You have been recently been hired as Q & R Manufacturing\'s chief financial offi

Question

You have been recently been hired as Q & R Manufacturing's chief financial officer (CFO) by the firm's chief executive officer (CEO). The CEO tells you that in the past, a lack of financial planning has frequently caused the firm to have to rush out and get outside funding by either borrowing money (selling bonds) or selling stock. He wants to avoid this going forward and has asked you to develop a plan (beginning with this year's projected income statement) that will let him know ahead of time if external funds will need to be raised to carry out next year's plans and budget. Maximizing shareholder wealth is the prime objective of a firm's management team. Shareholder wealth, in turn, comes from stock appreciation, increased dividends, or both. What could cause a company's declared dividends to be raised, enhancing shareholder wealth? Provide 2 examples. In your posting, you must also specifically link things or actions that occur that could cause dividends to be increased. Also , include some comments that link dividend policy and the payout ratio to the increase in dividends.

Explanation / Answer

Every corporation has the same goal in mind: to maximize shareholder wealth. This goal is fulfilled in two different ways, by re-investing cash into the business to stimulate its growth, or by payingdividendsto shareholders. A dividend can take the form of either cash orstock. In the case of acash dividend, a shareholder will receive cash based on the the number of shares they own. Let's say a corporation declares a cash dividend of $0.25 per share, if an investor owns 10,000 shares, then this investor would receive $2,500.

If, on the other hand, an investor still owns the same 10,000 shares, but the company declares a stock dividend of 0.2, this would mean that for every share owned, 0.2 of a share (called afractional share) is "paid" to the shareholder. So, for our investor with 10,000 shares, after the dividend was collected they would own 12,000 shares (10,000 x 1.2). The effect of this stock dividend on the stock price, however, may not be as positive. The stock dividend, and astock split, will increase the number ofshares outstanding, and with all other things remaining the same, the stock price will fall. Therefore, the stock price woulddilutefrom either a stock dividend or a stock split.

Stock prices are based on the value of the firm divided by the number of shares outstanding. If the number of shares outstanding increases, the stock price will fall. For example, say there is a firm with amarket capof $750 million, and there are 200 million shares outstanding at the stock price of $3.75 ($750/200). If there is a stock dividend declared of 0.2, then the number of shares outstanding will increase by 20% to 240 million. With this new number of shares outstanding, and the company's market cap remains the same, but the share price will now decrease to $3.13 ($750/240). Conversely, the same results would occur if the firm decided to split the stock 6:5, which means that for every 5 shares currently owned, the shareholders will receive a total of 6 stocks after the split. The number of shares outstanding would increase to 240 million (200 x 1.2), and the market price would be diluted to $3.13.

One positive characteristic of the stock dividend and stock split, is that ownership is not further diluted. That is to say, all shareholders will own the same proportionate amount of the company after the dividend or split as they did before

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