Chapter 18: Dividend Policy and Retained Earnings
Chapter 18
Dividend Policy and Retained Earnings
Discussion Questions
18-1.
How does the marginal principle of retained earnings relate to the returns that a
stockholder may make in other investments?
18-2.
Discuss the difference between a passive and an active dividend policy.
18-3.
How does the stockholder, in general, feel about the relevance of dividends?
18-4.
Explain the relationship between a company’s growth possibilities and its
dividend policy.
Chapter 18: Dividend Policy and Retained Earnings
18-5.
Since initial contributed capital theoretically belongs to the stockholders, why are
there legal restrictions on paying out the funds to the stockholders?
18-6.
Discuss how desire for control may influence a firm’s willingness to pay
dividends.
18-7.
If you buy stock on the ex-dividend date, will you receive the upcoming quarterly
dividend?
18-8.
How is a stock split (versus a stock dividend) treated on the financial
statements of a corporation?
Chapter 18: Dividend Policy and Retained Earnings
18-9.
Why might a stock dividend or a stock split be of limited value to an investor?
18-10.
Does it make sense for a corporation to repurchase its own stock? Explain.
18-11.
What advantages to the corporation and the stockholder do dividend
reinvestment plans offer?
Chapter 18: Dividend Policy and Retained Earnings
1. Payout ratio (LO18-1) Moon and Sons Inc. earned $120 million last year and retained $72
million. What is the payout ratio?
18-1. Solution:
Moon and Sons Inc.
2. Payout ratio (LO18-1) Ralston Gourmet Foods Inc. earned $360 million last year and
retained $252 million. What is the payout ratio?
18-2. Solution:
Ralston Gourmet Foods Inc.
Chapter 18: Dividend Policy and Retained Earnings
3. Payout ratio (LO18-1) Swank Clothiers earned $640 million last year and had a 30
percent payout ratio. How much did the firm add to its retained earnings?
18-3. Solution:
Swank Clothiers
4. Dividends, retained earnings, and yield (LO18-1) Polycom Systems earned $553 million
last year and paid out 25 percent of earnings in dividends.
18-4. Solution:
Polycom Systems
a. Addition to retained earnings= Earnings – Dividends
5. Growth and dividend policy (LO18-2) The following companies have different financial
statistics. What dividend policies would you recommend for them? Explain your reasons.
Chapter 18: Dividend Policy and Retained Earnings
18-5. Solution:
6. Limits on dividends (LO18-3) Planetary Travel Co. has $240,000,000 in stockholders’
equity. Eighty million dollars is listed as common stock and the balance is in retained
earnings. The firm has $500,000,000 in total assets and 2 percent of this value is in cash.
Earnings for the year are $40,000,000 and are included in retained earnings.
18-6. Solution:
Planetary Travel Co.
a. The legal limit is equal to retained earnings
Retained earnings = Stockholder’s equity – Common stock
Chapter 18: Dividend Policy and Retained Earnings
c. Payout ratio = Dividends/Earnings
= $10,000,000/40,000,000 = 25%
7. Life cycle growth and dividends (LO18-2) A financial analyst is attempting to assess the
future dividend policy of Environmental Systems by examining its life cycle. She anticipates
no payout of earnings in the form of cash dividends during the development stage (I). During
the growth stage (II), she anticipates 12 percent of earnings will be distributed as dividends.
As the firm progresses to the expansion stage (III), the payout ratio will go up to 35 percent
and eventually reach 58 percent during the maturity stage (IV).
Environmental Systems
a.
Earnings
Payout Ratio
Dividends
b. Total Dividends = Shares × Dividends per share
= 325 × $2.15
= $698.75
Aftertax income = Total dividends × (1 – T)
= $698.75 × (1 – .15)
= $698.75 × (.85)
Chapter 18: Dividend Policy and Retained Earnings
= $593.94
c. Stock dividends or stock splits are most likely to be utilized
during stage II (growth) or stage III (expansion).
8. Stock split and stock dividend (LO18-4) Squash Delight Inc. has the following balance
sheet:
Assets
Cash................................................................ $ 100,000
Accounts receivable ....................................... 300,000
Fixed assets .................................................... 600,000
Total assets ............................................ $1,000,000
Liabilities
Accounts payable ......................... $ 150,000
Chapter 18: Dividend Policy and Retained Earnings
18-8. Solution:
Squash Delight Inc.
a. 2 for 1 stock split
* Common stock (100,000 shares @ $1 par) $100,000
Capital excess of par 200,000
Retained earnings 500,000
* The only account affected
9. Policy on payout ratio (LO18-1) In doing a five-year analysis of future dividends, the
Dawson Corporation is considering the following two plans. The values represent
dividends per share.
Year Plan A Plan B
1 .................. $1.70 $ .60
2 .................. 1.70 2.50
3 .................. 1.70 .30
4 .................. 1.90 5.00
5 .................. 1.90 1.30
a. How much in total dividends per share will be paid under each plan over five years?
Chapter 18: Dividend Policy and Retained Earnings
18-9. Solution:
Dawson Corporation
Present value of future dividends
$6.53
Present value of future dividends
$6.28
10. Dividend yield (LO18-1) The stock of Pills Berry Company is currently selling at $60 per
share. The firm pays a dividend of $1.80 per share.
18-10. Solution:
Pills Berry Company
11. Dividend yield (LO18-1) The shares of the Dyer Drilling Co. sell for $60. The firm has a
P/E ratio of 15. Forty percent of earnings is paid out in dividends. What is the firm’s
dividend yield?
18-11. Solution:
Dyer Drilling Company
Earnings per share = Stock price/Price – Earnings ratio
Chapter 18: Dividend Policy and Retained Earnings
5.6 percent, and dividends are distributed quarterly. Based solely on the impact of the cash
Peabody Mining Company
Annual dividend = 5.6% × $50 = $2.80
Quarterly dividend = $2.80/4 = $.70
The stock should go down by $.70 to $49.30.
13. Stock dividend and cash dividend (LO18-4) The Western Pipe Company has the
following capital section in its balance sheet. Its stock is currently selling for $6 per share.
Western Pipe Co.
After first transaction
Common stock (57,500 shares at $2 par) ........... $ 115,000
Chapter 18: Dividend Policy and Retained Earnings
Capital in excess of par* ..................................... 130,000
Retained earnings ................................................ 205,000
$450,000
*Capital in excess of par = 100,000 + 7500($6 – $4) =130,000
14. Cash dividend policy (LO18-1) Phillips Rock and Mud is trying to determine the
maximum amount of cash dividends it can pay this year. Assume its balance sheet is as
follows:
Assets
Cash................................................................ $ 386,000
Accounts receivable ....................................... 836,000
Fixed assets .................................................... 1,048,000
Total assets ............................................ $2,270,000
Chapter 18: Dividend Policy and Retained Earnings
Phillips Rock and Mud
a. From a legal viewpoint, the firm can pay cash dividends
equal to retained earnings of $1,145,000. On a per share
basis, this represents $3.88 per share.
Retained earnings $1,145,000 $3.88
Shares 295,000
==
This would not be realistic in light of the firm’s cash
balance.
b.
Cash $386,000 $1.31
Shares 295,000
==
c. Stockholders’ equity = Common stock + Retained earnings
Chapter 18: Dividend Policy and Retained Earnings
$1,440,000 = $295,000 + $1,145,000
15. Dividends and stockholder wealth maximization (LO18-2) The Vinson Corporation has
earnings of $500,000 with 250,000 shares outstanding. Its P/E ratio is 20. The firm is
holding $300,000 of funds to invest or pay out in dividends. If the funds are retained, the
aftertax return on investment will be 15 percent, and this will add to present earnings. The
15 percent is the normal return anticipated for the corporation, and the P/E ratio would
remain unchanged. If the funds are paid out in the form of dividends, the P/E ratio will
increase by 10 percent because the stockholders in this corporation have a preference for
dividends over retained earnings. Which plan will maximize the market value of the stock?
18-15. Solution:
Vinson Corporation
Retained Earnings
Incremental earnings = 15% × $300,000 = $45,000
Chapter 18: Dividend Policy and Retained Earnings
Earnings per share =
Price of stock = P/E × EPS
= 22 × $2.00 = $44.00
The payout option provides the maximum market value.
16. Dividend valuation model and wealth maximization (LO18-2) Omni Telecom is trying
to decide whether to increase its cash dividend immediately or use the funds to increase its
future growth rate. It will use the dividend valuation model originally presented in Chapter
10 for purposes of analysis. The model was shown as Formula 10-9 and is reproduced next
(with a slight addition in definition of terms):
01
D
PKg
e
=−
P0 = Price of the stock today
D1 = Dividend at the end of the first year
D0 × (1 + g)
D0 = Dividend today
Chapter 18: Dividend Policy and Retained Earnings
18-16. Solution:
Omni Telecom
a. Plan A – Increase cash dividend immediately
.10 .05 .05
−
b. Plan B – Increase growth rate
D
Chapter 18: Dividend Policy and Retained Earnings
c. Plan B, which calls for using funds to increase the growth
rate, will produce a higher value.
17. Stock split and its effects (LO18-4) Wilson Pharmaceuticals’ stock has done very well in
the market during the last three years. It has risen from $55 to $80 per share. The firm’s
current statement of stockholders’ equity is as follows:
Common stock (5 million shares issued
at a par value of $10 per share) .............
$ 50,000,000
Paid-in capital in excess of par ................
13,000,000
Retained earnings .....................................
57,000,000
Wilson Pharmaceutical
a. Ten (10) million shares would be outstanding at a par value
of $5 per share. Everything else will be the same.
b. Fifteen (15) million shares would be outstanding at a par
value of $3.33 per share. Everything else will be the same.
c. EPS before split = $11,000,000/5,000,000 shares
= $2.20 EPS
EPS after 2-1 split = $11,000,000/10,000,000 shares
= $1.10 EPS
Chapter 18: Dividend Policy and Retained Earnings
EPS after 3-1 split = $11,000,000/15,000,000 shares
= $.73 EPS
18-17. (Continued)
d. P/E × EPS =Price
Price after 2-1 split = 36.36 × $1.10 = $40.00
Price after 3-1 split = 36.36 × $.73 = $26.54
18. Stock dividend and its effect (LO18-4) Ace Products sells marked playing cards to
blackjack dealers. It has not paid a dividend in many years, but is currently contemplating
some kind of dividend. The capital accounts for the firm are as follows:
Common stock (2,400,000 shares at $5 par) .......
$12,000,000
Capital in excess of par* .....................................
5,000,000
Retained earnings ................................................
23,000,000
Net worth .........................................................
$40,000,000
*The increase in capital in excess of par as a result of a stock dividend
is equal to the new shares created times (Market price – Par value).
Chapter 18: Dividend Policy and Retained Earnings
18-18. Solution:
Ace Products
a. Common stock (2,640,000 shares at $5 par) $13,200,000
18-18. (Continued)
**$23,000,000 Beginning retained earnings account
– $1,200,000 Transfer to common stock account
– $3,600,000 Transfer to capital in excess of par account
$18,200,000 Ending retained earnings account
Chapter 18: Dividend Policy and Retained Earnings
19. Stock dividend and cash dividend (LO18-4) Health Systems Inc. is considering a 15
percent stock dividend. The capital accounts are as follows:
Common stock (6,000,000 shares at $10 par) .......
$60,000,000
Capital in excess of par* .......................................
35,000,000
Retained earnings ..................................................
75,000,000
Net worth ...........................................................
$170,000,000
*The increase in capital in excess of par as a result of a stock dividend
is equal to the shares created times (Market price – Par value).
The company’s stock is selling for $32 per share. The company had total earnings of
$19,200,000 with 6,000,000 shares outstanding and earnings per share were $3.20. The
firm has a P/E ratio of 10.
Health Systems Inc.
a. Common stock (6,900,000 shares at $10 par) . $69,000,000
*Capital in excess of par ................................ 54,800,000
**Retained earnings ......................................... 46,200,000
Net worth................................................. $170,000,000
Chapter 18: Dividend Policy and Retained Earnings
18-19. (Continued)
*900,000 shares × ($32 Market price – $10 Stock price)
– 19,800,000 Transfer to capital in excess of par account
$ 46,200,000 Ending retained earnings account
($2.40 rounding difference)
e. After
92 × $32 = $2,944
Chapter 18: Dividend Policy and Retained Earnings
g.
Divided Cash dividend $1.25 3.91%
Yield Market price $32.00
= = =
20. Reverse stock split (LO18-4) Worst Buy Company has had a lot of complaints from
customers of late and its stock price is now only $2 per share. It is going to employ a one-
for-five reverse stock split to increase the stock value. Assume Dean Smith owns 140
shares.
Worst Buy Company
a. Number of shares after reverse stock split
= Original shares divided by the reverse split ratio
= 140/5 = 28 shares
b. Anticipated stock price
= Original stock price × Reverse split ratio
= $2 × 5 = $10
c. Actual stock price based on the 80 percent assumption
$10 Anticipated stock price
80% Assumption
d. Dean Smith’s total holdings
Chapter 18: Dividend Policy and Retained Earnings
Before reverse stock split
140 shares × $2 = $280
After reverse stock split
28 shares × $8.00 = $224
His holdings have decreased by $56 ($280 – $224)
20. The firm has $4 million in excess cash.
a. Compute the current price of the stock.
b. If the $4 million is used to pay dividends, how much will dividends per share be?
c. If the $4 million is used to repurchase shares in the market at a price of $54 per share,
Carlton Corporation
a. Price = P/E × EPS
EPS = $5 mil. in earnings/2 mil. shares = $2.50
Price = 20 × $2.50 = $50
b. $4 mil./2 mil. = $2 dividends per share
c. $4,000,000/$54 = 74,074 shares reacquired
Chapter 18: Dividend Policy and Retained Earnings
d. Shares outstanding after repurchase
2,000,000 – 74,074 = 1,925,926
EPS = $5,000,000/1,925,926 = $2.60
e. Price = P/E × EPS = 20 × $2.60 = $52.00
$52 – $50 = $2
18-21. (Continued)
f. No. With the cash dividend:
Market value per share $50
Cash dividend per share 2
Total value $52
With the repurchase of stock:
Total value per share $52
g. The (potential) appreciation in value associated with a stock
repurchase defers the capital gains tax until the stock is
Chapter 18: Dividend Policy and Retained Earnings
being taken over as a merger candidate. The reduction in
shares also reduces the total cash dividend paid out by the
company.
22. Retaining funds versus paying them out (LO18-1) The Hastings Sugar Corporation has
the following pattern of net income each year, and associated capital expenditure projects.
The firm can earn a higher return on the projects than the stockholders could earn if the
funds were paid out in the form of dividends.
Year
Net Income
Profitable Capital
Expenditure
1………
$14 million
$ 7 million
2………
16 million
11 million
3………
12 million
6 million
Hastings Sugar Corporation
a. Dividends represent what is left over after profitable capital
expenditures are undertaken.
Year
Net
Income
–
Profitable
Capital
Expenditures
Dividends
1
$14 mil.
$ 7 mil.
$ 7 mil.
Chapter 18: Dividend Policy and Retained Earnings
2
16 mil.
11 mil.
5 mil.
3
12 mil.
6 mil.
6 mil.
4
16 mil.
8 mil.
8 mil.
5
16 mil.
9 mil.
7 mil.
Total cash dividends
$22.2 mil.
Chapter 18: Dividend Policy and Retained Earnings
COMPREHENSIVE PROBLEM
Modern Furniture Company (Dividend payments versus stock repurchases) (LO18-5)
Modern Furniture Company had finally arrived at the point where it had a sufficient excess cash
flow of $4.8 million to consider paying a dividend. It had 3 million shares of stock outstanding
and was considering paying a cash dividend of $1.60 per share. The firm’s total earnings were
$12 million, providing $4.00 in earnings per share. The stock traded in the market at $88.00 per
share.
However, Al Rosen, the chief financial officer, was not sure that paying a cash dividend was the
best route to go. He had recently read a number of articles in The Wall Street Journal about the
advantages of stock repurchases and before he made a recommendation to the CEO and board of
directors, he decided to do a number of calculations.
a. P/E ratio = Price/EPS
= $88/$4 = 22
Dividend payout ratio =
Chapter 18: Dividend Policy and Retained Earnings
Dividend per share/Earnings per share = $1.60/$4.00 = 40%
c. Portfolio value
Stock (100 shares × $88) $8,800