Brand-name Corporation (B) The price earnings ratio for Brand-name Corporation had remained consistently below the industry average in recent years, and managers were searching for a way to improve...

Brand-name Corporation (B) The price earnings ratio for Brand-name Corporation had remained consistently below the industry average in recent years, and managers were searching for a way to improve the price of the stock. Dividend policy was being examined as part of an overall review of company policy. As shown in Table 18-6, Brand-name Corpo-ration had followed a policy of paying a stable dividend equal to about one-fourth of earnings. Managers had increased divi-dends in response to increased earnings only when they were confident that the higher earnings would continue. Although this seemed like a sound policy, all policies were up for consideration as frustration about low stock prices grew. Opinions about dividend policy were sharply split. The controller, Mark John-son, was of the opinion that the company should cut out dividends entirely. He noted that dividends resulted in immedi-ate taxes while capital gains would not be taxed until the investor sold the stock. He based his opinions primarily on the infor-mation in Tables 18-7 and 19-2. He noted that company C reduced its dividend in 1992, and the stock price did not decline. He also observed that two companies had paid no dividends in recent years, and both companies had relatively high price-earnings ratios. In light of the need for an additional $20 million of capital, he rec-ommended that the company end its pol-
icy of paying cash dividends and begin paying stock dividends instead. Karen Miller, the treasurer, disagreed. She agreed that the companies that had never paid dividends seemed to get by without harm, but cutting dividends was another matter. While the stock price did not fall for the company that reduced divi-dends, stock prices increased for most companies in the industry. The company that reduced its dividend suffered a de-cline in relative price. Investors were ex-pecting a dividend, and the price of Brand-name's stock would almost certainly fall if dividends were cut. Miller also examined the relationship between dividend payout ratio and price. She excluded the two companies that paid no dividends because they probably ap-pealed to a special investor group that did not want dividends. She noted that the seven companies paying out less than a third of their earnings in dividends had price-earnings ratios averaging 12.8. The three companies paying out at least three-fourths of their earnings in dividends had price-earnings ratios averaging 24.8. She suggested an immediate increase in divi-dends in pursuit of a new target payout ratio of three-fourths of earnings.
Case Questions 1. Describe the relationship between div-idend payout ratios and price-earnings