In January 2016, the board of directors of Penny Corporation, one of the nations largest retail store chains, was having its regularly scheduled meeting to establish and declare the next quarterly dividend. (Statements for the firm and industry are shown in Figures 1 and 2.) However, this meeting wasnt so regular. One of the directors, Sidney Mobler, who was also a vice president in the company and chief financial officer, had brought a guest: Don Jackson, a financial analyst. Don had spent a considerable amount of time in the finance department and more than a few hours in Mr. Moblers office developing a proposal concerning the companys dividend policy. He had finally convinced Mr. Mobler to allow him to present his idea to the board. Ladies and gentlemen, Don began, after being introduced by Mr. Mobler, Ill skip the preliminaries and get right to the point. I think that Montgomerys dividend policy is not in the best interest of the stockholders. Observing the rather chilly stares from around the room, he hastened on: Now, I dont mean we have a bad policy, or anything like that; its just that I think we could do an even better job of increasing our stockholders wealth with a few small changes. He paused for effect. Let me explain. Up to now our policy has been to pay a constant dividend every year, while increasing it occasionally to reflect the companys growth in sales and income. The problem is, that policy takes no account of the investment opportunities that the company has from year to year. In other words, this year we will use most of our net income to pay the same, or a greater, dividend than last year, even though there might be company investments available that would pay a much greater return if we committed the funds to the firms investments instead. In effect, the stockholders are being shortchanged: They will realize perhaps a 6 percent yield on their investment as a result of receiving the dividend, when they could realize a 12 percent or higher return as a result of the companys return on its investments. I see this as a serious shortcoming in the management of the stockholders funds. Now, fortunately, correcting this situation is not difficult. All you have to do is adopt what is called a residual dividend policy. That is, each year the firm would Reminder: a. . allocate money from income to those capital spending projects for which the return that is, IRRis greater than the cost of capital. Any money that is not used in the capital budget would be paid out to the stockholders in the form of dividends. In this way the firm would ensure that the stockholders money is working the hardest way it can for them. Figure 1 Selected financial data, Penny Corporation (in millions, except per share data) 2009 2010 2011 2012 2013 2014 2015 Sales....................................................... $27,357.4 $30,019.8 $35,882.9 $38,828.0 $40,715.3 $44,281.5 $48,000.0 Net income.............................................. $ 650.1 $ 861.2 $ 1,342.2 $ 1,454.8 $ 1,303.3 $ 1,351.3 $ 1,700.0 Amount to preferred dividends................ $ 16.7 $ 21.5 $ 16.8 $ 22.6 Amount to common dividends................. $ 429.1 $ 476.3 $ 537.0 $ 630.8 $ 639.0 $ 648.3 $ 725.4 Amount to retained earnings................... $ 221.0 $ 384.9 $ 805.2 $ 807.3 $ 642.8 $ 686.2 $ 952.0 Common shares outstanding.................. 347.9 351.4 354.6 361.6 363.1 376.6 378.0 Earnings per share (on average common shares).................................................. $ 1.96 $ 2.46 $ 3.80 $ 4.06 $ 3.60 $ 3.65 $ 4.51 DPS (on average common shares)......... $ 1.36 $ 1.36 $ 1.48 $ 1.70 $ 1.76 $ 1.76 $ 1.96 Payout ratio (DPS/EPS)* ........................ 69.4% 55.3% 38.9% 41.8% 48.9% 48.2% 43.5% Total retained earnings ........................... $ 7,041.2 $ 7,426.1 $ 8,231.3 $ 9,038.6 $ 9,681.4 $10,367.6 $11,319.6 Cash balance.......................................... $ 1,170.7 $ 1,307.6 $ 1,502.5 $ 1,765.0 $ 2,357.2 $ 2,984.4 $ 3,235.0 *DPS (dividends per share)/EPS (earnings per share) Figure 2 Selected financial data, other retail chains 2009 2010 2011 2012 2013 2014 2015 Dillard Department Store: EPS............................. $0.69 $0.93 $1.38 $1.82 $2.29 $2.35 $2.50 DPS............................. $0.05 $0.05 $0.08 $0.09 $0.10 $0.12 $0.13 Payout ratio................. 7.3% 5.4% 5.8% 5.0% 4.4% 5.1% 5.2% Dollar General:................ EPS............................. $0.38 $0.61 $0.81 $1.10 $0.95 $0.23 $0.30 DPS............................. $0.09 $0.11 $0.13 $0.17 $0.20 $0.20 $0.20 Payout ratio................. 23.7% 18.0% 16.1% 15.5% 21.1% 87.0% 66.7% Limited, Inc.:.................... EPS............................. $0.10 $0.19 $0.37 $0.51 $0.80 $1.21 $1.40 DPS............................. $0.01 $0.02 $0.04 $0.08 $0.11 $0.16 $0.24 Payout ratio................. 10.0% 10.5% 10.8% 15.7% 13.8% 13.2% 17.1% Nordstrom, Inc.:............... EPS............................. $0.35 $0.38 $0.54 $0.55 $0.66 $0.91 $1.10 DPS............................. $0.06 $0.06 $0.07 $0.10 $0.11 $0.13 $0.18 Payout ratio................. 17.1% 15.8% 13.0% 18.2% 16.7% 14.3% 16.4% J.C. Penney:.................... EPS............................. $2.75 $2.94 $3.13 $2.91 $2.66 $3.53 $4.70 DPS............................. $0.92 $1.00 $1.08 $1.18 $1.18 $1.24 $1.48 Payout ratio................. 33.5% 34.0% 34.5% 40.6% 44.4% 35.1% 31.5% Wal-Mart Stores: ............. EPS............................. $0.16 $0.23 $0.35 $0.48 $0.58 $0.80 $1.10 DPS............................. $0.02 $0.02 $0.04 $0.05 $0.07 $0.09 $0.12 Payout ratio................. 12.5% 8.7% 11.4% 10.4% 12.1% 11.3% 10.9% Note: DPS refers to dividends per share, EPS to earnings per share. Mr. Clarence Autry, who was also on the board of directors of the Exxon corporation and no stranger to the world of corporate finance, broke in. Young man, he said dryly, your proposal ignores reality. Its not whether the stockholders are theoretically better off that counts, its what they want. You cannot tell the stockholders youre doing whats best for them by cutting the dividend; the dividend is what they want. Not only is that dividend sure money in their pockets now, but the fact that its the same size as last time, or even higher, is a signal to them that their company is doing well and will continue to do so in the future. These decisions cant always be made on the basis of good-looking formulas from the back room, you know. Ms. Barbara Reynolds, who was the head of directors auditing committee, and somewhat of an accounting expert, agreed with Mr. Autry. Thats a good point, Clarence, and one thats well recognized by our competitors, too. If you check, I dont think youll find a single one of them thats cut their dividend in the last six years, even though their net income may have declined significantly. Furthermore, the whole argument is meaningless, anyway, because the dividend is not really competing with the capital budget for fundswe dont turn away profitable projects in favor of paying the dividend. If there are worthy projects in which we want to invest, and we would rather use our available cash to pay the dividend, then we seek financing for the investments from outside sources. In a way, we can have our cake and eat it too. She chuckled, pleased at the analogy. Don Jackson, however, was not to be intimidated so easily. Yes, maam, what you say is true, he replied, and I would respond that competitors are not treating their stockholders fairly, either. Furthermore, you do seek outside financing occasionally for large projects, but there are two problems associated with doing it routinely, as you suggest. First, it might be viewed as borrowing, or issuing stock, to pay the dividend, which would cast the company in a very poor light. Second, its more expensive to finance from outside sources than from inside due to the fees charged by the investment banker. Therefore, I believe you should exhaust our inside sources of financing before turning to the outside. Ms. Reynolds held her ground. Thats all very well, but its still not necessary to cut the dividend in order to fund the capital budget. As a last resort, if the companys cash balances were about to be drawn down too low, we could always declare a stock dividend instead of a cash dividend. Ladies, gentlemen, Mr. Edward Asking, the chairman, intervened, your comments are all very perceptive, but we must move on to the business at hand. All those in favor of changing to a residual policy, please raise your hand. Questions (Equally Weighted) 1. Refer to Figure 1. Would you say that Pennys policy up to now has been to pay a constant dividend, with occasional increases as the company grows? 2. Refer to Figure 2. What type of dividend policies would you say are being practiced by Pennys competitors in the retailing industry? 3 What kind of signal a change to residual dividend policy will send to the shareholders and the investment community? 4. How does the residual dividend policy support Modigliani and Millers (MM) theory about dividend policy in a world with no taxes? 5. Do you go along with Clarence Autrys comment that its what the stockholders want that counts, not their total rate of return? Why or why not? 6. Barbara Reynolds suggests that, if cash is needed for the capital budget, a stock dividend could be substituted for the cash dividend. Do you agree? How do you think the stockholders would react? Regardless of their reaction, is the stock dividend an equivalent substitute for the cash dividend? 7. After all is said and done, do you think the firms dividend policy matters? If so, what do you think Pennys policy should be? Additional Question #8. Assume that Penny Corporation is a cash-only company. The company is now considering switching to a 30-day credit policy with no discounts. What factors should the firm consider before making the switch? Discuss.