five factors that firms consider in establishing a dividend policy. They are legal constraints, contractual constraints, the firm\u2019s growth prospects, owner considerations, and market considerations.<\/p>\n<div>\n<p><strong><span>dividend policy<\/span><\/strong><\/p>\n<p>The firm\u2019s plan of action to be followed whenever it makes a dividend decision.<\/p>\n<\/div>\n<div>\n<h2><strong>LEGAL CONSTRAINTS<\/strong><\/h2>\n<p>Most states prohibit corporations from paying out as cash dividends any portion of the firm\u2019s \u201clegal capital,\u201d which is typically measured by the par value of common stock. Other states define legal capital to include not only the par value of the common stock but also any paid-in capital in excess of par. These\u00a0<em>capital impairment restrictions<\/em>\u00a0are generally established to provide a sufficient equity base to protect creditors\u2019 claims. An example will clarify the differing definitions of capital.<\/p>\n<div>\n<h2><strong>Example 14.4<\/strong><\/h2>\n<p>The stockholders\u2019 equity account of Miller Flour Company, a large grain processor, is presented in the following table.<\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"2\">\n<p><strong>Miller Flour Company Stockholders\u2019 Equity<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock at par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$100,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0200,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0140,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$440,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>In states where the firm\u2019s 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\u2019s legal capital includes all paid-in capital, the firm could pay out only $140,000 in cash dividends.<\/p>\n<\/div>\n<p>Firms sometimes impose an earnings requirement limiting the amount of dividends. With this restriction, the firm cannot pay more in cash dividends than the sum of its most recent and past retained earnings. However,\u00a0<em>the firm is not prohibited from paying more in dividends than its current earnings<\/em>.<span><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fn4\">4<\/a><\/span><\/p>\n<p><small>4. A firm that has an operating loss in the current period can still pay cash dividends as long as sufficient retained earnings against which to charge the dividend are available and, of course, as long as it has the cash with which to make the payments.<\/small><\/p>\n<div>\n<h2><strong>Example 14.5<\/strong><\/h2>\n<p>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\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14box29\">Example 14.4<\/a>\u00a0indicates, the firm has past retained earnings of $140,000. Thus, it can legally pay dividends of up to $170,000.<\/p>\n<\/div>\n<p>If a firm has overdue liabilities or is legally insolvent or bankrupt, most states prohibit its payment of cash dividends. In addition, the Internal Revenue Service prohibits firms from accumulating earnings to reduce the owners\u2019 taxes. If the IRS can determine that a firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received, it may levy an\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_210\">excess earnings accumulation tax<\/a><\/strong>\u00a0on any retained earnings above $250,000 for most businesses.<\/p>\n<div>\n<p><strong><span>excess earnings accumulation tax<\/span><\/strong><\/p>\n<p>The tax the IRS levies on retained earnings above $250,000 for most businesses when it determines that the firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received.<\/p>\n<\/div>\n<p>During the recent financial crisis, a number of financial institutions received federal financial assistance. Those firms had to agree to restrictions on dividend payments to shareholders until they repaid the money that they received from the government. Bank of America, for example, had more than 30 years of consecutive dividend increases before accepting federal bailout money. As part of its bailout, Bank of America had to cut dividends to $0.01 per share.<\/p>\n<\/div>\n<div>\n<h2><strong>CONTRACTUAL CONSTRAINTS<\/strong><\/h2>\n<p>Often, the firm\u2019s 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. Constraints on dividends help to protect creditors from losses due to the firm\u2019s insolvency.<\/p>\n<\/div>\n<div>\n<h2><strong>GROWTH PROSPECTS<\/strong><\/h2>\n<p>The firm\u2019s financial requirements are directly related to how much it expects to grow and what assets it will need to acquire. It must evaluate its profitability and risk to develop insight into its ability to raise capital externally. In addition, the firm must determine the cost and speed with which it can obtain financing. Generally, a large, mature firm has adequate access to new capital, whereas a rapidly growing firm may not have sufficient funds available to support its acceptable projects. A growth firm is likely to have to depend heavily on internal financing through retained earnings, so it is likely to pay out only a very small percentage of its earnings as dividends. A more established firm is in a better position to pay out a large proportion of its earnings, particularly if it has ready sources of financing.<\/p>\n<\/div>\n<div>\n<h2><strong>OWNER CONSIDERATIONS<\/strong><\/h2>\n<p>The firm must establish a policy that has a favorable effect on the wealth of the\u00a0<em>majority<\/em>\u00a0of owners. One consideration is the\u00a0<em>tax status of a firm\u2019s owners<\/em>. If a firm has a large percentage of wealthy stockholders who have sizable incomes, it may decide to pay out a\u00a0<em>lower<\/em>\u00a0percentage of its earnings to allow the owners to delay the payment of taxes until they sell the stock. Because cash dividends are taxed at the same rate as capital gains (as a result of the 2003 and 2012 Tax Acts), this strategy benefits owners through the tax deferral rather than as a result of a lower tax rate. Lower-income shareholders, however, who need dividend income, will prefer a\u00a0<em>higher<\/em>\u00a0payout of earnings.<\/p>\n<p>A second consideration is the\u00a0<em>owners\u2019 investment opportunities<\/em>. A firm should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments of equal risk. If it appears that the owners have better opportunities externally, the firm should pay out a higher percentage of its earnings. If the firm\u2019s investment opportunities are at least as good as similar-risk external investments, a lower payout is justifiable.<\/p>\n<p>A final consideration is the\u00a0<em>potential dilution of ownership<\/em>. If a firm pays out a high percentage of earnings, new equity capital will have to be raised with common stock. The result of a new stock issue may be dilution of both control and earnings for the existing owners. By paying out a low percentage of its earnings, the firm can minimize the possibility of such dilution.<\/p>\n<\/div>\n<div>\n<h2><strong>MARKET CONSIDERATIONS<\/strong><\/h2>\n<p>One of the more recent theories proposed to explain firms\u2019 payout decisions is called the\u00a0<em>catering theory<\/em>. According to the\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_83\">catering theory<\/a>,<\/strong>\u00a0investors\u2019 demands for dividends fluctuate over time. For example, during an economic boom accompanied by a rising stock market, investors may be more attracted to stocks that offer prospects of large capital gains. When the economy is in recession and the stock market is falling, investors may prefer the security of a dividend. The catering theory suggests that firms are more likely to initiate dividend payments or to increase existing payouts when investors exhibit a strong preference for dividends. Firms\u00a0<em>cater to<\/em>\u00a0the preferences of investors.<\/p>\n<div>\n<p><strong><span>catering theory<\/span><\/strong><\/p>\n<p>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.<\/p>\n<\/div>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTION<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u20139<\/span><\/strong><\/span><\/p>\n<p>What five factors do firms consider in establishing\u00a0<em>dividend policy<\/em>? Briefly describe each of them.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><span><strong>14.5\u00a0<\/strong><\/span><strong>Types of Dividend Policies<\/strong><\/h2>\n<p><strong><span>LG 4<\/span><\/strong><\/p>\n<p>The firm\u2019s dividend policy must be formulated with two objectives in mind: providing for sufficient financing and maximizing the wealth of the firm\u2019s owners. Three different dividend policies are described in the following sections. A particular firm\u2019s cash dividend policy may incorporate elements of each.<\/p>\n<div>\n<h2><strong>CONSTANT-PAYOUT-RATIO DIVIDEND POLICY<\/strong><\/h2>\n<p>One type of dividend policy involves use of a constant payout ratio. The\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_178\">dividend payout ratio<\/a><\/strong>indicates the percentage of each dollar earned that the firm distributes to the owners in the form of cash. It is calculated by dividing the firm\u2019s cash dividend per share by its earnings per share. With a<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_109\">constant-payout-ratio dividend policy<\/a>,<\/strong>\u00a0the firm establishes that a certain percentage of earnings is paid to owners in each dividend period.<\/p>\n<div>\n<p><strong><span>dividend payout ratio<\/span><\/strong><\/p>\n<p>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\u2019s cash dividend per share by its earnings per share.<\/p>\n<\/div>\n<div>\n<p><strong><span>constant-payout-ratio dividend policy<\/span><\/strong><\/p>\n<p>A dividend policy based on the payment of a certain percentage of earnings to owners in each dividend period.<\/p>\n<\/div>\n<p>The problem with this policy is that if the firm\u2019s earnings drop or if a loss occurs in a given period, the dividends may be low or even nonexistent. Because dividends are often considered an indicator of the firm\u2019s future condition and status, the firm\u2019s stock price may be adversely affected.<\/p>\n<div>\n<h2><strong>Example 14.6<\/strong><\/h2>\n<p>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\u2019s policy is to pay no cash dividends. Data on Peachtree\u2019s earnings, dividends, and average stock prices for the past 6 years follow.<\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Earnings\/share<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Dividends\/share<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Average price\/share<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u2212$0.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$0.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$42.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a03.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.20<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a052.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a01.75<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.70<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a048.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u22121.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a038.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2011<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a02.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.80<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a046.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2010<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a04.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.80<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a050.00<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Dividends increased in 2013 and in 2014 but decreased in the other years. In years of decreasing dividends, the firm\u2019s stock price dropped; when dividends increased, the price of the stock increased. Peachtree\u2019s sporadic dividend payments appear to make its owners uncertain about the returns they can expect.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>REGULAR DIVIDEND POLICY<\/strong><\/h2>\n<p>The\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_479\">regular dividend policy<\/a><\/strong>\u00a0is based on the payment of a fixed-dollar dividend in each period. Often, firms that use this policy increase the regular dividend once a\u00a0<em>sustainable<\/em>\u00a0increase in earnings has occurred. Under this policy, dividends are almost never decreased.<\/p>\n<div>\n<p><strong><span>regular dividend policy<\/span><\/strong><\/p>\n<p>A dividend policy based on the payment of a fixed-dollar dividend in each period.<\/p>\n<\/div>\n<div>\n<h2><strong>Example 14.7<\/strong><\/h2>\n<p>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\u2019s earnings, dividends, and average stock prices for the past 12 years follow.<\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Earnings\/share<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Dividends\/share<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Average price\/share<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$4.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$47.50<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03.90<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a046.50<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a04.60<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a045.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a04.20<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a043.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2011<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a05.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a042.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2010<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a038.50<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2009<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a06.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a038.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2008<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a036.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2007<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.75<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a033.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2006<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a033.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2005<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.70<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a033.50<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2004<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.85<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a035.00<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Whatever the level of earnings, Woodward Laboratories paid dividends of $1.00 per share through 2012. In 2013, the dividend increased to $1.50 per share because earnings in excess of $4.00 per share had been achieved for 3 years. In 2013, the firm also had to establish a new earnings plateau for further dividend increases. Woodward Laboratories\u2019 average price per share exhibited a stable, increasing behavior in spite of a somewhat volatile pattern of earnings.<\/p>\n<\/div>\n<p>Often, a regular dividend policy is built around a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_561\">target dividend-payout ratio<\/a>.<\/strong>\u00a0Under this policy, the firm attempts to pay out a certain\u00a0<em>percentage<\/em>\u00a0of earnings, but rather than let dividends fluctuate, it pays a stated dollar dividend and adjusts that dividend toward the target payout as proven earnings increases occur. For instance, Woodward Laboratories appears to have a target payout ratio of around 35 percent. The payout was about 35 percent ($1.00 \u00f7 $2.85) when the dividend policy was set in 2004, and when the dividend was raised to $1.50 in 2013, the payout ratio was about 33 percent ($1.50 \u00f7 $4.60).<\/p>\n<div>\n<p><strong><span>target dividend-payout ratio<\/span><\/strong><\/p>\n<p>A dividend policy under which the firm attempts to pay out a certain\u00a0<em>percentage<\/em>\u00a0of earnings as a stated dollar dividend and adjusts that dividend toward a target payout as proven earnings increases occur.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>LOW-REGULAR-AND-EXTRA DIVIDEND POLICY<\/strong><\/h2>\n<p>Some firms establish a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_337\">low-regular-and-extra dividend policy<\/a>,<\/strong>\u00a0paying a low regular dividend, supplemented by an additional (\u201cextra\u201d) dividend when earnings are higher than normal in a given period. By calling the additional dividend an\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_221\">extra dividend<\/a>,<\/strong>\u00a0the firm avoids setting expectations that the dividend increase will be permanent. This policy is especially common among companies that experience cyclical shifts in earnings.<\/p>\n<div>\n<p><strong><span>low-regular-and-extra dividend policy<\/span><\/strong><\/p>\n<p>A dividend policy based on paying a low regular dividend, supplemented by an additional (\u201cextra\u201d) dividend when earnings are higher than normal in a given period.<\/p>\n<\/div>\n<div>\n<p><strong><span>extra dividend<\/span><\/strong><\/p>\n<p>An additional dividend optionally paid by the firm when earnings are higher than normal in a given period.<\/p>\n<\/div>\n<p>By establishing a low regular dividend that is paid each period, the firm gives investors the stable income necessary to build confidence in the firm, and the extra dividend permits them to share in the earnings from an especially good period. Firms using this policy must raise the level of the regular dividend once proven increases in earnings have been achieved. The extra dividend should not be a regular event; otherwise, it becomes meaningless. The use of a target dividend-payout ratio in establishing the regular dividend level is advisable.<\/p>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTION<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u201310<\/span><\/strong><\/span><\/p>\n<p>Describe a constant-payout-ratio dividend policy, a regular dividend policy, and a low-regular-and-extra dividend policy. What are the effects of these policies?<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><span><strong>14.6\u00a0<\/strong><\/span><strong>Other Forms of Dividends<\/strong><\/h2>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<p>Two common transactions that bear some resemblance to cash dividends are stock dividends and stock splits. Although the stock dividends and stock splits are closely related to each other, their economic effects are quite different than those of cash dividends or share repurchases.<\/p>\n<div>\n<h2><strong>STOCK DIVIDENDS<\/strong><\/h2>\n<p>A\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_541\">stock dividend<\/a><\/strong>\u00a0is the payment, to existing owners, of a dividend in the form of stock. Often firms pay stock dividends as a replacement for or a supplement to cash dividends. 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.<\/p>\n<div>\n<p><strong><span>stock dividend<\/span><\/strong><\/p>\n<p>The payment, to existing owners, of a dividend in the form of stock.<\/p>\n<\/div>\n<div>\n<h2><strong>Accounting Aspects<\/strong><\/h2>\n<p>In an accounting sense, the payment of a stock dividend is a shifting of funds between stockholders\u2019 equity accounts rather than an outflow of funds. When a firm declares a stock dividend, the procedures for announcement and distribution are the same as those described earlier for a cash dividend. The accounting entries associated with the payment of a stock dividend vary depending on its size. A\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_530\">small (ordinary) stock dividend<\/a><\/strong>\u00a0is a stock dividend that represents less than 20 percent to 25 percent of the common stock outstanding when the dividend is declared. Small stock dividends are most common.<\/p>\n<div>\n<p><strong><span>small (ordinary) stock dividend<\/span><\/strong><\/p>\n<p>A stock dividend representing less than 20 percent to 25 percent of the common stock outstanding when the dividend is declared.<\/p>\n<\/div>\n<div>\n<h2><strong>Example 14.8<\/strong><\/h2>\n<p>The current stockholders\u2019 equity on the balance sheet of Garrison Corporation, a distributor of prefabricated cabinets, is as shown in the following accounts.<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u2003300,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (100,000 shares at $4 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u2008\u2003400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u2008\u2003600,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u2008\u2003700,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$2,000,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>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. Because 10,000 new shares (10% of 100,000) are issued at the prevailing market price of $15 per share, $150,000 ($15 per share \u00d7 10,000 shares) is shifted from retained earnings to the common stock and paid-in capital accounts. A total of $40,000 ($4 par \u00d7 10,000 shares) is added to common stock, and the remaining $110,000 [($15 \u2212 $4) \u00d7 10,000 shares] is added to the paid-in capital in excess of par. The resulting account balances are as follows:<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u2003300,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (110,000 shares at $4 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u2008\u2003440,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u2008\u2003710,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u2008\u2003550,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$2,000,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>The firm\u2019s total stockholders\u2019 equity has not changed; funds have merely been\u00a0<em>shifted<\/em>\u00a0among stockholders\u2019 equity accounts.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Shareholder\u2019s Viewpoint<\/strong><\/h2>\n<p>The shareholder receiving a stock dividend typically receives nothing of value. After the dividend is paid, the per-share value of the shareholder\u2019s 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\u2019s proportion of ownership in the firm also remains the same, and\u00a0<em>as long as the firm\u2019s earnings remain unchanged,<\/em>\u00a0so does his or her share of total earnings. (However, if the firm\u2019s earnings and cash dividends increase when the stock dividend is issued, an increase in share value is likely to result.)<\/p>\n<div>\n<h2><strong>Example 14.9<\/strong><\/h2>\n<p>Ms. X owned 10,000 shares of Garrison Corporation\u2019s stock. The company\u2019s 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% (10,000 shares \u00f7 100,000 shares) of the firm\u2019s stock, which was selling for $15 per share. Earnings per share were $2.20 ($220,000 \u00f7 100,000 shares). Because Ms. X owned 10,000 shares, her earnings were $22,000 ($2.20 per share \u00d7 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 \u00f7 110,000 shares). The market price of the stock can be expected to drop to $13.64 per share [$15 \u00d7 (1.00 \u00f7 1.10)], which means that the market value of Ms. X\u2019s holdings is $150,000 (11,000 shares \u00d7 $13.64 per share). This is the same as the initial value of her holdings (10,000 shares \u00d7 $15 per share). The future earnings per share drops to $2 ($220,000 \u00f7 110,000 shares) because the same $220,000 in earnings must now be divided among 110,000 shares. Because Ms. X still owns 10% of the stock, her share of total earnings is still $22,000 ($2 per share \u00d7 11,000 shares).<\/p>\n<\/div>\n<p>In summary, if the firm\u2019s earnings remain constant and total cash dividends do not increase, a stock dividend results in a lower per-share market value for the firm\u2019s stock.<\/p>\n<\/div>\n<div>\n<h2><strong>The Company\u2019s Viewpoint<\/strong><\/h2>\n<p>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 so as to maximize future earnings, the market value of the firm should at least remain unchanged. However, if the stock dividend is paid so as to retain cash to satisfy past-due bills, a decline in market value may result.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>STOCK SPLITS<\/strong><\/h2>\n<p>Although not a type of dividend,\u00a0<em>stock splits<\/em>\u00a0have an effect on a firm\u2019s share price similar to that of stock dividends. A\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_546\">stock split<\/a><\/strong>\u00a0is a method commonly used to lower the market price of a firm\u2019s stock by increasing the number of shares belonging to each shareholder. In a 2-for-1 split, for example, two new shares are exchanged for each old share, with each new share being worth half the value of each old share. A stock split has no effect on the firm\u2019s capital structure and is usually nontaxable.<\/p>\n<div>\n<p><strong><span>stock split<\/span><\/strong><\/p>\n<p>A method commonly used to lower the market price of a firm\u2019s stock by increasing the number of shares belonging to each shareholder.<\/p>\n<\/div>\n<p>Quite often, a firm believes that its stock is priced too high and that lowering the market price will enhance trading activity. Stock splits are often made prior to issuing additional stock to enhance that stock\u2019s 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 because\u00a0<em>total<\/em>\u00a0dividends paid commonly increase slightly after a split.<span><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14fn5\">5<\/a><\/span><\/p>\n<div>\n<h2><strong>Example 14.10<\/strong><\/h2>\n<p><strong><span>My<\/span>\u00a0<span>Finance<\/span>\u00a0<span>Lab Solution Video<\/span><\/strong><\/p>\n<p>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\u2019 equity is shown in the following table.<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"2\">\n<p><strong>Before split<\/strong><\/p>\n<hr\/>\n<\/td>\n<td rowspan=\"1\" colspan=\"2\">\n<p><strong>After 2-for-1 split<\/strong><\/p>\n<hr\/>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p><strong>Common stock<\/strong><\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><strong>Common stock<\/strong><\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0(200,000 shares at $2 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0400,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0(400,000 shares at $1 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a04,000,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in-capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a04,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a02,000,000<\/span><\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a02,000,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$6,400,000<\/span><\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$6,400,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>The insignificant effect of the stock split on the firm\u2019s books is obvious.<\/p>\n<\/div>\n<p>Stock can be split in any way desired. Sometimes a\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/bm01_gloss_490\">reverse stock split<\/a><\/strong>\u00a0is made: The firm exchanges a certain number of outstanding shares for one new share. For example, in a 1-for-3 split, one new share is exchanged for three old shares. In a reverse stock split, the firm\u2019s stock price rises due to the reduction in shares outstanding. Firms may conduct a reverse split if their stock price is getting so low that the exchange where the stock trades threatens to delist the stock. For example, the New York Stock Exchange requires that the average closing price of a listed security must be no less than $1 over any consecutive 30-day trading period. In June 2010, the video chain Blockbuster asked shareholders to approve a reverse stock split to prevent the NYSE from delisting Blockbuster\u2019s stock. Shareholders didn\u2019t approve the measure, and the NYSE delisted Blockbuster stock the following month.<\/p>\n<div>\n<p><strong><span>reverse stock split<\/span><\/strong><\/p>\n<p>A method used to raise the market price of a firm\u2019s stock by exchanging a certain number of outstanding shares for one new share.<\/p>\n<\/div>\n<p><small>5. Eugene F. Fama, Lawrence Fisher, Michael C. Jensen, and Richard Roll, \u201cThe Adjustment of Stock Prices to New Information,\u201d\u00a0<em>International Economic Review<\/em>\u00a010 (February 1969), pp. 1\u201321, found that the stock price increases before the split announcement and that the increase in stock price is maintained if dividends per share are increased but is lost if dividends per share are\u00a0<em>not<\/em>\u00a0increased, following the split.<\/small><\/p>\n<div>\n<h2><strong>Personal Finance Example 14.11<\/strong><\/h2>\n<p>Shakira Washington, a single investor in the 25% 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 \u00d7 $60 per share). Because the firm\u2019s 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.<\/p>\n<p>Because the stock will split 3 for 1, after the split Shakira will own 780 shares (3 \u00d7 260 shares). She should expect the market price of the stock to drop to $20 (1\/3 \u00d7 $60) immediately after the split; the value of her after-split holding will be $15,600 (780 shares \u00d7 $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.<\/p>\n<\/div>\n<div>\n<h2><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"21\" height=\"14\"\/>\u00a0<\/span><strong>REVIEW QUESTIONS<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong><span>14\u201311<\/span><\/strong><\/span><\/p>\n<p>Why do firms issue\u00a0<em>stock dividends?<\/em>\u00a0Comment on the following statement: \u201cI have a stock that promises to pay a 20 percent stock dividend every year, and therefore it guarantees that I will break even in 5 years.\u201d<\/p>\n<\/div>\n<div><span><strong><span>14\u201312<\/span><\/strong><\/span><\/p>\n<p>Compare a\u00a0<em>stock split<\/em>\u00a0with a\u00a0<em>stock dividend<\/em>.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Summary<\/strong><\/h2>\n<div>\n<h2><strong>FOCUS ON VALUE<\/strong><\/h2>\n<p>Payout policy refers to the cash flows that a firm distributes to its common stockholders. A share of common stock gives its owner the right to receive all future dividends. The present value of all those future dividends expected over a firm\u2019s assumed infinite life determines the firm\u2019s stock value.<\/p>\n<p>Corporate payouts not only represent cash flows to shareholders but also contain useful information about the firm\u2019s current and future performance. Such information affects the shareholders\u2019 perception of the firm\u2019s risk. A firm can also pay stock dividends, initiate stock splits, or repurchase stock. All these dividend-related actions can affect the firm\u2019s risk, return, and value as a result of their cash flows and informational content.<\/p>\n<p>Although the theory of relevance of dividends is still evolving, the behavior of most firms and stockholders suggests that dividend policy affects share prices. Therefore, financial managers try to develop and implement dividend policy that is consistent with the firm\u2019s goal of\u00a0<strong>maximizing stock price.<\/strong><\/p>\n<\/div>\n<div>\n<h2><strong>REVIEW OF LEARNING GOALS<\/strong><\/h2>\n<p><strong><span>LG 1<\/span>\u00a0Understand cash payout procedures, their tax treatment, and the role of dividend reinvestment plans.<\/strong>\u00a0The board of directors makes the cash payout decision and, for dividends, establishes the record and payment dates. As a result of tax-law changes in 2003 and 2012, most taxpayers pay taxes on corporate dividends at a maximum rate of 5 percent to 15 percent, depending on the taxpayer\u2019s tax bracket. Some firms offer dividend reinvestment plans that allow stockholders to acquire shares in lieu of cash dividends.<\/p>\n<p><strong><span>LG 2<\/span>\u00a0Describe the residual theory of dividends and the key arguments with regard to dividend irrelevance and relevance.<\/strong>\u00a0The 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.<\/p>\n<p><strong><span>LG 3<\/span>\u00a0Discuss the key factors involved in establishing a dividend policy.<\/strong>\u00a0A firm\u2019s dividend policy should provide for sufficient financing and maximize stockholders\u2019 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\u2019s \u201clegal capital,\u201d nor can firms with overdue liabilities and legally insolvent or bankrupt firms pay cash dividends. Contractual constraints result from restrictive provisions in the firm\u2019s loan agreements. Growth prospects affect the relative importance of retaining earnings rather than paying them out in dividends. The tax status of owners, the owners\u2019 investment opportunities, and the potential dilution of ownership are important owner considerations. Finally, market considerations are related to the stockholders\u2019 preference for the continuous payment of fixed or increasing streams of dividends.<\/p>\n<p><strong><span>LG 4<\/span>\u00a0Review and evaluate the three basic types of dividend policies.<\/strong>\u00a0With 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\u2019s earnings are higher than normal.<\/p>\n<p><strong><span>LG 5<\/span>\u00a0Evaluate stock dividends from accounting, shareholder, and company points of view.<\/strong>\u00a0Firms 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\u2019 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.<\/p>\n<p><strong><span>LG 6<\/span>\u00a0Explain stock splits and the firm\u2019s motivation for undertaking them.<\/strong>\u00a0Stock splits are used to enhance trading activity of a firm\u2019s shares by lowering or raising their market price. A stock split merely involves accounting adjustments; it has no effect on the firm\u2019s cash or on its capital structure and is usually nontaxable.<\/p>\n<p>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.<\/p>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Opener-in-Review<\/strong><\/h2>\n<p>The chapter opener described Whirlpool\u2019s decision to dramatically increase its dividend in early 2013 to $0.625 per share. When it made that announcement, Whirlpool indicated that the date of record for the dividend would be Friday, May 17, and that the payment date would be Saturday, June 15. When would you expect the stock to go ex dividend? The market price of Whirlpool stock just before the ex dividend date was $129. Immediately after the stock went ex dividend, the market price was $129.67. Is that price change surprising? Calculate the return that an investor might have earned if she had purchased the stock before the ex dividend date, sold the stock immediately afterward, and received the dividend a few weeks later.<\/p>\n<\/div>\n<div>\n<h2><strong>Self-Test Problem<\/strong><\/h2>\n<p><strong><span>(Solutions in<\/span>\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/app01\"><span>Appendix<\/span><\/a><span>)<\/span><\/strong><\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<div>\n<div>\n<div><span><strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14st01\">ST14\u20131<\/a><\/strong><\/span><\/p>\n<p><strong>Stock repurchase<\/strong>\u00a0The Off-Shore Steel Company has earnings available for common stockholders of $2 million and has 500,000 shares of common stock outstanding at $60 per share. The firm is currently contemplating the payment of $2 per share in cash dividends.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Calculate the firm\u2019s current\u00a0<em>earnings per share (EPS)<\/em>\u00a0and\u00a0<em>price\/earnings (P\/E) ratio<\/em>.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>If the firm can repurchase stock at $62 per share, how many shares can be purchased in lieu of making the proposed cash dividend payment?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>How much will the EPS be after the proposed repurchase? Why?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>If the stock sells at the old P\/E ratio, what will the market price be after repurchase?<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Compare and contrast the earnings per share before and after the proposed repurchase.<\/span><\/li>\n<li><span><strong>f.<\/strong><\/span><span>Compare and contrast the stockholders\u2019 position under the dividend and repurchase alternatives.<\/span><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Warm-Up Exercises<\/strong><\/h2>\n<p><strong><span>All problems are available in<\/span>\u00a0<span>My<\/span><span>Finance<\/span><span>Lab<\/span>.<\/strong><\/p>\n<div>\n<div>\n<div><span><strong>E14\u20131<\/strong><\/span><\/p>\n<p>Stephanie\u2019s Cafes, Inc., has declared a dividend of $1.30 per share for shareholders of record on Tuesday, May 2. The firm has 200,000 shares outstanding and will pay the dividend on May 24. How much cash will be needed to pay the dividend? When will the stock begin selling\u00a0<em>ex dividend?<\/em><\/p>\n<p><strong><span>LG 1<\/span><\/strong><\/p>\n<\/div>\n<div><span><strong>E14\u20132<\/strong><\/span><\/p>\n<p>Chancellor Industries has retained earnings available of $1.2 million. The firm plans to make two investments that require financing of $950,000 and $1.75 million, respectively. Chancellor uses a target capital structure with 60% debt and 40% equity. Apply the\u00a0<em>residual theory<\/em>\u00a0to determine what dividends, if any, can be paid out, and calculate the resulting<em>dividend payout ratio<\/em>.<\/p>\n<p><strong><span>LG 2<\/span><\/strong><\/p>\n<\/div>\n<div><span><strong>E14\u20133<\/strong><\/span><\/p>\n<p>Ashkenazi Companies has the following stockholders\u2019 equity account:<\/p>\n<p><strong><span>LG 3<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (350,000 shares at $3 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1,050,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02,500,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u2008\u2003750,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$4,300,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Assuming that state laws define legal capital solely as the par value of common stock, how much of a\u00a0<em>per-share dividend<\/em>\u00a0can Ashkenazi pay? If legal capital were more broadly defined to include all paid-in capital, how much of a\u00a0<em>per-share dividend<\/em>\u00a0could Ashkenazi pay?<\/p>\n<\/div>\n<div><span><strong>E14\u20134<\/strong><\/span><\/p>\n<p>The board of Kopi Industries is considering a new dividend policy that would set dividends at 60% of earnings. The recent past has witnessed earnings per share (EPS) and dividends paid per share as shown in the following table.<\/p>\n<p><strong><span>LG 4<\/span><\/strong><\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>EPS<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Dividend\/share<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1.75<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$0.95<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.95<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.05<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.25<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.25<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.30<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Based on Kopi\u2019s historical dividend payout ratio, discuss whether a\u00a0<em>constant payout ratio<\/em>\u00a0of 60% would benefit shareholders.<\/p>\n<\/div>\n<div><span><strong>E14\u20135<\/strong><\/span><\/p>\n<p>The current stockholders\u2019 equity account for Hilo Farms is as follows:<\/p>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (50,000 shares at $3 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$150,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0250,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0450,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$850,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>Hilo has announced plans to issue an additional 5,000 shares of common stock as part of its stock dividend plan. The current market price of Hilo\u2019s common stock is $20 per share. Show how the proposed\u00a0<em>stock dividend<\/em>\u00a0would affect the stockholder\u2019s equity account.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Problems<\/strong><\/h2>\n<p><strong><span>All problems are available in<\/span>\u00a0<span>My<\/span><span>Finance<\/span><span>Lab<\/span>.<\/strong><\/p>\n<p><strong><span>LG 1<\/span><\/strong><\/p>\n<div>\n<div>\n<div><span><strong>P14\u20131<\/strong><\/span><\/p>\n<p><strong>Dividend payment procedures<\/strong>\u00a0At the quarterly dividend meeting, Wood Shoes declared a cash dividend of $1.10 per share for holders of record on Monday, July 10. The firm has 300,000 shares of common stock outstanding and has set a payment date of July 31. Prior to the dividend declaration, the firm\u2019s key accounts were as follows:<\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Cash<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$500,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividends payable<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2,500,000<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Show the entries after the meeting adjourned.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>When is the\u00a0<em>ex dividend<\/em>\u00a0date?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>What values would the key accounts have after the July 31 payment date?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>What effect, if any, will the dividend have on the firm\u2019s total assets?<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Ignoring general market fluctuations, what effect, if any, will the dividend have on the firm\u2019s stock price on the ex dividend date?<\/span><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Personal Finance Problem<\/strong><\/h2>\n<p><strong><span>LG 1<\/span><\/strong><\/p>\n<div>\n<div>\n<div><span><strong>P14\u20132<\/strong><\/span><\/p>\n<p><strong>Dividend payment<\/strong>\u00a0Kathy Snow wishes to purchase shares of Countdown Computing, Inc. The company\u2019s board of directors has declared a cash dividend of $0.80 to be paid to holders of record on Wednesday, May 12.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>What is the last day that Kathy can purchase the stock (trade date) and still receive the dividend?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>What day does this stock begin trading ex dividend?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>What change, if any, would you expect in the price per share when the stock begins trading on the ex dividend day?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>If Kathy held the stock for less than one quarter and then sold it for $39 per share, would she achieve a higher investment return by (1) buying the stock\u00a0<em>prior to<\/em>\u00a0the ex dividend date at $35 per share and collecting the $0.80 dividend or (2) buying it\u00a0<em>on<\/em>\u00a0the ex dividend date at $34.20 per share but not receiving the dividend?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20133<\/strong><\/span><\/p>\n<p><strong>Residual dividend policy<\/strong>\u00a0As president of Young\u2019s of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks about the company\u2019s dividend policy. In fact, the stockholder has asked you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following:<\/p>\n<p><strong><span>LG 2<\/span><\/strong><\/p>\n<ul>\n<li><span>(1)<\/span><span>The company follows a residual dividend policy.<\/span><\/li>\n<li><span>(2)<\/span><span>The total capital budget for next year is likely to be one of three amounts, depending on the results of capital budgeting studies that are currently under way. The capital expenditure amounts are $2 million, $3 million, and $4 million.<\/span><\/li>\n<li><span>(3)<\/span><span>The forecasted level of potential retained earnings next year is $2 million.<\/span><\/li>\n<li><span>(4)<\/span><span>The target or optimal capital structure is a debt ratio of 40%.<\/span><\/li>\n<\/ul>\n<p>You have decided to respond by sending the stockholder the best information available to you.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Describe a\u00a0<em>residual dividend policy<\/em>.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Compute the amount of the dividend (or the amount of new common stock needed) and the dividend payout ratio for each of the three capital expenditure amounts.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Compare, contrast, and discuss the amount of dividends (calculated in part\u00a0<strong>b<\/strong>) associated with each of the three capital expenditure amounts.<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20134<\/strong><\/span><\/p>\n<p><strong>Dividend constraints<\/strong>\u00a0The Howe Company\u2019s stockholders\u2019 equity account follows:<\/p>\n<p><strong><span>LG 3<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (400,000 shares at $4 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1,600,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a01,900,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$4,500,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>The earnings available for common stockholders from this period\u2019s operations are $100,000, which have been included as part of the $1.9 million retained earnings.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>What is the\u00a0<em>maximum dividend per share<\/em>\u00a0that the firm can pay? (Assume that legal capital includes\u00a0<em>all<\/em>\u00a0paid-in capital.)<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without borrowing?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in parts\u00a0<strong>a<\/strong>\u00a0and\u00a0<strong>b.<\/strong><\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Indicate the effects of an $80,000 cash dividend on stockholders\u2019 equity.<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20135<\/strong><\/span><\/p>\n<p><strong>Dividend constraints<\/strong>\u00a0A firm has $800,000 in paid-in capital, retained earnings of $40,000 (including the current year\u2019s earnings), and 25,000 shares of common stock outstanding. In the current year, it has $29,000 of earnings available for the common stockholders.<\/p>\n<p><strong><span>LG 3<\/span><\/strong><\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>What is the most the firm can pay in cash dividends to each common stockholder? (Assume that legal capital includes\u00a0<em>all<\/em>\u00a0paid-in capital.)<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>What effect would a cash dividend of $0.80 per share have on the firm\u2019s balance sheet entries?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>If the firm cannot raise any new funds from external sources, what do you consider the key constraint with respect to the magnitude of the firm\u2019s dividend payments? Why?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20136<\/strong><\/span><\/p>\n<p><strong>Low-regular-and-extra dividend policy<\/strong>\u00a0Bennett Farm Equipment Sales, Inc., is in a highly cyclic business. Although the firm has a target payout ratio of 25%, its board realizes that strict adherence to that ratio would result in a fluctuating dividend and create uncertainty for the firm\u2019s stockholders. Therefore, the firm has declared a regular dividend of $0.50 per share per year with extra cash dividends to be paid when earnings justify them. Earnings per share for the last several years are shown in the following table.<\/p>\n<p><strong><span>LG 4<\/span><\/strong><\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>EPS<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$3.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.40<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$2.80<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2011<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.15<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2010<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.97<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Calculate the\u00a0<em>payout ratio<\/em>\u00a0for each year on the basis of the regular $0.50 dividend and the cited EPS.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Calculate the difference between the regular $0.50 dividend and a 25% payout for each year.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Bennett has established a policy of paying an extra dividend of $0.25 only when the difference between the regular dividend and a 25% payout amounts to $1.00 or more. Show the regular and extra dividends in those years when an extra dividend would be paid. What would be done with the \u201cextra\u201d earnings that are not paid out?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>The firm expects that future earnings per share will continue to cycle but will remain above $2.20 per share in most years. What factors should be considered in making a revision to the amount paid as a regular dividend? If the firm revises the regular dividend, what new amount should it pay?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20137<\/strong><\/span><\/p>\n<p><strong>Alternative dividend policies<\/strong>\u00a0Over the last 10 years, a firm has had the earnings per share shown in the following table.<\/p>\n<p><strong><span>LG 4<\/span><\/strong><\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Earnings per share<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$4.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03.80<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a02.80<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2011<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a03.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2010<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$2.40<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2009<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2008<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.80<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2007<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u22120.50<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2006<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.25<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>If the firm\u2019s dividend policy were based on a\u00a0<em>constant payout ratio<\/em>\u00a0of 40% for all years with positive earnings and 0% otherwise, what would be the annual dividend for each year?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>If the firm had a dividend payout of $1.00 per share, increasing by $0.10 per share whenever the dividend payout fell below 50% for two consecutive years, what annual dividend would the firm pay each year?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>If the firm\u2019s policy were to pay $0.50 per share each period except when earnings per share exceed $3.00, when an extra dividend equal to 80% of earnings beyond $3.00 would be paid, what annual dividend would the firm pay each year?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Discuss the pros and cons of each dividend policy described in parts\u00a0<strong>a<\/strong>\u00a0through\u00a0<strong>c.<\/strong><\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20138<\/strong><\/span><\/p>\n<p><strong>Alternative dividend policies<\/strong>\u00a0Given the earnings per share over the period 2008\u20132015 shown in the following table, determine the annual dividend per share under each of the policies set forth in parts\u00a0<strong>a<\/strong>\u00a0through\u00a0<strong>d.<\/strong><\/p>\n<p><strong><span>LG 4<\/span><\/strong><\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Year<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Earnings per share<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2015<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1.40<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2014<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.56<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2013<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2012<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u22120.85<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2011<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.05<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2010<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.60<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2009<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>2008<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a00.44<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Pay out 50% of earnings in all years with positive earnings.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Pay $0.50 per share and increase to $0.60 per share whenever earnings per share rise above $0.90 per share for two consecutive years.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Pay $0.50 per share except when earnings exceed $1.00 per share, in which case pay an extra dividend of 60% of earnings above $1.00 per share.<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Combine the policies described in parts\u00a0<strong>b<\/strong>\u00a0and\u00a0<strong>c.<\/strong>\u00a0When the dividend is raised (in part<strong>b<\/strong>), raise the excess dividend base (in part\u00a0<strong>c<\/strong>) from $1.00 to $1.10 per share.<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Compare and contrast each of the dividend policies described in parts\u00a0<strong>a<\/strong>\u00a0through\u00a0<strong>d.<\/strong><\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u20139<\/strong><\/span><\/p>\n<p><strong>Stock dividend: Firm<\/strong>\u00a0Columbia Paper has the following stockholders\u2019 equity account. The firm\u2019s common stock has a current market price of $30 per share.<\/p>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$100,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (10,000 shares at $2 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a020,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0280,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0100,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$500,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Show the effects on Columbia of a 5% stock dividend.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Show the effects of (1) a 10% and (2) a 20% stock dividend.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>In light of your answers to parts\u00a0<strong>a<\/strong>\u00a0and\u00a0<strong>b,<\/strong>\u00a0discuss the effects of stock dividends on stockholders\u2019 equity.<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201310<\/strong><\/span><\/p>\n<p><strong>Cash versus stock dividend<\/strong>\u00a0Milwaukee Tool has the following stockholders\u2019 equity account. The firm\u2019s common stock currently sells for $4 per share.<\/p>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0100,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (400,000 shares at $1 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0200,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0\u00a0320,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$1,020,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Show the effects on the firm of a\u00a0<em>cash<\/em>\u00a0dividend of $0.01, $0.05, $0.10, and $0.20 per share.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Show the effects on the firm of a 1%, 5%, 10%, and 20%\u00a0<em>stock<\/em>\u00a0dividend.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Compare the effects in parts\u00a0<strong>a<\/strong>\u00a0and\u00a0<strong>b.<\/strong>\u00a0What are the significant differences between the two methods of paying dividends?<\/span><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Personal Finance Problem<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong>P14\u201311<\/strong><\/span><\/p>\n<p><strong>Stock dividend: Investor<\/strong>\u00a0Sarah Warren currently holds 400 shares of Nutri-Foods. The firm has 40,000 shares outstanding. The firm most recently had earnings available for common stockholders of $80,000, and its stock has been selling for $22 per share. The firm intends to retain its earnings and pay a 10% stock dividend.<\/p>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>How much does the firm currently earn per share?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>What proportion of the firm does Sarah currently own?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>What proportion of the firm will Sarah own after the stock dividend? Explain your answer.<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>At what market price would you expect the stock to sell after the stock dividend?<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Discuss what effect, if any, the payment of stock dividends will have on Sarah\u2019s share of the ownership and earnings of Nutri-Foods.<\/span><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Personal Finance Problem<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong>P14\u201312<\/strong><\/span><\/p>\n<p><strong>Stock dividend: Investor<\/strong>\u00a0Security Data Company has outstanding 50,000 shares of common stock currently selling at $40 per share. The firm most recently had earnings available for common stockholders of $120,000, but it has decided to retain these funds and is considering either a 5% or a 10% stock dividend in lieu of a cash dividend.<\/p>\n<p><strong><span>LG 5<\/span><\/strong><\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Determine the firm\u2019s current\u00a0<em>earnings per share<\/em>.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>If Sam Waller currently owns 500 shares of the firm\u2019s stock, determine his proportion of ownership currently and under each of the proposed stock dividend plans. Explain your findings.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Calculate and explain the market price per share under each of the stock dividend plans.<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>For each of the proposed stock dividends, calculate the earnings per share after payment of the stock dividend.<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>What is the value of Sam\u2019s holdings under each of the plans? Explain.<\/span><\/li>\n<li><span><strong>f.<\/strong><\/span><span>Should Sam have any preference with respect to the proposed stock dividends? Why or why not?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201313<\/strong><\/span><\/p>\n<p><strong>Stock split: Firm<\/strong>\u00a0Growth Industries\u2019 current stockholders\u2019 equity account is as follows:<\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (600,000 shares at $3 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a01,800,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0200,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0\u00a0800,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$3,200,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Indicate the change, if any, expected if the firm declares a 2-for-1 stock split.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Indicate the change, if any, expected if the firm declares a 1-for-<img decoding=\"async\" src=\"\" alt=\"1 1 over 2\"\/>\u00a0<em>reverse<\/em>\u00a0stock split.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Indicate the change, if any, expected if the firm declares a 3-for-1 stock split.<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Indicate the change, if any, expected if the firm declares a 6-for-1 stock split.<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Indicate the change, if any, expected if the firm declares a 1-for-4\u00a0<em>reverse<\/em>\u00a0stock split.<\/span><\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Personal Finance Problem<\/strong><\/h2>\n<div>\n<div>\n<div><span><strong>P14\u201314<\/strong><\/span><\/p>\n<p><strong>Stock splits<\/strong>\u00a0Nathan Detroit owns 400 shares of the food company General Mills, Inc., which he purchased during the recession in January 2009 for $35 per share. General Mills is regarded as a relatively safe company because it provides a basic product that consumers need in good and bad economic times. Nathan read in the\u00a0<em>Wall Street Journal<\/em>\u00a0that the company\u2019s board of directors had voted to split the stock 2-for-1. In June 2010, just before the stock split, General Mills shares were trading for $75.14.<\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<p>Answer the following questions about the impact of the stock split on his holdings and taxes. Nathan is in the 28% federal income tax bracket.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>How many shares of General Mills will Nathan own after the stock split?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Immediately after the split, what do you expect the value of General Mills to be?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Compare the total value of Nathan\u2019s stock holdings before and after the split, given that the price of General Mills stock immediately after the split was $37.50. What do you find?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Does Nathan experience a gain or loss on the stock as a result of the 2-for-1 split?<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>What is Nathan\u2019s tax liability from the event?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201315<\/strong><\/span><\/p>\n<p><strong>Stock split versus stock dividend: Firm<\/strong>\u00a0Mammoth Corporation is considering a 3-for-2 stock split. It currently has the stockholders\u2019 equity position shown. The current stock price is $120 per share. The most recent period\u2019s earnings available for common stock are included in retained earnings.<\/p>\n<p><strong><span>LG 5 LG 6<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a01,000,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (100,000 shares at $3 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0300,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a01,700,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a010,000,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$13,000,000<\/span><\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>What effects on Mammoth would result from the\u00a0<em>stock split?<\/em><\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>What change in stock price would you expect to result from the stock split?<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>What is the maximum cash dividend per share that the firm could pay on common stock before and after the stock split? (Assume that legal capital includes\u00a0<em>all<\/em>\u00a0paid-in capital.)<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Contrast your answers to parts\u00a0<strong>a<\/strong>\u00a0through\u00a0<strong>c<\/strong>\u00a0with the circumstances surrounding a 50%\u00a0<em>stock dividend<\/em>.<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Explain the differences between stock splits and stock dividends.<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201316<\/strong><\/span><\/p>\n<p><strong>Stock dividend versus stock split: Firm<\/strong>\u00a0The board of Wicker Home Health Care, Inc., is exploring ways to expand the number of shares outstanding in an effort to reduce the market price per share to a level that the firm considers more appealing to investors. The options under consideration are a 20% stock dividend and, alternatively, a 5-for-4 stock split. At the present time, the firm\u2019s equity account and other per-share information are as follows:<\/p>\n<p><strong><span>LG 5 LG 6<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock (100,000 shares at $1 par)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0100,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Paid-in capital in excess of par<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0900,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Retained earnings<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>\u00a0\u00a0700,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0Total stockholders\u2019 equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p><span>$1,700,000<\/span><\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Price per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0$30.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0$3.60<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividend per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0$1.08<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Show the effect on the equity accounts and per-share data of a 20%\u00a0<em>stock dividend<\/em>.<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Show the effect on the equity accounts and per-share data of a 5-for-4\u00a0<em>stock split<\/em>.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>Which option will accomplish Wicker\u2019s goal of reducing the current stock price while maintaining a stable level of retained earnings?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>What legal constraints might encourage the firm to choose a stock split over a stock dividend?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201317<\/strong><\/span><\/p>\n<p><strong>Stock repurchase<\/strong>\u00a0The following financial data on the Bond Recording Company are available:<\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<div>\n<table>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings available for common stockholders<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$800,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Number of shares of common stock outstanding<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings per share ($800,000 \u00f7 400,000)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0$2<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Market price per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0$20<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Price\/earnings (P\/E) ratio ($20 \u00f7 $2)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a010<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>The firm is currently considering whether it should use $400,000 of its earnings to pay cash dividends of $1 per share or to repurchase stock at $21 per share.<\/p>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>Approximately how many shares of stock can the firm repurchase at the $21-per-share price, using the funds that would have gone to pay the cash dividend?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>Calculate the\u00a0<em>EPS<\/em>\u00a0after the repurchase. Explain your calculations.<\/span><\/li>\n<li><span><strong>c.<\/strong><\/span><span>If the stock still sells at 10 times earnings, what will the\u00a0<em>market price<\/em>\u00a0be after the repurchase?<\/span><\/li>\n<li><span><strong>d.<\/strong><\/span><span>Compare the pre- and postrepurchase earnings per share.<\/span><\/li>\n<li><span><strong>e.<\/strong><\/span><span>Compare and contrast the stockholders\u2019 positions under the dividend and repurchase alternatives. What are the tax implications under each alternative?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201318<\/strong><\/span><\/p>\n<p><strong>Stock repurchase<\/strong>\u00a0Harte Textiles, Inc., a maker of custom upholstery fabrics, is concerned about preserving the wealth of its stockholders during a cyclic downturn in the home furnishings business. The company has maintained a constant dividend payout of $2.00 tied to a target payout ratio of 40%. Management is preparing a share repurchase recommendation to present to the firm\u2019s board of directors. The following data have been gathered from the last 2 years.<\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>2014<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>2015<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings available for common stockholders<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1,260,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1,200,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Number of shares outstanding<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0300,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0300,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0$4.20<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0$4.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Market price per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0$23.50<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0$20.00<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Price\/earnings ratio<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a05.6<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a05.0<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<ul>\n<li><span><strong>a.<\/strong><\/span><span>How many shares should the company have outstanding in 2015 if its earnings available for common stockholders in that year are $1,200,000 and it pays a dividend of $2.00, given that its desired payout ratio is 40%?<\/span><\/li>\n<li><span><strong>b.<\/strong><\/span><span>How many shares would Harte have to repurchase to have the level of shares outstanding calculated in part\u00a0<strong>a<\/strong>?<\/span><\/li>\n<\/ul>\n<\/div>\n<div><span><strong>P14\u201319<\/strong><\/span><\/p>\n<p><strong>ETHICS PROBLEM<\/strong>\u00a0Assume that you are the CFO of a company contemplating a stock repurchase next quarter. You know that there are several methods of reducing the current quarterly earnings, which may cause the stock price to fall prior to the announcement of the proposed stock repurchase. What course of action would you recommend to your CEO? If your CEO came to you first and recommended reducing the current quarter\u2019s earnings, what would be your response?<\/p>\n<p><strong><span>LG 6<\/span><\/strong><\/p>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<\/div>\n<div>\n<h2><strong>Spreadsheet Exercise<\/strong><\/h2>\n<p><span><img loading=\"lazy\" decoding=\"async\" src=\"\" alt=\"\" width=\"110\" height=\"88\"\/><\/span><\/p>\n<p>One way to lower the market price of a firm\u2019s stock is via a stock split. Rock-O Corporation finds itself in a different situation: Its stock has been selling at relatively low prices. To increase the market price of the stock, the company chooses to use a\u00a0<em>reverse stock split<\/em>\u00a0of 2-for-3.<\/p>\n<p>The company currently has 700,000 common shares outstanding and no preferred stock. The common stock carries a par value of $1. At this time, the paid-in capital in excess of par is $7,000,000, and the firm\u2019s retained earnings are $3,500,000.<\/p>\n<div>\n<h2><strong>TO DO<\/strong><\/h2>\n<p>Create a spreadsheet to determine the following:<\/p>\n<ul>\n<li><span><strong>a.<\/strong>\u00a0<\/span><span>The stockholders\u2019 equity section of the balance sheet\u00a0<em>before<\/em>\u00a0the reverse stock split.<\/span><\/li>\n<li><span><strong>b.<\/strong>\u00a0<\/span><span>The stockholders\u2019 equity section of the balance sheet\u00a0<em>after<\/em>\u00a0the reverse stock split.<\/span><\/li>\n<\/ul>\n<div>\n<p><strong><span>My<\/span>\u00a0<span>Finance<\/span>\u00a0<span>Lab<\/span><\/strong><\/p>\n<p>Visit\u00a0<strong><a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; background-color: transparent;\" href=\"http:\/\/www.myfinancelab.com\/\"><span>www.myfinancelab.com<\/span><\/a><\/strong>\u00a0for\u00a0<strong>Chapter Case:\u00a0<em>Establishing General Access Company\u2019s Dividend Policy and Initial Dividend,<\/em><\/strong>\u00a0Group Exercises, and numerous online resources.<\/p>\n<\/div>\n<\/div>\n<\/div>\n<p>\u00a0<\/p>\n<div>\n<h2><span><strong>Integrative Case 6\u00a0<\/strong><\/span><strong>O\u2019Grady Apparel Company<\/strong><\/h2>\n<p>O\u2019Grady Apparel Company was founded nearly 160 years ago when an Irish merchant named Garrett O\u2019Grady landed in Los Angeles with an inventory of heavy canvas, which he hoped to sell for tents and wagon covers to miners headed for the California goldfields. Instead, he turned to the sale of harder-wearing clothing.<\/p>\n<p>Today, O\u2019Grady Apparel Company is a small manufacturer of fabrics and clothing whose stock is traded in the OTC market. In 2015, the Los Angeles\u2013based company experienced sharp increases in both domestic and European markets resulting in record earnings. Sales rose from $15.9 million in 2014 to $18.3 million in 2015 with earnings per share of $3.28 and $3.84, respectively.<\/p>\n<p>European sales represented 29% of total sales in 2015, up from 24% the year before and only 3% in 2010, 1 year after foreign operations were launched. Although foreign sales represent nearly one-third of total sales, the growth in the domestic market is expected to affect the company most markedly. Management expects sales to surpass $21 million in 2016, and earnings per share are expected to rise to $4.40. (Selected income statement items are presented in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14tab1\">Table 1<\/a>.)<\/p>\n<p>Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned that available funds are not being used to their fullest potential. The projected $1,300,000 of internally generated 2016 funds is expected to be insufficient to meet the company\u2019s expansion needs. Management has set a policy of maintaining the current capital structure proportions of 25% long-term debt, 10% preferred stock, and 65% common stock equity for at least the next 3 years. In addition, it plans to continue paying out 40% of its earnings as dividends. Total capital expenditures are yet to be determined.<\/p>\n<p>Jennings has been presented with several competing investment opportunities by division and product managers. However, because funds are limited, choices of which projects to accept must be made. A list of investment opportunities is shown in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14tab2\">Table 2<\/a>. To analyze the effect of the increased financing requirements on the weighted average cost of capital (WACC), Jennings contacted a leading investment banking firm that provided the financing cost data given in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14tab3\">Table 3<\/a>. O\u2019Grady is in the 40% tax bracket.<\/p>\n<div>\n<h2><strong>TABLE 1<\/strong><\/h2>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"5\">\n<p><strong>Selected Income Statement Items<\/strong><\/p>\n<\/th>\n<\/tr>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>2013<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>2014<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>2015<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Projected 2016<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Net sales<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$13,860,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$15,940,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$18,330,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$21,080,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Net profits after taxes<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0$1,520,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0$1,750,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0$2,020,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0$2,323,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Earnings per share (EPS)<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a02.88<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03.28<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03.84<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a04.40<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Dividends per share<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.15<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.31<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.54<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.76<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<div>\n<h2><strong>TABLE 2<\/strong><\/h2>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"3\">\n<p><strong>Investment Opportunities<\/strong><\/p>\n<\/th>\n<\/tr>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Investment opportunity<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Internal rate of return (IRR)<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Initial investment<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>A<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>21%<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$400,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>B<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>19\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>200,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>C<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>24\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>700,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>D<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>27\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>500,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>E<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>18\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>300,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>F<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>22\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>600,000<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>G<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>17\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>500,000<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<div>\n<h2><strong>TABLE 3<\/strong><\/h2>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Financing Cost Data<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p><strong>Long-term debt:<\/strong>\u00a0The firm can raise $700,000 of additional debt by selling 10-year, $1,000, 12% annual interest rate bonds to net $970 after flotation costs. Any debt in excess of $700,000 will have a before-tax cost,\u00a0<em>r<\/em><span><em>d<\/em><\/span>, of 18%.<\/p>\n<p><strong>Preferred stock:<\/strong>\u00a0Preferred stock, regardless of the amount sold, can be issued with a $60 par value and a 17% annual dividend rate. It will net $57 per share after flotation costs.<\/p>\n<p><strong>Common stock equity:<\/strong>\u00a0The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm\u2019s stock is currently selling for $20 per share. The firm expects to have $1,300,000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $16 per share after underpricing and flotation costs.<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<div>\n<h2><strong>TO DO<\/strong><\/h2>\n<ul>\n<li><span><strong>a.<\/strong>\u00a0<\/span><span>Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete the table.<\/span>\n<div>\n<table>\n<thead>\n<tr>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Source of capital<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>Range of new financing<\/strong><\/p>\n<\/th>\n<th rowspan=\"1\" colspan=\"1\">\n<p><strong>After-tax cost (%)<\/strong><\/p>\n<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Long-term debt<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$0\u2013$700,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>_________<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$700,000 and above<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>_________<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Preferred stock<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$0 and above<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>_________<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>Common stock equity<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$0\u2013$1,300,000<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>_________<\/p>\n<\/td>\n<\/tr>\n<tr>\n<td rowspan=\"1\" colspan=\"1\">\n<p>\u00a0<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>$1,300,000 and above<\/p>\n<\/td>\n<td rowspan=\"1\" colspan=\"1\">\n<p>_________<\/p>\n<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<\/li>\n<li><span><strong>b.<\/strong><\/span>\n<ul>\n<li><span>(1)<\/span>\u00a0<span>Determine the\u00a0<em>break point<\/em>\u00a0associated with common equity. A break point represents the total amount of financing that the firm can raise before it triggers an increase in the cost of a particular financing source. For example, O\u2019Grady plans to use 25% long-term debt in its capital structure. So, for every $1 in debt that the firm uses, it will use $3 from other financing sources (total financing is then $4, and because $1 comes from long-term debt, its\u00a0share in the total is the desired 25%). From\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14tab3\">Table 3<\/a>, we see that after the firm raises $700,000 in long-term debt, the cost of this financing source begins to rise. Therefore, the firm can raise total capital of $2.8 million before the cost of debt will rise ($700,000 in debt plus $2.1 million in other sources to maintain the 25% proportion for debt), and $2.8 million is the break point for debt. If the firms wants to maintain a capital structure with 25% long-term debt and it also wants to raise more than $2.8 million in total financing, it will require more than $700,000 in long-term debt, and it will trigger the higher cost of the additional debt it issues beyond $700,000.<\/span><\/li>\n<li><span>(2)<\/span>\u00a0<span>Using the break points developed in part (1), determine each of the ranges of\u00a0<em>total<\/em>\u00a0new financing over which the firm\u2019s weighted average cost of capital (WACC) remains constant.<\/span><\/li>\n<li><span>(3)<\/span>\u00a0<span>Calculate the weighted average cost of capital for each range of total new financing. Draw a graph with the WACC on the vertical axis and total money raised on the horizontal axis, and show how the firm\u2019s WACC increases in \u201csteps\u201d as the amount of money raised increases.<\/span><\/li>\n<\/ul>\n<\/li>\n<li><span><strong>c.<\/strong><\/span>\n<ul>\n<li><span>(1)<\/span>\u00a0<span>Sort the investment opportunities described in\u00a0<a rel=\"nofollow noopener\" target=\"_blank\" style=\"max-width: 100%; color: #0d8cd6; font-weight: bold; background-color: transparent;\" href=\"https:\/\/jigsaw.vitalsource.com\/books\/9781323102923\/content\/id\/ch14tab2\">Table 2<\/a>\u00a0from highest to lowest return, and plot a line on the graph you drew in part (3) above showing how much money is required to fund the investments, starting with the highest return and going to the lowest. In other words, this line will plot the relationship between the IRR on the firm\u2019s investments and the total financing required to undertake those investments.<\/span><\/li>\n<li><span>(2)<\/span>\u00a0<span>Which, if any, of the available investments would you recommend that the firm acce<\/span>pt? Explain your answer.<\/li>\n<\/ul>\n<\/li>\n<li><span><strong>d.<\/strong><\/span>\n<ul>\n<li><span><span>(1)<\/span>\u00a0<span>Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged\u00a0<em>capital structure<\/em>\u00a0consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings? (<em>Note:<\/em>\u00a0Rework parts\u00a0<strong>b<\/strong>\u00a0and\u00a0<strong>c<\/strong>\u00a0using these capital structure weights.)<\/span><\/span><\/li>\n<li><span><span>(2)<\/span>\u00a0<span>Which capital structure\u2014the original one or this one\u2014seems better? Why?<\/span><\/span><\/li>\n<\/ul>\n<\/li>\n<li><span><strong>e.<\/strong><\/span>\n<ul>\n<li><span>(1)<\/span>\u00a0<span>What type of\u00a0<em>dividend policy<\/em>\u00a0does the firm appear to employ? Does it seem appropriate given the firm\u2019s recent growth in sales and profits and given its current investment opportunities?<\/span><\/li>\n<li><span>(2)<\/span>\u00a0<span>Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part\u00a0<strong>c<\/strong>(2)?<\/span><\/li>\n<\/ul>\n<\/li>\n<\/ul>\n<\/div>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>Resource:\u00a0Principles of Managerial Finance, Ch. 14 Complete\u00a0the Integrative Case 6 O&#8217;Grady Apparel Company.\u00a0 Please after reading the chapter, I have highlighted the questions that you need to answer. ONLY THE HIGHLIGHTED SECTION IS MINE TO ANSWER THIS IS A TEAM ASSIGNMENT. \u00a0 d. (1)\u00a0Assuming that the specific financing costs do not change, what effect would [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[31],"tags":[],"class_list":["post-6801","post","type-post","status-publish","format-standard","hentry","category-homework-help"],"_links":{"self":[{"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/posts\/6801","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/comments?post=6801"}],"version-history":[{"count":0,"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/posts\/6801\/revisions"}],"wp:attachment":[{"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/media?parent=6801"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/categories?post=6801"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/assignmenttutors.net\/blog\/wp-json\/wp\/v2\/tags?post=6801"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}