©2009 McGraw-Hill Ryerson Limited 1 of Dividend Policy and Retained Earnings Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 23 Chapter 18 - Outline Dividends vs. Retained Earnings Theories of Dividend Policy Dividend Policy in Practice Other Factors Influencing Dividend Policy Alternatives to Cash Dividend Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 23 Learning Objectives 1.Discuss management’s decision criteria as to whether internally generated funds should be re-invested or paid out as dividends. (LO1) 2.Describe a dividend payment as a passive or active decision based on investor preference and the informational content of dividends. Calculate dividend payout ratios and dividend yields. (LO2)

©2009 McGraw-Hill Ryerson Limited 4 of 23 Learning Objectives 3.Outline the factors to be considered in dividend policy. Calculate aftertax income from dividends and calculate share prices based on earnings multiples. (LO3) 4.Outline dividend payment procedures. (LO4) 5.Describe the effect of stock splits and stock dividends on the position of the shareholders. Calculate the changes in the balance sheet that result. (LO5)

©2009 McGraw-Hill Ryerson Limited 5 of 23 Learning Objectives 6.Discuss the reasons for a share repurchase. (LO6) 7.Explain a dividend reinvestment plan. (LO7)

©2009 McGraw-Hill Ryerson Limited 6 of 23 Dividends vs. Retained Earnings A company has a choice or decision regarding what to do with its profits: –Pay them out to shareholders as OR –Retain the earnings in the business There is disagreement as to whether investors prefer dividends or reinvestment LO1

©2009 McGraw-Hill Ryerson Limited 7 of 23 Theories of Dividend Policy 1. Irrelevance of Dividend Policy Proposition: under ideal conditions, dividend policy is irrelevant and doesn’t affect share price. Logic: shareholders can create dividends on their own – –homemade dividends. LO1

©2009 McGraw-Hill Ryerson Limited 8 of 23 Figure 18-1 Homemade dividends LO1

©2009 McGraw-Hill Ryerson Limited 9 of 23 Theories of Dividend Policy 2. Relevance of Dividend Policy Proposition: dividend policy is relevant and a positive relationship exists between dividends and share price because a) dividends resolve uncertainty and b) dividends have information content – The corporate is saying it had a good year. As the real world is not perfect, dividend policy seems to be relevant. LO1

©2009 McGraw-Hill Ryerson Limited 10 of 23 Dividend Policy in Practice Cash dividends are usually paid quarterly, but annual dividend is used to calculate Payout Ratio = Dividend per Share/Earnings per Share Dividend Yield = Dividend per Share/Current Stock Price LO2

©2009 McGraw-Hill Ryerson Limited 11 of 23 LO2 Table 18-1 Earnings and dividends of selected Canadian corporations

©2009 McGraw-Hill Ryerson Limited 12 of 23 Dividend Policy in Practice 1. Dividend Stability Compared with volatile earnings, dividends are much more stable and predictable (Figure 18-2). 2. Life Cycle Growth and Dividends Dividend policy is reflected in 4 stages (Figure 18-3): Stage I - Development –no cash dividends Stage II - Growth –stock dividends, low cash dividends Stage III - Expansion –stock dividends, moderate cash dividends, stock splits Stage IV - Maturity –moderate to high cash dividends LO2

©2009 McGraw-Hill Ryerson Limited 13 of 23 Figure 18-2 Corporate earnings and dividends, all industries LO2 Source: Statistics Canada, “Financial Statistics for Enterprises”, Catalogue No , Tables 1 and 2.

©2009 McGraw-Hill Ryerson Limited 14 of 23 Development Stage I Development Stage I Growth Stage II Growth Stage II Expansion Stage III Expansion Stage III Maturity Stage IV Maturity Stage IV No cash dividends Stock dividends Low cash dividends Stock dividends Low to moderate cash dividends Stock splits Moderate to high cash dividends Sales ($) Development Expansion Maturit y Decline Time Growth Figure 18-3 Life cycle growth and dividend policy LO3

©2009 McGraw-Hill Ryerson Limited 15 of 23 Other Factors Influencing Dividend Policy Legal and lender restrictions Cash position of the firm Access to capital markets Desire for control Tax position of shareholders LO3

©2009 McGraw-Hill Ryerson Limited 16 of 23 Sample Calculation of Tax* on Individual Dividend Receipt Dividend received $1,000 Gross-up Taxable amount ,450 Federal tax (at 29%) Federal tax credit (18.97% of $1,450) Federal tax payable Provincial tax payable (10% of $1,450) Provincial tax credit (9% of $1,450) Provincial tax payable Total taxes payable Net dividend ($1,000 - $160) $840 *based upon an Alberta resident in the top tax bracket for 2008 LO3

©2009 McGraw-Hill Ryerson Limited 17 of 23 Dividend Payment Procedures Example: BMO’s Board of directors declare a quarterly dividend: Declaration date:May 27, 2008 Amount:$0.70 per share Record date:August 1, 2008 Ex-dividend date:July 30, 2008 Payment date:August 28, 2008 LO4

©2009 McGraw-Hill Ryerson Limited 18 of 23 Alternatives to Cash Dividend (1) Stock Dividend: a distribution of additional shares of stock There is no benefit from a stock dividend unless total cash dividends increase. Managers either retain cash for profitable investment opportunities or cover up their ineffectiveness in generating cash. LO5

©2009 McGraw-Hill Ryerson Limited 19 of 23 Stock Dividend Table 18-4 XYZ Corporation’s financial position before stock dividend CapitalCommon stock (1 million shares issued) $15,000,000 accountsRetained earnings ,000,000 Net worth $30,000,000 Table 18-5 XYZ Corporation’s financial position after stock dividend CapitalCommon stock (1.1 million shares issued). $16,500,000 accountsRetained earnings ,500,000 Net worth $30,000,000 LO5

©2009 McGraw-Hill Ryerson Limited 20 of 23 Alternatives to Cash Dividend (2) Stock Split: similar to a stock dividend, only more shares are distributed Market value of stock is unchanged initially. Primary purpose: to lower the share price into a more popular trading range LO5

©2009 McGraw-Hill Ryerson Limited 21 of 23 Before Common stock (1 million shares issued) $15,000,000 Retained earnings 15,000,000 $30,000,000 After Common stock (2 million shares issued) $15,000,000 Retained earnings 15,000,000 $30,000,000 Table 18-6 XYZ Corporation before and after stock split LO5

©2009 McGraw-Hill Ryerson Limited 22 of 23 Alternatives to Cash Dividend (3) Stock Repurchase In theory, benefits to the shareholder are the same as cash dividend. However, this changes if taxes and transaction costs are considered. Other reasons for stock repurchase: * keeping under-priced shares from further price erosion * executing for employee stock options * used as a protective device against takeover LO5

©2009 McGraw-Hill Ryerson Limited 23 of 23 Summary and Conclusions A profitable company must decide whether to retain (reinvest) earnings or to pay a cash dividend. Dividend policy relevance theory seems to be valid in our imperfect world. Two measures of dividend policy are payout ratio and dividend yield. Dividend stability is related to information content of dividend. Dividend policy changes as a firm goes through life cycle. Shareholders’ preferences and other factors also influence dividend policy. Firms also use stock dividend, split and repurchase as alternatives to cash dividend.