This case requires students to apply theoretical concepts relating to dividend policy in a realistic situation. It covers the full range of ideas studied in the chapter and asks students to extend those ideas intuitively to a few new situations such as the signaling function of cash dividends. The case also examines dividends from the point of view of investor wealth and requires students to perform the related computations.

1. The following is a partial list of comments made by staffers at the meeting. To help Frank make a decision, identify the dividend policy or theory they reflect and comment on the usefulness of each.

a. “What difference does it make if we pay dividends or not? Shareholders can always sell a few shares and make their own dividends?” Response: “That works for the big shareholders, but what about the little guys?”

b. “From a tax perspective, our shareholders would be better off paying the capital gains tax than paying the tax on dividends.”

c. “Stock prices go up and down due to market factors we can’t control. A dividend is something you can count on.”

d. “The fact is some of our shareholders want dividends. You heard that at the shareholders’ meeting.” Response: “That’s right, but of course maybe some of them don’t. They might prefer that we try to grow the business faster.”

e. “Our business has been doing well, but these are tough times. A lot of retailers are hurting, and the market is down. By paying a dividend, we send a message to our shareholders that we expect to stay strong for the foreseeable future.”

f. “Before we think of paying dividends, we should be sure that we have enough cash to cover our operating expenses and capital budget.” Response: “That’s right, and once we start paying dividends, we will never be able to cut them.”

2. When Frank thought he had gathered enough ideas about dividend theory and policy, he asked the following question: “Let’s say we decide that our shareholders want some kind of distribution. What’s the best way to do it?” Evaluate the merits of the following suggestions.

a. “How about a 20% or 30% stock dividend? They will feel like they’re getting something, and it won’t use any cash.”

b. “Our stock has been trading between $65 and $80 for the last year. How about a 2 for 1 or 3 for 1 stock split.”

c. “What about a stock repurchase plan?”

d. Frank: “Nice thoughts, but the institutional investors seem to be the ones asking for dividends. They won’t be easily fooled. Let’s focus on cash dividends for now.”

3. Assume that an investor holds 1000 shares of East Coast stock which is trading at $72 per share immediately before the following actions. Calculate the probable value of the stock, the amount of cash received, and total investor wealth immediately after the following actions. Consider each action independently.

a. East Coast pays a 20% stock dividend.

b. East Coast splits its stock 3 for 1.

c. East Coast pays a $2.00 per share cash dividend. The tax rate on dividends is 15%.

d. East Coast pays a $2.00 per share cash dividend. The investor holds her shares in a tax-sheltered retirement account.

e. The investor sells 100 shares which were purchased for $52 per share. The tax rate on capital gains is 15%

4. The table below shows, in thousands of dollars, normal, best case and worst case projections for East Coast’s cash flow from operations, maintenance costs, investments in new assets, and excess cash for the next four years.

a. If East Cost adopts a sticky dividend policy, what is the highest dividend it will pay in year 1?

b. If it grows dividends at a constant percentage rate, what is the highest sustainable rate it can adopt?

c. East Coast has 42.5 million shares outstanding. If it decides to increase dividends by a constant amount, rather than a constant percentage, how much will it increase the dividend per share in year 2?

d. Suppose East Coast adopted a strict residual dividend policy. Year 1 ends up with the excess projected in the best case scenario, but year 2 ends up with the worst case. What would be the dividend per share in each year? Why might such a policy not be desirable?