Chapter 8 Notes – Common Stocks

Stock dividends and related concepts
- Types of dividends:
- Cash dividends
- Stock dividends (dividends paid in additional shares)
- Property dividends (dividends paid in assets other than cash, e.g., shares of a subsidiary)
- Irregular dividends
- Do not occur at regular intervals or do not have a fixed amount
- Example: Real Estate Investment Trusts (REITs) due to special tax laws
- Payout concepts
- Payout ratio (DPO – Dividend Payout Ratio): the proportion of earnings distributed as dividends
  - ext{Payout ratio} = DPO = rac{ ext{Dividends}}{ ext{Net Income}}
- Retention ratio: the proportion of earnings retained
  - ext{Retention ratio} = 1 - DPO
  - Also described as the portion of earnings not paid out and added to retained earnings
Dividend Policy Considerations
- Dividend policy determines what portion of earnings is paid out as cash/dividends, stock dividends, property dividends, and whether payments are regular or irregular
- Key dates in dividend policy
- Record date: the date on which a stockholder must own shares to receive dividends
- Ex-Dividend date: when the stock trades without the right to receive the upcoming dividend; buyers prior to this date do not receive the dividend
- Payment date: the actual date dividends are paid to holders of record
- Implications for firm value
- In the short run, increasing the dividend payout can increase the stock price
- In the long run, higher payout can reduce funds available for reinvestment, potentially hindering growth and depressing stock price
- Board of Directors’ role
- Tailor an optimal dividend policy to maximize firm value (stock price) by balancing short-term and long-term considerations
Stock Dividends and Splits
- Similar economic effect, but different in accounting
- Both are forms of recapitalization, not cash dividends
- Ownership stake:
- Stock dividends and stock splits do not change proportional ownership of existing shareholders
- Stock dividends specifics
- Often paid in common stock (stock dividend in lieu of, or together with, cash dividends)
- Motive: conserve cash, retain earnings for new investments, or replace cash dividends due to financial difficulty
Effects of Stock Dividends
- Accounting and ownership effects
- New shares issued; number of shares outstanding increases by the same percentage as the stock dividend
- Par value remains unchanged
- Value of new shares is funded by retained earnings and transferred to common stock and additional paid-in capital (APIC)
- Total net worth remains unchanged
- Earnings per share (EPS) decreases by the same percentage as the stock dividend
- Proportion of total earnings available to common stockholders remains unchanged
Problem on Stock Dividends and Effects (ZZZ Company)
- Given (last year book values):
- Common stock: par $1, 2,000,000 shares → $2,000,000
- Additional paid-in capital (APIC): $8,000,000
- Retained earnings: $10,000,000
- Net worth: $20,000,000
- Net income after tax: $2,000,000
- Stock dividend: 10%
- Current market price: $50
- a) New capital structure after 10% stock dividend
- New shares issued: 10% of 2,000,000 = 200,000 shares
- Common stock (par $1):
  - Original common stock value: $2,000,000
  - Increase due to 200,000 additional shares: +$200,000
  - New common stock value: 2{,}000{,}000 + 200{,}000 = 2{,}200{,}000
- APIC: increases by the market value over par for the new shares
  - Increment to APIC: $( ext{Market price} - ext{Par}) \times \text{new shares} = (50 - 1) \times 200{,}000 = 9{,}800{,}000$
  - New APIC total: 8{,}000{,}000 + 9{,}800{,}000 = 17{,}800{,}000
- Retained earnings:
  - Stock dividends are funded from retained earnings at the market value of the new shares
  - Debit Retained Earnings: $10{,}000{,}000$ (total RE is reduced by the market value of the stock dividend)
  - In theory, RE after a 10% stock dividend becomes $0$ (market value transferred equals $10{,}000{,}000$)
  - Therefore Retained earnings after dividend: 0
- Net worth (Total equity) remains unchanged: 20{,}000{,}000
- Summary after dividend:
  - Common stock: 2{,}200{,}000
  - APIC: 17{,}800{,}000
  - Retained earnings: 0
  - Net worth: 20{,}000{,}000
- b) EPS before and after the stock dividends
- Shares outstanding before: 2,000,000
- Earnings after tax: $2,000,000
- EPS (Before stock dividends):
  - ext{EPS}_{ ext{before}} = \frac{2{,}000{,}000}{2{,}000{,}000} = \$1.00
- Shares outstanding after: 2,200,000
- EPS (After stock dividends):
  - ext{EPS}_{ ext{after}} = \frac{2{,}000{,}000}{2{,}200{,}000} = \$0.9091 \approx \$0.91
Stock Splits
- Definition and mechanics
- New shares are issued and the par value adjusts (e.g., 2-for-1 split halves par value)
- Par value change example: 2-for-1 split → par value halves, number of shares doubles
- No transfer of funds from retained earnings
- Effects on EPS and market price
- EPS is cut in proportion to the stock split
- Market price is reduced proportionally to maintain value parity
- Example: 2-for-1 split
  - If initially 2,000,000 shares, par $1, market price $50
  - New par value: $0.50; new shares: 4,000,000
  - Net worth and retained earnings unchanged
  - EPS after split: reduced by factor of 2
Problem on Stock Split (ZZZ Company)
- Given (last year book values):
- Common stock: par $1, 2,000,000 shares → $2,000,000
- APIC: $8,000,000
- Retained earnings: $10,000,000
- Net worth: $20,000,000
- Net income after tax: $2,000,000
- Stock split: 2-for-1
- a) New capital structure after split
- Shares double to 4,000,000; par value halved to $0.50
- Common stock value: par value × new shares = $0.50 × 4,000,000 = $2,000,000
  - Note: this keeps common stock at $2,000,000 (consistent with unchanged par value accounting)
- APIC remains $8,000,000
- Retained earnings remains $10,000,000
- Net worth remains $20,000,000
- b) EPS before and after the stock split
- EPS before: ext{EPS}_{ ext{before}} = \frac{2{,}000{,}000}{2{,}000{,}000} = \$1.00
- EPS after: ext{EPS}_{ ext{after}} = \frac{2{,}000{,}000}{4{,}000{,}000} = \$0.50
Stock Repurchases (Share Buybacks)
- Motivations for repurchasing shares
- To adjust capital structure
- To forestall potential hostile takeovers
- As an alternative to paying cash dividends
- Methods of repurchases
- Open market purchases
- Tender offer to buy shares at a specified price within a period
- Negotiated purchase of a block of shares
Advantages and Disadvantages of Stock Repurchases
- Advantages
- Reduces the number of shares outstanding, potentially increasing EPS and stock value
- Allows use of excess cash to buy back shares (e.g., to cover executive stock options/warrants future exercises)
- Can be used to cover conversion of convertible securities
- Disadvantages
- IRS concern: may be viewed as tax avoidance of dividends, potentially triggering accumulated earnings tax
- SEC concern: can be seen as price manipulation to inflate stock price ahead of new stock issues
Quick reference formulas
- Payout ratio and retention
- ext{Payout ratio} = DPO = rac{ ext{Dividends}}{ ext{Net Income}}
- ext{Retention ratio} = 1 - DPO
- ext{Retention ratio} = \frac{ ext{Increase in Retained Earnings}}{ ext{Net Income}}
- Earnings per share (EPS)
- ext{EPS} = \frac{ ext{Net Income}}{ ext{Number of Shares Outstanding}}
- Stock dividends: ownership unchanged, but equity accounts reallocate from RE to paid-in capital
- Stock splits: ownership and market capitalization remain, par value and EPS adjust by the split factor
Key concepts to remember for exams
- Difference between stock dividends and stock splits (both are non-cash, but accounting treatments differ)
- How stock dividends affect common stock, APIC, and retained earnings
- How EPS is impacted by changes in the number of shares outstanding due to dividends or splits
- Implications of dividend policy on stock price in short vs. long term
- Various mechanisms and trade-offs involved in stock repurchases