Topic 11 – Tutorial Questions + Answers
Discussion Questions
Briefly describe the sequence of events of a firm's dividend payment.
The board of directors sets the dividend for a firm. The date on which the board of directors announces
the dividend is called the declaration date. Dividends will be paid to those who are registered
shareholders as of the record date. Two business days prior to the record date is the ex-dividend date.
Shares bought on the ex-dividend date or later do not come with the dividend. Dividend checks are
mailed to shareholders on the payment date.
Question 1
Dividend policy Here are several “facts” about typical corporate dividend policies. Which are true and
which false?
a. Managers and investors seem more concerned with dividend changes than with dividend levels.
b. Managers often increase dividends temporarily when earnings are unexpectedly high for a year or
two.
c. Companies undertaking substantial share repurchases usually finance them with an off- setting
reduction in cash dividends.
Answer
a.
True. Dividend changes convey information to investors.
b.
False. Dividends are “smoothed.” Managers rarely increase regular dividends temporarily. They
may pay a special dividend, however.
c.
False. Dividends are rarely cut when repurchases are being made.
Question 2
On the ex-dividend date, stock price of the company will fall by the exact of dividends per share,
assuming efficient markets.
Here are key financial data for House of Herring Inc.:
Earnings per share for 2025
$5.50
Number of shares outstanding
40 million
Target payout ratio
50%
Planned dividend per share
$2.75
Stock price, year-end 2025
$130
House of Herring plans to pay the entire dividend early in January 2026. All corporate and personal taxes
were repealed in 2024.
a) Other things equal, what will be House of Herring’s stock price after the planned dividend
payout?
b) Suppose the company cancels the dividend and announces that it will use the money saved to
repurchase shares. What happens to the stock price on the announcement date? Assume that
investors learn nothing about the company’s prospects from the announcement. How many
shares will the company need to repurchase?
c) Suppose that, instead of cancelling the dividend, the company increases dividends to $5.50 per
share and then issues new shares to recoup the extra cash paid out as dividends. What happens
to the with- and ex-dividend share prices? How many shares will need to be issued? Again,
assume investors learn nothing from the announcement about House of Herring’s prospects.
a.
Ex-dividend price = cum-dividend price – dividend
Ex-dividend price = $130 – 2.75
Ex-dividend price = $127.25
b.
The stock price will remain at $130.
Shares repurchased = repurchase amount / price
Shares repurchased = ($2.75 × 40m) / $130
Shares repurchased = 846,154
c.
The with-dividend price remains at $130.
Ex-dividend price = cum-dividend price – dividend
Ex-dividend price = $130 – 5.50
Ex-dividend price =
$124.50
Shares issued = new dividend amount / ex-dividend price
Shares issued = [($5.50 – 2.75) × 40m] / ($130 – 5.50)
Shares issued = 883,534
Question 3
Comment briefly on each of the following statements:
a) “Unlike new capital, which needs a stream of new dividends to service it, retained earnings have
zero cost.”
This statement is false. Retained earnings are money not paid out to shareholders at the end of
the year. The company retains this money to invest on behalf of shareholders. In turn,
shareholders require a return on this investment, which is the cost of equity. Retained earnings
are not without cost.
b) “If a company repurchases stock instead of paying a dividend, the number of shares falls and
earnings per share rise. Thus, stock repurchase must always be preferred to paying dividends.”
If a firm pays dividends => shareholders must pay taxes on the dividends received.
If a firm repurchases stocks => shareholders must pay capital gains tax (if any capital gains).
If capital gains tax < dividend tax => it is better for shareholders to have share repurchases.
The answer to this question depends strictly on tax rates, not EPS.
a.
One way to think of retained earnings is that, from an economic standpoint, the
company earns money on behalf of the shareholders, who then immediately reinvest
the earnings in the company. Thus, retained earnings do not represent free capital.
Retained earnings carry the full cost of equity capital (although issue costs associated
with raising new equity capital are avoided).
b.
If the tax on capital gains is less than that on dividends, the conclusion of this statement
is correct; i.e., a stock repurchase is always preferred over dividends. This conclusion,
however, is strictly because of taxes. Earnings per share is irrelevant.