Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

18. Dividends and Dividend
    Policy

© The McGraw−Hill^653

Companies, 2002

In the real world, to the extent that repurchases benefit the firm, we would argue that

they do so primarily because of the tax considerations we discussed before.

STOCK DIVIDENDS AND STOCK SPLITS

Another type of dividend is paid out in shares of stock. This type of dividend is called a

stock dividend. A stock dividend is not a true dividend because it is not paid in cash.

The effect of a stock dividend is to increase the number of shares that each owner holds.

Because there are more shares outstanding, each is simply worth less.

A stock dividend is commonly expressed as a percentage; for example, a 20 percent

stock dividend means that a shareholder receives one new share for every five currently

owned (a 20 percent increase). Because every shareholder receives 20 percent more

stock, the total number of shares outstanding rises by 20 percent. As we will see in a mo-

ment, the result is that each share of stock is worth about 20 percent less.

Astock splitis essentially the same thing as a stock dividend, except that a split is

expressed as a ratio instead of a percentage. When a split is declared, each share is split

up to create additional shares. For example, in a three-for-one stock split, each old share

is split into three new shares.

Some Details on Stock Splits and Stock Dividends

Stock splits and stock dividends have essentially the same impacts on the corporation

and the shareholder: they increase the number of shares outstanding and reduce the

value per share. The accounting treatment is not the same, however, and it depends on

two things: (1) whether the distribution is a stock split or a stock dividend and (2) the

size of the stock dividend if it is called a dividend.

By convention, stock dividends of less than 20 to 25 percent are called small stock

dividends.The accounting procedure for such a dividend is discussed next. A stock div-

idend greater than this value of 20 to 25 percent is called a large stock dividend.Large

stock dividends are not uncommon. For example, in 2000, Corning announced a 200

percent stock dividend, and, in 1999, biotechnology company Amgen announced a 100

percent stock dividend, to name a few. Except for some relatively minor accounting dif-

ferences, this has the same effect as a two-for-one stock split.

Example of a Small Stock Dividend The Peterson Co., a consulting firm specializ-

ing in difficult accounting problems, has 10,000 shares of stock outstanding, each sell-

ing at $66. The total market value of the equity is $66 10,000 $660,000. With a 10

percent stock dividend, each stockholder receives one additional share for each 10

owned, and the total number of shares outstanding after the dividend is 11,000.

Before the stock dividend, the equity portion of Peterson’s balance sheet might look

like this:

CONCEPT QUESTIONS

18.7a Why might a stock repurchase make more sense than an extra cash dividend?

18.7bWhy don’t all firms use stock repurchases instead of cash dividends?

626 PART SIX Cost of Capital and Long-Term Financial Policy

18.8

stock dividend
A payment made by a
firm to its owners in the
form of stock, diluting
the value of each share
outstanding.

stock split
An increase in a firm’s
shares outstanding
without any change in
owners’ equity.

Current information on
firms announcing stock
splits and dividends is
available at http://www.e-
analytics.com/splitd.htm.