CFIN_13.pdf

Capital Structure and Dividend Policy 1

CAPITAL STRUCTURE AND DIVIDEND POLICY

Capital Structure

In the section of the notes titled Cost of Capital, we examined how the cost of capital is determined.

From those notes, you should have discovered that each type of funds the firm uses has a cost and that

the required rate of return for the firm is the weighted average of the costs of the individual

components of capitalthat is, debt, preferred stock, and common equitywhich is designated the

weighted average cost of capital, or WACC. The WACC is calculated as follows:

)e

r or s

r(s

w ps

rps

w dT

rd

w

WACCequitycommon

ofCost

equitycommon

of oportionPr

stock preferred

ofCost

stock preferred

of oportionPr

debt ofcost

taxAfter

debt of

oportionPr

The question we address in this section is whether the amount, or proportion, of each type of funds the

firm uses affects the overall value of the WACC. The above equation suggests that the required rate of

return, which is WACC, is affected by the proportion of debt, wd, the proportion of preferred stock,

wps, and the proportion of common equity, ws, the firm uses. But, the individual component costs of

capital might also be affected by the proportions of each type of funds that the firm uses. For example,

all else equal, the more debt a firm uses, the higher its cost of debt. In any event, if the overall WACC

is affected by how the firm finances itselfthat is, how much debt and equity it usesthen we want

the be able to determine the proportion of each type of funds the firm should use to maximize its value.

The Target Capital Structurecapital structure refers to the combination of funds, in the form of

debt and equity, a firm uses to finance its assets. A firm usually sets a target capital structure,

which is the proportion of debt and equity it wants to use to finance investments, that is used as a

benchmark when raising funds for investing in new capital budgeting projects. Generally if a firm

uses more debt, the risk associated with its future earnings is increased. At the same time, however,

because debt has a fixed cost (that is, interest), more debt allows the firm to earn a higher expected

rate of return. Thus, there is a risk/return tradeoff associated with increasing (decreasing) debt. The

firm should use the amount of debt that maximizes the value of the firm. Stated differently, at the

best, or optimal, capital structure, the value of the firm is maximized because the overall WACC is

minimized.

The following factors should be considered when making decisions about the capital structure of a

firm:

1. Business riskfirms with greater business risk generally cannot take on as much debt as firms

with less business risk. A more detailed discussion of business risk is given below.

2. Tax positionremember interest on debt is tax deductible, which makes debt attractive as a

source of financing. Also remember that more debt generally implies a greater chance of

bankruptcy, which is extremely expensive.

3. Financial flexibilityto strengthen its balance sheet, a firm might raise funds by issuing more


common stock. On a relative basis, a stronger financial positionthat is, stronger balance

sheetgenerally implies the firm is better able to raise funds in the capital markets in a

slumping economy.

4. Managerial attitude (conservatism or aggressiveness)some financial managers are more

conservative than others when it comes to using debt, thus they are inclined to use less debt, all

else equal.

Business and Financial Riskthe risk associated with a firm can be divided into two components:

(1) the risk associated with the type of business the firm operatesthat is, competitive conditions,

whether the industry is capital-intensive or labor-intensive, dangers associated with the

manufacturing process, and so forthis termed its business risk; and the risk associated with how

the firm is financedthat is, what portion of the financing is debt and what portion is equityis

termed its financial risk.

o Business riskwe evaluate business risk by examining the stability of a firms operations and

its ability to maintain operating income. Generally less business risk is associated with greater

stability in sales, operating expenses, and the like, greater flexibility in the ability to change

selling prices, and less relative fixed operating costs (that is, operating leverage, which was

discussed in the section of the notes titled Forecasting, Planning, and Control).

o Financial riskthis risk is associated with the ability of a firm to meet its financial obligations,

which means this form of risk arises when the firm uses sources of financing that require fix

payments or obligationsthat is, financial leverage (discussed in the section of the notes titled

Forecasting, Planning, and Control) exists. Financial risk affects the ability of a firm to

generate stable income for common stockholdersthat is, financial risk affects the risk of

common stock.

Determining the Optimal Capital Structureremember that the optimal capital structure is the

combination of debt and equity that maximizes the value of the firm.

o EBIT/EPS analysis of the effect of financial leveragewe can evaluate the attractiveness of a

particular capital structure by examining how changing the proportion of debt a firm uses

affects its EPS. To illustrate, consider the following information for a hypothetical firm:

Total capital = $2,000,000

Type of Economy Operating Income (EBIT) Probability

Boom $800,000 0.3

Normal 400,000 0.5

Recession 100,000 0.2

Amount of Debt Shares of

Used by the Firm Debt/Asset Ratio Interest Rate, rd Stock Outstanding*

$ 500,000 25.0% 9.0% 300,000

1,000,000 50.0 11.0 200,000

1,500,000 75.0 20.0 100,000


* If the firm only uses equitythat is, there is no debtthere will be 400,000 shares of stock

outstanding. To evaluate the impact of changing the capital structure, we keep the amount of

total capital the samethat is, $2,000,000. Therefore, if the firm is financed with $500,000

debt, the remaining $1,500,000 in capital will be equity and only 75 percent of the equity that

exists if no debt is used will exist if 25 percent of the firms capital structure is debt. In this

case, the number of shares of stock outstanding will be 300,000 = 0.75 400,000. The

number of shares outstanding under the other alternatives is similarly computed.

Based on this information, the EPS for each situation is as follows:

Type of Economy Boom Normal Recession

Probability 0.3 0.5 0.2 Proportion of Debt (D/A) = 0%

EBIT $800,000 $400,000 $100,000

Interest 0 0 0

Earnings before taxes 800,000 400,000 100,000

Taxes (40%) (320,000) (160,000) (40,000)

Net income $480,000 $240,000 $ 60,000

EPS (400,000 shares) $1.20 $0.60 $0.15

Expected EPS $0.69

Standard deviation of EPS $0.37

Proportion of Debt (D/A) = 25%

EBIT $800,000 $400,000 $100,000

Interest (45,000) (45,000) (45,000)

Earnings before taxes 755,000 355,000 55,000

Taxes (40%) (302,000) (142,000) (22,000)

Net income $453,000 $213,000 $ 33,000

EPS (300,000 shares) $1.51 $0.71 $0.11

Expected EPS $0.83



EBIT $800,000 $400,000 $100,000

Interest (110,000) (110,000) (110,000)

Earnings before taxes 690,000 290,000 (10,000)

Taxes (40%) (276,000) (116,000) 4,000

Net income $414,000 $174,000 $ (6,000)

EPS (200,000 shares) $2.07 $0.87 $(0.03)

Expected EPS $1.05




EBIT $800,000 $400,000 $100,000

Interest (300,000) (300,000) (300,000)

Earnings before taxes 500,000 100,000 (200,000)

Taxes (40%) (200,000) (40,000) 80,000

Net income $300,000 $ 60,000 $(120,000)

EPS (100,000 shares) $3.00 $0.60 $(1.20)

Expected EPS $0.96


Summarizing the results provided above, we have the following:

Proportion

of Debt Expected EPS Standard Deviation

0.0% $0.69 $0.37

25.0 0.83 0.50

50.0 1.05 0.75

75.0 0.96 1.50

According to this information, the firms EPS peaks at a capital structure that includes 50

percent debt and 50 percent equity. However, this capital structure might not be optimal, as we

will see in the sections that follow.

EPS Indifference analysis--if our hypothetical firm wants to decide between two capital

structures, say, all equity financing and 50 percent debt, then the financial manager would want

to know at what levels of sales it is better to be an all equity firm and at what levels of sales it

would be better to be financed with 50 percent debt. This decision can be made by graphing

EPS for both financing plans at various levels of sales. The following graph shows the EPS

figures for our hypothetical firm at different sales levels assuming the firm has fixed operating

costs equal to $400,000 and variable operating costs equal to 60 percent of sales.

2.0 3.0 4.01.0

0.50

1.00

1.50

2.00

2.50

3.00

-0.50

-1.00

EPS ($)

Sales(millions)

50% DebtFinancing

100% StockFinancing

Advantageof Equity

EPS Indifference$1.55 million

0.33

Advantageof Debt


The preferred financing plan is the one that produces the higher EPS. Thus, as you can see from

the graph, financing the firm with all equity is preferable if sales are below $1.55 million;

otherwise, the financing plan with 50 percent debt is preferred.

The effect of capital structure on stock prices and the cost of capitalwhen we try to find the

optimal capital structure for a firm, we want to determine the mix of debt and equity that

maximizes the value of the firmthat is, its stock pricenot the EPS. The proportion of debt

in the optimal capital structure will be less than the proportion of debt needed to maximize EPS

because the market valuation of the stock, P0, considers the risk associated with the firms

operations expected well into the future and EPS is based only on the firms operations

expected for the next few years.

To determine a firms optimal capital structure, first consider the fact that the relationship of the

cost of equity, rs, and the amount of debt the firm uses to finance its assets can be illustrated as

follows:

Required Return on

Equity, ks (%)

% Debt in Capital Structure

ks = kRF + risk premium

Risk-free rate of return

Premium for business risk at aparticular level of operations

Premium for financial risk

kRF

According to the graph, for a given level of operations, the required return on (cost of) equity,

rs, is affected by the firms financial risk, which is based on the amount of debt used to finance

its assets. Although debt increases the cost of equity, the tax benefit associated with using debt

(interest paid is tax deductible) generally requires firms to use some debt to finance assets. But,

at some point, the tax benefit is overshadowed by the additional risk the firm incurs by

increasing the amount of debt it uses, which causes the cost of additional debt to increase

significantly. In other words, the risk of bankruptcy increases so significantly that increases in

the cost of debt, rd, more than offset the benefit associated with the tax deductibility of the

interest payments. Therefore, the relationship of the cost of debt, the cost of equity, and the

WACC with the amount of debt used to finance assets might look like the following:

rs (%)

rRF

rs = rRF


After-tax costof debt, kdT

WACC

Cost ofCapital (%)

Proportion of Debt inthe Capital Structure

Optimal Amountof Debt

MinimumWACC

Cost ofequity, ks

As you can see from the graph, (1) if the firm uses only equity to finance its assets (that is, zero

debt is used) then WACC = rs; (2) as the firm begins to use some debt for financing, WACC

declines, primarily because the tax benefit offered by the debt more than offsets the increased cost

of equity, rs; (3) at some point the tax benefit associated with debt is more than offset by increases

in the before-tax cost of debt and the cost of equity that result from increases in the risk

associated with the additional debt and, at this point, WACC begins to increase; and (4) the point

where WACC is the lowest is the optimal capital structurethis is the point where the value of

the firm is maximized. Remember that WACC represents a cost to the firmthat is, it is the

average rate of return the firm pays for the funds it uses to finance its assets, which is similar to

the interest paid by an individual on a mortgageand, rationally, the firm wants to minimize any

of its costs, all else equal.

Degree of Leveragethe information provided in this section has been discussed in great detail in

the section of the notes titled Forecasting, Planning, and Control, so this section should serve as a

review. As we will illustrate in this section, all else equal, if a firm can reduce its operating

leverage, it can use more debt (that is, increase its financial leverage), and vice versa.

o Degree of operating leverage (DOL)remember that DOL refers to the percentage change in

operating income, designated either NOI or EBIT, that results from a particular percentage

change in sales. In previous notes, we showed that DOL can be computed as follows:

FVCS

VCS

F)VP(Q

)VP(Q

salein change%

NOIin change %DOL

where Q represents the number of products (units) the firm currently sells, P is the price per

unit, V is the variable cost ratio (as a percent of sales), F is the fixed operating costs, S is

current sales stated in dollars such that S = Q P, and VC is the total variable costs of

operations such that VC = Q V.

rdT

rs


All else equal, firms with riskier operations have higher DOLs.

o Degree of financial leverage (DFL)refers to the percentage change in EPS that results from a

particular percentage change in earnings before interest and taxes, EBIT. DFL is computed as

follows:

IFVCS

FVCS

IEBIT

EBIT

EBITin change %

EPSin change %DFL

where I is the dollar interest paid on outstanding debt. The DFL equation given here applies

only to firms that have no preferred stock outstanding.

All else equal, firms with riskier financial positions have higher DFLs.

o Degree of total leverage (DTL)refers to the percentage change in EPS that results from a

particular percentage change in sales. DTL combines DOL and DFL, and it is computed as follows:

IFVCS

VCS

IF)VP(Q

)VP(Q

DFLDOLsalein change %

EPSin change %DTL

All else equal, firms that have high DTLs are considered riskier in general than firms with low

DTLs.

To illustrate the concept of leverage, consider the following situation:

Current Sales 10%

Expected Less Than

Sales Expected % Sales $875,000 $787,500 -10.00%

Variable operating costs (70% of sales) (612,500) (551,250) -10.00%

Gross profit 262,500 236,250 -10.00%

Fixed operating costs (150,000) (150,000) 0.00%

Net operating income, NOI = EBIT 112,500 86,250 -23.33%

Interest ( 50,000) ( 50,000) 0.00%

Taxable income 62,500 36,250 -42.00%

Taxes (40%) ( 25,000) ( 14,500) -42.00%

Net income $ 37,500 $ 21,750 -42.00%

DOL = 2.33 = $262,500/$112,500

DFL = 1.80 = $112,500/($112,500 - $50,000)

DTL = 4.20 = 2.33 1.80 = $262,500/($112,500 - $50,000)


The table shows that when DOL = 2.33, a 10 percent decrease (increase) in sales will cause a

23.3 percent decrease (increase) in NOI; when DFL = 1.80, a 23.3 percent decrease (increase) in

EBIT will cause a 42.0 percent decrease (increase) in EPS (net income divided by the number

of shares of common stock that are outstanding); and, in combination, when DTL = 4.20, a 10

percent decrease (increase) in sales will cause a 42 percent decrease (increase) in EPS.

The concept of leverage can be used to determine the impact that a change in capital structure

will have on the riskiness, thus the WACC, of a firm.

Liquidity and Capital Structurea manager might not operate at the optimal capital structure

because s/he might (1) find it difficult, if not impossible, to determine the optimal capital structure;

(2) be reluctant to take on the amount of debt necessary to achieve the optimal capital structure

(that is, have a conservative attitude toward debt financing); or (3) provide important services that

prohibit him or her from endangering the ability of the firm to survive, which might be the case if

the firm is financed using the optimal mix of capital.

Often, firms use measures of financial liquidity, such as the times-interest-earned (TIE) ratio, to

provide an indication of financial strength. Remember that the TIE ratio gives an indication of how

many times a firm can cover the interest payments associated with its debt financing. Generally, a

firm with a higher TIE ratio is said to have greater financial liquidity and lower threat of

bankruptcy than a firm with a lower TIE ratio.

Capital Structure Theoryacademicians have proposed many theories regarding the capital

structures of firms. The two major theories are summarized as follows:

o Trade-off theorymore than 40 years ago Franco Modigliani and Merton Miller, who have

since won the Nobel prize for Economics, developed a theory that showed firms should favor

using debt in their capital structures because the tax deductibility of interest payments is such a

benefit. Under a very restrictive set of assumptions, they showed that the value of a firm

increases as it uses more and more debt. In fact, according to their theory, the value of the firm

is maximized when it is financed with nearly 100 percent debt. However, the theory ignored the

costs associated with bankruptcy, which can be considerable. When the costs of bankruptcy are

considered, there is a point where the benefit of the tax deductibility of debt is more than offset

by increases in the cost of debt and the cost of equity that result from the risk associated with

the firms heavy use of debt.

o Signaling theorymost people agree that managers and other insiders possess more

information about the firm than outside investors. The fact that managers have asymmetric

information, which means they have some information that outside investors do not, could

mean that any action taken by a firm, including how it raises funds (capital), might provide a

signal to the less-informed investors. For example, studies have shown that when firms issue

new common stock to raise funds the per share value of the stock decreases. It has been

suggested that this occurs because managers would only issue new common stock if they felt

that the firms future prospects were unfavorable. Consider the fact that when new stock is

issued, new stockholders join the firms existing stockholders to share in any future changes in

value. Thus, if the firms future was extremely optimistic, managers would want to make


existing stockholders happy by allowing them to receive all of the increase in value that will

result from the favorable prospects, which means managers would choose to issue debt rather

than equity. When debt is issued, only the contracted costs need to be paidthat is, fixed

interest and the repayment of the debtand the remaining gains from the favorable projects

accrue to the stockholders.

Variations in Capital Structures among Firmsthere are wide differences in capital structures

among firms in the United States. Much of the difference depends on the type of operations,

including the stability of sales that is associated with the firm. For example, firms in industries that

have high degrees of research and development costs, such as pharmaceuticals, generally have

capital structures that contain lower proportions of debt than firms in industries that have relatively

stable, predictable cash flows, such as utilities.

Capital Structures around the Worldcapital structures vary significantly around the world. In

countries where the debt is closely held so that the costs of monitoring firms are relatively low (that

is, where bank loans or syndicates are used), firms have greater proportions of debt than firms in

countries where debt is held by a large number of diverse investors. In countries where firms are

required to regularly provide information about operations and finances to stockholders, firms have

greater proportions of equity than firms in countries where such information is not required. In

essence, whichever form of financing is more easily monitored by investors to ensure their best

interests are being followed by management is the one that is more prevalent in capital structures.

Dividend Policy

Dividends are cash payments made to stockholders. Decisions about when and how much of earnings

should be paid as dividends are part of the firms dividend policy. Earnings that are paid out as

dividends cannot be used by the firm to invest in projects with positive net present valuesthat is, to

increase the value of the firm. The dividend policy that maximizes the value of the firm is said to be the

optimal dividend policy.

Dividend Policy and Stock Valueresearchers argue whether there exists an optimal dividend

policy. Some academicians argue that a firms dividend policy does not affect the value of a firm

(dividend irrelevance theory), while other argue that the dividend policy is an important factor in

the determination of a firm=s value (dividend relevance theory).

Investors and Dividend Policyinvestors reactions to changes in dividend policies can be

summarized as follows:

o Information content, or signalingthere is a belief that managers change dividends (increase or

decrease) only when it is necessarythat is, decreases occur only when the firm is facing

financial difficulty, while increases occur only when it is expected that the firm can continue to

pay higher dividends long into the future. If this is true, then changes in a firms dividend policy

provide information to investors, who will react accordingly. For example, investors would


consider an increase (decrease) in dividends to be good (bad) news, and thus increase (decrease)

the price of the firms stock.

o Clientele effectinvestors might choose a particular stock due to the firms dividend policy

that is, some investors prefer dividends and others do not. If such a clientele effect does exist,

then we would expect that a firms stock price will change when its dividend policy is changed.

o Free cash flow hypothesisif investors truly want managers to maximize the value of the firm,

then dividends should be paid only when the firm has no investments with positive net present

values. In other words, a firm should pay dividends only when it has funds that are not needed

to invest in positive NPV projectsthat is, only free cash flows should be paid as dividends. If

this theory is correct, then we might expect a firms stock price to increase when it decreases

dividends to invest in positive NPV projects, and we might expect the stock price to decrease

when the firm increases dividends because it no longer has as many positive NPV projects as it

did in prior years.

Dividend Policy in Practiceprocedures that are followed in practice include the following:

o Types of dividend payments

Residual dividend policyas an investor, you should want the firm to retain any earnings it can invest at a rate of return that is at least as high as your opportunity cost. Firms that agree

with this concept might follow a residual dividend policy where dividends are paid only if

earnings are greater than what is needed to finance the equity portion of the firms optimal

capital budget for the year. Therefore, if the residual dividend policy is followed, the firm

should not pay dividends when it is necessary to issue new common stock to provide equity

financing for the current capital budgeting needs.

Stable, predictable dividendssome managers believe that dividends should never be decreased unless it is absolutely necessary. These managers probably follow a stable,

predictable dividend policy, which requires that the firm pays a dividend that is the same

every year or is constant for some period and then is increased at particular intervalsthat

is, dividend payments are fairly predictable. Greater predictability is associated with greater

certainty and lees risk, which implies a lower overall WACC and a higher firm value. In

practice, more firms actually follow some form of this dividend policy.

Constant payout ratioa firms dividend payout ratio is defined as the proportion of earnings per share (EPS) that is paid out as dividends (DPS)that is, payout ratio =

DPS/EPS. Firms that follow a constant payout ratio dividend policy pay the same

percentage of earnings as dividends each year. For example, a firm might pay 60 percent of

its earnings as dividends. If so, then dividends will fluctuate as earnings fluctuate.

Low regular dividend plus extrasrequires a firm to pay some minimum dollar dividend each year and then to pay an extra dividend when the firms performance is above normal

(or above some minimum standard)

o Payment proceduresdividends are usually paid quarterly. The following dates are important

when establishing a dividend policy:

Declaration datethe date the board of directors states that a dividend will be paid to stockholders. A dividend is not a liability to the firm until it is declared.

Holder-of-record datethe date the firm opens its ownership books to determine who will receive dividends. Persons whose names appear in the ownership books after the


holder-of-record date, which is also termed the date of record, but prior to the date the

dividend is paid will not receive a dividend payment.

Ex-dividend datetwo working days before the holder-of-record date. Ex dividend means without dividend; so, on the ex-dividend date, the stock begins to sell without the right to

receive the next dividend payment. In essence, the stock sells without the right to receive

the dividend payment because there is not enough time for the names of new stockholders

to be registered before the holder-of-record date.

Payment datethe date the firm mails the dividend checks. o Dividend reinvestment plansplans that permit stockholders to have dividend payments

automatically reinvested in the firms stock. Dividend reinvestment plans, which are referred to

as DRIPs, allow stockholders to buy additional shares of a firms stock on a pro rata basis using

the cash dividend paid by the firm. Often there are little or no brokerage fees involved with

DRIPs.

Factors Influencing Dividend Policywhen developing a dividend policy, the following factors

should be considered:

o Constraints on dividend paymentsthe amount of dividends a firm pays might be limited by:

(1) restrictions in debt agreements that state the maximum amount of dividends that can be paid

in any year; (1) the amount of retained earnings, which represents the maximum amount of

dividends that can be paid at any time; (2) the liquidity position of the firmif cash is not

available, dividends cannot be paid; and (4) limits of the IRS on the amount of earnings a firm

can retain for non-specific reasons.

o Investment opportunitiesfirms that need great amounts of funds for positive NPV

investments usually pay relatively lower amounts of dividends than firms with few positive

NPV investments.

o Alternative sources of capitalthe higher the costs of issuing new common stock, generally the

lower the relative amount of dividends paid by a firm; firms that are concerned about diluting

current ownership through new issues of common stock are likely to pay relatively low

dividends.

o Effects of dividend policy on rsin an effort to minimize its WACC through the cost of equity,

rs, a firm will examine the effect a dividend policy has on its required rate of return. Factors

such as risk perception, information content (signaling), and preference for current returns

versus future returns (that is, dividend yield or capital gains) are considered when the dividend

policy is established.

Stock Splits and Stock Dividendsto this point, we have examined the dividend policy that relates

to cash payments. Some firms pay dividends in the form of stock or change the number of shares of

stock that is outstanding through a stock split. As you will discover in the discussion that follows,

neither of these actions by themselves has economic value in the sense that each does nothing to

change stockholders wealth.

o Stock splitsan action taken by a firm to change the number of outstanding shares of stock.

Many firms believe their stock has an optimal price range within which their stock should trade.

If the price of the stock exceeds the price range, then the firm will execute a stock split. If a

firm initiates a 2-for-1 stock split, each existing stockholder will receive two shares of stock for


each one share he or she now owns. This action should cut the market price of the stock exactly

in half. But, there is evidence that shows the price of the stock actually settles above one half

the pre-split price. Perhaps the reason this occurs is because investors believe the split provides

positive information; specifically that the firm expects the price of the stock to increase further

above the optimal range in the future. In any event, there really is no specific economic value

associated with a stock split. As an investor, unless the market reacts positively or negatively to

the split, the only effect the split has is to increase the number of shares of stock you own, with

each share valued at a lower relative price such that your wealth position has not changed.

o Stock dividendsdividends paid in the form of stock rather than cash. Like stock splits, a stock

dividend does not have specific economic value; rather, it increases the total number of shares

of stock each stockholder owns. At the same time, the stock price per share decreases because

investors have not provided any funds for the additional shares of stock. A firm might use a

stock dividend to keep the price of its stock within a particular range.

o Balance sheet effectsfor stock splits, the only effect on the balance sheet is that the number of

shares outstanding changes relative to the split, which also changes the stated par value of the

stock (if there is one). If a firm executes a 2-for-1 split, for example, it would double the

number of shares outstanding and halve the par value of the stock reported on the balance sheet.

The total dollar values in each common equity account would not change. When a stock

dividend is paid, on the other hand, the firm must transfer capital from retained earnings to the

Common stock account and the Additional paid-in capital account to reflect the fact that a

dividend was paid. The transfer from retained earnings is computed as follows:

stock theof

priceMarket percent a asdividendStock

goutstandinshares ofNumber

earnings retained fromed transferrFunds

To illustrate, consider a firm that decides to pay a 5 percent stock dividend. The market price of

the firms stock is $80 and it has 20 million shares of $2 par stock outstanding before the stock

dividend. According to the above equation, the amount transferred would be:

000,000,80$80$000,000,180$)05.0(000,000,20earnings retained

fromTransfer

After the stock dividend, the firm would show $80 million less in retained earnings. In the

common equity portion of the its balance sheet, there would now be 21 million shares of stock

outstanding (20 million existing shares plus one million shares associated with the stock

dividend), the Common equity account would increase by $2 million (1 million shares $2

par), and the Additional paid-in capital would increase by $78 million ($80 million less that

$2 million increase in Common equity).

o Price effectseven though both stock splits and stock dividends only increase the number of

outstanding shares of stock, studies have shown that the market price of the stock affected by

such actions might changeif investors expect future earnings and cash dividends to increase

(decrease), then the price will increase (decrease) above the relative price associated with the

stock split or the stock dividend. For example, if investors believe a firm initiated a 2-for-1

stock split because its future earnings will cause the price of the stock to increase well above its


optimal range, then their reaction to the split will cause the post-split price of the stock to be

greater than one half the pre-split price. If the future expectations do not pan out, however, the

price of the stock will eventually settle at about one half the pre-split price.

Dividend Policies around the Worldthere is great variation in dividend policies of firms in

different parts of the world. In most parts of the world, dividend policies are based on local tax

laws. For example, in countries where the tax on capital gains is less than the tax on dividends,

firms tend to retain greater amounts of earnings than in countries where the tax on dividends is

relatively small. Also, in countries that have few regulations to protect small stockholders,

companies tend to pay greater amounts of earnings as dividends.

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CFIN_13.pdf