Resource: Principles of Managerial Finance, Ch. 14
Complete the Integrative Case 6 O’Grady Apparel Company.
Please after reading the chapter, I have highlighted the questions that you need to answer. ONLY THE HIGHLIGHTED SECTION IS MINE TO ANSWER THIS IS A TEAM ASSIGNMENT.
- (1) Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings? (Note: Rework parts b and c using these capital structure weights.)
- (2) Which capital structure–the original one or this one–seems better? Why?
Below is Chapter 14
14 Payout Policy
- LG 1 Understand cash payout procedures, their tax treatment, and the role of dividend reinvestment plans.
- LG 2 Describe the residual theory of dividends and the key arguments with regard to dividend irrelevance and relevance.
- LG 3 Discuss the key factors involved in establishing a dividend policy.
- LG 4 Review and evaluate the three basic types of dividend policies.
- LG 5 Evaluate stock dividends from accounting, shareholder, and company points of view.
- LG 6 Explain stock splits and the firm’s motivation for undertaking them.
Why This Chapter Matters to You
In your professional life
ACCOUNTING You need to understand the types of dividends and payment procedures for them because you will need to record and report the declaration and payment of dividends; you also will provide the financial data that management must have to make dividend decisions.
INFORMATION SYSTEMS You need to understand types of dividends, payment procedures, and the financial data that the firm must have to make and implement dividend decisions.
MANAGEMENT To make appropriate dividend decisions for the firm, you need to understand types of dividends, arguments about the relevance of dividends, the factors that affect dividend policy, and types of dividend policies.
MARKETING You need to understand factors affecting dividend policy because you may want to argue that the firm would be better off retaining funds for use in new marketing programs or products, rather than paying them out as dividends.
OPERATIONS You need to understand factors affecting dividend policy because you may find that the firm’s dividend policy imposes limitations on planned expansion, replacement, or renewal projects.
In your personal life
Many individual investors buy common stock for the anticipated cash dividends. From a personal finance perspective, you should understand why and how firms pay dividends and the informational and financial implications of receiving them. Such understanding will help you select common stocks that have dividend-paying patterns consistent with your long-term financial goals.
Whirlpool Corporation Increasing Dividends
In another sign of an improving economy, Whirlpool Corporation, the worldwide appliance manufacturer, announced that it would increase the quarterly dividend that it paid to its stockholders by 25 percent, up to 62.5 cents per share from 50 cents in the previous quarter. Whirlpool’s CEO, Jeff Fettig, explained, “Our actions have delivered a strong financial position enabling us to enhance returns to shareholders through a dividend increase. This dividend increase underscores our confidence that our long-term growth and innovation strategy will continue to create value for our shareholders.” Markets reacted to this news by increasing Whirlpool’s stock price by 3.2 percent.
Why does Whirlpool pay dividends? Fettig’s press release suggests two possibilities. One is that by paying dividends the company can “enhance returns” to shareholders. In other words, Whirlpool believes that returns to shareholders will be higher if the firm pays a dividend (and increases it) than if the firm does not pay a dividend. That sounds logical, but consider that when a firm pays a dividend, it is simply taking cash out of its bank account and putting that cash in the hands of shareholders. Presumably, after a firm pays a dividend, its share price will reflect that it no longer holds as much cash as it did prior to the dividend payment. In other words, paying a dividend may simply be just switching money from one pocket (the company’s) to another (the shareholder’s).
Another reason that Whirlpool may pay a dividend is revealed in the second part of Fettig’s statement. Whirlpool increased its dividend to “underscore our confidence.” In other words, Whirlpool executives are telling the market that the firm’s financial position is strong enough and its prospects bright enough that managers are confident that they can afford to increase the dividend by 25 percent and still run the company effectively. Indeed, Whirlpool’s history suggests that managers use caution when increasing dividends. From 1995 to 2013, Whirlpool increased its dividend on just three occasions. Compare that record with the dividend history of Emerson Electric Co., a company that as of 2013 had increased its dividend for 54 consecutive years. Apparently Emerson and Whirlpool adopt different policies with respect to dividend increases.
14.1 The Basics of Payout Policy
The term payout policy refers to the decisions that firms make about whether to distribute cash to shareholders, how much cash to distribute, and by what means the cash should be distributed. Although these decisions are probably less important than the investment decisions covered inChapters 10 through 12 and the financing choices discussed in Chapter 13, they are nonetheless decisions that managers and boards of directors face routinely. Investors monitor firms’ payout policies carefully, and unexpected changes in those policies can have significant effects on firms’ stock prices. The recent history of Whirlpool Corporation, briefly outlined in the chapter opener, demonstrates many of the important dimensions of payout policy.
Decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed.
ELEMENTS OF PAYOUT POLICY
Dividends are not the only means by which firms can distribute cash to shareholders. Firms can also conduct share repurchases, in which they typically buy back some of their outstanding common stock through purchases in the open market. Whirlpool Corporation, like many other companies, uses both methods to put cash in the hands of their stockholders. In addition to increasing its dividend payout, Whirlpool also resumed its share repurchase program in 2013, which had been halted during the economic recession. At the time of resuming the share repurchase program, the company’s free cash flow was between $600 million and $650 million and expected to increase to between $650 million and $700 million. Whirlpool’s chief executive officier, Jeff Fettig, stated that “sales increased in every region of the world” as the company continued to expand its margins and that as the company continued to execute its “long-term growth strategy . . . [it would] continue to drive actions to further create value for . . . shareholders.”
If we generalize the lessons about payout policy, we may expect the following to be true:
- 1. Rapidly growing firms generally do not pay out cash to shareholders.
- 2. Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms to initiate cash payouts to investors. The ownership base of the company can also be an important factor in the decision to distribute cash.
- 3. Cash payouts can be made through dividends or share repurchases. Many companies use both methods. In some years, more cash is paid out via dividends, but sometimes share repurchases are larger than dividend payments.
- 4. When business conditions are weak, firms are more willing to reduce share buybacks than to cut dividends.
TRENDS IN EARNINGS AND DIVIDENDS
Figure 14.1 illustrates both long-term trends and cyclical movements in earnings and dividends paid by large U.S. firms that are part of the Standard & Poor’s 500 Stock Composite Index. The figure plots monthly earnings and dividend payments from 1950 through the first quarter of 2013. The top line represents the earnings per share of the S&P 500 index, and the lower line represents dividends per share. The vertical bars highlight ten periods during which the U.S. economy was in recession. Several important lessons can be gleaned from the figure. First, observe that over the long term the earnings and dividends lines tend to move together. Figure 14.1 uses a logarithmic scale, so the slope of each line represents the growth rate of earnings or dividends. Over the 60 years shown in the figure, the two lines tend to have about the same slope, meaning that earnings and dividends grow at about the same rate when you take a long-term perspective. It makes perfect sense: Firms pay dividends out of earnings, so for dividends to grow over the long-term, earnings must grow too.
FIGURE 14.1 Per Share Earnings and Dividends of the S&P 500 Index
Monthly U.S. dollar amount of earnings and dividends per share of the S&P 500 index from 1950 through the first quarter of 2013 (the figure uses a logarithmic vertical scale)
Second, the earnings series is much more volatile than the dividends series. That is, the line plotting earnings per share is quite bumpy, but the dividend line is much smoother, which suggests that firms do not adjust their dividend payments each time earnings move up or down. Instead, firms tend to smooth dividends, increasing them slowly when earnings are growing rapidly and maintaining dividend payments, rather than cutting them, when earnings decline.
To see this second point more clearly, look closely at the vertical bars in Figure 14.1. It is apparent that during recessions corporate earnings usually…