C H APTER 17

DIVIDENDS AND
DIVIDEND POLICY

Barrick Gold
Courtesy of
O n May 2, 2012, Barrick Gold, the world’s
largest gold miner, headquartered
Toronto, reported a big first quarter profit of around
in
were known for paying low dividends, Barrick had
increased its dividend by 260 percent in 5 years due
to its superior earnings and operating cash flows.
US $1 billion. As a result, the company decided to Explaining dividends and dividend policy is the focus
hike its dividend by 33 percent to 20 cents US a of this chapter.
share from 15 cents US. While other gold companies

L e a r n i ng After studying this chapter, you should understand:

Ob j e c ti v e s LO1 Dividend types and how dividends are paid.
LO2 The issues surrounding dividend policy decisions.
LO3 The difference between cash and stock dividends.
LO4 Why share repurchases are an alternative to dividends.

Dividend policy is an important subject in corporate finance, and dividends are a major cash
outlay for many corporations. At first glance, it may seem obvious that a firm would always want
to give as much as possible back to its shareholders by paying dividends. It might seem equally
obvious, however, that a firm can always invest the money for its shareholders instead of paying
it out. The heart of the dividend policy question is just this: Should the firm pay out money to its
shareholders, or should the firm take that money and invest it for its shareholders?
It may seem surprising, but much research and economic logic suggest that dividend policy
doesn’t matter. In fact, it turns out that the dividend policy issue is much like the capital structure
question. The important elements are not difficult to identify, but the interactions between those
elements are complex and no easy answer exists.
Dividend policy is controversial. Many implausible reasons are given for why dividend policy
might be important, and many of the claims made about dividend policy are economically illogi-
cal. Even so, in the real world of corporate finance, determining the most appropriate dividend
policy is considered an important issue. It could be that financial managers who worry about
dividend policy are wasting time, but it could be true that we are missing something important
in our discussions.
In part, all discussions of dividends are plagued by the “two-handed lawyer” problem. Former
U.S. President Harry S. Truman, while discussing the legal implications of a possible presidential
decision, asked his staff to set up a meeting with a lawyer. Supposedly, Truman said, “But I don’t
want one of those two-handed lawyers.” When asked what a two-handed lawyer was, he replied,
“You know, a lawyer who says, ‘On the one hand I recommend you do so and so because of
the following reasons, but on the other hand I recommend that you don’t do it because of these
other reasons.’ ”
Unfortunately, any sensible treatment of dividend policy appears to be written by a two-
handed lawyer (or, in fairness, several two-handed financial economists). On the one hand, there
are many good reasons for corporations to pay high dividends; on the other hand, there are also
many good reasons to pay low dividends or no dividends.
We cover three broad topics that relate to dividends and dividend policy in this chapter. First,
we describe the various kinds of dividends and how dividends are paid. Second, we consider an

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 Chapter 17: Dividends and Dividend Policy 491

idealized case in which dividend policy doesn’t matter. We then discuss the limitations of this
case and present some practical arguments for both high- and low-dividend payouts. Finally, we
conclude the chapter by looking at some strategies that corporations might employ to implement
a dividend policy.

17.1 Cash Dividends and Dividend Payment

dividend The term dividend usually refers to cash paid out of earnings. If a payment is made from sources
Payment made out of a firm’s other than current or accumulated retained earnings, the term distribution rather than dividend
earnings to its owners, either
is sometimes used. However, it is acceptable to refer to a distribution from earnings as a dividend
in the form of cash or stock.
and a distribution from capital as a liquidating dividend. More generally, any direct payment by
distribution the corporation to the shareholders may be considered a dividend or a part of dividend policy.
Payment made by a firm to Figure 17.1 shows how the dividend decision is part of distributing the firm’s cash flow over dif-
its owners from sources other
than current or accumulated
ferent uses.
earnings. Dividends come in several different forms. The basic types of cash dividends are:
1. Regular cash dividends.
2. Extra dividends.
3. Special dividends.
4. Liquidating dividends.
Later in the chapter, we discuss dividends that are paid in stock instead of cash, and we also con-
sider an alternative to cash dividends, stock repurchase.

Cash Dividends
regular cash dividend The most common type of dividend is a cash dividend. Commonly, public companies pay regular
Cash payment made by a cash dividends four times a year. As the name suggests, these are cash payments made directly to
firm to its owners in the
shareholders, and they are made in the regular course of business. In other words, management
normal course of business,
usually made four times a sees nothing unusual about the dividend and no reason it won’t be continued.
year. Sometimes firms pay a regular cash dividend and an extra cash dividend. By calling part of the
payment extra, management is indicating it may or may not be repeated in the future. A special divi-
dend is similar, but the name usually indicates that this dividend is viewed as a truly unusual or one-
time event and won’t be repeated. For example, in May 2010, Sears Canada paid a special dividend
of $3.50 per share. The total payout of $368 million was the largest one-time corporate dividend in
history. Finally, a liquidating dividend usually means that some or all of the business has been liqui-
dated, that is, sold off. Debt covenants, discussed in Chapter 7, offer the firm’s creditors protection
against liquidating dividends that could violate their prior claim against assets and cash flows.
However it is labelled, a cash dividend payment reduces corporate cash and retained earnings,
except in the case of a liquidating dividend (where capital may be reduced).

FIGURE 17.1

Distribution of
Internal New
corporate cash flow cash flow financing

Total
cash flow

New investments To Existing

and acquisitions shareholders operations

Stock Cash
repurchases dividends

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 492 Part 6: Cost of Capital and Long-Term Financial Policy

Standard Method of Cash Dividend Payment

The decision to pay a dividend rests in the hands of the board of directors of the corporation.
When a dividend has been declared, it becomes a debt of the firm and cannot be rescinded eas-
ily. Sometime after it has been declared, a dividend is distributed to all shareholders as of some
specific date.
Commonly, the amount of the cash dividend is expressed in dollars per share (dividends per
share). As we have seen in other chapters, it is also expressed as a percentage of the market price
(the dividend yield) or as a percentage of earnings per share (the dividend payout).

Dividend Payment: A Chronology

The mechanics of a dividend payment can be illustrated by the example in Figure 17.2 and the
following description:
declaration date 1. Declaration date. On January 15, the board of directors passes a resolution to pay a divi-
Date on which the board of dend of $1 per share on February 16 to all holders of record as of January 30.
directors passes a resolution
to pay a dividend. 2. Ex-dividend date. To make sure that dividend cheques go to the right people, brokerage
firms and stock exchanges establish an ex-dividend date. This date is two business days be-
ex-dividend date fore the date of record (discussed next). If you buy the stock before this date, then you are
Date two business days
before the date of record,
entitled to the dividend. If you buy on this date or after, then the previous owner gets it.
establishing those individuals The ex-dividend date convention removes any ambiguity about who is entitled to the div-
entitled to a dividend. idend. Since the dividend is valuable, the stock price is affected when it goes “ex.” We exam-
ine this effect later.
In Figure 17.2, Wednesday, January 28, is the ex-dividend date. Before this date, the stock
is said to trade “with dividend” or “cum dividend.” Afterwards the stock trades “ex dividend.”
date of record 3. Date of record. Based on its records, the corporation prepares a list on January 30 of all in-
Date on which holders of dividuals believed to be shareholders as of this date. These are the holders of record and Janu-
record are designated to
ary 30 is the date of record. The word believed is important here. If you buy the stock just
receive a dividend.
before this date, the corporation’s records may not reflect that fact. Without some modifica-
tion, some of the dividend cheques would go to the wrong people. This is the reason for the
ex-dividend day convention.
date of payment 4. Date of payment. The dividends are paid on February 16.
Date of the dividend
payment.
More on the Ex-Dividend Date
The ex-dividend date is important and is a common source of confusion. We examine what hap-
pens to the stock when it goes ex, meaning that the ex-dividend date arrives. To illustrate, suppose
we have a stock that sells for $10 per share. The board of directors declares a dividend of $1 per
share, and the record date is Thursday, June 14. Based on our previous discussion, we know that
the ex date will be two business (not calendar) days earlier on Tuesday, June 12.

FIGURE 17.2

Procedure for dividend Days

payment Thursday, Wednesday, Friday, Monday,
January January January February
15 28 30 16
Declaration Ex-dividend Record Payment
date date date date

1. Declaration date: The board of directors declares a payment of dividends.

2. Ex-dividend date: A share of stock goes ex dividend on the date the seller is entitled to keep the dividend; under TSX rules, shares are traded ex
dividend on and after the second business day before the record date.
3. Record date: The declared dividends are distributable to shareholders of record on a specific date.
4. Payment date: The dividend payment date.

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 Chapter 17: Dividends and Dividend Policy 493

FIGURE 17.3

Price behaviour Ex-date

around ex-dividend Price = $10
–t ••• –2 –1 0 +1 +2 ••• t
date for a $1 cash
$1 is the ex-dividend price drop
dividend
Price = $9

The stock price will fall by the amount of the dividend on the ex date (time 0). If the dividend is $1 per share, the price will be equal to
$10 - $1 = $9 on the ex date:
Before ex date (-1) dividend = 0 Price = $10
Ex-date (0) dividend = $1 Price = $9

If you buy the stock on Monday, June 11, right as the market closes, you’ll get the $1 dividend
because the stock is trading cum dividend. If you wait and buy it right as the market opens on
Tuesday, you won’t get the $1 dividend. What will happen to the value of the stock overnight?
If you think about it, the stock is obviously worth about $1 less on Tuesday morning, so its
price will drop by this amount between close of business on Monday and the Tuesday opening. In
general, we expect the value of a share of stock to go down by about the dividend amount when
the stock goes ex dividend. The key word here is about. Since dividends are taxed, the actual price
drop might be closer to some measure of the after-tax value of the dividend. Determining this
value is complicated because of the different tax rates and tax rules that apply for different buyers.
The series of events described here is illustrated in Figure 17.3.
The amount of the price drop is a matter for empirical investigation. Researchers have argued
that, due to personal taxes, the stock price should drop by less than the dividend.1 For example,
consider the case with no capital gains taxes. On the day before a stock goes ex dividend, share-
holders must decide either to buy the stock immediately and pay tax on the forthcoming dividend,
or to buy the stock tomorrow, thereby missing the dividend. If all investors are in a 30 percent
bracket for dividends and the quarterly dividend is $1, the stock price should fall by $.70 on the
ex-dividend date. If the stock price falls by this amount on the ex-dividend date, then purchasers
receive the same return from either strategy.

E X A MP L E 17 .1 : “Ex” Marks the Day

The board of directors of Divided Airlines has declared a The ex date is two business days before the date of re-
dividend of $2.50 per share payable on Tuesday, May 30, cord, Tuesday, May 9, so the stock will go ex on Friday,
to shareholders of record as of Tuesday, May 9. Cal Icon May 5. Cal buys the stock on Tuesday, May 2, so Cal has
buys 100 shares of Divided on Tuesday, May 2, for $150 purchased the stock cum dividend. In other words, Cal gets
per share. What is the ex date? Describe the events that will $2.50 × 100 = $250 in dividends. The payment is made on
occur with regard to the cash dividend and the stock price. Tuesday, May 30. When the stock does go ex on Friday, its
value drops overnight by about $2.50 per share (or maybe
a little less due to personal taxes).

Concept Questions

1. What are the different types of cash dividends?

2. What are the mechanics of the cash dividend payment?
3. How should the price of a stock change when it goes ex dividend?

1
The original argument was advanced and tested for the United States by E. Elton and M. Gruber, “Marginal Stockholder
Tax Rates and the Clientele Effect,” Review of Economics and Statistics 52 (February 1970). Canadian evidence (discussed
briefly later in this chapter) is from J. Lakonishok and T. Vermaelen, “Tax Reform and Ex-Dividend Day Behavior,” Jour-
nal of Finance 38 (September 1983) pp. 1157–80, and L. D. Booth and D. J. Johnston, “The Ex-Dividend Day Behavior of
Canadian Stock Prices: Tax Changes and Clientele Effects,” Journal of Finance 39 (June 1984), pp. 457–76.

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 494 Part 6: Cost of Capital and Long-Term Financial Policy

17.2 Does Dividend Policy Matter?

To decide whether or not dividend policy matters, we first have to define what we mean by divi-
dend policy. All other things being the same, of course dividends matter. Dividends are paid in
cash, and cash is something that everybody likes. The question we are discussing here is whether
the firm should pay out cash now or invest the cash and pay it out later. Dividend policy, therefore,
is the time pattern of dividend payout. In particular, should the firm pay out a large percentage of
its earnings now or a small (or even zero) percentage? This is the dividend policy question.

An Illustration of the Irrelevance of Dividend Policy

A powerful argument can be made that dividend policy does not matter. We illustrate this by con-
sidering the simple case of Wharton Corporation. Wharton is an all-equity firm that has existed
for 10 years. The current financial managers plan to dissolve the firm in two years. The total cash
flows that the firm will generate, including the proceeds from liquidation, are $10,000 in each of
the next two years.

CURRENT POLICY: DIVIDENDS SET EQUAL TO CASH FLOW At the present

time, dividends at each date are set equal to the cash flow of $10,000. There are 100 shares out-
standing, so the dividend per share will be $100. In Chapter 8, we stated that the value of the stock
is equal to the present value of the future dividends. Assuming a 10 percent required return, the
value of a share of stock today, P0, is:
P0 = D1/(1 + R)1 + D2/(1 + R)2
= $100/1.10 + $100/1.21 = $173.55
The firm as a whole is thus worth 100 × $173.55 = $17,355.
Several members of the board of Wharton have expressed dissatisfaction with the current
dividend policy and have asked you to analyze an alternative policy.

ALTERNATIVE POLICY: INITIAL DIVIDEND IS GREATER THAN CASH

FLOW Another policy is for the firm to pay a dividend of $110 per share on the first date,
which is, of course, a total dividend of $11,000. Because the cash flow is only $10,000, an extra
$1,000 must somehow be raised. One way to do it is to issue $1,000 of bonds or stock at Date 1.
Assume that stock is issued. The new shareholders desire enough cash flow at Date 2 so that they
earn the required 10 percent return on their Date 1 investment.2
What is the value of the firm with this new dividend policy? The new shareholders invest $1,000.
They require a 10 percent return, so they demand $1,000 × 1.10 = $1,100 of the Date 2 cash flow,
leaving only $8,900 to the old shareholders. The dividends to the old shareholders would be:
Date 1 Date 2
Aggregate dividends to old shareholders $11,000 $8,900
Dividends per share 110 89

The present value of the dividends per share is therefore:

P0 = $110/1.10 + $89/1.102 = $173.55
This is the same present value as we had before.
The value of the stock is not affected by this switch in dividend policy even though we had
to sell some new stock just to finance the dividend. In fact, no matter what pattern of dividend
payout the firm chooses, the value of the stock is always the same in this example. In other words,
for the Wharton Corporation, dividend policy makes no difference. The reason is simple: Any
increase in a dividend at some point in time is exactly offset by a decrease somewhere else, so the
net effect, once we account for time value, is zero.

HOMEMADE DIVIDENDS There is an alternative and perhaps more intuitively appeal-

ing explanation about why dividend policy doesn’t matter in our example. Suppose individual
investor X prefers dividends per share of $100 at both Dates 1 and 2. Would he or she be disap-

2
The same results would occur after an issue of bonds, though the arguments would be less easily presented.

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 Chapter 17: Dividends and Dividend Policy 495

pointed when informed that the firm’s management is adopting the alternative dividend policy
(dividends of $110 and $89 in the two dates, respectively)? Not necessarily, because the investor
could easily reinvest the $10 of unneeded funds received on Date 1 by buying more Wharton
stock. At 10 percent, this investment grows to $11 at Date 2. Thus, the investor would receive the
desired net cash flow of $110 - 10 = $100 at Date 1 and $89 + 11 = $100 at Date 2.
Conversely, imagine Investor Z, preferring $110 of cash flow at Date 1 and $89 of cash flow at
Date 2, finds that management pays dividends of $100 at both Dates 1 and 2. This investor can sim-
ply sell $10 worth of stock to boost his or her total cash at Date 1 to $110. Because this investment
returns 10 percent, Investor Z gives up $11 at Date 2 ($10 × 1.1), leaving him with $100 - 11 = $89.
Our two investors are able to transform the corporation’s dividend policy into a different policy
homemade dividends by buying or selling on their own. The result is that investors are able to create homemade divi-
Idea that individual investors dends. This means dissatisfied shareholders can alter the firm’s dividend policy to suit themselves.
can undo corporate dividend
As a result, there is no particular advantage to any one dividend policy that the firm might choose.
policy by reinvesting
dividends or selling shares Many corporations actually assist their shareholders in creating homemade dividend policies
of stock. by offering automatic dividend reinvestment plans (ADPs or DRIPs). As the name suggests, with
such a plan, shareholders have the option of automatically reinvesting some or all of their cash
dividends in shares of stock.
Under a new issue dividend reinvestment plan, investors buy new stock issued by the firm.
They may receive a small discount on the stock, usually under 5 percent, or be able to buy without
a broker’s commission. This makes dividend reinvestment very attractive to investors who do not
need cash flow from dividends. Since the discount or lower commission compares favourably
with issue costs for new stock discussed in Chapter 15, dividend reinvestment plans are popular
with large companies like BCE that periodically seek new common stock.3
Investment dealers also use financial engineering to create homemade dividends (or homemade
stripped common shares capital gains). Called stripped common shares, these vehicles entitle holders to receive either all
Common stock on which the dividends from one or a group of well-known companies or an installment receipt that pack-
dividends and capital gains
ages any capital gain in the form of a call option. The option gives the investor the right to buy the
are repackaged and sold
separately. underlying shares at a fixed price and so it is valuable if the shares appreciate beyond that price.

A TEST Our discussion to this point can be summarized by considering the following true/
false test questions:
1. True or false: Dividends are irrelevant.
2. True or false: Dividend policy is irrelevant.
The first statement is surely false, and the reason follows from common sense. Clearly, investors
prefer higher dividends to lower dividends at any single date if the dividend level is held constant
at every other date. To be more precise regarding the first question, if the dividend per share at
a given date is raised while the dividend per share at each other date is held constant, the stock
price rises. The reason is that the present value of the future dividends must go up if this occurs.
This action can be accomplished by management decisions that improve productivity, increase
tax savings, strengthen product marketing, or otherwise improve cash flow.
The second statement is true, at least in the simple case we have been examining. Dividend
policy by itself cannot raise the dividend at one date while keeping it the same at all other dates.
Rather, dividend policy merely establishes the trade-off between dividends at one date and divi-
dends at another date. Once we allow for time value, the present value of the dividend stream is
unchanged. Thus, in this simple world, dividend policy does not matter, because managers choos-
ing either to raise or to lower the current dividend do not affect the current value of their firm.
However, we have ignored several real-world factors that might lead us to change our minds; we
pursue some of these in subsequent sections.

Concept Questions

1. How can an investor create a homemade dividend?

2. Are dividends irrelevant?

3
Reinvested dividends are still taxable.

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 496 Part 6: Cost of Capital and Long-Term Financial Policy

17.3 Real-World Factors Favouring a Low Payout

The example we used to illustrate the irrelevance of dividend policy ignored taxes and flotation
costs. In other words, we assumed perfect capital markets in which these and other imperfections
did not exist. In this section, we see that these factors might lead us to prefer a low-dividend payout.

Taxes
The logic we used to establish that dividend policy does not affect firm value ignored the real-
world complication of taxes. In Canada, both dividends and capital gains are taxed at effective
rates less than the marginal tax rates.
For dividends, we showed in Chapter 2 that individual investors face a lower tax rate due to
the dividend tax credit. Capital gains in the hands of individuals are taxed at 50 percent of the
marginal tax rate. Since taxation only occurs when capital gains are realized, capital gains are very
lightly taxed in Canada. On balance, capital gains are subject to lower taxes than dividends.
A firm that adopts a low-dividend payout reinvests the money instead of paying it out. This
reinvestment increases the value of the firm and of the equity. All other things being equal, the net
effect is that the capital gains portion of the return is higher in the future. So, the fact that capital
gains are taxed favourably may lead us to prefer this approach.
This tax disadvantage of dividends doesn’t necessarily lead to a policy of paying no dividends.
Suppose a firm has some excess cash after selecting all positive NPV projects. The firm might
consider the following alternatives to a dividend:
1. Select additional capital budgeting projects. Because the firm has taken all the available posi-
tive NPV projects already, it must invest its excess cash in negative NPV projects. This is
clearly a policy at variance with the principles of corporate finance and represents an exam-
ple of the agency costs of equity introduced in Chapter 1. Still, research suggests that some
companies are guilty of doing this.4 It is frequently argued that managers who adopt nega-
tive NPV projects are ripe for takeover, leveraged buyouts, and proxy fights.
2. Repurchase shares. A firm may rid itself of excess cash by repurchasing shares of stock. In
both the United States and Canada, investors can treat profits on repurchased stock in pub-
lic companies as capital gains and pay somewhat lower taxes than they would if the cash
were distributed as a dividend.
3. Acquire other companies. To avoid the payment of dividends, a firm might use excess cash to
acquire another company. This strategy has the advantage of acquiring profitable assets.
However, a firm often incurs heavy costs when it embarks on an acquisition program. In ad-
dition, acquisitions are invariably made above the market price. Premiums of 20 to 80 per-
cent are not uncommon. Because of this, a number of researchers have argued that mergers
are not generally profitable to the acquiring company, even when firms are merged for a
valid business purpose.5 Therefore, a company making an acquisition merely to avoid a divi-
dend is unlikely to succeed.
4. Purchase financial assets. The strategy of purchasing financial assets in lieu of a dividend
payment can be illustrated with the following example.
Suppose the Regional Electric Company has $1,000 of extra cash. It can retain the cash and invest
it in Treasury bills yielding 8 percent, or it can pay the cash to shareholders as a dividend. Share-
holders can also invest in Treasury bills with the same yield. Suppose, realistically, that the tax
rate is 44 percent on ordinary income like interest on Treasury bills for both the company and
individual investors and the individual tax rate on dividends is 30 percent. What is the amount of
cash that investors have after five years under each policy?
Dividends paid now:
If dividends are paid now, shareholders will receive $1,000 before taxes, or $1,000 × (1 - .30) =

4
M. C. Jensen, “Agency Costs of Free Cash Flows, Corporate Finance and Takeovers,” American Economic Review, May
1986, pp. 323–29.
5
The original hypothesis comes from R. Roll, “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business
(1986). Chapter 23 presents some Canadian examples.

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 Chapter 17: Dividends and Dividend Policy 497

$700 after taxes. This is the amount they invest. If the rate on T-bills is 8 percent, before taxes, then
the after-tax return is 8% × (1 - .44) = 4.48% per year. Thus, in five years, the shareholders have:
$700 × (1 + 0.0448)5 = $871.49
Company retains cash:
If Regional Electric Company retains the cash, invests in Treasury bills, and pays out the proceeds
five years from now, then $1,000 will be invested today. However, since the corporate tax rate is
44 percent, the after-tax return from the T-bills will be 8% × (1 - .44) = 4.48% per year. In five
years, the investment will be worth:
$1,000 × (1 + 0.0448)5 = $1,244.99
If this amount is then paid out as a dividend, after taxes the shareholders receive:
$1,244.99 × (1 - .30) = $871.49
In this case, dividends are the same after taxes whether the firm pays them now or later after
investing in Treasury bills. The reason is that the firm invests exactly as profitably as the share-
holders do on an after-tax basis.
This example shows that for a firm with extra cash, the dividend payout decision depends on
personal and corporate tax rates. All other things the same, when personal tax rates are higher
than corporate tax rates, a firm has an incentive to reduce dividend payouts. This would have
occurred if we changed our example to have the firm invest in preferred stock instead of T-bills.
(Recall from Chapter 8 that corporations enjoy a 100 percent exclusion of dividends from tax-
able income.) However, if personal tax rates on dividends are lower than corporate tax rates (for
investors in lower tax brackets or tax-exempt investors), a firm has an incentive to pay out any
excess cash in dividends.
These examples show that dividend policy is not always irrelevant when we consider personal
and corporate taxes. To continue the discussion, we go back to the different tax treatment of divi-
dends and capital gains.

EXPECTED RETURN, DIVIDENDS, AND PERSONAL TAXES We illustrate the

effect of personal taxes by considering a situation where dividends are taxed and capital gains are
not taxed—a scenario that is not unrealistic for many Canadian individual investors. We show
that a firm that provides more return in the form of dividends has a lower value (or a higher pre-
tax required return) than one whose return is in the form of untaxed capital gains.
Suppose every shareholder is in the top tax bracket (tax rate on dividends of 30 percent) and
is considering the stocks of Firm G and Firm D. Firm G pays no dividend, and Firm D pays a
dividend. The current price of the stock of Firm G is $100, and next year’s price is expected to be
$120. The shareholder in Firm G thus expects a $20 capital gain. With no dividend, the return is
$20/$100 = 20%. If capital gains are not taxed, the pre-tax and after-tax returns must be the same.6
Suppose the stock of Firm D is expected to pay a $20 dividend next year. If the stocks of Firm G
and Firm D are equally risky, the market prices must be set so that their after-tax expected returns
are equal. The after-tax return on Firm D thus has to be 20 percent.
What will be the price of stock in Firm D? The after-tax dividend is $20 × (1 - .30) = $14, so
our investor has a total of $114 after taxes. At a 20 percent required rate of return (after taxes), the
present value of this after-tax amount is:
Present value = $114/1.20 = $95.00
The market price of the stock in Firm D thus must be $95.00.

Some Evidence on Dividends and Taxes in Canada

Is our example showing higher pre-tax returns for stocks that pay dividends realistic for Canadian
capital markets? Since tax laws change from budget to budget, we have to exercise caution in inter-
preting research results. Before 1972, capital gains were untaxed in Canada (as in our simplified

6
Under current tax law, if the shareholder in Firm G does not sell the shares for a gain, it will be an unrealized capital
gain, which is not taxed.

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 498 Part 6: Cost of Capital and Long-Term Financial Policy

example). Research suggests stocks that paid dividends had higher pre-tax returns prior to 1972.
From 1972 to 1977, the same study detected no difference in pre-tax returns.7
In 1985, the lifetime exemption on capital gains was introduced. Recent research found that
investors anticipated this tax break for capital gains and bid up the prices of stocks with low divi-
dend yields. Firms responded by lowering their dividend payouts. This all ended in 1994 when the
federal budget ended the capital gains exemption.8 In 2000, the federal budget lowered the taxable
portion of capital gains from 75 to 50 percent. In November 2005, the government of Canada ini-
tiated changes with the goal of making dividend-paying stocks more attractive relative to income
trusts by increasing the gross-up and the dividend tax credit.9 We suspect that from the viewpoint
of individual investors, higher dividends require larger pre-tax returns.
Another way of measuring the effective tax rates on dividends and capital gains in Canada is to
look at ex-dividend day price drops. We showed earlier that, ignoring taxes, a stock price should
drop by the amount of the dividend when it goes ex dividend. This is because the price drop
offsets what investors lose by waiting to buy the stock until it goes ex dividend. If dividends are
taxed and capital gains are tax free, the price drop should be lower, equal to the after-tax value of
the dividend. However, if gains are taxed too, the price drop needs to be adjusted for the gains tax.
An investor who waits for the stock to go ex dividend buys at a lower price and hence has a larger
capital gain when the stock is sold later.
All this allowed researchers to infer tax rates from ex-dividend day behaviour. One study con-
cludes that marginal investors who set prices are taxed more heavily on dividends than on capital
gains.10 This supports our argument: Individual investors likely look for higher pre-tax returns on
dividend paying stocks.

Flotation Costs
In our example illustrating that dividend policy doesn’t matter, we saw that the firm could sell
some new stock if necessary to pay a dividend. As we mentioned in Chapter 15, selling new stock
can be very expensive. If we include flotation costs in our argument, then we find that the value of
the stock decreases if we sell new stock.
More generally, imagine two firms that are identical in every way except that one pays out a
greater percentage of its cash flow in the form of dividends. Since the other firm plows back more,
its equity grows faster. If these two firms are to remain identical, the one with the higher payout
has to sell some stock periodically to catch up. Since this is expensive, a firm might be inclined to
have a low payout.

Dividend Restrictions
In some cases, a corporation may face restrictions on its ability to pay dividends. For example,
as we discussed in Chapter 7, a common feature of a bond indenture is a covenant prohibiting
dividend payments above some level.

Concept Questions

1. What are the tax benefits of low dividends?

2. Why do flotation costs favour a low payout?

7
I. G. Morgan, “Dividends and Stock Price Behaviour in Canada,” Journal of Business Administration 12 (Fall 1989).
8
B. Amoako-adu, M. Rashid, and M. Stebbins, “Capital Gains Tax and Equity Values: Empirical Test of Stock Price Re-
action to the Introduction and Reduction of Capital Gains Tax Exemption, Journal of Banking and Finance 16 (1992),
pp. 275–87; F. Adjaoud and D. Zeghal, “Taxation and Dividend Policy in Canada: New Evidence,” FINECO (2nd Se-
mester) 1993, pp. 141–54.
9
We discuss these tax changes in detail in Chapter 2.
10
L. Booth and D. Johnston, “Ex-Dividend Day Behavior.” Their research also showed that interlisted stocks, traded on
exchanges in both the United States and Canada, tended to be priced by U.S. investors and not be affected by Canadian
tax changes. J. Lakonishok and T. Vermaelen, “Tax Reforms and Ex-Dividend Day Behavior,” Journal of Finance, Sep-
tember 1983, pp. 1157–58, gives a competing explanation in terms of tax arbitrage by short-term traders.

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 Chapter 17: Dividends and Dividend Policy 499

17.4 Real-World Factors Favouring a High Payout

In this section, we consider reasons a firm might pay its shareholders higher dividends even if it
means the firm must issue more shares of stock to finance the dividend payments.
In a classic textbook, Benjamin Graham and David Dodd, have argued that firms should gen-
erally have high-dividend payouts because:
1. “The discounted value of near dividends is higher than the present worth of distant
dividends.”
2. Between “two companies with the same general earning power and same general position in
an industry, the one paying the larger dividend will almost always sell at a higher price.”11
Two factors favouring a high-dividend payout have been mentioned frequently by proponents of
this view: the desire for current income and the resolution of uncertainty.

Desire for Current Income

It has been argued that many individuals desire current income. The classic example is the group
of retired people and others living on fixed incomes, the proverbial “widows and orphans.” It is
argued that this group is willing to pay a premium to get a higher dividend yield. If this is true, it
lends support to the second claim by Graham, Dodd, and Cottle.
It is easy to see, however, that this argument is not relevant in our simple case. An individual
preferring high current cash flow but holding low-dividend securities could easily sell shares to
provide the necessary funds. Similarly, an individual desiring a low current cash flow but holding
high-dividend securities can just reinvest the dividend. This is just our homemade dividend argu-
ment again. Thus, in a world of no transaction costs, a high current dividend policy would be of
no value to the shareholder.
The current income argument may have relevance in the real world. Here the sale of low-
dividend stocks would involve brokerage fees and other transaction costs. Such a sale might
also trigger capital gains taxes. These direct cash expenses could be avoided by an investment in
high-dividend securities. In addition, the expenditure of the shareholder’s own time when selling
securities and the natural (but not necessarily rational) fear of consuming out of principal might
further lead many investors to buy high-dividend securities.
Even so, to put this argument in perspective, remember that financial intermediaries such as
mutual funds can (and do) perform these repackaging transactions for individuals at very low
cost. Such intermediaries could buy low-dividend stocks, and, by a controlled policy of realizing
gains, they could pay their investors at a higher rate.

Uncertainty Resolution
We have just pointed out that investors with substantial current consumption needs prefer high
current dividends. In another classic treatment, the late Professor Myron Gordon argued that a
high-dividend policy also benefits shareholders because it resolves uncertainty.12
According to Gordon, investors price a security by forecasting and discounting future divi-
dends. Gordon then argues that forecasts of dividends to be received in the distant future have
greater uncertainty than do forecasts of near-term dividends. Because investors dislike uncer-
tainty, the stock price should be low for those companies that pay small dividends now in order
to remit higher dividends later.
Gordon’s argument is essentially a “bird-in-hand” story. A $1 dividend in a shareholder’s
pocket is somehow worth more than that same $1 in a bank account held by the corporation. By
now, you should see the problem with this argument. A shareholder can create a bird in hand very
easily just by selling some stock.

11
Benjamin Graham & David Dodd (2008) Security Analysis: Sixth Edition, Foreword by Warren Buffett, McGraw-Hill
Professional.
12
M. Gordon, The Investment, Financing and Valuation of the Corporation (Homewood, IL: Richard D. Irwin, 1961).

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 500 Part 6: Cost of Capital and Long-Term Financial Policy

Tax and Legal Benefits from High Dividends

Earlier, we saw that dividends were taxed more heavily than capital gains for individual investors.
This fact is a powerful argument for a low payout. However, a number of other investors do not
receive unfavourable tax treatment from holding high-dividend yield, rather than low-dividend
yield, securities.

CORPORATE INVESTORS A significant tax break on dividends occurs when a corpora-

tion owns stock in another corporation. A corporate shareholder receiving either common or
preferred dividends is granted a 100 percent dividend exclusion.13 Since the 100 percent exclusion
does not apply to capital gains, this group is taxed unfavourably on capital gains.
As a result of the dividend exclusion, high-dividend, low capital gains stocks may be more
appropriate for corporations to hold. As we discuss elsewhere, this is why corporations hold a
substantial percentage of the outstanding preferred stock in the economy. This tax advantage of
dividends also leads some corporations to hold high-yielding stocks instead of long-term bonds
because there is no similar tax exclusion of interest payments to corporate bondholders.

TAX-EXEMPT INVESTORS We have pointed out both the tax advantages and disadvan-
tages of a low-dividend payout. Of course, this discussion is irrelevant to those in zero tax brack-
ets. This group includes some of the largest investors in the economy, such as pension funds,
endowment funds, and trust funds.
There are some legal reasons for large institutions to favour high-dividend yields: First, insti-
tutions such as pension funds and trust funds are often set up to manage money for the benefit
of others. The managers of such institutions have a fiduciary responsibility to invest the money
prudently. It has been considered imprudent in courts of law to buy stock in companies with no
established dividend record.
Second, institutions such as university endowment funds and trust funds are frequently
prohibited from spending any of the principal. Such institutions might, therefore, prefer high-
dividend yield stocks so they have some ability to spend. Like widows and orphans, this group
thus prefers current income. Unlike widows and orphans, in terms of the amount of stock owned,
this group is very large and its market share is expanding rapidly.

Conclusion
Overall, individual investors (for whatever reason) may have a desire for current income and may
thus be willing to pay the dividend tax. In addition, some very large investors such as corporations
and tax-free institutions may have a very strong preference for high-dividend payouts.

Concept Questions

1. Why might some individual investors favour a high-dividend payout?

2. Why might some non-individual investors prefer a high-dividend payout?

17.5 A Resolution of Real-World Factors?

In the previous sections, we presented some factors that favour a low-dividend policy and others
that favour high dividends. In this section, we discuss two important concepts related to divi-
dends and dividend policy: the information content of dividends and the clientele effect. The first
topic illustrates both the importance of dividends in general and the importance of distinguishing
between dividends and dividend policy. The second topic suggests that, despite the many real-
world considerations we have discussed, the dividend payout ratio may not be as important as we
originally imagined.

13
For preferred stock, we assume the issuer has elected to pay the refundable withholding tax on preferred dividends.

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 Chapter 17: Dividends and Dividend Policy 501

Information Content of Dividends

To begin, we quickly review some of our earlier discussion. Previously, we examined three differ-
ent positions on dividends:
1. Based on the homemade dividend argument, dividend policy is irrelevant.
2. Because of tax effects for individual investors and new issues costs, a low-dividend policy
is the best.
3. Because of the desire for current income and related factors, a high-dividend policy is the
best.
If you wanted to decide which of these positions is the right one, an obvious way to get started
would be to look at what happens to stock prices when companies announce dividend changes.
You would find with some consistency that stock prices rise when the current dividend is unex-
pectedly increased, and they generally fall when the dividend is unexpectedly decreased. What
does this imply about any of the three positions just stated?
At first glance, the behaviour we describe seems consistent with the third position and incon-
sistent with the other two. In fact, many writers have argued this. If stock prices rise on dividend
increases and fall on dividend decreases, isn’t the market saying it approves of higher dividends?
Other authors have pointed out that this observation doesn’t really tell us much about dividend
policy. Everyone agrees that dividends are important, all other things being equal. Companies
only cut dividends with great reluctance. Thus, a dividend cut is often a signal that the firm is
in trouble.
More to the point, a dividend cut is usually not a voluntary, planned change in dividend policy.
Instead, it usually signals that management does not think the current dividend policy can be
maintained. As a result, expectations of future dividends should generally be revised downward.
The present value of expected future dividends falls and so does the stock price.
In this case, the stock price declines following a dividend cut because future dividends are
generally lower, not because the firm changes the percentage of its earnings it will pay out in the
form of dividends.

Dividend Signalling in Practice

To give a particularly dramatic example, consider what happened to Perpetual Energy Inc., a
natural gas-focused Canadian Corporation, on October 19, 2011. A dramatic decrease in natural
gas prices made it difficult for the company to continue dividend payment. This was shocking
news to the shareholders and the share price lost about one-third of its market value in a single
day at the time of announcement. Of course, the phenomenon of a stock price decrease in the
face of a dividend cut is not restricted to Canada. In February 2011, bookseller Barnes and Noble
announced that it was suspending its $1 per share annual dividend in order to invest in digital
products. In response, the stock price declined by around 14 percent.
In a similar vein, an unexpected increase in the dividend or dividend initiation signals good
news. Management raises the dividend only when future earnings, cash flow, and general pros-
pects are expected to rise enough so that the dividend does not have to be cut later. A dividend
increase is management’s signal to the market that the firm is expected to do well. The stock reacts
favourably because expectations of future dividends are revised upward, not because the firm has
increased its payout. Since the firm has to come up with cash to pay dividends, this kind of signal
is more convincing than calling a press conference to announce good earnings prospects. For
example, Apple Inc. announced that it was planning to resume the payment of dividends in 2012,
which was a stellar year for the company.
Management behaviour is consistent with the notion of dividend signalling. In 1989, for exam-
ple, the Bank of Montreal’s earnings per share dropped from $4.89 the previous year to $.04 due to
increased loan loss provisions for LDC debt. Yet the annual dividend was increased slightly from
$2.00 to $2.12 per share. The payout ratio skyrocketed to 5300 percent ($2.12/$.04). Management
signalled the market that earnings would recover in 1990, which they did. Investors turned to
the idea of dividend signalling when evaluating bank stocks in the crash of 2008 and early 2009.
Discounting the fear of bank dividend cuts, in February 2009, Sherry Cooper, Chief Economist,

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 502 Part 6: Cost of Capital and Long-Term Financial Policy

BMO Capital Markets noted that “aside from the National Bank, none of the other five Canadian
banks have cut their dividend since the Great Depression.”14
Generally, the stock price reacts to the dividend change. The reaction can be attributed to
changes in the amount of future dividends, not necessarily a change in dividend payout pol-
information content effect icy. This signal is called the information content effect of the dividend. The fact that dividend
The market’s reaction to a changes convey information about the firm to the market makes it difficult to interpret the effect
change in corporate dividend
of dividend policy of the firm.
payout.

The Clientele Effect

In our earlier discussion, we saw that some groups (wealthy individuals, for example) have an
incentive to pursue low-payout (or zero-payout) stocks. Other groups (corporations, for example)
have an incentive to pursue high-payout stocks. Companies with high payouts thus attract one
group and low-payout companies attract another.
Table 17.1 shows the dividends paid by the 15 largest Canadian companies in terms of market
capitalization. In April 2012, mining stocks such as Potash Corp. and oil and gas stocks like Sun-
cor Energy paid low dividends. Banks and utilities paid relatively high dividends.
Groups of investors attracted to different payouts are called clienteles, and what we have
clientele effect described is a clientele effect. The clientele effect argument states that different groups of invest-
Stocks attract particular ors desire different levels of dividends. When a firm chooses a particular dividend policy, the
groups based on dividend
only effect is to attract a particular clientele. If a firm changes its dividend policy, it just attracts a
yield and the resulting tax
effects. different clientele.
What we are left with is a simple supply and demand argument. Suppose that 40 percent of
all investors prefer high dividends, but only 20 percent of the firms pay high dividends. Here the
high-dividend firms are in short supply; thus, their stock prices rise. Consequently, low-dividend
firms would find it advantageous to switch policies until 40 percent of all firms have high payouts.
At this point, the dividend market is in equilibrium. Further changes in dividend policy are point-
less because all of the clienteles are satisfied. The dividend policy for any individual firm is now
irrelevant.

TA BL E 1 7.1

Largest TSX companies by market capitalization and dividends for April 13, 2012
Rank Company Market cap ($ billion) Dividend Yield (%)
1 Royal Bank of Canada 80.6 4.1
2 Toronto-Dominion Bank 74.2 3.5
3 Bank of Nova Scotia 61.5 4.1
4 Suncor Energy 47.5 1.4
5 Barrick Gold Corp. 41.5 1.4
6 Imperial Oil Ltd. 37.0 1.1
7 Bank of Montreal 36.9 4.9
8 Potash Corp. of Saskatchewan Inc. 36.7 1.3
9 Canadian Natural Resources Ltd. 35.1 1.3
10 Canadian National Railway Co 34.6 1.9
11 GoldCorp Inc. 33.8 1.3
12 BCE Inc. 30.7 5.5
13 Enbridge Inc. 30.2 2.9
14 Canadian Imperial Bank of Commerce 30.0 4.8
15 TransCanada Corp. 29.9 4.1

Source: Drawn from Canadian Business, Investor 500, 2012.

14
National Post, February 2, 2009

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 Chapter 17: Dividends and Dividend Policy 503

To see if you understand the clientele effect, consider the following statement: “In spite of the
theoretical argument that dividend policy is irrelevant or that firms should not pay dividends,
many investors like high dividends. Because of this fact, a firm can boost its share price by having
a higher dividend payout ratio.” True or false?
The answer is false if clienteles exist. As long as enough high-dividend firms satisfy the divi-
dend-loving investors, a firm won’t be able to boost its share price by paying high dividends.

Concept Questions

1. How does the market react to unexpected dividend changes? What does this tell us about
dividends? About dividend policy?
2. What is a dividend clientele? All things considered, would you expect a risky firm with
significant but highly uncertain growth prospects to have a low- or high-dividend payout?

17.6 Establishing a Dividend Policy

How do firms actually determine the level of dividends that they pay at a particular time? As we
have seen, there are good reasons for firms to pay high dividends and there are good reasons to
pay low dividends.
We know some things about how dividends are paid in practice. Firms don’t like to cut divi-
dends. We saw this with Bank of Montreal earlier. As Table 17.2 shows, two chartered banks, Bank
of Montreal and Bank of Nova Scotia, have been paying dividends for over 170 years.

TA BL E 17 .2

Paying dividends Stock Year Dividend Payments Began

Bank of Montreal 1829
Bank of Nova Scotia 1833
Royal Bank 1870

In the next section, we discuss a particular dividend policy strategy. In doing so, we emphasize the
real-world features of dividend policy. We also analyze an alternative to cash dividends, a stock
repurchase.

Residual Dividend Approach

Earlier, we noted that firms with higher dividend payouts have to sell stock more often. As we
have seen, such sales are not very common and they can be very expensive. Consistent with this,
we assume that the firm wishes to minimize the need to sell new equity. We also assume that the
firm wishes to maintain its current capital structure.15
If a firm wishes to avoid new equity sales, then it has to rely on internally generated equity to finance
new, positive NPV projects.16 Dividends can only be paid out of what is left over. This leftover is
residual dividend called the residual, and such a dividend policy would be called a residual dividend approach.
approach With a residual dividend policy, the firm’s objective is to meet its investment needs and main-
Policy where a firm pays tain its desired debt/equity ratio before paying dividends. To illustrate, imagine that a firm has
dividends only after meeting
its investment needs while
$1,000 in earnings and a debt/equity ratio of .50. Notice that, since the debt/equity ratio is .50,
maintaining a desired debt-
to-equity ratio. 15
As in our discussion of the cost of capital in Chapter 14, the capital structure should be measured using market value
weights.
16
Our discussion of sustainable growth in Chapter 4 is relevant here. We assumed there that a firm has a fixed capital
structure, profit margin, and capital intensity. If the firm raises no new equity and wishes to grow at some target rate,
there is only one payout ratio consistent with these assumptions.

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 504 Part 6: Cost of Capital and Long-Term Financial Policy

the firm has 50 cents in debt for every $1.50 in value. The firm’s capital structure is thus 1/3 debt
and 2/3 equity.
The first step in implementing a residual dividend policy is to determine the amount of funds
that can be generated without selling new equity. If the firm reinvests the entire $1,000 and pays
no dividend, equity increases by $1,000. To keep the debt/equity ratio at .50, the firm must borrow
an additional $500. The total amount of funds that can be generated without selling new equity is
thus $1,000 + 500 = $1,500.
The second step is to decide whether or not a dividend will be paid. To do this, we compare the
total amount that can be generated without selling new equity ($1,500 in this case) with planned
capital spending. If funds needed exceed funds available, no dividend is paid. In addition, the
firm will have to sell new equity to raise the needed finance or else (more likely) postpone some
planned capital spending.
If funds needed are less than funds generated, a dividend will be paid. The amount of the
dividend is the residual, that is, that portion of the earnings not needed to finance new projects.
For example, suppose we have $900 in planned capital spending. To maintain the firm’s capital
structure, this $900 must be financed 2/3 equity and 1/3 debt. So, the firm actually borrows 1/3
× $900 = $300. The firm spends 2/3 × $900 = $600 of the $1,000 in equity available. There is a
$1,000 - 600 = $400 residual, so the dividend is $400.
In sum, the firm has after-tax earnings of $1,000. Dividends paid are $400. Retained earnings
are $600, and new borrowing totals $300. The firm’s debt/equity ratio is unchanged at .50.
The relationship between physical investment and dividend payout is presented for six differ-
ent levels of investment in Table 17.3 and illustrated in Figure 17.4. The first three rows of the table
can be discussed together, because in each case no dividends are paid.

FIGURE 17.4

Relationship between Dividends in dollars

dividends and
investment in residual 1,000 •
dividend policy
667 •
This figure illustrates that a firm
with many investment
opportunities will pay small 333 •
amounts of dividends and a firm
with few investment opportunities
will pay relatively large amounts 0 • • • •
of dividends.
New investment
–333 •0 500 1,000 1,500 2,000 2,500 3,000 in dollars

TA BL E 1 7.3

Dividend policy under the residual approach

(1) (2) (3) (4) (5)
After tax New Additional Retained Additional (6)
Row Earnings Investment Debt Earnings Stock Dividends
1 $1,000 $3,000 $1,000 $1,000 $1,000 $0
2 1,000 2,000 667 1,000 333 0
3 1,000 1,500 500 1,000 0 0
4 1,000 1,000 333 667 0 333
5 1,000 500 167 333 0 667
6 1,000 0 0 0 0 1,000

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 Chapter 17: Dividends and Dividend Policy 505

In row 1, for example, note that new investment is $3,000. Additional debt of $1,000 and equity
of $2,000 must be raised to keep the debt/equity ratio constant. Since this latter figure is greater
than the $1,000 of earnings, all earnings are retained. Additional stock to be raised is also $1,000.
In this example, since new stock is issued, dividends are not simultaneously paid out.
In rows 2 and 3, investment drops. Additional debt needed goes down as well since it is equal
to 1/3 of investment. Because the amount of new equity needed is still greater than or equal to
$1,000, all earnings are retained and no dividends are paid.
We finally find a situation in row 4 where a dividend is paid. Here, total investment is $1,000.
To keep our debt/equity ratio constant, 1/3 of this investment, or $333, is financed by debt. The
remaining 2/3 or $667, comes from internal funds, implying that the residual is $1,000 - 667 =
$333. The dividend is equal to this $333 residual.
In this case, note that no additional stock is issued. Since the needed investment is even lower
in rows 5 and 6, new debt is reduced further, retained earnings drop, and dividends increase.
Again, no additional stock is issued.
Given our discussion, we expect those firms with many investment opportunities to pay a
small percentage of their earnings as dividends and other firms with fewer opportunities to pay
a high percentage of their earnings as dividends. Young, fast-growing firms commonly employ
a low payout ratio, whereas older, slower-growing firms in more mature industries use a higher
ratio. This pattern is consistent with firms’ practice in the U.S. and Canada.17
We see this pattern somewhat in Table 17.4 where the Bank of Montreal is a slower-growing
firm with a high payout; Canadian Tire is a faster-growing firm with a pattern of low payouts.
Bank of Montreal had a steady payout in most of the years, but the payout increased to 91 percent
on one occasion in 2009. This illustrates that firms will sometimes accept a significantly differ-
ent payout ratio in order to avoid dividend cuts. In the case of Bank of Montreal, the change was
driven by a drop in EPS in 2009 (due to the financial crisis in the U.S.).

TA BL E 17 .4

The stability of Bank of Montreal Canadian Tire

dividends EPS DPS Payout EPS DPS Payout
2000 3.30 1.00 30 2000 1.89 0.40 21
2001 2.72 1.12 41 2001 2.25 0.40 18
2002 2.73 1.20 44 2002 2.56 0.40 16
2003 3.51 1.34 38 2003 3.06 0.40 13
2004 4.53 1.59 35 2004 3.60 0.475 13
2005 4.74 1.85 39 2005 4.04 0.56 14
2006 5.25 2.26 43 2006 4.35 0.66 15
2007 4.18 2.71 65 2007 5.05 0.74 15
2008 3.79 2.80 74 2008 4.59 0.84 18
2009 3.09 2.80 91 2009 4.10 0.84 20
2010 4.78 2.80 59 2010 5.45 0.91 17
Source: Annual reports
2011 5.28 2.80 53 2011 5.73 1.13 20
from sedar.com

Dividend Stability
The key point of the residual dividend approach is that dividends are paid only after all profit-
able investment opportunities are exhausted. Of course, a strict residual approach might lead to
a very unstable dividend policy. If investment opportunities in one period are quite high, divi-
dends would be low or zero. Conversely, dividends might be high in the next period if investment
opportunities are considered less promising.

17
Current research shows that in many other countries where shareholders have weaker legal rights, dividends are not
linked to firm growth. Rather, they are seen as a way of prying wealth loose from the hands of controlling shareholders:
R. LaPorta, F. Lopez-de-Silanes, A. Schleifer, and R.W. Vishny, “Agency Problems and Dividend Policies Around the
World,” Journal of Finance 2000.

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 506 Part 6: Cost of Capital and Long-Term Financial Policy

Consider the case of Big Department Stores Inc., a retailer whose annual earnings are forecasted
to be equal from year to year but whose quarterly earnings change throughout the year. They are
low in each year’s first quarter because of the post-Christmas business slump. Although earnings
increase only slightly in the second and third quarters, they advance greatly in the fourth quarter as
a result of the Christmas season. A graph of this firm’s earnings is presented in Figure 17.5.

FIGURE 17.5

Earnings for Big Earnings per share

Department Stores (EPS)
Inc. 1,000

667

EPS
333

Time
–333
(quarters)
1 2 3 4 1 2 3 4 1 2 3 4
Year 1 Year 2 Year 3

The firm can choose between at least two types of dividend policies. First, each quarter’s dividend
can be a fixed fraction of that quarter’s earnings. Here, dividends vary throughout the year. This is
a cyclical dividend policy. Second, each quarter’s dividend can be a fixed fraction of yearly earn-
ings, implying that all dividend payments would be equal. This is a stable dividend policy. These
two types of dividend policies are displayed in Figure 17.6.

FIGURE 17.6

Alternative dividend Dollars

policies for Big
Department Stores
Inc.

EPS

Cyclical
dividends

Cyclical dividend policy: Dividends

Stable dollar
are a constant proportion of earnings dividends
at each pay date. Stable dividend Time
policy: Dividends are a constant (quarters)
proportion of earnings over an 1 2 3 4 1 2 3 4 1 2 3 4
earnings cycle. Year 1 Year 2 Year 3

Corporate executives generally agree that a stable policy is in the interest of the firm and its share-
holders. Dividend stability complements investor objectives of information content, income,
and reduction in uncertainty. Institutional investors often follow “prudence” tests that restrict

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 Chapter 17: Dividends and Dividend Policy 507

investment in firms that do not pay regular dividends. For all these reasons a stable dividend
policy is common. For example, looking back at Table 17.4, the dividends paid by these large
Canadian firms are much less volatile through time than their earnings.
The dividend policy might also depend on the class of shares. For example, in case of dual class
shares the different classes of shareholders have different voting rights and dividend payments.

A Compromise Dividend Policy

In practice, many firms appear to follow what amounts to a compromise dividend policy. Such a
policy is based on five main goals:
1. Avoid cutting back on positive NPV projects to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt/equity ratio.
5. Maintain a target dividend payout ratio.
These goals are ranked more or less in order of their importance. In our strict residual approach,
we assumed that the firm maintained a fixed debt/equity ratio. Under the compromise approach,
that debt/equity ratio is viewed as a long-range goal. It is allowed to vary in the short run if neces-
sary to avoid a dividend cut or the need to sell new equity.
In addition to a strong reluctance to cut dividends, financial managers tend to think of divi-
dend payments in terms of a proportion of income, and they also tend to think investors are
target payout ratio entitled to a “fair” share of corporate income. This share is the long-run target payout ratio, and
A firm’s long-term desired it is the fraction of the earnings that the firm expects to pay as dividends under ordinary circum-
dividend-to-earnings ratio.
stances. Again, this is viewed as a long-range goal, so it might vary in the short run if needed. As
a result, in the long run, earnings growth is followed by dividend increases, but only with a lag.
One can minimize the problems of dividend instability by creating two types of dividends:
regular and extra. For companies using this approach, the regular dividend would likely be a rela-
tively small fraction of permanent earnings, so that it could be sustained easily. Extra dividends
would be granted when an increase in earnings was expected to be temporary.
Since investors look on an extra dividend as a bonus, there is relatively little disappointment
when an extra dividend is not repeated.

Some Sur vey Evidence on Dividends

A recent study surveyed a large number of Canadian financial executives regarding dividend
policy. Table 17.5 shows the top 5 factors influencing dividend policy.
As shown in Table 17.5, financial managers are highly disinclined to cut dividends. Moreover,
they are very conscious of their previous dividends and desire to maintain a relatively steady
dividend. In contrast, concerns about dividends affecting the firm’s stock price are somewhat less
important.

TA BL E 17 .5

Factors influencing Factor Moderate or High Level of Importance (%)

dividend policy of 1. Stability of earnings 95.7
Canadian financial 2. Pattern of past dividends 95.7
firms 3. Level of current earnings 87.0
4. Level of expected future earnings 82.6
5. Concern about affecting the stock price 47.8

Source: Adapted from Table 2 of Baker, H.K., Dutta, S., And Saadi, S. (2008), “How Managers Of Financial Versus Non-Financial Firms View Dividends: The
Canadian Evidence”, Global Finance Journal, 19, pp. 171–186.

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 508 Part 6: Cost of Capital and Long-Term Financial Policy

Table 17.6 is drawn from the same survey, but here the responses address the top five reasons
for Canadian financial firms paying dividends Not surprisingly given the responses in Table 17.5
and our earlier discussion, the highest priority is maintaining a consistent dividend policy. The
next several items are also consistent with our previous analysis. Financial managers are very
concerned about earnings stability and future earnings levels in making dividend decisions, and
they consider the availability of good investment opportunities. Survey respondents also believed
that firm should disclose to investors its reasons for changing the cash dividend.
In contrast to our discussion in the earlier part of this chapter on taxes and flotation costs, the
Canadian. financial managers in this survey did not think that personal taxes paid on dividends
by shareholders are very important.

TA BL E 1 7.6

Explanation for paying dividends: Canadian financial firms

Percent Who Agree or
Policy Statements Strongly Agree (%)
1. A firm should strive to maintain an uninterrupted record of dividend payments. 96.0
2. Investors generally regard dividend changes as signals about a firm’s future prospects. 95.1
3. A firm should adequately disclose to investors its reasons for changing its cash 91.3
dividend.
4. A firm’s stock price generally falls when the firm unexpectedly decreases its dividend. 90.9
5. A firm’s stock price generally rises when the firm unexpectedly increases its dividend. 87.0

Source: Adapted from Table 3 and Table 4 of Baker, H.K., Dutta, S., and Saadi, S. (2008), “How Managers of Financial versus Non-Financial Firms View Dividends:
The Canadian Evidence”, Global Finance Journal, 19, pp. 171–186.

Concept Questions

1. What is a residual dividend policy?

2. What is the chief drawback to a strict residual policy? What do many firms do in practice?

17.7 Stock Repurchase: An Alternative to Cash Dividends

When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another way
repurchase is to repurchase its own shares. Over recent years, share repurchase has grown in importance
Another method used to pay relative to dividends. Consider Figure 17.7, which shows the dividends and share repurchases for
out a firm’s earnings to its
Canadian firms over the years from 1987 to 2008. As can be seen, the ratio of repurchases to earn-
owners, which provides more
preferable tax treatment than ings was far less than the ratio of dividends to earnings in the early years.
dividends. Following the market crash of 2008 and early 2009, the number of Canadian companies
announcing share repurchases increased. For example, in February 2012, Tim Hortons announced
a program to repurchase $200 million in shares. Also, in December 2011, Air Canada. announced
a stock repurchase program, to increase the value of its shares, which were depressed due to ongo-
ing labour talks, economic uncertainty, and dwindling growth prospects.

Cash Dividends versus Repurchase

Imagine an all-equity company with excess cash of $300,000. The firm pays no dividends, and its
net income for the year just ended is $49,000. The market value statement of financial position at
the end of the year is represented below.
Market Value Statement of Financial Position (before paying out excess cash)
Excess cash $ 300,000 $ 0 Debt
Other assets 700,000 1,000,000 Equity
Total $ 1,000,000 $ 1,000,000

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 Chapter 17: Dividends and Dividend Policy 509

FIGURE 17.7

Dividends and Share

Repurchases of 0.8
Canadian firms:
1987–2008

0.6

% of Firms
Figure 5 of Mitchell, Chris,
Share Repurchases
“Essays on Capital Gains, Dividends
Household Consumption and
Corporate Payout Policy”
0.4
(2012). Electronic Thesis and
Dissertation Repository. Paper
687. ir.lib.uwo.ca/etd/687
Repurchase data covering the
years 1987–2000 provided by 0.2
McNally, William J. and Brian
F. Smith. “Long-Run Returns
Following Open Market Share
Repurchases.” 2007. Journal
of Banking and Finance. Vol. 0.0
31, Issue 3, 703–717. 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

There are 100,000 shares outstanding. The total market value of the equity is $1 million, so the
stock sells for $10 per share. Earnings per share (EPS) were $49,000/100,000 = $.49, and the
price/earnings ratio (P/E) is $10/$.49 = 20.4.
One option the company is considering is a $300,000/100,000 = $3 per share extra cash divi-
dend. Alternatively, the company is thinking of using the money to repurchase $300,000/$10 =
30,000 shares of stock.
If commissions, taxes, and other imperfections are ignored in our example, the shareholders
shouldn’t care which option is chosen. Does this seem surprising? It shouldn’t, really. What is hap-
pening here is that the firm is paying out $300,000 in cash. The new statement of financial position
is represented below.
Market Value Statement of Financial Position
(after paying out excess cash as dividends)
Excess cash $ 0 $ 0 Debt
Other assets 700,000 700,000 Equity
Total $ 700,000 $ 700,000

If the cash is paid out as a dividend, there are still 100,000 shares outstanding, so each is worth $7.
The fact that the per-share value fell from $10 to $7 isn’t a cause for concern. Consider a share-
holder who owns 100 shares. At $10 per share before the dividend, the total value is $1,000.
After the $3 dividend, this same shareholder has 100 shares worth $7 each, for a total of $700,
plus 100 × $3 = $300 in cash, for a combined total of $1,000. This just illustrates what we saw
earlier: A cash dividend doesn’t affect a shareholder’s wealth if there are no imperfections. In this
case, the stock price simply fell by $3 when the stock went ex dividend.
Also, since total earnings and the number of shares outstanding haven’t changed, EPS is still
49 cents. The price/earnings ratio (P/E), however, falls to $7/.49 = 14.3. Why we are looking at
accounting earnings and P/E ratios will be apparent just below.
Alternatively, if the company repurchases 30,000 shares, there will be 70,000 left outstanding.
The statement of financial position looks the same.
Market Value Statement of Financial Position
(after paying out excess cash as stock repurchase)
Excess cash $ 0 $ 0 Debt
Other assets 700,000 700,000 Equity
Total $ 700,000 $ 700,000

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 510 Part 6: Cost of Capital and Long-Term Financial Policy

The company is worth $700,000 again, so each remaining share is worth $700,000/70,000 = $10
each. Our shareholder with 100 shares is obviously unaffected. For example, if the shareholder
were so inclined, he or she could sell 30 shares and end up with $300 in cash and $700 in stock,
just as if the firm pays the cash dividend. This is another example of a homemade dividend.
In this second case, EPS goes up since total earnings are the same while the number of shares
goes down. The new EPS will be $49,000/70,000 = $.70 per share. However, the important thing
to notice is that the P/E ratio is $10/$.70 = 14.3, just as it was following the dividend.
This example illustrates the important point that, if there are no imperfections, a cash dividend
and a share repurchase are essentially the same thing. This is just another illustration of dividend
policy irrelevance when there are no taxes or other imperfections.

Real-World Considerations in a Repurchase

In the real world, there are some accounting differences between a share repurchase and a cash
dividend, but the most important difference is in the tax treatment. A repurchase has a significant
tax advantage over a cash dividend. A dividend is taxed, and a shareholder has no choice about
whether or not to receive the dividend. In a repurchase, a shareholder pays taxes only if (1) the
shareholder actually chooses to sell, and (2) the shareholder has a taxable capital gain on the sale.
Normally, at any time, about one-third of TSX listed companies have announced their inten-
tions to repurchase stock through the exchange. This means they plan to buy up to 5 percent of
their stock for their treasury. Because of the favourable tax treatment of capital gains, a repurchase
is a very sensible alternative to an extra dividend.
Share repurchases can be used to achieve other corporate goals such as altering the firm’s
capital structure or as a takeover defence. Many firms repurchase shares because management
believes the stock is undervalued. This reason for repurchasing is controversial because it contra-
dicts the efficient market hypothesis. However, there is considerable evidence that firms repur-
chasing shares do experience an increase in shareholder return.18

Share Repurchase and EPS

You may read in the popular financial press that a share repurchase is beneficial because earnings per
share increase. As we have seen, this will happen. The reason is simply that a share repurchase reduces
the number of outstanding shares, but it has no effect on total earnings. As a result, EPS rises.
However, the financial press may place undue emphasis on EPS figures in a repurchase agreement.
In our example above, we saw that the value of the stock wasn’t affected by the EPS change. In fact,
the price/earnings ratio was exactly the same when we compared a cash dividend to a repurchase.
Since the increase in earnings per share is exactly tracked by the increase in the price per share,
there is no net effect. Put another way, the increase in EPS is just an accounting adjustment that
reflects (correctly) the change in the number of shares outstanding.
In the real world, to the extent that repurchases benefit the firm, we would argue that they do
so primarily because of the tax considerations we discussed above.

Concept Questions

1. Why might a stock repurchase make more sense than an extra cash dividend?
2. Why don’t all firms use stock repurchases instead of cash dividends?

17.8 Stock Dividends and Stock Splits

stock dividend Another type of dividend is paid out in shares of stock. This type of dividend is called a stock divi-
Payment made by a firm to dend. A stock dividend is not a true dividend because it is not paid in cash. The effect of a stock
its owners in the form of
stock, diluting the value of
18
each share outstanding. This evidence is in: D. Ikenberry, J. Lakonishok, and T. Vermaelen, “Stock Repurchases in Canada: Performance and
Strategic Trading,” Journal of Finance, October 2000. For a contradictory view, see K. Li and W. McNally, “Information
Signalling or Agency Conflicts: What Explains Canadian Open Market Share Repurchases?” Working Paper, Wilfrid
Laurier University, March 2000.

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 Chapter 17: Dividends and Dividend Policy 511

dividend is to increase the number of shares that each owner holds. Since there are more shares
outstanding, each is simply worth less.
A stock dividend is commonly expressed as a percentage; for example, a 20 percent stock
dividend means that a shareholder receives one new share for every five currently owned (a 20
percent increase). Since every shareholder owns 20 percent more stock, the total number of shares
outstanding rises by 20 percent. As we see in a moment, the result would be that each share of
stock is worth about 20 percent less.
stock split A stock split is essentially the same thing as a stock dividend, except that a split is expressed
An increase in a firm’s shares as a ratio instead of a percentage. When a split is declared, each share is split to create additional
outstanding without any
shares. For example, Coca-Cola stock split two-for-one in 2012 and each old share was split into
change in owner’s equity.
two new shares.

Some Details on Stock Splits and Stock Dividends

Stock splits and stock dividends have essentially the same impacts on the corporation: They
increase the number of shares outstanding and reduce the value per share. Also, both options will
have a similar impact on future cash dividends. When stocks split, the cash dividend per share is
reduced accordingly. The accounting treatment is not the same, however. Under TSX rules, the
maximum stock dividend is 25 percent, anything larger is considered a stock split. Further, stock
dividends are taxable, but stock splits are not.

EXAMPLE OF A STOCK DIVIDEND The Peterson Company, a consulting firm spe-

cializing in difficult accounting problems, has 10,000 shares of stock, each selling at $66. The total
market value of the equity is $66 × 10,000 = $660,000. With a 10 percent stock dividend, each
shareholder receives one additional share for each 10 presently owned, and the total number of
shares outstanding after the dividend is 11,000.
Before the stock dividend, the equity portion of Peterson’s statement of financial position
might look like this:
Common stock (10,000 shares outstanding) $210,000
Retained earnings 290,000
Total owners’ equity $500,000

The amount of the stock dividend is transferred from retained earnings to common stock. Since
1000 new shares are issued, the common stock account is increased by $66,000 (1000 shares at
$66 each). Total owners’ equity is unaffected by the stock dividend because no cash has come in
or out, so retained earnings is reduced by the entire $66,000. The net effect of these machinations
is that Peterson’s equity accounts now look like this:
Common stock (11,000 shares outstanding) $276,000
Retained earnings 224,000
Total owners’ equity $500,000

EXAMPLE OF A STOCK SPLIT A stock split is conceptually similar to a stock divi-

dend, but it is commonly expressed as a ratio. For example, in a three-for-two split, each share-
holder receives one additional share of stock for each two held originally, so a three-for-two split
amounts to a 50 percent stock dividend. Again, no cash is paid out, and the percentage of the
entire firm that each shareholder owns is unaffected.
The accounting treatment of a stock split is a little different (and simpler) from that of a stock
dividend. Suppose Peterson decides to declare a two-for-one stock split. The number of shares
outstanding doubles to 20,000. The owner’s equity after the split is the same as before the split
except the new number of shares is noted.
Common stock (20,000 shares outstanding) $210,000
Retained earnings 290,000
Total owners’ equity $500,000

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 512 Part 6: Cost of Capital and Long-Term Financial Policy

Value of Stock Splits and Stock Dividends

The laws of logic tell us that stock splits and stock dividends can (1) leave the value of the firm
unaffected, (2) increase its value, or (3) decrease its value. Unfortunately, the issues are complex
enough that one cannot easily determine which of the three relationships holds.
THE BENCHMARK CASE A strong case can be made that stock dividends and splits do
not change either the wealth of any shareholder or the wealth of the firm as a whole. In our prior
example, the equity was worth a total of $660,000. With the stock dividend, the number of shares
increased to 11,000, so it seems that each would be worth $660,000/11,000 = $60.
For example, a shareholder who had 100 shares worth $66 each before the dividend would
have 110 shares worth $60 each afterwards. The total value of the stock is $6,600 either way; so
the stock dividend doesn’t really have any economic affect.
With the stock split, there were 20,000 shares outstanding, so each should be worth
$660,000/20,000 = $33. In other words, the number of shares doubles and the price halves. From
these calculations, it appears that stock dividends and splits are just paper transactions.
Although these results are relatively obvious, there are reasons that are often given to suggest
that there may be some benefits to these actions. The typical financial manager is aware of many
real-world complexities, and, for that reason, the stock split or stock dividend decision is not
treated lightly in practice.
TRADING RANGE Proponents of stock dividends and stock splits frequently argue that a
trading range security has a proper trading range. When the security is priced above this level, many investors
Price range between highest do not have the funds to buy the common trading unit called a round lot (usually 100 shares).
and lowest prices at which a
Although this argument is a popular one, its validity is questionable for a number of reasons.
stock is traded.
Mutual funds, pension funds, and other institutions have steadily increased their trading activity
since World War II and now handle a sizeable percentage of total trading volume (over half of
the trading volume on both the TSX and NYSE). Because these institutions buy and sell in huge
amounts, the individual share price is of little concern. Furthermore, we sometimes observe share
prices that are quite large without appearing to cause problems.
Finally, there is evidence that stock splits may actually decrease the liquidity of the company’s
shares. Following a two-for-one split, the number of shares traded should more than double if liquid-
ity is increased by the split. This doesn’t appear to happen, and the reverse is sometimes observed.
Regardless of the impact on liquidity, firms do split their stock. Some managers believe that keeping
the share price within a range attractive to individual investors helps promote Canadian ownership.

Reverse Splits
reverse split A less frequently encountered financial maneuver is the reverse split. In a one-for-three reverse
Procedure where a firm’s split, each investor exchanges three old shares for one new share. As mentioned previously with
number of shares
reference to stock splits and stock dividends, a case can be made that a reverse split changes noth-
outstanding is reduced.
ing substantial about the company.
Given real-world imperfections, three related reasons are cited for reverse splits. First, trans-
action costs to shareholders may be less after the reverse split. Second, the liquidity and market-
ability of a company’s stock might be improved when its price is raised to the popular trading
range. Third, stocks selling below a certain level are not considered respectable, meaning that
investors underestimate these firms’ earnings, cash flow, growth, and stability. Some financial
analysts argue that a reverse split can achieve instant respectability. As with stock splits, none of
these reasons is particularly compelling, especially the third one.
There are two other reasons for reverse splits. First, stock exchanges have minimum price per
share requirements. A reverse split may bring the stock price up to such a minimum. Second,
companies sometimes perform reverse splits and, at the same time, buy out any shareholders who
end up with less than a certain number of shares. This second tactic can be abusive if used to force
out minority shareholders.
In the aftermath of the tech bubble, a number of technology firms made the decision to under-
take reverse splits. More recently, in 2009, Domtar Corporation, the Montreal-based largest inte-
grated producer of uncoated free sheet paper in North America, underwent a reverse stock split at
a 1-for-12 ratio. Domtar management cited two reasons for undertaking a reverse split—to return
the company’s share price to a level similar to that of other widely owned companies and to attract
a broader range of institutional investors.

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 Chapter 17: Dividends and Dividend Policy 513

Concept Questions

1. What is the effect of a stock split on shareholder wealth?

2. How does the accounting treatment of a stock split differ from that used with a small stock
dividend?

17.9 SUMMARY AND CONCLUSIONS

In this chapter, we discussed the types of dividends and how they are paid. We then defined divi-
dend policy and examined whether or not dividend policy matters. Finally, we illustrated how a
firm might establish a dividend policy and described an important alternative to cash dividends,
a share repurchase.
In covering these subjects, we saw that:
1. Dividend policy is irrelevant when there are no taxes or other imperfections because share-
holders can effectively undo the firm’s dividend strategy. A shareholder who receives a divi-
dend greater than desired can reinvest the excess. Conversely, the shareholder who receives
a dividend that is smaller than desired can sell extra shares of stock.
2. Individual shareholder income taxes and new issue flotation costs are real-world consider-
ations that favour a low-dividend payout. With taxes and new issue costs, the firm should
pay out dividends only after all positive NPV projects have been fully financed.
3. There are groups in the economy that may favour a high payout. These include many large
institutions such as pension plans. Recognizing that some groups prefer a high payout and
some prefer a low payout, the clientele effect supports the idea that dividend policy responds
to the needs of shareholders. For example, if 40 percent of the shareholders prefer low divi-
dends and 60 percent of the shareholders prefer high dividends, approximately 40 percent of
companies will have a low-dividend payout, while 60 percent will have a high payout. This
sharply reduces the impact of any individual firm’s dividend policy on its market price.
4. A firm wishing to pursue a strict residual dividend payout will have an unstable dividend.
Dividend stability is usually viewed as highly desirable. We therefore discussed a compro-
mise strategy that provides for a stable dividend and appears to be quite similar to the divi-
dend policies many firms follow in practice.
5. A stock repurchase acts much like a cash dividend, but can have a significant tax advantage.
Stock repurchases are therefore a very useful part of over-all dividend policy.
To close our discussion of dividends, we emphasize one last time the difference between divi-
dends and dividend policy. Dividends are important, because the value of a share of stock is
ultimately determined by the dividends that are paid. What is less clear is whether or not the time
pattern of dividends (more now versus more later) matters. This is the dividend policy question,
and it is not easy to give a definitive answer to it.

Key Terms
clientele effect (page 502) repurchase (page 508)
date of payment (page 492) residual dividend approach (page 503)
date of record (page 492) reverse split (page 512)
declaration date (page 492) stock dividend (page 510)
distribution (page 491) stock split (page 511)
dividend (page 491) stripped common shares (page 495)
ex-dividend date (page 492) target payout ratio (page 507)
homemade dividends (page 495) trading range (page 512)
information content effect (page 502)
regular cash dividend (page 491)

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 514 Part 6: Cost of Capital and Long-Term Financial Policy

Chapter Review Problems and Self-Test

17.1 Residual Dividend Policy The Rapscallion Corporation $1.50 per share and the stock sells for $15. The market value
practices a strict residual dividend policy and maintains a statement of financial position before paying out the $300 is
capital structure of 40 percent debt, 60 percent equity. Earn- as follows:
ings for the year are $2,500. What is the maximum amount of Statement of Financial Position
capital spending possible without new equity? Suppose that (before paying out excess cash)
planned investment outlays for the coming year are $3,000. Excess cash $ 300 $ 400 Debt
Will Rapscallion be paying a dividend? If so, how much? Other assets 1,600 1,500 Equity
17.2 Repurchase versus Cash Dividend Trantor Corporation is Total $ 1,900 $ 1,900
deciding whether to pay out $300 in excess cash in the form of
Evaluate the two alternatives for the effect on the price per
an extra dividend or a share repurchase. Current earnings are
share of the stock, the EPS, and the P/E ratio.

Answers to Self-Test Problems

17.1 Rapscallion has a debt/equity ratio of .40/.60 = 2/3. If the entire $2,500 in earnings were reinvested, $2,500 × 2/3 = $1,667 in new bor-
rowing would be needed to keep the debt/equity unchanged. Total new financing possible without external equity is thus $2,500 + 1,667
= $4,167.
If planned outlays are $3,000, this amount can be financed 60 percent with equity. The needed equity is thus $3,000 × .60 = $1,800. This
is less than the $2,500 in earnings, so a dividend of $2,500 - 1,800 = $700 would be paid.
17.2 The market value of the equity is $1,500. The price per share is $15, so there are 100 shares outstanding. The cash dividend would
amount to $300/100 = $3 per share. When the stock goes ex dividend, the price drops by $3 per share to $12. Put another way, the total
assets decrease by $300, so the equity value goes down by this amount to $1,200. With 100 shares, this is $12 per share. After the divi-
dend, EPS is the same, $1.50, but the P/E ratio is $12/1.50 = 8 times.
With a repurchase, $300/15 = 20 shares would be bought up, leaving 80. The equity again is worth $1,200 total. With 80 shares, this is
$1,200/80 = $15 per share, so the price doesn’t change. Total earnings for Trantor must be $1.5 × 100 = $150. After the repurchase, EPS
is higher at $150/80 = $1.875. The P/E ratio, however, is still $15/1.875 = 8 times.

Concepts Review and Critical Thinking Questions

1. (LO2) How is it possible that dividends are so important, but, was made. How would you interpret this change in the stock
at the same time, dividend policy could be irrelevant? price (that is, what would you say caused it)?
2. (LO4) What is the impact of a stock repurchase on a compa- 8. (LO2) The DRK Corporation has recently developed a divi-
ny’s debt ratio? Does this suggest another use for excess cash? dend reinvestment plan, or DRIP. The plan allows investors to
3. (LO2) What is the chief drawback to a strict residual divi- reinvest cash dividends automatically in DRK in exchange for
dend policy? Why is this a problem? How does a compromise new shares of stock. Over time, investors in DRK will be able
policy work? How does it differ from a strict residual policy? to build their holdings by reinvesting dividends to purchase
4. (LO1) On Tuesday, December 8, Hometown Power Co.’s additional shares of the company.
board of directors declares a dividend of 75 cents per share Over 1000 companies offer dividend reinvestment plans.
payable on Wednesday, January 17, to shareholders of record Most companies with DRIPs charge no brokerage or service
as of Wednesday, January 3. When is the ex-dividend date? If fees. In fact, the shares of DRK will be purchased at a 10 per-
a shareholder buys stock before that date, who gets the divi- cent discount from the market price. A consultant for DRK
dends on those shares, the buyer or the seller? estimates that about 75 percent of DRK’s shareholders will
5. (LO1) Some corporations, like one British company that of- take part in this plan. This is somewhat higher than
fers its large shareholders free crematorium use, pay dividends the average.
in kind (that is, offer their services to shareholders at below- Evaluate DRK’s dividend reinvestment plan. Will it in-
market cost). Should mutual funds invest in stocks that pay crease shareholder wealth? Discuss the advantages and disad-
these dividends in kind? (The fundholders do not receive vantages involved here.
these services.) 9. (LO2) For initial public offerings of common stock, 1993 was
6. (LO2) If increases in dividends tend to be followed by (im- a very big year, with over $43 billion raised by the process.
mediate) increases in share prices, how can it be said that divi- Relatively few of the firms involved paid cash dividends. Why
dend policy is irrelevant? do you think that most chose not to pay cash dividends?
7. (LO2) Last month, East Coast Power Company, which had 10. (LO2) York University pays no taxes on its capital gains or on
been having trouble with cost overruns on a nuclear power its dividend income and interest income. Would it be irratio-
plant that it had been building, announced that it was “tempo- nal to find low-dividend, high-growth stocks in its portfolio?
rarily suspending payments due to the cash flow crunch asso- Would it be irrational to find preferred shares in its portfolio?
ciated with its investment program.” The company’s stock Explain.
price dropped from $28.50 to $25 when this announcement

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 Chapter 17: Dividends and Dividend Policy 515

Questions and Problems

Basic 1. Dividends and Taxes (LO2) Pandosy Inc. has declared a $5.10 per share dividend. Suppose capital gains are not taxed, but
(Questions dividends are taxed at 15 percent. Pandosy sells for $93.85 per share, and the stock is about to go ex dividend. What do you think
1–13)
the ex-dividend price will be?
2. Stock Dividends (LO3) The owners’ equity accounts for Okanagan International are shown here:
Common stock ($1 par value) $ 20,000
Capital Surplus 285,000
Retained earnings 638,120
Total owners’ equity $ 943,120

a. If Okanagan stock currently sells for $30 per share and a 10 percent stock dividend is declared, how many new shares will
be distributed? Show how the equity accounts would change.
b. If Okanagan declared a 25 percent stock dividend, how would the accounts change?
3. Stock Splits (LO3) For the company in Problem 2, show how the equity accounts will change if:
a. Okanagan declares a four-for-one stock split. How many shares are outstanding now?
b. Okanagan declares a one-for-five reverse stock split. How many shares are outstanding now?
4. Stock Splits and Stock Dividends (LO3) Mill Creek Corporation (MCC) currently has 425,000 shares of stock outstanding that
sell for $80 per share. Assuming no market imperfections or tax effects exist, what will the share price be after:
a. MCC has a five-for-three stock split?
b. MCC has a 15 percent stock dividend?
c. MCC has a 42.5 percent stock dividend?
d. MCC has a four-for-seven reverse stock split?
Determine the new number of shares outstanding in parts (a) through (d).
55. Regular Dividends (LO1) The statement of financial position for Knox Corp. is shown here in market value terms. There are
9,000 shares of stock outstanding.
Market Value Statement of Financial Position
Cash $ 43,700 Equity $353,700
Fixed assets 310,000
Total $ 353,700 Total $353,700

The company has declared a dividend of $1.40 per share. The stock goes ex dividend tomorrow. Ignoring any tax effects, what is
the stock selling for today? What will it sell for tomorrow? What will the statement of financial position look like after the
dividends are paid?
6. Share Repurchase (LO4) In the previous problem, suppose Knox has announced it is going to repurchase $12,600 worth of
stock. What effect will this transaction have on the equity of the firm? How many shares will be outstanding? What will the price
per share be after the repurchase? Ignoring tax effects, show how the share repurchase is effectively the same as a cash dividend.
7. Stock Dividends (LO3) The market value statement of financial position for McKinley Manufacturing is shown here. McKinley
has declared a 25 percent stock dividend. The stock goes ex dividend tomorrow (the chronology for a stock dividend is similar to
that for a cash dividend). There are 14,000 shares of stock outstanding. What will the ex-dividend price be?
Market Value Statement of Financial Position
Cash $ 86,000 Debt $145,000
Fixed assets 630,000 Equity 571,000
Total $ 716,000 Total $716,000

8. Stock Dividends (LO3) The company with the common equity accounts shown here has declared a 15 percent stock dividend
when the market value of its stock is $43 per share. What effects on the equity accounts will the distribution of the stock
dividend have?
Common stock ($1 par value) $ 385,000
Capital surplus 846,000
Retained earnings 3,720,000
Total owners’ equity $ 4,951,000

9. Stock Splits (LO3) In the previous problem, suppose the company instead decides on a four-for-one stock split. The firm’s 75-
cent per share cash dividend on the new (post-split) shares represents an increase of 10 percent over last year’s dividend on the
presplit stock. What effect does this have on the equity accounts? What was last year’s dividend per share?
10. Residual Dividend Policy (LO2) Crawford Inc., a litter recycling company, uses a residual dividend policy. A debt-equity ratio
of 1.0 is considered optimal. Earnings for the period just ended were $1,400, and a dividend of $420 was declared. How much in
new debt was borrowed? What were total capital outlays?

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 516 Part 6: Cost of Capital and Long-Term Financial Policy

11. Residual Dividend Policy (LO2) Rutland Corporation has declared an annual dividend of $0.50 per share. For the year just
ended, earnings were $8 per share.
a. What is Rutland’s payout ratio?
b. Suppose Rutland has seven million shares outstanding. Borrowing for the coming year is planned at $14 million. What are
planned investment outlays assuming a residual dividend policy? What target capital structure is implicit in these
calculations?
12. Residual Dividend Policy (LO2) Summerland Corporation follows a strict residual dividend policy. Its debt-equity ratio is 1.5.
a. If earnings for the year are $145,000, what is the maximum amount of capital spending possible with no new equity?
b. If planned investment outlays for the coming year are $790,000, will Summerland pay a dividend? If so, how much?
c. Does Summerland maintain a constant dividend payout? Why or why not?
13. Residual Dividend Policy (LO2) Penticton Rock (PR) Inc. predicts that earnings in the coming year will be $54 million. There
are 19 million shares, and PR maintains a debt-equity ratio of 1.2.
a. Calculate the maximum investment funds available without issuing new equity and the increase in borrowing that goes
along with it.
b. Suppose the firm uses a residual dividend policy. Planned capital expenditures total $74 million. Based on this information,
what will the dividend per share be?
c. In part (b), how much borrowing will take place? What is the addition to retained earnings?
d. Suppose PR plans no capital outlays for the coming year. What will the dividend be under a residual policy? What will new
borrowing be?
Intermediate 14. Homemade Dividends (LO2) You own 1000 shares of stock in Armstrong Corporation. You will receive a $1.85 per share
(Questions dividend in one year. In two years, Armstrong will pay a liquidating dividend of $58 per share. The required return on
14–16)
Armstrong stock is 15 percent. What is the current share price of your stock (ignoring taxes)? If you would rather have equal
dividends in each of the next two years, show how you can accomplish this by creating homemade dividends. Hint: Dividends
will be in the form of an annuity.
15. Homemade Dividends (LO2) In the previous problem, suppose you want only $750 total in dividends the first year. What will
your homemade dividend be in two years?
16. Stock Repurchase (LO4) Salmon Arm Corporation is evaluating an extra dividend versus a share repurchase. In either case,
$11,000 would be spent. Current earnings are $1.40 per share, and the stock currently sells for $58 per share. There are
2,000 shares outstanding. Ignore taxes and other imperfections in answering the first two questions.
a. Evaluate the two alternatives in terms of the effect on the price per share of the stock and shareholder wealth.
b. What will be the effect on Salmon Arm’s EPS and PE ratio under the two different scenarios?
c. In the real world, which of these actions would you recommend? Why?
Challenge 17. Expected Return, Dividends, and Taxes (LO2) The Sicamous Company and the Revelstoke Company are two firms whose
(Questions business risk is the same but that have different dividend policies. Sicamous pays no dividend, whereas Revelstoke has an
17–20)
expected dividend yield of 4 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent.
Sicamous has an expected earnings growth rate of 15 percent annually, and its stock price is expected to grow at this same rate. If
the after-tax expected returns on the two stocks are equal (because they are in the same risk class), what is the pre-tax required
return on Revelstoke’s stock?
18. Dividends and Taxes (LO2) As discussed in the text, in the absence of market imperfections and tax effects, we would expect
the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of
taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-
dividend price:19
(P0 - PX)/D = (1 - TP)/(1 - TG)
where P0 is the price just before the stock goes ex, PX is the ex-dividend share price, D is the amount of the dividend per share, TP
is the relevant marginal personal tax rate on dividends, and TG is the effective marginal tax rate on capital gains.
a. If TP = TG = 0, how much will the share price fall when the stock goes ex?
b. If TP = 15 percent and TG = 0, how much will the share price fall?
c. If TP = 15 percent and TG = 30 percent, how much will the share price fall?
d. Suppose the only owners of stock are corporations. Recall that corporations get at least a 100 percent exemption from
taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporation’s
income and capital gains tax rates are both 35 percent, what does this model predict the ex-dividend share price will be?
e. What does this problem tell you about real-world tax considerations and the dividend policy of the firm?

19
N. Elton and M. Gruber, “Marginal Stockholder Tax Rates and the Clientele Effect,” Review of Economics and Statis-
tics 52 (February 1970).

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 Chapter 17: Dividends and Dividend Policy 517

19. Dividends versus Reinvestment (LO2) Nelson Business Machine Co. (NBM) has $3 million of extra cash after taxes have been
paid. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulting
investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in Treasury
bills yielding 3 percent or a 5 percent preferred stock. CRA regulations allow the company to exclude from taxable income 100
percent of the dividends received from investing in another company’s stock. Another alternative is to pay out the cash now as
dividends. This would allow the shareholders to invest on their own in Treasury bills with the same yield, or in preferred stock.
The corporate tax rate is 40 percent. Assume the investor has a 40 percent personal income tax rate, which is applied to interest
income. The personal dividend tax rate is 20 percent on common stock dividends after applying the dividend tax credit. Should
the cash be paid today or in three years? Which of the two options generates the highest after-tax income for the shareholders?
20. Dividends versus Reinvestment (LO2) After completing its capital spending for the year, Banff Manufacturing has $1,000 extra
cash. Banff ’s managers must choose between investing the cash in Canada bonds that yield 6 percent or paying the cash out to
investors who would invest in the bonds themselves.
a. If the corporate tax rate is 35 percent, what personal tax rate after applying the dividend tax credit would make the invest-
ors equally willing to receive the dividend or to let Banff invest the money?
b. Is the answer to (a) reasonable? Why or why not?
c. Suppose the only investment choice is a preferred stock that yields 9 percent. The corporate dividend exclusion of 100
percent applies. What personal tax rate will make the shareholders indifferent to the outcome of Banff’s dividend decision?
d. Is this a compelling argument for a low dividend-payout ratio? Why or why not?

M IN I CA S E

Kelowna Microchips Inc. QUESTIONS

Kelowna Microchips Inc. (KMI) is a small company founded 15 1. Justin believes the company should use the extra cash to
years ago by electronics engineers Justin Langer and Suzanne pay a special one-time dividend. How will this proposal
Maher. KMI manufactures integrated circuits to capitalize on affect the stock price? How will it affect the value of the
the complex mixed-signal design technology and has recently company?
entered the market for frequency timing generators, or silicon 2. Suzanne believes the company should use the extra cash
timing devices, which provide the timing signals or “clocks” to pay off debt and upgrade and expand its existing
necessary to synchronize electronic systems. Its clock products manufacturing capability. How would Suzanne’s propos-
originally were used in PC video graphics applications, but the als affect the company?
market subsequently expanded to include motherboards, PC 3. Andrew favors a share repurchase. He argues that a re-
peripheral devices, and other digital consumer electronics, purchase will increase the company’s P/E ratio, return on
such as digital television boxes and game consoles. KMI also assets, and return on equity. Are his arguments correct?
designs and markets custom application specific integrated How will a share repurchase affect the value of the
circuits (ASICs) for industrial customers. The ASIC’s design company?
combines analog and digital, or mixed-signal, technology. In
4. Another option discussed by Justin, Suzanne, and Andrew
addition to Justin and Suzanne, Andrew Keegan, who pro-
would be to begin a regular dividend payment to share-
vided capital for the company, is the third primary owner.
holders. How would you evaluate this proposal?
Each owns 25 percent of the one million shares outstanding.
The company has several other individuals, including current 5. One way to value a share of stock is the dividend growth,
employees, who own the remaining shares. or growing perpetuity, model. Consider the following:
The dividend payout ratio is 1 minus b, where b is the
Recently, the company designed a new computer mother-
“retention” or “plowback” ratio. So, the dividend next
board. The company’s design is both more efficient and less
year will be the earnings next year, E1, times 1 minus the
expensive to manufacture, and the KMI design is expected to
retention ratio. The most commonly used equation to
become standard in many personal computers. After investi-
calculate the growth rate is the return on equity times the
gating the possibility of manufacturing the new motherboard,
retention ratio. Substituting these relationships into the
KMI determined that the costs involved in building a new
dividend growth model, we get the following equation
plant would be prohibitive. The owners also decided that they
to calculate the price of a share of stock today:
were unwilling to bring in another large outside owner. In-
E1(1 - b)
stead, KMI sold the design to an outside firm. The sale of the P0 = _____________ where Rs = Expected rate of return
motherboard design was completed for an after-tax payment Rs - ROE × b
of $40 million. What are the implications of this result in terms of
whether the company should pay a dividend or upgrade
and expand its manufacturing capability? Explain.

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 518 Part 6: Cost of Capital and Long-Term Financial Policy

Internet Application Questions

1. Buying back a company’s own shares is an alternative way of distributing corporate assets. Share buybacks involve both capital
structure and dividend policy. In fact, share repurchases have overtaken dividends as the most popular means of cash payouts
by corporations in the U.S. The following link explains the advantages of share repurchases, and also cautions against cases
where repurchases have not or will not work.
fool.com/EveningNews/FOTH/1998/foth981019.htm
Discuss the following questions after reading the link above.
a. Show that share repurchases and dividend payments are equivalent, in the sense that they do not affect relative corporate
value.
b. The link above argues that Circus Circus (NYSE: CIR) and Trump (NYSE: DJT) should have avoided buying back their
shares. Do you agree with the admonition that highly leveraged firms should not use share buybacks? What are you assuming
about dividend policy when you answer this question?
c. The link also contends that share buybacks enhance shareholder value when done properly and cites three companies as
virtuous examples: Coke (NYSE: KO), Intel (Nasdaq: INTC), and Chrysler (NYSE: C). Keeping in mind that the article was
written in October 1998, what lessons do you draw from the successful repurchase strategies of these firms?
2. Dividend reinvestment plans (DRIPs) permit shareholders to automatically reinvest cash dividends in the company. To find
out more about DRIPs go to fool.com/School/Drips.htm?ref=SchAg. What are the advantages that Motley Fool lists for DRIPs?
What are the different types of DRIPs? What is a Direct Purchase Plan? How does a Direct Purchase Plan differ from a DRIP?
3. Information on recently announced dividends and stock splits for the U.S. markets can be found at earnings.com. How many
companies went “ex” today? What is the largest declared dividend? Are there any reverse splits listed? What is the largest split
in terms of the number of shares?
4. How many times has Royal Bank of Canada stock split? Go to the website rbc.com and visit the “Investor Relations” section.
You will find share information, including dates of stock splits. Were there any splits accomplished in unique ways? When did
the splits occur?
5. Go to canadiandividendstock.com/best-canadian-dividend-stocks/ and find the best Canadian dividend stocks for the most
recent date. This website highlights some Canadian stocks which are high dividend achievers. To find the dividend history of
Canadian stocks visit ca.dividendinvestor.com/

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