Foundations of Financial Management: An Analysis (part 70)

The only man who never makes mistakes is the man who never does anything. 

Theodore Roosevelt

 Dividend Policy and Retained Earnings

(Part B)

by

Charles Lamson

Dividend Stability

In considering stockholder desires and dividend policy, a primary factor is the maintenance of stability and dividend payments. The corporate management must not only ask, "How many profitable investments do we have this year?" It must also ask, " What has been the pattern of dividend payments in the last few years?" Though earnings may change from year to year, the dollar amount of cash dividends tends to be much more stable, increasing in value only as new permanent levels of income are achieved.

By maintaining a record of relatively stable dividends, corporate management hopes to lower the discount rate applied to future dividends of the firm, thus raising the value of the firm. The operative rule appears to be that a stockholder would much prefer to receive $1 a year for three years, rather than a $0.75 for the first year, $1.50 for the second year, and $0.75 for the third year for the same total of $3. Once again, we temper our policy of marginal analysis of retained earnings to include a notion of stockholder preference, with the emphasis on stability of dividends.

Other Factors Influencing Dividend Policy

Corporate management must also consider the legal basis of dividends, the cash flow position of the firm, and the corporation's access to capital markets. Other factors that must be considered include management's desire for control and the tax and financial positions of shareholders. Each is briefly discussed.

Legal Rules

Most states forbid firms to pay dividends that would impair the initial capital contributions to the firm. For this reason dividends may be distributed only from past and current earnings. To pay dividends in excess of this amount would mean the corporation is returning to investors their original capital contribution (raiding the capital). If the ABC company has the following statement of net worth, the maximum dividend payment would be 20 million dollars.

Why all the concern about impairing permanent capital? Since the firm is going to pay dividends only to those who contributed capital in the first place, what is the problem? Clearly there is no abuse to the stockholders, but what about the creditors? They have extended credit on the assumption that a given capital base would remain intact throughout the life of the loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place.

Even the laws against having dividends exceed the total of past and current earnings (retained earnings) may be inadequate to protect creditors. Because retained earnings are merely an accounting concept and in no way certify the current liquidity of the firm, a company paying dividends equal to retained earnings may, in certain cases, jeopardize the operation of the firm. Let us examine Table 2.

Table 2 Dividend policy considerations

Theoretically, management could pay up to 15 million dollars in dividends by selling assets even though current earnings are only $1,500,000. In most cases such frivolous action would not be taken; but the mere possibility encourages creditors to closely watch the balance sheets of corporate debtors and, at times, to impose additional limits on dividend payments as a condition for the granting of credit.

Cash Position of the Firm

Not only do retained earnings fail to portray a liquidity position of the firm, but there are also limitations to the use of current earnings as an indicator of liquidity. A growth firm producing the greatest gains in earnings may be in the poorest cash position. As sales and earnings expand rapidly, there is an accompanying buildup in receivables and inventory that may far outstrip cash flow generated through earnings. Note that the cash balance of $500,000 in Table 2 represent only one-third of the current earnings of $1,500,000. A firm must do a complete funds flow analysis, which was covered in Part 6 and Part 7 of this analysis, before establishing a dividend policy,

Access to Capital Markets

The medium-to-large-size firm with a good record of performance may have relatively easy access to the financial markets. A company in such a position may be willing to pay dividends now, knowing it can sell new common stock or bonds in the future if funds are needed. Some corporations may even issue debt or stock now and use part of the proceeds to ensure the maintenance of current dividends. Though this policy seems at variance with the concept of a dividend as a reward, management may justify its action on the basis of maintaining stable dividends.

Desire for Control

Management must also consider the effect of the dividend policy on its collective ability to maintain control. The directors and officers of a small, closely held firm may be hesitant to pay any dividends. For fear of diluting the cash position of the firm.

A larger firm with a broad base of shareholders, may face a different type of threat in regard to dividend policy. Stockholders, spoiled by a past record of dividend payments, may demand the ouster of management if dividends are withheld.

Dividend Payment Procedures

Given that we have examined the many factors that influence dividend policy, let us track the actual procedures for pronouncing and paying a dividend. Though dividends are quoted on an annual basis, the payments actually take place over four quarters during the year. If we divide the annual dividend per share by the current stock price, the result is called the dividend yield, which is the percentage return provided by the cash dividend based on the current market price.

Three key dates are associated with the declaration of a quarterly dividend: the ex-dividend date, the holder-of-record date, and the payment date.

We begin with the holder-of-record date. On this date the firm examines its books to determine who is entitled to a cash dividend. To have your name included on the corporate books, you must have bought or owned the stock before the ex-dividend date, which is two business days before the holder-of-record date. If you bought the stock on the ex-dividend date or later, your name will eventually be transferred to the corporate books, but you bought the stock without the current quarterly dividend privilege. Thus we say you bought the stock ex-dividend. As an example, a stock with a holder-of-record date of March 4 will go ex-dividend on March 2. You must buy the stock by March 1 (3 days before the holder-of-record date and a day before the ex-dividend date) to get the dividend. Investors are very conscious of the date on which the stock goes ex-dividend, and the value of the stock will go down by the value of the quarterly dividend on the ex-dividend date (all other things being equal). Finally, in our example, we might assume the dividend payment date is April 1 and checks will go out to entitled stockholders on or about this time. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 536-540*

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