Question

A financial analyst is attempting to assess the future dividend policy of Environmental Systems by examining its life cycle. She anticipates no payout of earnings in the form of cash dividends during the development stage (I). During the growth stage (II), she anticipates 12 percent of earnings will be distributed as dividends. As the firm progresses to the expansion stage (III), the payout ratio will go up to 35 percent and will eventually reach 58 percent during the maturity stage (IV).

a Assuming earnings per share will be as follows during each of the four stages, indicate the cash dividend per share (if any) during each stage.

Stage I	\(0.10
Stage II	\)1.80
Stage III	\(2.80
Stage IV	\)3.70

b. Assume in Stage IV that an investor owns 325 shares and is in a 15 percent tax bracket. What will be the investor’s after-tax income from the cash dividend?

c. In what two stages is the firm most likely to utilize stock dividends or stock splits?

Short answer

The dividend in stage I is 0, stage II is $0.22, stage III is $0.98, and stage IV is $2.15. The after-tax income will be $593.94. The company will utilise stock dividends and split them into stages II and III.

Step-by-step solution

Calculation of cash dividend

	Earnings	Pay-out ratio	Dividends
Stage I	$0.10	0	0
Stage II	$1.80	12%	$0.22
Stage III	$2.80	35%	$0.98
Stage IV	$3.70	58%	$2.15

Calculation of after-tax income

The after-tax income will be $593.94.

$$\begin{gathered} \text{Dividend}=\text{Shares}\times \text{Dividends per share} \\ =325\times \$2.15 \\ =\$698.75 \end{gathered}$$

$$\begin{gathered} \text{After - tax income}=\text{Dividend}\times \left(1-\text{Tax rate}\right) \\ =\$698.75\times \left(1-0.15\right) \\ =\$698.75\times 0.85 \\ =\$593.94 \end{gathered}$$

The stages where the company should utilize stock dividends and stock splits

The company is most likely to utilise the stock dividend and split during stages II and III as stage II is the growth stage and stage III is the expansion stage.