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CHAPTER FIVE
Qualitative Questions
Question 1
■
Shareholders prefer to have cash dividends paid to them now rather than waiting for
potential payments in the future.
■
Future cash flows from retained earnings are riskier than current dividends.
■
Investors will be willing to pay more for high-dividend-paying firms than low-dividendpaying firms.
■
If all else is equal, investors demand a higher rate of return when the dividend payout is
reduced.
Question 2
■
In perfect markets, taxes and transaction costs are zero.
■
Value depends on a firm’s asset investment policy rather than on how earnings are split
between dividends and retained earnings.
■
Retaining earnings increases share value and investors who desire cash for consumption
can sell a portion of their holdings.
■
If a dividend payment requires management to issue new shares, it only transfers the risk
and ownership from current owners to new owners.
Question 3
■
Investors who are not happy with the firm’s dividend policy will trade securities to create
homemade dividends.
■
Transaction costs make homemade dividends expensive.
■
A firm can pay dividends and, at the same time, sell shares to raise funds for investment.
■
The existence of flotation costs makes the cost of raising funds from the market more
expensive than retained earnings.
Question 4
■
Capital gains are generally taxed at a lower effective rate than dividend income and the
investor has the ability to defer capital gains.
■
Low-dividend-paying stocks provide more capital gains and less dividend income than
stocks paying high dividends.
■
The impact of taxes is complicated by the existence of tax-exempt institutional investors
and individual investors who prefer capital gains.
■
The clientele effect suggests that investors will invest in shares that suit their tax needs.
Question 5
■
Changes in dividends are considered to signal useful information to investors concerning
a company’s future prospects.
■
The quality of the information contained in dividend changes depends on the pattern of
dividends established by a firm.
■
An increase in the current dividend payout is viewed as a message that management
anticipates a permanently higher level of cash flows from investment.
■
An increase in dividend is often accompanied by an increase in share price.
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Question 6
■
Different groups of shareholders prefer different dividend policies.
■
Management’s reluctance to alter established dividend policies provides a possible explanation for clientele effects.
■
If a dividend announcement is as expected, the market price remains unchanged.
Question 7
■
Legal restrictions may be imposed by legislative authorities.
■
Investors may impose restrictive constraints in the form of protective covenants included
in debt and preferred share contracts.
■
There may be restrictions on cash distributions because of the lack of liquidity.
■
The volatility of a firm’s earnings may constrain the firm from increasing dividends.
Question 8
■
Regular cash dividends
■
Extra or special cash dividends
■
Stock dividends
Question 9
■
Corporations often set their dividend payments lower than expected earnings.
■
Firms resist cutting dividends to avoid conveying negative signals about their prospects.
■
Regular and predictable payments tend to occur on a quarterly basis.
■
Firms avoid paying dividends during the early stages of their life cycles.
Question 10
■
According to the residual strategy, the firm pays any cash not needed for financing profitable internal projects.
■
Under the constant payout ratio policy, the firm pays a constant proportion of earnings in
dividends.
■
Under the constant dollar dividend policy, the firm pays a constant amount quarterly.
■
Firms may pay extra and special dividends.
Question 11
■
Announcement date
■
Record date
■
Ex-dividend date
■
Dividend-on date
■
Payment date
Question 12
48
■
Stock dividends are additional shares of stock distributed to existing shareholders in place
of cash dividends.
■
Often, firms maintain the cash dividend per share following a stock dividend.
■
A stock split increases the number of shares outstanding without issuing new shares and
selling them in the market.
■
Often, stock splits are accompanied by an increase in total dividends.
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Question 13
■
Share repurchases decrease the number of shares outstanding and lead to a higher market price per share.
■
Shareholders who wish to receive cash can sell a portion of their holdings to substitute for
the cash dividend.
■
Share repurchases are perfect substitutes for cash dividends when markets are perfect.
■
Shareholders who pay more taxes on dividends than on capital gains prefer stock repurchases to dividends.
Question 14
■
In an open market purchase, the firm acquires shares at the going market price.
■
In an offer to purchase, shareholders tender their shares at a premium within a particular
time period.
■
In a negotiated purchase, the firm purchases a large block of shares from one or more
holders on a negotiated basis.
Qualitative Multiple Choice Questions
Question 1
iii) Constant dollar dividend policy
Question 2
i) The firm acquires the shares from stockbrokers at the going market price.
Question 3
ii) Shareholders have a choice with a share repurchase—they can tender their shares or
they can refuse to tender.
Question 4
i) January 29, 2003
Question 5
ii) Tax-exempt institutions are willing to pay a premium for shares that pay high dividends,
but this will not affect share prices, as long as the existence of tax clienteles can be predicted and as long as there are enough investors in each tax situation.
Question 6
iv) Pay out dividends as a residual, after financing all positive NPV investment projects
Question 7
ii) The existence of tax clienteles implies that each firm will attract a specific group of
investors, depending on their dividend policy.
Question 8
ii) Perfect market view
Question 9
iv) Shareholders solve the problem of reinvesting small amounts of cash.
Question 10
iv) The dividend paid each period is a function of current earnings and current investment
opportunities.
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Question 11
iv) The cash account
Question 12
ii) Shareholders have a choice with share repurchases.
Quantitative Multiple Choice Questions
Question 1
ii) $1.96
Standard deviation of DPS = standard deviation of EPS × dividend payout ratio
= $5.60 (0.35) = $1.96
Question 2
ii) $17,589
Number of shares purchased =
250,000
= 10,000
25
Dividends received = 10,000(2.25) = $22,500
Dividend income, after tax = $22,5000 − $22,5000(1.45)
(0.29 − 0.189655)(1.5)
= $22,500 − $4,911 = $17,589
Question 3
ii) 20%
Equity needed to finance budget = 0.6 × $5 million = $3 million
Net income $3.75 million
Less: equity retained: $3 million
Thus, dividends payable $0.75 million
Payout ratio =
$0.75 million
= 20%
$3.75 million
Question 4
iii) $29.40
Current EPS =
P/ E ratio =
EPS after repurchase =
$126 million
= $2.52 per share
50 million shares
$26.46
= 10.5 times
$2.52
$126 million
= $2.80 per share
45 million shares
Expected market price after repurchase = 10.5 × $2.80 = $18.175 = $29.40
Quantitative Problems
Problem 1
In this question, a firm is implementing a residual dividend policy. A stock dividend and a stock
split must also be described, as these are potential alternatives for the firm, for the current year.
50
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a)
Calgina follows a residual dividend policy, and it maintains a 55% debt-to-equity ratio. It
must finance $3,500,000 for the four new projects with this debt-to-equity ratio.
0.55 =
E =
D
, so D = 0.55E
E
$3,500,000
= $2,258,065
1.55
This $2,258,065 is the amount of the investment outlays that will be financed from current earnings
attributable to common shareholders. The remaining $1,241,935 will be raised by issuing new debt.
To confirm:
1,241,935
= 55%
$2,258,065
An alternative calculation of debt and equity proportion:
D = 0.55
E = 1.0
V = 1.55
D + E = 1.55
D
0.55
=
V
1.55
1
E
=
V
1.55
b) The firm has $2,500,000 current earnings available to common shareholders and requires
$2,258,065 of equity financing for its new investments. The remainder can be paid out
as dividends:
$2,500,000 − $2,258,065 = $241,935
c)
i) If no dividends are paid and all $2,500,000 of earnings available to common shareholders is invested in new projects, then the total amount of investment could be:
$2,500,000
(or $2,500,000(1.55)) = $3,875,000
0.64516
ii) New debt of $1,3750,000 ($2,500,000 × 0.55) would be required to maintain a
55% debt-to-equity ratio.
d) A stock dividend is the distribution of additional shares to existing shareholders. There is
e)
no cash involved; instead, there is an accounting transfer or capitalization from the
retained earnings account to the common share account. The number of outstanding
shares increases, but there is no change in the total value of equity—it is just distributed
proportionately to its existing shareholders.
A stock split is an action taken to increase the number of shares outstanding without issuing new shares. A firm issues new shares and distributes them to current shareholders in proportion to shareholders’ ownership in the original shares. The book value of shares is split to
reflect the new number of shares. Total shareholders’ wealth and firm value are unaffected.
Problem 2
a) i) 2008 dividends = (1.07)(2007 dividends) = (1.07)($7,200,000) = $7,704,000
ii) 2007 payout ratio =
$7,200,000
= 40%
$18,000,000
2008 dividends = (40%)($28,800,000) = $11,520,000
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iii) Equity financing = $16,800,000(0.7) = $11,760,000
2008 dividends = net income - equity financing
= $28,800,000 - $11,760,000
= $17,040,000
All of the equity financing is done with earnings as long as they are available.
iv) The regular dividends would be the 2007 dividends plus a 7% growth:
Regular dividends = (1.07)($7,200,000) = $7,704,000
The residual policy calls for dividends of $17,040,000. Therefore, the extra dividend
would be:
Extra dividend = $17,040,000 - $7,704,000 = $9,336,000
b) Policy iv), based on the regular dividend with an extra dividend, seems most logical. If
implemented properly, it would lead to correct capital budgeting and correct financing
decisions, and it would convey correct signals to investors.
c)
Cost of equity =
D1
$18,000,000
+ g =
+ 7% = 12%
P0
$360,000,000
d) Other possible forms of remuneration are stock dividends, stock splits, and share repurchases.
Cases
Case 1: Antibury Inc.
a) Under the cash dividend policy, Antibury Inc. will pay out 70% of earnings as dividends.
Earnings are projected to be $3,257,143 and there are 1,500,000 shares outstanding.
Total cash dividends = 0.70 ($3,257,143) = $2,280,000
Dividend per share =
$2,280,000
= $1.52
1,500,000
Therefore, a holder of 200 shares will receive $304.00.
The cash dividends will reduce retained earnings to $15,000,000 - $2,280,0000 =
$12,720,000
Total-debt-to-total-equity =
b)
(4,700,000 + 5,000,000)
= 0.68214
(1,500,000 + 12,720,000)
i) If all cash is retained and a 30% stock dividend is paid, then the number of common
shares outstanding will increase to 1,500,000 (1.3) = 1,950,000 shares.
A holder of 200 shares will receive 60 additional common shares.
ii) There will be a transfer from the retained earnings account to the common shares
account, equal to 30% of the market value of all outstanding shares:
0.30($15)(1,500,000) = $6,750,000
The new balance of common shares = 1,500,000 − 6,750,000
= $8,250,000
The new balance of retained earnings = 15,000,000 – 6,750,000
= $8,250,000
Total-debt-to-total-equity ratio =
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(4,700,000 + 5,000,000)
9,700,000
=
= 0.5878
(8,250,000 + 8,250,000)
16,500,000
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iii) Next year, if earnings remain at $3,257,143 and the payout remains at 70%, the firm
will pay out cash dividends of $2,280,000 to holders of the 1,950,000 shares:
Dividend per share =
$2,280,000
= $1.169 L $1.17
1,950,000
For 260 shares, dividend = $304.20
c)
i) If the firm opts for a share repurchase, with a payout of $2,280,000, and if the share
price remains at $15, the firm can repurchase $2,280,000
= 152,000 shares.
$15
ii) Remaining shares outstanding = 1,500,000 - 152,000 = 1,348,000 shares
iii) If earnings and payout remain unchanged in the following year, the per-share dividend
will be:
Earnings(0.7)
$3,257,143(0.7)
$2,280,000
=
=
= $1.69
new number of shares
1,348,000
1,348,000
For 180 shares,* dividend = $304.20
* Note: % ownership before =
d)
200
1,500,000
= 0.00013333.
% ownership after must remain the same; 1,348,000(.00013333) = 179.73
≈ 180 shares.
The policies differ on a variety of dimensions. If tax differences are not present, a cash dividend is equivalent to a share repurchase. The capital structure of the firm, as measured
by the debt-to-equity ratio, is affected by dividend payout policy. Also, if there is a link
between investment opportunities and dividend payout policies, firms should restrict cash
dividends so as to enable them to undertake positive NPV projects, as implied in part b).
Case 2: JoliBrand Corp.
In a world that is perfect, except for the existence of corporate taxes, a firm is considering
changing its capital structure. The impetus for the change is the realization that the firm has a
capital structure inconsistent with others in the industry. Using the M&M with corporate taxes
model, students must identify the new level of debt required to achieve the desired target capital structure. The analysis continues by determining how many common shares to repurchase
with the new debt, and then by considering the impact on the dividend payout of the firm
under alternative dividend payout policies. Overall impact on the cash flows of the firm can
then be calculated, since interest payments will increase while dividend payments to common
shareholders will fall. This integrative problem incorporates capital structure, dividend policy,
and cash management.
a) As JBC changes its capital structure, its value will change due to the interest tax shields
on additional debt. This must be taken into account when identifying the required
amount of additional debt, since the target capital structure is defined in terms of the
total debt to total market value ratio.
New value = old value + tax rate ⫻ amount of additional debt
Old value = $81,000,000 + $22,000,000 + $48,000,000 = $151,000,000
$70,000,000
JBC now has a total debt to market value ratio of $151,000,000
= 46.36%, which is
below the industry norm. JBC should issue more debt to achieve its objective.
The new total debt to market value ratio is to be the industry norm of 60%:
(New firm value)(60%) = $70 million existing debt + value of new debt
(151,000,000 + 0.34 ⫻ new debt)(0.60) = $70,000,000 + new debt
90,600,000 + 0.204 new debt = 70,000,000 + new debt
90,600,000 − 70,000,000 = 0.796 new debt
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New debt =
20,600,000
= $25,879,397 required to be issued
0.796
To verify:
New firm value = 151,000,000 + 0.34(25,879,397)
= 151,000,000 + 8,798,995 = 159,798,9951
New debt-to-market-value ratio =
1
(70,000,000 + 25,879,397)
95,879,397
=
= 60%
159,798,995
159,798,995
Alternative solution
Value without debt:
VB = VA + BTC
151,000 = VA + 70,000(0.34)
VA = 127,200
Value with 60% debt
VB = 127,200 + 0.34(0.60)VB
VB = 127,200 + 0.204VB
VB = 159,798,995
b) Before the change in capital structure, JBC had 10,000,000 shares outstanding with a
total market value of $81,000,000 so the share price was $8.10 each.
Every current shareholder can expect to receive a fair share of the new higher firm value
after the proposed change in capital structure.
The increase in firm value of $6,120,000 ($18,000,000 × 0.34) is therefore shared
among all 10,000,000 shares:
New share value =
($81,000,000 + $6,120,000)
= $8.712
10,000,000
Shares to be repurchased = a
c)
$18,000,000
b = 2,066,116 shares
$8.712
Shares remaining outstanding = 10,000,000 - 2,066,116 = 7,933,884 shares @ $8.712
each
The increase in firm value of $6,800,000 ($20,000,000 × 0.34) is therefore shared
among all 10,000,000 shares:
New share value =
Shares to be repurchased =
($81,000,000 + $6,800,000)
= $8.78
10,000,000
$20,000,000
= 2,277,904 shares
$8.78
Shares remaining outstanding = 10,000,000 - 2,277,904 = 7,722,096 shares @ $8.78
each
If JBC continues its policy of paying common shareholders an annual dividend of $2 per share,
it will pay out $4,555,808 less in dividends as a consequence of the change in capital structure.
New debt yielding 10% with a value of $20,000,000 will require interest payments of
$2,000,000 ($20,000,000 × 0.10).
After tax, the interest expense will be $1,320,000 [$2,000,000 × (1 - 0.34)].
The net effect is a reduction in cash outflows of $4,555,808 - $1,320,000 = $3,235,808.
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d) JBC could adopt a constant dividend payout percentage. Annual earnings would be
multiplied by this percentage to identify total cash dividends for the year. Per-share
dividends would be this total amount divided by the number of shares outstanding.
Under this policy, per-share dividends fluctuate from year to year, with earnings.
Shareholders do not have the stable cash flows they receive under the current
constant-dollar dividend policy.
JBC could also adopt a residual dividend payout policy. Dividends would then be
paid only after all positive NPV projects had been undertaken. That is, only residual
funds are paid out and the rest is retained in the firm for reinvestment. Under this policy, annual dividends fluctuate with annual investment opportunities, with given levels
of earnings. Again, shareholders are unlikely to have the stability of dividends that they
enjoy under the current policy.
CHAPTER SIX
Qualitative Questions
Question 1
■
■
■
■
Sponsors guarantee that the project will be completed on time and will meet certain
specifications or quality tests.
Sponsors guarantee the supply of raw materials to the project during or after completion.
Sponsors guarantee purchasing part or all of the output from or services of a project.
Sponsors effectively guarantee the project against default.
Question 2
■
■
■
Calculate the cash flows obtained from the project assuming the project will be financed
with all equity (unlevered project).
Determine the cost of capital assuming an all-equity firm.
Discount the unlevered cash flows by the unlevered cost of equity.
Question 3
■
■
■
■
■
■
Calculate the base-case NPV (all equity).
Calculate the incremental cash flows obtained if the firm uses a source other than equity
to finance the project.
Determine the after-tax cost of debt for the firm.
Determine the interest tax shield.
Discount the present value of incremental cash flows at the after-tax cost of debt.
Add the present value of the finance-related benefits and costs to present value from the
base-case NPV.
Question 4
■
■
■
■
Leasing uses up the firm’s debt capacity in the same manner as debt.
Lease payments magnify the variability of the net cash flows to shareholders.
Leasing allows the lessee to avoid the investment outlays that would be required to
purchase.
Leasing requires periodic cash outflows similar to those required to service debt.
Question 5
■
■
■
The entire periodic lease payment can be claimed as a tax-deductible expense.
Lessees cannot claim capital cost allowances on the leased equipment.
The lessee loses the advantages derived from the asset’s residual value.
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