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CAPITAL STRUCTURE AND DIVIDEND POLICY

Capital Structure
In the section of the notes titled Cost of Capital, we examined how the cost of capital is determined.
From those notes, you should have discovered that each type of funds the firm uses has a cost and that
the required rate of return for the firm is the weighted average of the costs of the individual
components of capitalthat is, debt, preferred stock, and common equitywhich is designated the
weighted average cost of capital, or WACC. The WACC is calculated as follows:
WACC

Pr oportion
of debt

After tax
cost of debt

w r
d dT

Pr oportion of
preferredstock

Cost of
preferredstock

Pr oportion of
commonequity

r
ps ps

Cost of
commonequity

w ( r or r )
s s
e

The question we address in this section is whether the amount, or proportion, of each type of funds the
firm uses affects the overall value of the WACC. The above equation suggests that the required rate of
return, which is WACC, is affected by the proportion of debt, wd, the proportion of preferred stock,
wps, and the proportion of common equity, ws, the firm uses. But, the individual component costs of
capital might also be affected by the proportions of each type of funds that the firm uses. For example,
all else equal, the more debt a firm uses, the higher its cost of debt. In any event, if the overall WACC
is affected by how the firm finances itselfthat is, how much debt and equity it usesthen we want
the be able to determine the proportion of each type of funds the firm should use to maximize its value.
The Target Capital Structurecapital structure refers to the combination of funds, in the form of
debt and equity, a firm uses to finance its assets. A firm usually sets a target capital structure,
which is the proportion of debt and equity it wants to use to finance investments, that is used as a
benchmark when raising funds for investing in new capital budgeting projects. Generally if a firm
uses more debt, the risk associated with its future earnings is increased. At the same time, however,
because debt has a fixed cost (that is, interest), more debt allows the firm to earn a higher expected
rate of return. Thus, there is a risk/return tradeoff associated with increasing (decreasing) debt. The
firm should use the amount of debt that maximizes the value of the firm. Stated differently, at the
best, or optimal, capital structure, the value of the firm is maximized because the overall WACC is
minimized.
The following factors should be considered when making decisions about the capital structure of a
firm:
1. Business riskfirms with greater business risk generally cannot take on as much debt as firms
with less business risk. A more detailed discussion of business risk is given below.
2. Tax positionremember interest on debt is tax deductible, which makes debt attractive as a
source of financing. Also remember that more debt generally implies a greater chance of
bankruptcy, which is extremely expensive.
3. Financial flexibilityto strengthen its balance sheet, a firm might raise funds by issuing more
Capital Structure and Dividend Policy 1

common stock. On a relative basis, a stronger financial positionthat is, stronger balance
sheetgenerally implies the firm is better able to raise funds in the capital markets in a
slumping economy.
4. Managerial attitude (conservatism or aggressiveness)some financial managers are more
conservative than others when it comes to using debt, thus they are inclined to use less debt, all
else equal.
Business and Financial Riskthe risk associated with a firm can be divided into two components:
(1) the risk associated with the type of business the firm operatesthat is, competitive conditions,
whether the industry is capital-intensive or labor-intensive, dangers associated with the
manufacturing process, and so forthis termed its business risk; and the risk associated with how
the firm is financedthat is, what portion of the financing is debt and what portion is equityis
termed its financial risk.
o Business riskwe evaluate business risk by examining the stability of a firms operations and
its ability to maintain operating income. Generally less business risk is associated with greater
stability in sales, operating expenses, and the like, greater flexibility in the ability to change
selling prices, and less relative fixed operating costs (that is, operating leverage, which was
discussed in the section of the notes titled Forecasting, Planning, and Control).
o Financial riskthis risk is associated with the ability of a firm to meet its financial obligations,
which means this form of risk arises when the firm uses sources of financing that require fix
payments or obligationsthat is, financial leverage (discussed in the section of the notes titled
Forecasting, Planning, and Control) exists. Financial risk affects the ability of a firm to
generate stable income for common stockholdersthat is, financial risk affects the risk of
common stock.
Determining the Optimal Capital Structureremember that the optimal capital structure is the
combination of debt and equity that maximizes the value of the firm.
o EBIT/EPS analysis of the effect of financial leveragewe can evaluate the attractiveness of a
particular capital structure by examining how changing the proportion of debt a firm uses
affects its EPS. To illustrate, consider the following information for a hypothetical firm:
Total capital = $2,000,000
Type of Economy
Boom
Normal
Recession
Amount of Debt
Used by the Firm
$ 500,000
1,000,000
1,500,000

Operating Income (EBIT)


$800,000
400,000
100,000

Debt/Asset Ratio
25.0%
50.0
75.0

Probability
0.3
0.5
0.2

Interest Rate, rd
9.0%
11.0
20.0

Capital Structure and Dividend Policy 2

Shares of
Stock Outstanding*
300,000
200,000
100,000

* If the firm only uses equitythat is, there is no debtthere will be 400,000 shares of stock
outstanding. To evaluate the impact of changing the capital structure, we keep the amount of
total capital the samethat is, $2,000,000. Therefore, if the firm is financed with $500,000
debt, the remaining $1,500,000 in capital will be equity and only 75 percent of the equity that
exists if no debt is used will exist if 25 percent of the firms capital structure is debt. In this
case, the number of shares of stock outstanding will be 300,000 = 0.75 400,000. The
number of shares outstanding under the other alternatives is similarly computed.
Based on this information, the EPS for each situation is as follows:
Type of Economy
Probability
Proportion of Debt (D/A) = 0%
EBIT
Interest
Earnings before taxes
Taxes (40%)
Net income
EPS (400,000 shares)
Expected EPS
Standard deviation of EPS

Boom
0.3

Normal
0.5

Recession
0.2

$800,000
0
800,000
(320,000)
$480,000
$1.20

$400,000
0
400,000
(160,000)
$240,000
$0.60
$0.69
$0.37

$100,000
0
100,000
(40,000)
$ 60,000
$0.15

Proportion of Debt (D/A) = 25%


EBIT
$800,000
Interest
(45,000)
Earnings before taxes
755,000
Taxes (40%)
(302,000)
Net income
$453,000
EPS (300,000 shares)
$1.51
Expected EPS
Standard deviation of EPS

$400,000
(45,000)
355,000
(142,000)
$213,000
$0.71
$0.83
$0.50

$100,000
(45,000)
55,000
(22,000)
$ 33,000
$0.11

Proportion of Debt (D/A) = 50%


EBIT
$800,000
Interest
(110,000)
Earnings before taxes
690,000
Taxes (40%)
(276,000)
Net income
$414,000
EPS (200,000 shares)
$2.07
Expected EPS
Standard deviation of EPS

$400,000
(110,000)
290,000
(116,000)
$174,000
$0.87
$1.05
$0.75

$100,000
(110,000)
(10,000)
4,000
$ (6,000)
$(0.03)

Capital Structure and Dividend Policy 3

Proportion of Debt (D/A) = 75%


EBIT
$800,000
Interest
(300,000)
Earnings before taxes
500,000
Taxes (40%)
(200,000)
Net income
$300,000
EPS (100,000 shares)
$3.00
Expected EPS
Standard deviation of EPS

$400,000
(300,000)
100,000
(40,000)
$ 60,000
$0.60
$0.96
$1.50

$100,000
(300,000)
(200,000)
80,000
$(120,000)
$(1.20)

Summarizing the results provided above, we have the following:


Proportion
of Debt
0.0%
25.0
50.0
75.0

Expected EPS
$0.69
0.83
1.05
0.96

Standard Deviation
$0.37
0.50
0.75
1.50

According to this information, the firms EPS peaks at a capital structure that includes 50
percent debt and 50 percent equity. However, this capital structure might not be optimal, as we
will see in the sections that follow.
EPS Indifference analysis--if our hypothetical firm wants to decide between two capital
structures, say, all equity financing and 50 percent debt, then the financial manager would want
to know at what levels of sales it is better to be an all equity firm and at what levels of sales it
would be better to be financed with 50 percent debt. This decision can be made by graphing
EPS for both financing plans at various levels of sales. The following graph shows the EPS
figures for our hypothetical firm at different sales levels assuming the firm has fixed operating
costs equal to $400,000 and variable operating costs equal to 60 percent of sales.
EPS ($)
3.00
2.50
2.00
1.50
1.00

50% Debt
Financing
Advantage
of Debt

EPS Indifference
$1.55 million

0.50
0.33
-0.50
-1.00

1.0

100% Stock
Financing

2.0

3.0

Advantage
of Equity

Capital Structure and Dividend Policy 4

Sales
(millions)
4.0

The preferred financing plan is the one that produces the higher EPS. Thus, as you can see from
the graph, financing the firm with all equity is preferable if sales are below $1.55 million;
otherwise, the financing plan with 50 percent debt is preferred.
The effect of capital structure on stock prices and the cost of capitalwhen we try to find the
optimal capital structure for a firm, we want to determine the mix of debt and equity that
maximizes the value of the firmthat is, its stock pricenot the EPS. The proportion of debt
in the optimal capital structure will be less than the proportion of debt needed to maximize EPS
because the market valuation of the stock, P0, considers the risk associated with the firms
operations expected well into the future and EPS is based only on the firms operations
expected for the next few years.
To determine a firms optimal capital structure, first consider the fact that the relationship of the
cost of equity, rs, and the amount of debt the firm uses to finance its assets can be illustrated as
follows:
Required Return on
Equity, krss (%)

krss = rkRF
RF + risk premium
Premium for
financial risk
Premium for business risk at a
particular level of operations

rkRF
RF
Risk-free rate of return
% Debt in
Capital Structure

According to the graph, for a given level of operations, the required return on (cost of) equity,
rs, is affected by the firms financial risk, which is based on the amount of debt used to finance
its assets. Although debt increases the cost of equity, the tax benefit associated with using debt
(interest paid is tax deductible) generally requires firms to use some debt to finance assets. But,
at some point, the tax benefit is overshadowed by the additional risk the firm incurs by
increasing the amount of debt it uses, which causes the cost of additional debt to increase
significantly. In other words, the risk of bankruptcy increases so significantly that increases in
the cost of debt, rd, more than offset the benefit associated with the tax deductibility of the
interest payments. Therefore, the relationship of the cost of debt, the cost of equity, and the
WACC with the amount of debt used to finance assets might look like the following:

Capital Structure and Dividend Policy 5

Cost of
Capital (%)

Cost of
equity, krss
WACC

Minimum
WACC

After-tax cost
of debt, rkdT
dT

Optimal Amount
of Debt

Proportion of Debt in
the Capital Structure

As you can see from the graph, (1) if the firm uses only equity to finance its assets (that is, zero
debt is used) then WACC = rs; (2) as the firm begins to use some debt for financing, WACC
declines, primarily because the tax benefit offered by the debt more than offsets the increased cost
of equity, rs; (3) at some point the tax benefit associated with debt is more than offset by increases
in the before-tax cost of debt and the cost of equity that result from increases in the risk
associated with the additional debt and, at this point, WACC begins to increase; and (4) the point
where WACC is the lowest is the optimal capital structurethis is the point where the value of
the firm is maximized. Remember that WACC represents a cost to the firmthat is, it is the
average rate of return the firm pays for the funds it uses to finance its assets, which is similar to
the interest paid by an individual on a mortgageand, rationally, the firm wants to minimize any
of its costs, all else equal.
Degree of Leveragethe information provided in this section has been discussed in great detail in
the section of the notes titled Forecasting, Planning, and Control, so this section should serve as a
review. As we will illustrate in this section, all else equal, if a firm can reduce its operating
leverage, it can use more debt (that is, increase its financial leverage), and vice versa.
o Degree of operating leverage (DOL)remember that DOL refers to the percentage change in
operating income, designated either NOI or EBIT, that results from a particular percentage
change in sales. In previous notes, we showed that DOL can be computed as follows:
DOL

% change in NOI
Q(P V)
S VC
%change in sale Q(P V) F S VC F

where Q represents the number of products (units) the firm currently sells, P is the price per
unit, V is the variable cost ratio (as a percent of sales), F is the fixed operating costs, S is
current sales stated in dollars such that S = Q P, and VC is the total variable costs of
operations such that VC = Q V.
Capital Structure and Dividend Policy 6

All else equal, firms with riskier operations have higher DOLs.
o Degree of financial leverage (DFL)refers to the percentage change in EPS that results from a
particular percentage change in earnings before interest and taxes, EBIT. DFL is computed as
follows:
DFL

% change in EPS
EBIT
S VC F
% change in EBIT EBIT I S VC F I

where I is the dollar interest paid on outstanding debt. The DFL equation given here applies
only to firms that have no preferred stock outstanding.
All else equal, firms with riskier financial positions have higher DFLs.
o Degree of total leverage (DTL)refers to the percentage change in EPS that results from a
particular percentage change in sales. DTL combines DOL and DFL, and it is computed as follows:
DTL

% change in EPS
DOL DFL
% change in sale
Q( P V )
S VC
Q(P V) F I S VC F I

All else equal, firms that have high DTLs are considered riskier in general than firms with low
DTLs.
To illustrate the concept of leverage, consider the following situation:
Current
Expected
Sales
Sales $875,000
$787,500
Variable operating costs (70% of sales) (612,500)
Gross profit
262,500
Fixed operating costs
(150,000)
Net operating income, NOI = EBIT
112,500
Interest
( 50,000)
Taxable income
62,500
Taxes (40%)
( 25,000)
Net income
$ 37,500

Sales 10%
Less Than
Expected
-10.00%
(551,250)
236,250
(150,000)
86,250
( 50,000)
36,250
( 14,500)
$ 21,750

DOL = 2.33 = $262,500/$112,500


DFL = 1.80 = $112,500/($112,500 - $50,000)
DTL = 4.20 = 2.33 1.80 = $262,500/($112,500 - $50,000)

Capital Structure and Dividend Policy 7

%
-10.00%
-10.00%
0.00%
-23.33%
0.00%
-42.00%
-42.00%
-42.00%

The table shows that when DOL = 2.33, a 10 percent decrease (increase) in sales will cause a
23.3 percent decrease (increase) in NOI; when DFL = 1.80, a 23.3 percent decrease (increase) in
EBIT will cause a 42.0 percent decrease (increase) in EPS (net income divided by the number
of shares of common stock that are outstanding); and, in combination, when DTL = 4.20, a 10
percent decrease (increase) in sales will cause a 42 percent decrease (increase) in EPS.
The concept of leverage can be used to determine the impact that a change in capital structure
will have on the riskiness, thus the WACC, of a firm.
Liquidity and Capital Structurea manager might not operate at the optimal capital structure
because s/he might (1) find it difficult, if not impossible, to determine the optimal capital structure;
(2) be reluctant to take on the amount of debt necessary to achieve the optimal capital structure
(that is, have a conservative attitude toward debt financing); or (3) provide important services that
prohibit him or her from endangering the ability of the firm to survive, which might be the case if
the firm is financed using the optimal mix of capital.
Often, firms use measures of financial liquidity, such as the times-interest-earned (TIE) ratio, to
provide an indication of financial strength. Remember that the TIE ratio gives an indication of how
many times a firm can cover the interest payments associated with its debt financing. Generally, a
firm with a higher TIE ratio is said to have greater financial liquidity and lower threat of
bankruptcy than a firm with a lower TIE ratio.
Capital Structure Theoryacademicians have proposed many theories regarding the capital
structures of firms. The two major theories are summarized as follows:
o Trade-off theorymore than 40 years ago Franco Modigliani and Merton Miller, who have
since won the Nobel prize for Economics, developed a theory that showed firms should favor
using debt in their capital structures because the tax deductibility of interest payments is such a
benefit. Under a very restrictive set of assumptions, they showed that the value of a firm
increases as it uses more and more debt. In fact, according to their theory, the value of the firm
is maximized when it is financed with nearly 100 percent debt. However, the theory ignored the
costs associated with bankruptcy, which can be considerable. When the costs of bankruptcy are
considered, there is a point where the benefit of the tax deductibility of debt is more than offset
by increases in the cost of debt and the cost of equity that result from the risk associated with
the firms heavy use of debt.
o Signaling theorymost people agree that managers and other insiders possess more
information about the firm than outside investors. The fact that managers have asymmetric
information, which means they have some information that outside investors do not, could
mean that any action taken by a firm, including how it raises funds (capital), might provide a
signal to the less-informed investors. For example, studies have shown that when firms issue
new common stock to raise funds the per share value of the stock decreases. It has been
suggested that this occurs because managers would only issue new common stock if they felt
that the firms future prospects were unfavorable. Consider the fact that when new stock is
issued, new stockholders join the firms existing stockholders to share in any future changes in
value. Thus, if the firms future was extremely optimistic, managers would want to make
Capital Structure and Dividend Policy 8

existing stockholders happy by allowing them to receive all of the increase in value that will
result from the favorable prospects, which means managers would choose to issue debt rather
than equity. When debt is issued, only the contracted costs need to be paidthat is, fixed
interest and the repayment of the debtand the remaining gains from the favorable projects
accrue to the stockholders.
Variations in Capital Structures among Firmsthere are wide differences in capital structures
among firms in the United States. Much of the difference depends on the type of operations,
including the stability of sales that is associated with the firm. For example, firms in industries that
have high degrees of research and development costs, such as pharmaceuticals, generally have
capital structures that contain lower proportions of debt than firms in industries that have relatively
stable, predictable cash flows, such as utilities.
Capital Structures around the Worldcapital structures vary significantly around the world. In
countries where the debt is closely held so that the costs of monitoring firms are relatively low (that
is, where bank loans or syndicates are used), firms have greater proportions of debt than firms in
countries where debt is held by a large number of diverse investors. In countries where firms are
required to regularly provide information about operations and finances to stockholders, firms have
greater proportions of equity than firms in countries where such information is not required. In
essence, whichever form of financing is more easily monitored by investors to ensure their best
interests are being followed by management is the one that is more prevalent in capital structures.

Dividend Policy
Dividends are cash payments made to stockholders. Decisions about when and how much of earnings
should be paid as dividends are part of the firms dividend policy. Earnings that are paid out as
dividends cannot be used by the firm to invest in projects with positive net present valuesthat is, to
increase the value of the firm. The dividend policy that maximizes the value of the firm is said to be the
optimal dividend policy.
Dividend Policy and Stock Valueresearchers argue whether there exists an optimal dividend
policy. Some academicians argue that a firms dividend policy does not affect the value of a firm
(dividend irrelevance theory), while other argue that the dividend policy is an important factor in
the determination of a firm=s value (dividend relevance theory).
Investors and Dividend Policyinvestors reactions to changes in dividend policies can be
summarized as follows:
o Information content, or signalingthere is a belief that managers change dividends (increase or
decrease) only when it is necessarythat is, decreases occur only when the firm is facing
financial difficulty, while increases occur only when it is expected that the firm can continue to
pay higher dividends long into the future. If this is true, then changes in a firms dividend policy
provide information to investors, who will react accordingly. For example, investors would

Capital Structure and Dividend Policy 9

consider an increase (decrease) in dividends to be good (bad) news, and thus increase (decrease)
the price of the firms stock.
o Clientele effectinvestors might choose a particular stock due to the firms dividend policy
that is, some investors prefer dividends and others do not. If such a clientele effect does exist,
then we would expect that a firms stock price will change when its dividend policy is changed.
o Free cash flow hypothesisif investors truly want managers to maximize the value of the firm,
then dividends should be paid only when the firm has no investments with positive net present
values. In other words, a firm should pay dividends only when it has funds that are not needed
to invest in positive NPV projectsthat is, only free cash flows should be paid as dividends. If
this theory is correct, then we might expect a firms stock price to increase when it decreases
dividends to invest in positive NPV projects, and we might expect the stock price to decrease
when the firm increases dividends because it no longer has as many positive NPV projects as it
did in prior years.
Dividend Policy in Practiceprocedures that are followed in practice include the following:
o Types of dividend payments
Residual dividend policyas an investor, you should want the firm to retain any earnings it
can invest at a rate of return that is at least as high as your opportunity cost. Firms that agree
with this concept might follow a residual dividend policy where dividends are paid only if
earnings are greater than what is needed to finance the equity portion of the firms optimal
capital budget for the year. Therefore, if the residual dividend policy is followed, the firm
should not pay dividends when it is necessary to issue new common stock to provide equity
financing for the current capital budgeting needs.
Stable, predictable dividendssome managers believe that dividends should never be
decreased unless it is absolutely necessary. These managers probably follow a stable,
predictable dividend policy, which requires that the firm pays a dividend that is the same
every year or is constant for some period and then is increased at particular intervalsthat
is, dividend payments are fairly predictable. Greater predictability is associated with greater
certainty and lees risk, which implies a lower overall WACC and a higher firm value. In
practice, more firms actually follow some form of this dividend policy.
Constant payout ratioa firms dividend payout ratio is defined as the proportion of
earnings per share (EPS) that is paid out as dividends (DPS)that is, payout ratio =
DPS/EPS. Firms that follow a constant payout ratio dividend policy pay the same
percentage of earnings as dividends each year. For example, a firm might pay 60 percent of
its earnings as dividends. If so, then dividends will fluctuate as earnings fluctuate.
Low regular dividend plus extrasrequires a firm to pay some minimum dollar dividend
each year and then to pay an extra dividend when the firms performance is above normal
(or above some minimum standard)
o Payment proceduresdividends are usually paid quarterly. The following dates are important
when establishing a dividend policy:
Declaration datethe date the board of directors states that a dividend will be paid to
stockholders. A dividend is not a liability to the firm until it is declared.
Holder-of-record datethe date the firm opens its ownership books to determine who
will receive dividends. Persons whose names appear in the ownership books after the
Capital Structure and Dividend Policy 10

holder-of-record date, which is also termed the date of record, but prior to the date the
dividend is paid will not receive a dividend payment.
Ex-dividend datetwo working days before the holder-of-record date. Ex dividend means
without dividend; so, on the ex-dividend date, the stock begins to sell without the right to
receive the next dividend payment. In essence, the stock sells without the right to receive
the dividend payment because there is not enough time for the names of new stockholders
to be registered before the holder-of-record date.
Payment datethe date the firm mails the dividend checks.
o Dividend reinvestment plansplans that permit stockholders to have dividend payments
automatically reinvested in the firms stock. Dividend reinvestment plans, which are referred to
as DRIPs, allow stockholders to buy additional shares of a firms stock on a pro rata basis using
the cash dividend paid by the firm. Often there are little or no brokerage fees involved with
DRIPs.
Factors Influencing Dividend Policywhen developing a dividend policy, the following factors
should be considered:
o Constraints on dividend paymentsthe amount of dividends a firm pays might be limited by:
(1) restrictions in debt agreements that state the maximum amount of dividends that can be paid
in any year; (1) the amount of retained earnings, which represents the maximum amount of
dividends that can be paid at any time; (2) the liquidity position of the firmif cash is not
available, dividends cannot be paid; and (4) limits of the IRS on the amount of earnings a firm
can retain for non-specific reasons.
o Investment opportunitiesfirms that need great amounts of funds for positive NPV
investments usually pay relatively lower amounts of dividends than firms with few positive
NPV investments.
o Alternative sources of capitalthe higher the costs of issuing new common stock, generally the
lower the relative amount of dividends paid by a firm; firms that are concerned about diluting
current ownership through new issues of common stock are likely to pay relatively low
dividends.
o Effects of dividend policy on rsin an effort to minimize its WACC through the cost of equity,
rs, a firm will examine the effect a dividend policy has on its required rate of return. Factors
such as risk perception, information content (signaling), and preference for current returns
versus future returns (that is, dividend yield or capital gains) are considered when the dividend
policy is established.
Stock Splits and Stock Dividendsto this point, we have examined the dividend policy that relates
to cash payments. Some firms pay dividends in the form of stock or change the number of shares of
stock that is outstanding through a stock split. As you will discover in the discussion that follows,
neither of these actions by themselves has economic value in the sense that each does nothing to
change stockholders wealth.
o Stock splitsan action taken by a firm to change the number of outstanding shares of stock.
Many firms believe their stock has an optimal price range within which their stock should trade.
If the price of the stock exceeds the price range, then the firm will execute a stock split. If a
firm initiates a 2-for-1 stock split, each existing stockholder will receive two shares of stock for
Capital Structure and Dividend Policy 11

each one share he or she now owns. This action should cut the market price of the stock exactly
in half. But, there is evidence that shows the price of the stock actually settles above one half
the pre-split price. Perhaps the reason this occurs is because investors believe the split provides
positive information; specifically that the firm expects the price of the stock to increase further
above the optimal range in the future. In any event, there really is no specific economic value
associated with a stock split. As an investor, unless the market reacts positively or negatively to
the split, the only effect the split has is to increase the number of shares of stock you own, with
each share valued at a lower relative price such that your wealth position has not changed.
o Stock dividendsdividends paid in the form of stock rather than cash. Like stock splits, a stock
dividend does not have specific economic value; rather, it increases the total number of shares
of stock each stockholder owns. At the same time, the stock price per share decreases because
investors have not provided any funds for the additional shares of stock. A firm might use a
stock dividend to keep the price of its stock within a particular range.
o Balance sheet effectsfor stock splits, the only effect on the balance sheet is that the number of
shares outstanding changes relative to the split, which also changes the stated par value of the
stock (if there is one). If a firm executes a 2-for-1 split, for example, it would double the
number of shares outstanding and halve the par value of the stock reported on the balance sheet.
The total dollar values in each common equity account would not change. When a stock
dividend is paid, on the other hand, the firm must transfer capital from retained earnings to the
Common stock account and the Additional paid-in capital account to reflect the fact that a
dividend was paid. The transfer from retained earnings is computed as follows:
Funds transferr ed
from retained earnings

Number of shares
outstanding

Stock dividend
as a percent

Market price
of the stock

To illustrate, consider a firm that decides to pay a 5 percent stock dividend. The market price of
the firms stock is $80 and it has 20 million shares of $2 par stock outstanding before the stock
dividend. According to the above equation, the amount transferred would be:
Transfer from
retained earnings

20,000,000 (0.05) $80 1,000,000 $80 $80,000,000

After the stock dividend, the firm would show $80 million less in retained earnings. In the
common equity portion of the its balance sheet, there would now be 21 million shares of stock
outstanding (20 million existing shares plus one million shares associated with the stock
dividend), the Common equity account would increase by $2 million (1 million shares $2
par), and the Additional paid-in capital would increase by $78 million ($80 million less that
$2 million increase in Common equity).
o Price effectseven though both stock splits and stock dividends only increase the number of
outstanding shares of stock, studies have shown that the market price of the stock affected by
such actions might changeif investors expect future earnings and cash dividends to increase
(decrease), then the price will increase (decrease) above the relative price associated with the
stock split or the stock dividend. For example, if investors believe a firm initiated a 2-for-1
stock split because its future earnings will cause the price of the stock to increase well above its
Capital Structure and Dividend Policy 12

optimal range, then their reaction to the split will cause the post-split price of the stock to be
greater than one half the pre-split price. If the future expectations do not pan out, however, the
price of the stock will eventually settle at about one half the pre-split price.
Dividend Policies around the Worldthere is great variation in dividend policies of firms in
different parts of the world. In most parts of the world, dividend policies are based on local tax
laws. For example, in countries where the tax on capital gains is less than the tax on dividends,
firms tend to retain greater amounts of earnings than in countries where the tax on dividends is
relatively small. Also, in countries that have few regulations to protect small stockholders,
companies tend to pay greater amounts of earnings as dividends.

Capital Structure and Dividend Policy 13

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