CHAPTER 17
DIVIDENDS AND DIVIDEND POLICY
Answers to Concepts Review and Critical Thinking Questions
1.
Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid.
Dividend policy is irrelevant when the timing of dividend payments doesn’t affect the present value of
all future dividends.
2.
A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could, if
desired, use excess cash to reduce debt instead. This is a capital structure decision.
3.
The chief drawback to a strict dividend policy is the variability in dividend payments. This is a
problem because investors tend to want a somewhat predictable cash flow. Also, if there is information content to dividend announcements, then the firm may be inadvertently telling the market that it
is expecting a downturn in earnings prospects when it cuts a dividend, when in reality its prospects are
very good. In a compromise policy, the firm maintains a relatively constant dividend. It increases
dividends only when it expects earnings to remain at a sufficiently high level to pay the larger
dividends, and it lowers the dividend only if it absolutely has to.
4.
Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a holiday,
and the exchanges are closed. Anyone who buys the stock before December 29 is entitled to the
dividend, assuming they do not sell it again before December 29.
5.
No, because the money could be better invested in stocks that pay dividends in cash that will benefit
the fundholders directly.
6.
The change in price is due to the change in dividends, not to the change in dividend policy. Dividend
policy can still be irrelevant without a contradiction.
7.
The stock price dropped because of an expected drop in future dividends. Since the stock price is the
present value of all future dividend payments, if the expected future dividend payments decrease, then
the stock price will decline.
8.
The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on their
own, and the shareholders must pay the taxes on the dividends either way. However, the shareholders
who take the option may benefit at the expense of the ones who don’t (because of the discount). Also
as a result of the plan, the firm will be able to raise equity by paying a 10% flotation cost (the
discount), which may be a smaller discount than the market flotation costs of a new issue for some
companies.
9.
If these firms just went public, they probably did so because they were growing and needed the
additional capital. Growth firms typically pay very small cash dividends, if they pay a dividend at all.
This is because they have numerous projects available, and they reinvest the earnings in the firm
instead of paying cash dividends.
10. It would not be irrational to find low-dividend, high-growth stocks. The University should be
indifferent between receiving dividends or capital gains since it does not pay taxes on either one
(ignoring possible restrictions on invasion of principal, etc.). The University would not be averse to
holding preferred shares since neither the income nor any capital gain would be taxable.
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Solutions to Questions and Problems
Basic
1.
after-tax dividend = $5.00(1 – .34) = $3.30;
2.
a.
new shares outstanding = 10,000(1.10) = 11,000; new shares issued = 1,000
capital surplus on new shares = 1,000($19) = $19,000
Common stock ($1 par value)
$ 11,000
Capital surplus
169,000
Retained earnings
532,500
$712,500
b.
new shares outstanding = 10,000(1.25) = 12,500; new shares issued = 2,500
Common stock ($1 par value)
$ 12,500
Capital surplus
197,500
Retained earnings
502,500
$712,500
a.
new shares outstanding = 10,000(5) = 50,000. The equity accounts are unchanged except the par
value of the stock is now $0.20 per share.
new shares outstanding = 10,000(1/4) = 2,500. The equity accounts are unchanged except the
par value of the stock is now $4.00 per share.
3.
b.
4.
a.
b.
c.
d.
e.
$70(3/5) = $42.00
$70(1/1.15) = $60.87
$70(1/1.425) = $49.12
$70(7/4) = $122.50
a: 100,000(5/3) = 166,667
c: 100,000(1.425) = 142,500
ex-dividend price = $80 – 3.30 = $76.70
b: 100,000(1.15) = 115,000
d: 100,000(4/7) = 57,143
5.
P0 = $150,000 equity/4,000 shares = $37.50 PX = $37.50 – 1.25 = $36.25
$1.25(4,000 shares) = $5,000; the equity and cash accounts will both decline by $5,000.
6.
Repurchasing the shares will reduce shareholders’ equity by $3,000.
shares bought = $3,000/$37.50 = 80; new shares outstanding = 3,920.
After repurchase, share price = $147,000 equity/3,920 shares = $37.50. The repurchase is effectively
the same as the cash dividend because you either hold a share worth $37.50, or a share worth $36.25
and $1.25 in cash. Therefore, you participate in the repurchase according to the dividend payout
percentage; you are unaffected.
7.
P0 = $350,000 equity/10,000 shares = $35.
PX = $350,000/12,000 shares = $29.17
8.
new shares outstanding = 350,000(1.08) = 378,000
capital surplus for new shares = 28,000($19) = $532,000
new shares outstanding = 10,000(1.20) = 12,000
Common stock ($1 par value)
Capital surplus
Retained earnings
9.
$ 378,000
2,182,000
2,440,000
$5,000,000
The equity accounts are unchanged except the new par value of the stock is $0.25 per share.
Dividends this year = $0.60(350,000 shares)(4/1 split) = $840,000
Last year’s dividends = $840,000/1.10 = $763,636.36
Dividends per share last year = $763,636.36/350,000 shares = $2.18
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10. equity portion of capital outlays = $900 – 420 = $480; D/E = .80 implies capital structure is .8/1.8
debt and 1/1.8 equity. Therefore, new borrowings = $384; total capital outlays = $864.
11. a.
b.
payout ratio = DPS/EPS = $0.50/$8 = .0625
equity portion of capital outlays = 7M shares ($8 – 0.50) = $52.5M
D/E ratio = $18M/$52.5M = 0.3429
12. a.
b.
maximum capital outlays with no equity financing = $140,000 + 3($140,000) = $560,000.
If planned capital spending is $770,000, then no dividend will be paid and new equity will be
issued since this exceeds the amount calculated in a.
No, they do not maintain a constant dividend payout because, with the strict residual policy, the
dividend will depend on the investment opportunities and earnings. As these two things vary,
the dividend payout will also vary.
c.
13. a.
b.
c.
d.
maximum investment with no equity financing = $45M + 2($45M) = $135M; debt = $90M
D/E = 2 implies capital structure is 2/3 debt and 1/3 equity.
equity portion of investment funds = 1/3($60M) = $20M. Residual = $45M – 20M = $25M
dividend per share = $25M/12M shares = $2.08
borrowing = $60M – 20M = $40M; addition to retained earnings = $20M
dividend per share = $45M/12M shares = $3.75; no new borrowing will take place
Intermediate
14. P0 = $0.60/1.15 + $30/1.152 = $23.20605
$23.20605 = D/1.15 + D/1.152; D = $14.27442
P1 = $30/1.15 = $26.08696
You want 1,000($14.27442) = $14,274.42 in one year, but you’ll only get 1,000($0.60) = $600.00.
Thus, sell ($14,274.42 – 600)/$26.08696 = 524.186 shares at time 1.
time 2 cash flow = $30(1,000 – 524.186) = $14,274.42
15. you only want $200 in year 1, so buy ($600 – 200)/$26.09 = 15.33 shares at time 1.
year 2: (1,000 + 15.33)($30) = $30,460
PV = $200/1.15 + ($30,460)/1.152 = $23,206.05
PV = 1,000($0.60)/1.15 + 1,000($30)/1.15 2 = $23,206.05
16. a.
b.
c.
DPS = $4,000/150 shares = $26.67; P X = $35 – 26.67 = $8.33 per share.
wealth of a shareholder = a share worth $8.33 plus $26.67 cash = $35.
repurchase:
$4,000/$35 = 114.29 shares will be repurchased. If you choose to let your
shares be repurchased, you have $35 in cash; if you keep your shares, they’re
still worth $35.
dividends:
EPS = $0.90; P/E = $8.33/$0.90 = 9.26
repurchase: EPS = $0.90(150)/(150  114.29) = $3.78; P/E = $35/$3.78 = 9.26
A share repurchase would seem to be the preferred course of action. Only those shareholders who
wish to sell will do so, giving the shareholder a tax timing option that he or she doesn’t get with a
dividend payment.
cash dividend:
Challenge
17. After-tax return
Pretax return
= g +D(1 – t) = .20
= g + .08(1 – .35) = .20
= g + D = .148 + .08 = 22.8%
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solving we get g = .148
18. a.
b.
c.
d.
e.
P0 – PX = D
P0 – PX = .72D
P0 – PX = .903D
P0 – PX = D[1 – (.35)(.30)]/.65 = 1.377D
Since different investors have widely varying tax rates on ordinary income and capital
gains, then dividend payments have different after-tax implications for different
investors. This differential taxation among investors is one aspect of what we have
called the clientele effect.
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