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LOS j: Compare and contrast the following dividend policies: residual dividend, longer-term residual dividend, dividend stability, and target payout ratio.

Which of the following dividend policies would a firm with temporary excess cash flows most likely use? A share repurchase program:

A)	and no payout of dividends.

B)	and a growing dividend model.

C)	in conjunction with a residual dividend model.

The residual dividend model allows firms to pay out dividends only if more earnings are available than are needed to support the optimal capital budget. Because dividend payouts can be unstable, a firm can supplement a low, stable dividend with a share repurchase program or with an extra dividend when times are good. Stock repurchases allow management to distribute cash without signaling information about future earnings. Abnormally good years could be followed with the purchase of shares, while selling shares would provide liquidity during temporary cash shortages.

Faltys Asset Management (FAM) follows a dividend growth investment strategy. The Faltys Dividend Growth Fund only invests in companies that have a dividend yield greater than the S&

500 and have the potential to increase that dividend each year at a rate that exceeds inflation. Warren Berlin, Director of Marketing for FAM has been developing a presentation book to present the fund to prospective clients. These prospective clients include retired individuals who want dividend income and trust companies who manage trust accounts which provide income to be distributed to beneficiaries. Which of the following dividend theories best describes the investment strategy and the marketing strategy of the fund?

Stable dividend

Clientele effect

Signaling effect

Bird-in-the-hand

Modigliani and Miller

The investment strategy would best be described as a stable dividend strategy. A stable dividend policy means that a company’s dividend payout is aligned with company’s long-term growth rate such that there is stability in the rate of increase for the dividend. The marketing strategy would best be described as the clientele effect. Berlin is pursuing specific groups of investors that prefer dividends. Note that the bird-in-in-the-hand theory states that investors prefer the certainty of dividends now to uncertain capital gains in the future, while Modigliani and Miller proposed that dividend policy has no impact on the price of a firm’s stock.

A)	Companies using a longer-term residual dividend policy pay a steady dividend based on long-term forecast of their capital budget.

B)	A target payout ratio approach is likely to result in a lower risk premium assigned to a company by investors.

C)	Companies following a dividend stability policy seek to pay a constant dollar amount per share over a long period of time.

Companies following a longer-term residual dividend approach forecast their capital budget over a longer time frame (5-10 years). Leftover earnings over this period are allocated as dividends and paid out in relatively equal amounts each year. The other statements are incorrect. With a stable dividend policy, companies seek to increase their dividend each year at a constant rate. A strict target payout approach means that dividends will vary in proportion with earnings, likely resulting in volatile dividends and a higher risk premium.

Hikaru Takei is the portfolio manager for the Reliant Dividend Focused Fund. Takei wants to add a firm to his portfolio that follows a stable dividend policy. Takei is considering investing in one of three companies:

A)	Barrett Satellite Systems.

B)	Kirk Beauty Supplies.

C)	Kelley Medical Devices.

Due to inflation considerations, a company with a stable dividend policy will have stability in the rate of increase for its dividend each year. This typically means aligning the company’s dividend growth rate with its long-term growth rate. Although the company with the fixed per share dividend is a tempting choice, once inflation is considered, a fixed $2.00 per share dividend is actually declining each year in terms of spending power.

The Skubin Candy Company is a highly profitable and rapidly growing maker of chocolates and other confections. Skubin’s management team is considering various dividend policies and is most concerned about the possibility of the dividend amount decreasing from one year to another and the negative reaction from investors that such a decrease may cause. Under which dividend policy would Skubin’s dividend be most likely to decline in a given year?

A)	Residual dividend.

B)	Target payout ratio.

C)	Longer-term residual dividend.

Since Skubin Candy Corporation is a profitable, rapidly growing company, a target payout policy is likely to lead to consistent dividend increases. A residual dividend approach, however, could lead to a decrease in the dividend if the company has sufficient positive NPV investment opportunities, thus leaving fewer dollars available for dividend payments.

The following financial data relates to the Carmichael Beverage Company for 2005:

First determine the WACC. WACC = w_d × k_d(1 ? t) + w_e × k_s, where k_sis the required return on retained earnings. WACC = (0.65)(0.12) + (0.35)(0.07) = 0.078 + 0.0245 = 0.1025 = 10.25%. Second, decide to accept projects A, B, and D since they are all greater than the WACC. Accepting these projects will result in a total capital budget of ($2,500,000 + $1,000,000 + $500,000) = $4,000,000. The equity portion is 65% × 4,000,000 = $2,600,000. From Carmichael’s net income, $4,000,000 ? $2,600,000 = $1,400,000 will be left over for dividends, which implies a payout ratio of $1,400,000 / $4,000,000 = 35%.

Tina Donaldson is the Chief Financial Officer for Outback Supply Corporation (OSC). OSC is considering revising its dividend payout policy and Donaldson has been asked by the board of directors to suggest alternatives for the board to consider. Donaldson prepares a memo listing the benefits of a residual dividend model. The memo includes three key points:

Point 1: A residual dividend policy is simple for the company to use and easy to implement.

Point 2: The residual dividend approach allows management to determine investment opportunities without having to take dividends into consideration.

Point 3: Because the firm is maximizing its positive net present value opportunities with a residual dividend model, investors are likely to perceive the firm as having less risk.

Which of Donaldson’s points describing advantages of the residual dividend approach are most accurate?

The residual dividend approach is easy for a company to use and implement – the company simply reinvests earnings needed to maintain and grow the business, and pays out any left over earnings out as dividends. The residual dividend approach also allows management to determine investment opportunities without having to take dividends into consideration. Note that the residual dividend approach is likely to lead to dividends that fluctuate dramatically from year to year. Since investors prefer stable dividends, they are likely to perceive a firm following a residual dividend approach as having greater risk, which is one of the disadvantages of the approach.

Stargell Industries follows a strict residual dividend policy. The company has a capital budget of $3,000,000. It has a target capital structure that consists of 30% debt and 70% equity. The company forecasts that its net income will be $3,500,000. What will be the company's expected dividend payout ratio this year?

In order to maintain the optimal capital structure, new projects will be financed with the same mix of debt and equity. Therefore, if the capital budget is $3,000,000 for next year the equity portion will be 70% of $3,000,000, or $2,100,000. The remainder will be financed with debt. If Net Income is $3,500,000 then dividends will be $1,400,000. (Dividends = Net Income ? Retained Earnings = $3,500,000 ? $2,100,000). The dividend payout ratio is equal to dividends divided by net income. $1,400,000 / $3,500,000 = 0.40 or 40%.

Under the residual dividend model, firms would do all of the following EXCEPT:

A)	borrow money to maintain the dividend payout schedule.

B)	pay dividends only if more earnings are available than needed to support the optimal capital budget.

C)	determine their optimal capital budgets.

Under the residual dividend model the optimal dividend payout is a function of four factors: investors' preferences for dividends vs. capital gains, the firm’s investment opportunity schedule (IOS), the firm’s target capital structure, and the availability and cost of external capital to the firm. The firm will pay dividends only if more earnings are available than are needed to support the optimal capital budget.