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began selling ex dividend on June 27. On August 1 the firm mailed dividend
checks to the holders of record as of July 1. This produced the following balances
in the key accounts of the firm:
Cash $120,000 Dividends payable
Retained earnings $
920,000 The net effect of declaring and paying the dividend was to reduce the firm’s total
assets (and stockholders’ equity) by $80,000. Dividend Reinvestment Plans
dividend reinvestment plans
Plans that enable stockholders to
use dividends received on the
firm’s stock to acquire additional
shares—at little or no transaction cost. Today many firms offer dividend reinvestment plans (DRIPs), which enable
stockholders to use dividends received on the firm’s stock to acquire additional
shares—even fractional shares—at little or no transaction cost. Some companies
even allow investors to make their initial purchases of the firm’s stock directly
from the company without going through a broker. With DRIPs, plan participants typically can acquire shares at about 5 percent below the prevailing market
price. From its point of view, the firm can issue new shares to participants more
economically, avoiding the underpricing and flotation costs that would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance
the market appeal of a firm’s shares. 562 PART 4 Long-Term Financial Decisions Review Questions
13–1 Who are holders of record? When does a stock sell ex dividend?
13–2 What benefit is available to participants in a dividend reinvestment plan?
How might the firm benefit? LG2 13.2 The Relevance of Dividend Policy
Numerous theories and empirical findings concerning dividend policy have been
reported in the financial literature. Although this research provides some interesting insights about dividend policy, capital budgeting and capital structure decisions are generally considered far more important than dividend decisions. In
other words, good investment and financing decisions should not be sacrificed
for a dividend policy of questionable importance.
A number of key questions have yet to be resolved: Does dividend policy
matter? What effect does dividend policy have on share price? Is there a model
that can be used to evaluate alternative dividend policies in view of share value?
Here we begin by describing the residual theory of dividends, which is used as a
backdrop for discussion of the key arguments in support of dividend irrelevance
and then those in support of dividend relevance. The Residual Theory of Dividends
residual theory of dividends
A school of thought that suggests
that the dividend paid by a firm
should be viewed as a residual—
the amount left over after all
acceptable investment opportunities have been undertaken. The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual—the amount left over after
all acceptable investment opportunities have been undertaken. Using this
approach, the firm would treat the dividend decision in three steps, as follows:
Step 1 Determine its optimal level of capital expenditures, which would be the
level generated by the point of intersection of the investment opportunities schedule (IO...
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