When firms earn income they have choices about what to do with that income. There are a number of options:

• Reinvest in operations.
• Acquire securities.
• Pay off debt.
• Distribute to shareholders.

This section deals with the policies that firms employ when distributing the income to shareholders.

Dividend policy involves three issues:

• What fraction of earnings should be distributed on average over time?
• Should the distribution be in the form of cash dividends or stock repurchases?
• Should the firm maintain a steady, stable dividend growth rate?

Firms can pay dividends in a number of ways.

Cash Dividends

A cash dividend is the type most people are familiar with. It is a cash amount, usually paid on a per share basis. It is paid out of retained earnings.

• Regular dividends
  These are dividends distributed by companies on a regular recurring basis, usually quarterly, semi-annually, or annually.
  Both evidence and logic suggest that investors prefer companies that follow a stable, predictable dividend policy. The "stable dividend policy" generally means increasing the dividend at a reasonably steady rate. It signals to investors that:
  • The company is growing.
  • The company is willing to share gains with shareholders.
  • The management has confidence in the future of the company.
  However, some investors interpret rising dividends as a tacit sign of lack of sufficient growth opportunities.

• Dividend reinvestment plans (DRIPs)
  A DRIP is a program run by a company for its shareholders. Instead of sending dividend checks to shareholders enrolled in a company's DRIP, the company reinvests those dividends by purchasing additional shares (or fractional shares) in the shareholder's name.
  Companies like DRIPs for several reasons.
  • DRIPs provide a stable base of shareholders who are likely to have a long-term, "buy and hold" investment philosophy. Individuals, particularly those who are dollar-cost averaging into their DRIPs, may see the drop in a stock's share price as a buying opportunity, as opposed to institutions and traders who move in and out of stocks with short-term goals in mind. This base of individual shareholders can help stabilize a company's share price.
  • DRIPs keep capital inside the company by not paying cash dividends outright and having those dividends reinvested in additional share purchases.
  • DRIPs can also help companies raise additional capital without making a public offering.
  For shareholders, the best part about DRIPs is that most DRIPs allow additional purchases to be made without a fee or commission. Some companies even offer the additional benefit of purchasing shares at a discount (usually 3-5%) to the market price.
  Disadvantages for shareholders:
  • Extra bookkeeping: Shareholders must keep scrupulous records, including all statements, in order to determine the cost basis of shares when they sell them.
  • Taxes: Dividends that are paid on shares of stocks are taxable as ordinary income on income tax returns, regardless of whether they are reinvested or received in cash. Shareholders must pay taxes on all dividends, reinvested or not, in the year in which they received them.

• Extra (or special) dividends
  An extra dividend is a non-recurring distribution of company assets, usually in the form of cash, to shareholders.
  • Generally, special dividends are declared after exceptionally strong company earnings results as a way to distribute the profits directly to shareholders.
  • Companies in cyclical industries are likely to use this form of dividend payment.
  • Extra dividends can also occur when a company wishes to make changes to its financial structure or spin off a subsidiary company to its shareholders. For example, GenTek Inc. issued a special cash dividend of $31 per share on Mar 16, 2005, in order to restructure toward a more debt-based financing mix.

• Liquidating dividends
  A liquidating dividend is a payment by a firm to shareholders from capital rather than from earnings. This isn't really a good thing. It usually occurs when a company dissolves its business or sells part of its business for cash, and distributes the proceeds to its shareholders. The distribution would be treated as a capital gain for tax purposes.

Stock Splits and Stock Dividends

There is a belief that there is an optimal price range for every share. This is the price for the share when the price/earnings ratio and hence the company's value is maximized. Consider a share that has become so costly that investors cannot afford to buy the share in the required even lot of 100 shares. To correct this situation the company would split its stock.

A stock split divides each outstanding share into several shares. In a 2-for-1 stock split, the holder of 1 share will get an additional share. This increases the number of shares outstanding and is generally used after a sharp price run-up to produce a large price reduction. Normally, splits reduce the price per share in proportion to the increase in shares; splits merely "divide the pie into smaller slices." However, firms generally split their stocks only if the price is quite high and management thinks the future is bright. Therefore, stock splits are often taken as positive signals and thus boost stock prices.

A stock dividend is a dividend paid in additional shares of stock rather than in cash. Stock dividends are expressed in percentages. For example, on a 100% stock dividend, a holder of 1 share will get an additional 1 share. Stock dividends used on a regular basis will keep stock prices more or less constrained. However, small stock dividends create bookkeeping problems and unnecessary expenses.

Both stock splits and dividends are used to keep stock prices within an "optimal" trading range. Stock splits or dividends are just more pieces of paper: they both divide the pie into smaller slices without affecting the fundamental position of the current stockholders. Each shareholder will own more shares, but each share is worth less; his or her slice of the firm's pie remains the same.

The benefits of a stock split or dividend for a company:

• The company doesn't need to spend any actual money issuing a dividend.
• More shares outstanding broaden the shareholder base. This is always a good thing for the company.
• Market folklore has it that a lower stock price will attract more investors.

Differences between cash dividends and stock splits or dividends:

• Capital structure
  • Stock splits or dividends have no impact on a company's capital structure. The market values of equity and debt remain unchanged.
  • Cash dividends transfer assets from the company to shareholders, thereby reducing the assets of the company and the market value of its equity. In other words, cash dividends increase leverage.

• Accounting treatment
  • Stock dividends shift retained earnings to the capital account. They merely reclassify certain amounts of shareholders' equity on the balance sheet.
  • Stock splits are accounted for as a reduction in the par value of the shares.
  • Cash dividends represent cash outflows and reductions in shareholders' equity.

For a shareholder, the benefit of a stock split or dividend is choice. The shareholder can either keep the shares and hopes that the company will be able to use the money not paid out in a cash dividend to earn a better rate of return than the investor could with the cash dividend or the shareholder could sell some of the new shares to create their own cash dividend. The biggest benefit of a stock split or dividend is that shareholders do not generally have to pay taxes on its value.

Taxes do need to be paid if a stock dividend has a cash-dividend option, even if the shares are kept instead of the cash.

The price of a stock typically rises shortly after the announcement of a stock dividend or split. However, the price increase is the result of positive signals of favorable prospects for earnings and dividends, not a desire for stock splits or dividends per se. Without good earnings or dividends news in the next few months, the stock price will fall back to the earlier level.

A reverse stock split reduces the number of shares and increases the share price proportionately. For example, if you own 10,000 shares of a company and it declares a one for ten reverse split, you will own a total of 1,000 shares after the split. A reverse stock split has no affect on the value of what shareholders own.

Companies often reverse split their stock when they believe its price is too low to attract investors. It's usually a bad sign if a company is forced to reverse split. Companies do it to make their stock look more valuable, but in reality nothing changes. A company may also do a reverse split to avoid being de-listed.

Practice Question 1

Which form of dividends leads to the situation that shareholders have to pay taxes without receiving any cash?

A. Special dividends
B. Liquidating dividends
C. DRIPs

Correct Answer: C

Practice Question 2

A stock split will change ______.

I. P/E
II. dividend yield
III. market value of the firm
IV. stock price

Correct Answer: IV

Practice Question 3

Which of the following forms of dividends should be treated as a capital gain for tax purposes?

A. DRIPs
B. Liquidating dividends
C. Special dividends

Correct Answer: B

Practice Question 4

A 1:2 split ______

I. is a stock split.
II. is a reverse stock split.
III. means a shareholder gets half as many shares, but at twice the price.
IV. means the holder of 1 share will get an additional share.

Correct Answer: II and III

Practice Question 5

Each dollar of a firm's after-tax earnings has two (and only two) outlets, which are ______ and ______.

A. cash dividends; coupon payments
B. coupon payments; retained earnings
C. retained earnings; cash dividends

Correct Answer: C

Each dollar of a firm's after-tax earnings has two (and only two) outlets which are retained earnings and cash dividends.

Practice Question 6

SuperKleen Mops plans to split its stock two-for-one. Which of the following most likely will NOT occur?

A. Price per share will fall by half.
B. The number of shares owned by each individual investor will double.
C. Par value per share will be reduced by half.
D. Total shareholders' equity will fall by half.
E. The number of shares outstanding will double.

Correct Answer: D

Practice Question 7

A stock dividend is recorded as a ______.

A. transfer from retained earnings to equity capital
B. reduction in the par value of each share
C. transfer from capital surplus to retained earnings

Correct Answer: A

Practice Question 8

Fernley Company has declared a 3 for 1 stock split. At the close of trading just prior to going ex-dividend, Fernley was at $60 per share. At the open of trading on the ex-date, the price will be closest to ______.

A. $20
B. $40
C. $60

Correct Answer: A

At the start of trading on the ex-distribution date, there will be three times as many shares outstanding as at the close of the previous day. Assuming no significant change in the total share value, the share price should be $60/3 = $20.

Practice Question 9

Bramley Company has declared a 20% stock dividend. At the close of trading just prior to going ex-dividend, Bramley was at $50 per share. At the open of trading on the ex-date, the price will be closest to ______.

A. $40.00
B. $41.67
C. $60.00

Correct Answer: B

At the start of trading on the ex-distribution date, there will be 20% more shares outstanding as at the close of the previous day. Assuming no significant change in the total share value, the share price should be $50/1.2 = $41.67.

Practice Question 10

A cash dividend, compared to a stock dividend, would most likely result in a ______ debt/equity ratio and a ______ current ratio.

A. higher; higher
B. higher; lower
C. lower; lower

Correct Answer: B

A cash dividend would decrease stockholders' equity, increasing the debt/equity ratio. It would also reduce cash, decreasing the current ratio.

Practice Question 11

A stock dividend would most likely result in a(n) ______ debt / equity ratio and a(n) ______ current ratio.

A. unchanged; lower
B. unchanged; unchanged
C. lower; unchanged

Correct Answer: B

A stock dividend would leave both of these ratios unchanged.

Practice Question 12

Select the INCORRECT statement(s).

I. A stock dividend should decrease share price, other things being equal.
II. A stock split should reduce the firm's P/E ratio.

A. I only
B. II only
C. Both I and II are incorrect.

Correct Answer: B

A stock split will reduce the price and earnings per share proportionately, leaving the price-to-earnings ratio the same.

Practice Question 13

Barklay Franton's firm is an all-equity firm that has earnings before tax of $200,000 and 20,000 shares of stock outstanding, with each share being worth $100. Assume that you own 2,000 shares, there are no taxes, and capital markets are perfect. Assume that the firm pays no dividend. How could you transact on your own initiative to pay yourself a dividend of $5 per share?

A. Sell 20 shares
B. Sell 100 shares
C. Sell 200 shares

Correct Answer: B

The total cash flow from a $5/share dividend would be $10,000 for you. Selling shares at $100/share, you would need to sell 100 shares to generate a $10,000 cash flow.

Practice Question 14

A company in Hong Kong (where there are no taxes on dividends and capital gains) is considering either paying a special dividend or repurchasing its own shares. Shareholders of the company would have ______

A. greater wealth if the company paid a special cash dividend.
B. greater wealth if the company repurchased its shares.
C. the same wealth under either a cash dividend or share repurchase program.

Correct Answer: C

null

Practice Question 15

Each of the following transactions has the effect of reducing retained earnings except ______.

I. stock splits
II. cash dividends
III. stock dividends
IV. dividends in kind

A. I and IV
B. I only
C. I, II, III and IV

Correct Answer: B

Stock splits have no effect on retained earnings. They are simply a redistribution of the same equity of a company with a different number of outstanding shares.

Practice Question 16

You own 100 shares of ABC Corp. and DEF Inc. ABC announces a 3 for 1 stock split, whereas DEF announces a 50% stock dividend. After receiving the new shares you will have ______.

A. 200 shares of ABC and 200 shares of DEF
B. 400 shares of ABC and 200 shares of DEF
C. 300 shares of ABC and 150 shares of DEF

Correct Answer: C

The 3 for 1 split multiplies holdings by 3, and the 50% stock dividend multiplies holdings by 1.5.