Chapter Nine
Picking the Equity Players
Chapter Nine
Picking the Equity Players
KEY POINTS
There are three key teaching points in this chapter:
1. The types of dividends and their payment procedure;
2. Why dividends and stock splits may be neutral events rather than windfall
gains;
3. Categories of common stock.
TEACHING CONSIDERATIONS
As an instructor, I find coverage of this material especially enjoyable. This
material is mostly investments material, and some students will have previously
encountered these ideas and key points. Still, the review is always worthwhile. I
highly recommend the shoebox example. The notion that dividends do not come
out of the sky, and that they are really a neutral occurrence at best, is both
disturbing and fascinating to many people. I find that the shoebox example is one
thing that students remember the longest from their study of the market. Stress the
importance of the ex-dividend date and the fact that it is a brokerage industry
tradition rather than being announced by the company. The ex-dividend date
convention arose because of investors’ dislike of the uncertainty surrounding mail
times, clerical screw-ups, and whether they would get the forthcoming dividend.
To deal with this, the brokerage industry established the uniform policy of
establishing an inviolable cut-off point two business days before the date of
record. A good analogy of the neutral nature of stock splits and stock dividends is
with the size of pizza slices. You cannot increase the quantity of pizza merely by
cutting the pie into more slices. The same thing is true of the value of a firm.
ANSWERS TO QUESTIONS
1. Its assets and its liabilities determine the value of a firm. You cannot increase
the value of the firm by increasing the number of ownership pieces into which
it is cut.
2. Stock dividends are “cheaper” than cash dividends, in that their only cost is
clerical and administrative. Cash dividends require a cash outlay in addition.
Chapter Nine
Picking the Equity Players
There is some psychological advantage to a stock dividend over no dividend,
and if this is the case stock dividends may have merit.
3. There is little empirical data on property dividends. The same principles,
however, should hold. Giving away company assets should reduce the value
of a share.
4. Changes in dividend policy are widely believed to have a signaling function.
When dividends are different from what analysts expect, the market invariably
tries to read something into the unexpected event. To this extent, the
statement has merit.
5. You could look at a plot of the stock price relative to some macroeconomic
measure related to the total economy such as GNP or housing starts.
6. This is true. An investor is interested in total return. In the absence of
dividends the stock price must advance in order for the stock to generate a
positive return. Funds that are paid out cannot be reinvested in the firm to
earn an additional return, but the investor can invest them. The classic “dog
stock” is one with no dividends whose price does not change.
7. The value of a share of stock comes from its being a claim on the assets (and
future earnings power) of the firm. The firm presumably has some value, and
the owner of the firm could realize this value by selling all the shares. The
shares, therefore, must have value or arbitrage would be present.
8. Negative changes in dividend policy are interpreted as bad signals in the
marketplace.
The firm seeks to maximize shareholder wealth, and
management may feel that payment of the dividend is the lesser of two evils.
9. A reduction in the discount rate corresponds to a reduction in risk. This
means that the valuation equation for the security has a smaller number in the
denominator, and therefore the present value of the anticipated cash flow
stream increases. This increases the market value of the security.
10. The ticket holder can 1) use the ticket (exercise the option), 2) sell the ticket
(sell the rights), or 3) abandon the tickets and not go to the game (let the rights
expire).
11. The board of directors seeks to maximize the aggregate value of the
company's shares. The price of an individual share does not matter; the total
value of all the shares does.
Chapter Nine
Picking the Equity Players
ANSWERS TO PROBLEMS
1. 1000 x 1.10 x 1.10 x 1.25 x 2 x 2 x 2 = 12,100
2. Student response.
3. The stock price might increase because of a change in a number of factors in
addition to an expected increase in future dividends. For example, the level of
risk may have decreased or interest rates may have declined. An increase in
the expected growth rate in dividends would increase the stock price, but that is
not the only reason for a stock price increase.
.
4. Student response.
5. Calculate g:
If originally you owned 1 share, now you have 4. Current dividends are
then $0.16 x 4 = $0.64.
.30(1 + g)10 = .64
g = (.64/.30).1 – 1 = 7.87%
PV 
$0.16(1.0787)
 $2.82
.14  .0787
6. Student response.
7. PV = $8
a. g1 = infinite
b. .10(1 + g)3 = .18
g = 21.6%