15 Answers To All Problems

Chapter 15 (13E)
Distributions to Shareholders: Dividends and

Share Repurchases
Answers to End-o-Chapter !uestions
15-1 The biggest advantage of having an announced dividend policy is that it would
reduce investor uncertainty, and reductions in uncertainty are generally associated
with lower capital costs and higher stock prices, other things equal. The disadvantage
is that such a policy might decrease corporate fexibility. However, the announced
policy would possibly include elements of fexibility. On balance, it would appear
desirable for directors to announce their policies.
15-" hile it is true that the cost of outside equity is higher than that of retained earnings,
it is not necessarily irrational for a !rm to pay dividends and sell stock in the same
year. "f the !rm has been paying a regular dividend, and then cuts it in order to
obtain equity capital from retained earnings, there might be an unfavorable e#ect on
the !rm$s stock price. "f investors lived in the world of certainty and rationality
postulated by %iller and %odigliani, then the statement would be true, but it is not
necessarily true in an uncertain world.
15-3 &ogic suggests that stockholders like stable dividends'many of them depend on
dividend income, and if dividends were cut, this might cause serious hardship. "f a
!rm$s earnings are temporarily depressed or if it needs a substantial amount of funds
for investment, then it might well maintain its regular dividend using borrowed funds
to tide it over until things returned to normal. Of course, this could not be done on a
sustained basis'it would be appropriate only on relatively rare occasions.
15-# a$ %% argue that dividend policy has no e#ect on rs, thus no e#ect on !rm value and
cost of capital. On the other hand, (& argue that investors view current dividends
as being less risky than potential future capital gains. Thus, (& claim that rs is
inversely related to dividend payout.
b$ %% could claim that tests which show that increased dividends lead to increased
stock prices demonstrate that dividend increases are causing investors to revise
earnings forecasts upward, rather than cause investors to lower rs. %%$s claim
could be countered by invoking the e)cient market hypothesis. That is, dividend
increases are built into expectations and dividend announcements could lower
stock price, as well as raise it, depending on how well the dividend increase
matches expectations. Thus, a bias towards price increases with dividend
increases supports (&.
c$ *ince there are clients who prefer di#erent dividend policies, %% could argue that
one policy is as good as another. +ut, if the clienteles are of di#ering si,es or
economic means, the clienteles might not be equal, and one dividend policy could
be preferential to another.
15-5 a$ -rom the stockholders$ point of view, an increase in the personal income tax rate
would make it more desirable for a !rm to retain and reinvest earnings.
Chapter 15: Distributions to Shareholders Answers and Solutions 1
% "&13 Cen'a'e (earnin'$ All Ri'hts Reserved$ )a* not be copied+ scanned+ or duplicated+ in whole or in part+ e,cept
or use as per-itted in a license distributed with a certain product or service or otherwise on a password-protected
website or classroo- use$
.onsequently, an increase in personal tax rates should lower the aggregate
payout ratio.
b$ "f the depreciation allowances were raised, cash fows would increase. ith higher
cash fows, payout ratios would tend to increase. On the other hand, the change
in tax/allowed depreciation charges would increase rates of return on investment,
other things being equal, and this might stimulate investment, and consequently
reduce payout ratios. On balance, it is likely that aggregate payout ratios would
rise, and this has in fact been the case.
c$ "f interest rates were to increase, the increase would make retained earnings a
relatively attractive way of !nancing new investment. .onsequently, the payout
ratio might be expected to decline. On the other hand, higher interest rates
would cause rd, rs, and !rms$ marginal costs of capital to rise'that would mean
that fewer pro0ects would qualify for capital budgeting and the residual would
increase 1other things constant2, hence the payout ratio might increase.
d$ 3 permanent increase in pro!ts would probably lead to an increase in dividends,
but not necessarily to an increase in the payout ratio. "f the aggregate pro!t
increase were a cyclical increase that could be expected to be followed by a
decline, then the payout ratio might fall, because !rms do not generally raise
dividends in response to a short/run pro!t increase.
e$ "f investment opportunities for !rms declined while cash infows remained
relatively constant, an increase would be expected in the payout ratio.
$ 4ividends are currently paid out of after/tax dollars, and interest charges from
before/tax dollars. 5ermission for !rms to deduct dividends as they do interest
charges would make dividends less costly to pay than before and would thus tend
to increase the payout ratio.
'$ This change would make capital gains less attractive and would lead to an
increase in the payout ratio.
15-. a$ The residual dividend policy is based on the premise that, since new common
stock is more costly than retained earnings, a !rm should use all the retained
earnings it can to satisfy its common equity requirement. Thus, the dividend
payout under this policy is a function of the !rm$s investment opportunities. *ee
Table 67.8 in the text for an illustration.
b$ 9es. 3 more shallow plot implies that changes from the optimal capital structure
have little e#ect on the !rm$s cost of capital, hence value. "n this situation,
dividend policy is less critical than if the plot were :/shaped.
15-/ "t is true that executives$ salaries are more highly correlated with the si,e of the !rm
than with pro!tability. This being the case, it might be in management$s own best
interest 1assuming that management does not have a substantial ownership position
in the !rm2 to see the si,e of the !rm increase whether or not this is optimal from
stockholders$ point of view. The larger the investment during any given year, the
larger the !rm will become. 3ccordingly, a !rm whose management is interested in
maximi,ing !rm si,e rather than the value of the existing common stock might push
investments down below the cost of capital. "n other words, management might
invest to a point where the marginal return on new investment is less than the cost of
capital.
" Answers and Solutions Chapter 15: Distributions to Shareholders
"f the !rm does invest to a point where the return on investment is less than the
cost of capital, the stock price must fall below what it otherwise would have been.
*tockholders would be given additional bene!ts from the higher retained earnings
1due to the !rm being larger2, and this might well push up the stock price, but the
increase in stock price would be less than the value of dividends received if the
company had paid out a larger percentage of its earnings.
15-0 The di#erence is largely one of accounting. "n the case of a split, the !rm simply
increases the number of shares and simultaneously reduces the par or stated value
per share. "n the case of a stock dividend, there must be a transfer from retained
earnings to capital stock. -or most !rms, a 6;;< stock dividend and a 8/for/6 stock
split accomplish exactly the same thing= hence, investors may choose either one.
15-1 "t is sometimes argued that there is an optimum price for a stock= that is, a price at
which 3.. will be minimi,ed, giving rise to a maximum price for any given
earnings. "f a !rm can use stock dividends or stock splits to keep its shares selling at
this price 1or in this price range2, then stock dividends and>or splits will have helped
maintain a high 5>? ratio. Others argue that stockholders simply like stock dividends
and>or splits for psychological or some other reasons. "f stockholders do like stock
dividends, using them would have the e#ect of keeping 5>? ratios high. -inally, it has
been argued that increases in the number of shareholders accompany stock
dividends and stock splits. One could, of course, argue that no causality is contained
in this relationship. "n other words, it could be that growth in ownership and stock
splits is a function of yet another variable.
15-1& a$ True. hen investors sell their stock they are sub0ect to capital gains taxes.
b$ True. "f a company$s stock splits 8 for 6, and you own 6;; shares, then after the
split you will own 8;; shares.
c$ True. 4ividend reinvestment plans that involve newly issued stock will increase
the amount of equity capital available to the !rm.
d$ -alse. The Tax .ode, through the tax deductibility of interest, encourages !rms to
use debt and thus pay interest to investors rather than dividends, which are not
tax deductible. "n addition, due to the deferral of capital gains taxes until a
capital asset is sold, the Tax .ode encourages investors in high tax brackets to
prefer !rms who retain earnings rather than those that pay large dividends.
e$ True. "f a company$s clientele prefers large dividends, the !rm is unlikely to adopt
a residual dividend policy. 3 residual dividend policy could mean low or ,ero
dividends in some years, which would upset the company$s developed clientele.
$ -alse. "f a !rm follows a residual dividend policy, all else constant, its dividend
payout will tend to decline whenever the !rm$s investment opportunities improve.
15-11 .atering theory suggests that investors$ preference for dividends varies over time
and that corporations adapt dividend policy to @caterA to the current desires of
investors. .onsequently, corporate managers are more likely to initiate dividends
when dividend/paying stocks are in favor with investors, and are more likely to omit
dividends when investors prefer capital gains.
Solutions to End-o-Chapter 2roble-s
15-1 B;< 4ebt= C;< ?quity= .apital budget D EC,;;;,;;;= F" D E8,;;;,;;;= 5O D G
?quity retained D ;.C1EC,;;;,;;;2 D EH;;,;;;.
F" E8,;;;,;;;
I 3dditions to J? H;;,;;;
?arnings remaining E6,6;;,;;;
5ayout D 77<. D
E8,;;;,;;;
E6,6;;,;;;
15-" 5; D EH;= *plit D C for 8= Few 5; D G
EK;. D
8 > C
EH;
15-3 F" D E8,;;;,;;;= *hares outstanding D 6,;;;,;;;= 5; D EC8= Jepurchase D 8;<= Few
?5* D G
Jepurchase D ;.8 6,;;;,;;; D 8;;,;;; shares.
Jepurchase amount D 8;;,;;; EC8 D EK,L;;,;;;.
?5*Old D
*hares
F"
D
6,;;;,;;;
E8,;;;,;;;
D E8.;;.
5>?Old D
E8
EC8
D 6K.
?5*Few D
;;; , 8;; ;;; , ;;; , 6
;;; , ;;; , 8 E
D
M;;,;;;
E8,;;;,;;;
D E8.7;.
?5* increases because the number of shares outstanding declines.
15-# 45* after split D E;.B7.
?quivalent pre/split dividend D E;.B7172 D EC.B7.
Few equivalent dividend D &ast year$s dividend16.;H2
EC.B7 D &ast year$s dividend16.;H2
&ast year$s dividend D EC.B7>6.;H D EC.LL.
# Answers and Solutions Chapter 15: Distributions to Shareholders
15-5 Jetained earnings D Fet income 16 I 5ayout ratio2
D E7,;;;,;;;1;.772 D E8,B7;,;;;.
?xternal equity neededN
Total equity required D 1Few investment216 I 4ebt ratio2
D E6;,;;;,;;;1;.K;2 D EK,;;;,;;;.
Few external equity needed D EK,;;;,;;; I E8,B7;,;;; D EC,87;,;;;.
15-. *tep 6N 4etermine the capital budget by selecting those pro0ects whose returns are
greater than the pro0ect$s risk/ad0usted cost of capital.
5ro0ects H and & should be chosen because "JJ O 3.., so the !rm$s capital
budget D E6; million.
*tep 8N 4etermine how much of the capital budget will be !nanced with equity.
.apital +udget ?quity <D ?quity required.
E6;,;;;,;;; ;.7 D E7,;;;,;;;.
*tep CN 4etermine dividends through residual model.
EB,8MB,7;; I E7,;;;,;;; D E8,8MB,7;;.
*tep LN .alculate payout ratio.
E8,8MB,7;;>EB,8MB,7;; D ;.C6CH D C6.CH<.
15-/ a$ Total dividends68 D Fet income68 5ayout ratio
D E6,M;;,;;; ;.L;
D EB8;,;;;.
45*68 D 4ividends68>*hares outstanding
D EB8;,;;;>7;;,;;;
D E6.LL.
b$ 4ividend yield D 45*>5;
D E6.LL>ELM.;;
D C<.
c$ Total dividends66 D Fet income66 5ayout ratio
D E6,7;;,;;; ;.L
D EK;;,;;;.
45*66 D 4ividends66>*hares outstanding
D EK;;,;;;>7;;,;;;
D E6.8;.
d$ 5ayout ratio D 4ividends>Fet income
D EK;;,;;;>E6,M;;,;;;
D ;.CCCC D CC
6
>C<.
e$ *ince the company would like to avoid transactions costs involved in issuing new
equity, it would be best for the !rm to maintain the same per/share dividend.
This will provide a stable dividend to investors, yet allow the !rm to expand
operations without signi!cantly a#ecting the dividend. 3 constant dividend
payout ratio would cause serious fuctuations to the dividend depending on the
level of earnings. "f earnings were high, then dividends would be high. However,
if earnings were low, then dividends would be low. This would cause great
uncertainty for investors regarding dividends and would cause the !rm$s stock
price to decline 1because investors prefer a more stable dividend policy2.
15-0 a$ +efore !nding the long/run growth rate, the dividend payout ratio must be
determined.
4ividend payout ratio D 45*>?5* D E;.B7>E8.87 D ;.CCCC.
The !rmPs long/run growth rate can be found by multiplying the portion of a !rmPs
earnings that are retained times the !rmPs return on equity.
g D JO? Jetention ratio
D 1Fet "ncome>?quity .apital2 16 I 4ividend payout ratio2
D 6M< 16 I ;.CCCC2 D 68<.
b$ The required return can be calculated using the 4.- approach.
rs D 46>5; Q g
D E;.B7>E68.7; Q ;.68
D ;.;K Q ;.68
D ;.6M or 6M<.
c$ The new payout ratio can be calculated asN
E6.7;>E8.87 D ;.KKKB.
The new long/run growth rate can now be calculated asN
g D JO? 16 I 4ividend payout ratio2
D 6M< 16 I ;.KKKB2 D K<.
The !rmPs required return would beN
rs D 46>5; Q g
D E6.7;>E68.7; Q ;.;K
D ;.68 Q ;.;K
D ;.6M or 6M<.
d$ The !rmPs original plan was to issue a dividend equal to E;.B7 per share, which
equates to a total dividend of E;.B7 times the number of shares outstanding. *o,
!rst the number of shares outstanding must be determined from the ?5*.
3mount of equity capital D Total assets ?quity ratio
D E6; million ;.K D EK million.
Fet income D ?quity capital JO? D EK million ;.6M D E6.;M million.
. Answers and Solutions Chapter 15: Distributions to Shareholders
?5* D Fet income>Fumber of shares
E8.87 D E6.;M million>Fumber of shares
Fumber of sharesD LM;,;;;.
ith LM;,;;; shares outstanding, the total dividend that would be paid would be
E;.B7 LM;,;;; shares D ECK;,;;;. The !rmPs current market capitali,ation is
EK.; million, determined by LM;,;;; shares at E68.7; per share. 1+: D %: per
problem.2 "f the stock dividend is implemented, it shall account for K< of the
!rmPs current market capitali,ation 1ECK;,;;;>EK,;;;,;;; D ;.;K2.
e$ "f the total amount of value to be distributed to shareholders is ECK;,;;;, at a
price of E68.7; per share, then the number of new shares issued would beN
Fumber of new shares D 4ividend value>5rice per share
D ECK;,;;;>E68.7;
D 8M,M;; shares.
The stock dividend will leave the !rmPs net income unchanged= therefore, the
!rmPs new ?5* is its net income divided by the new total number of shares
outstanding.
Few ?5*D Fet income>1Old shares outstanding Q Few shares outstanding2
D E6,;M;,;;;>1LM;,;;; Q 8M,M;;2
D E8.688K.
The dilution of earnings per share is the di#erence between old ?5* and new ?5*.
4ilution of ?5* D Old ?5* I Few ?5*
D E8.87 I E8.688K
D E;.68BL R E;.6C per share.
15-1 a$ 6. 8;68 4ividends D 16.6;218;66 4ividends2
D 16.6;21EC,K;;,;;;2 D EC,HK;,;;;.
8. 8;66 5ayout D EC,K;;,;;;>E6;,M;;,;;; D ;.CCCC D CC
6
>C<.
8;68 4ividends D 1;.CCCC218;68 Fet income2
D 1;.CCCC21E6L,L;;,;;;2 D EL,M;;,;;;.
1FoteN "f the payout ratio is rounded o# to CC<, 8;68 dividends are then
calculated as EL,B78,;;;.2
C. ?quity !nancing D EM,L;;,;;;1;.K;2 D E7,;L;,;;;.
8;68 4ividends D Fet income I ?quity !nancing
D E6L,L;;,;;; I E7,;L;,;;; D EH,CK;,;;;.
3ll of the equity !nancing is done with retained earnings as long as they are
available.
L. The regular dividends would be 6;< above the 8;66 dividendsN
Jegular dividends D 16.6;21EC,K;;,;;;2 D EC,HK;,;;;.
Chapter 15: Distributions to Shareholders Answers and Solutions /
The residual policy calls for dividends of EH,CK;,;;;. Therefore, the extra
dividend, which would be stated as such, would be
?xtra dividend D EH,CK;,;;; I EC,HK;,;;; D E7,L;;,;;;.
3n even better use of the surplus funds might be a stock repurchase.
b$ 5olicy L, based on the regular dividend with an extra, seems most logical.
"mplemented properly, it would lead to the correct capital budget and the correct
!nancing of that budget, and it would give correct signals to investors.
c$ rs D
;
6
5
4
Q g D
;; E6M;,;;;,;
EH,;;;,;;;
Q 6;< D 67<.
d$ g D Jetention rate1JO?2
;.6; D S6 I 1EC,K;;,;;;>E6;,M;;,;;;2T1JO?2
JO? D ;.6;>;.KKKB D ;.67 D 67<.
e$ 3 8;68 dividend of EH,;;;,;;; may be a little low. The cost of equity is 67<, and
the average return on equity is 67<. However, with an average return on equity
of 67<, the marginal return is lower yet. That suggests that the capital budget is
too large, and that more dividends should be paid out. Of course, we really
cannot be sure of this'the company could be earning low returns 1say 6;<2 on
existing assets yet have extremely pro!table investment opportunities this year
1say averaging C;<2 for an expected overall average JO? of 67<. *till, if this
year$s pro0ects are like those of past years, then the payout appears to be slightly
low.
0 Answers and Solutions Chapter 15: Distributions to Shareholders
Co-prehensive3Spreadsheet 2roble-
Note to Instructors:
4he solution to this proble- is not provided to students at the bac5 o their te,t$
6nstructors can access the Excel 7le on the te,tboo58s website or the 6nstructor8s
Resource CD$
15-1& a$ .apital budget D E6;,;;;,;;;= .apital structure D K;< equity, L;< debt=
.ommon shares outstanding D 6,;;;,;;;.
Jetained earnings needed D E6;,;;;,;;;1;.K2 D EK,;;;,;;;.
b$ 3ccording to the residual dividend model, only E8 million is available for
dividends.
F" I Jetained earnings needed for capital pro0ects D Jesidual dividend
EM,;;;,;;; I EK,;;;,;;; D E8,;;;,;;;.
45* D E8,;;;,;;;>6,;;;,;;; D E8.;;.
5ayout ratio D E8,;;;,;;;>EM,;;;,;;; D 87<.
c$ Jetained earnings available D EM,;;;,;;; I EC.;;16,;;;,;;;2
D E7,;;;,;;;.
d$ Fo. "f the company maintains its EC.;; 45*, only E7 million of retained earnings
will be available for capital pro0ects. However, if the !rm is to maintain its current
capital structure EK million of equity is required. This would necessitate the
company having to issue E6 million of new common stock.
e$ .apital budget D E6; million= 4ividends D EC million= F" D EM million=
.apital structure D G
J? available D EM,;;;,;;; I EC,;;;,;;;
D E7,;;;,;;;.
5ercentage of capital budget !nanced with J? D
; E6;,;;;,;;
E7,;;;,;;;
D 7;<.
5ercentage of capital budget !nanced with debt D
; E6;,;;;,;;
E7,;;;,;;;
D 7;<.
$ 4ividends D EC million= .apital budget D E6; million= K;< equity, L;< debt= F" D
EM million.
?quity needed D E6;,;;;,;;;1;.K2 D EK,;;;,;;;.
J? available D EM,;;;,;;; I EC.;;16,;;;,;;;2
D E7,;;;,;;;.
Chapter 15: Distributions to ShareholdersComprehensive/Spreadsheet Problem 1
?xternal 1Few2 equity needed D EK,;;;,;;; I E7,;;;,;;;
D E6,;;;,;;;.
'$ 4ividends D EC million= F" D EM million= .apital structure D K;< equity, L;< debt.
J? available D EM,;;;,;;; I EC,;;;,;;;
D 7,;;;,;;;.
e$re forcing the J? available D Jequired equity to fund the new capital budget.
Jequired equity D .apital budget1Target equity ratio2
E7,;;;,;;; D .apital budget1;.K2
.apital budget D EM,CCC,CCC.
Therefore, if +uena Terra cuts its capital budget from E6; million to EM.CC million,
it can maintain its EC.;; 45*, its current capital structure, and still follow the
residual dividend policy.
h$ The !rm can do one of four thingsN
162 .ut dividends.
182 .hange capital structure, that is, use more debt.
1C2 .ut its capital budget.
1L2 "ssue new common stock.
Jeali,e that each of these actions is not without consequences to the company$s
cost of capital, stock price, or both.
"f retained earnings are not su)cient to fund its capital budget, then the !rm
must issue new common stock if it does not want to forgo any investment
opportunities. However, this will raise the !rm$s cost of equity, which will raise its
3... The !rm may be able to increase its debt ratio, so as to increase its
retained earnings breakpoint'which will allow it to use retained earnings rather
than new common equity to fund its capital budget. The e#ect on 3.. would
be negligible. The !rm could also forgo investment opportunities= however, this
would result in not maximi,ing the !rm$s value. -inally, the !rm could reduce
dividends'which would increase the !rm$s retained earnings. However,
dividends are @stickyA so this would also have a negative impact on the !rm$s
3.. 1increasing it2. The @bestA alternative to the !rm is probably @ad0ustingA its
debt ratio as this probably has the least impact on the !rm$s 3...
1& Comprehensive/Spreadsheet Problem Chapter 15: Distributions to
Shareholders
6nte'rated Case
15-11
Southeastern Steel Co-pan*
Dividend Policy
Southeastern Steel Co-pan* (SSC) was or-ed 5 *ears a'o to e,ploit
a new continuous castin' process$ SSC8s ounders+ Donald 9rown and
)ar'o :alencia+ had been e-plo*ed in the research depart-ent o a
-a;or inte'rated-steel co-pan*< but when that co-pan* decided
a'ainst usin' the new process (which 9rown and :alencia had
developed)+ the* decided to stri5e out on their own$ =ne advanta'e
o the new process was that it re>uired relativel* little capital
co-pared to the t*pical steel co-pan*+ so 9rown and :alencia have
been able to avoid issuin' new stoc5 and thus own all o the shares$
?owever+ SSC has now reached the sta'e in which outside e>uit*
capital is necessar* i the 7r- is to achieve its 'rowth tar'ets *et still
-aintain its tar'et capital structure o .&@ e>uit* and #&@ debt$
4hereore+ 9rown and :alencia have decided to ta5e the co-pan*
public$ Antil now+ 9rown and :alencia have paid the-selves
reasonable salaries but routinel* reinvested all ater-ta, earnin's in
the 7r-< so the 7r-8s dividend polic* has not been an issue$
?owever+ beore tal5in' with potential outside investors+ the* -ust
decide on a dividend polic*$
Assu-e that *ou were recentl* hired b* Arthur Ada-son B
Co-pan* (AA)+ a national consultin' 7r-+ which has been as5ed to
help SSC prepare or its public oCerin'$ )artha )illon+ the senior AA
consultant in *our 'roup+ has as5ed *ou to -a5e a presentation to
9rown and :alencia in which *ou review the theor* o dividend polic*
and discuss the ollowin' >uestions$
Chapter 15: Distributions to Shareholders Interated Case 11
A$ (1) Dhat is -eant b* the ter- dividend polic*E
Answer: FShow S15-1 and S15-" here$G Dividend polic* is de7ned as
the 7r-8s polic* with re'ard to pa*in' out earnin's as
dividends versus retainin' the- or reinvest-ent in the
7r-$ Dividend polic* reall* involves three 5e* issues: (1)
?ow -uch should be distributedE (") Should the distribution
be as cash dividends+ or should the cash be passed on to
shareholders b* repurchasin' so-e o the stoc5 the* holdE
(3) ?ow stable should the distribution be+ that is+ should the
unds paid out ro- *ear to *ear be stable and dependable+
which stoc5holders would probabl* preer+ or be allowed to
var* with the 7r-8s cash Hows and invest-ent
re>uire-ents+ which would probabl* be better ro- the
7r-8s standpointE
A$ (") E,plain brieH* the dividend irrelevance theor* that was put
orward b* )odi'liani and )iller$ Dhat were the 5e*
assu-ptions underl*in' their theor*E
Answer:FShow S15-3 here$G Dividend irrelevance reers to the theor*
that investors are indiCerent between dividends and capital
'ains+ -a5in' dividend polic* irrelevant with re'ard to its
eCect on the value o the 7r-$
4he dividend irrelevance theor* was proposed b* ))+
but the* had to -a5e so-e ver* restrictive assu-ptions to
IproveJ it$ 4hese assu-ptions include+ a-on' other thin's+
that no ta,es are paid on dividends+ that stoc5s can be
bou'ht and sold with no transactions costs+ and that
ever*oneKinvestors and -ana'ers ali5eKhas the sa-e
inor-ation re'ardin' 7r-s8 uture earnin's$ )) ar'ued
1" Interated Case Chapter 15: Distributions to Shareholders
that pa*in' out a dollar per share o dividends reduces the
'rowth rate in earnin's and dividends+ because new stoc5
will have to be sold to replace the capital paid out as
dividends$ Ander their assu-ptions+ a dollar o dividends
will reduce the stoc5 price b* e,actl* L1$ 4hereore+
accordin' to ))+ stoc5holders should be indiCerent
between dividends and capital 'ains$
A$ (3) Dh* do so-e investors preer hi'h-dividend-pa*in' stoc5s+
while other investors preer stoc5s that pa* low or
none,istent dividendsE
Answer: FShow S15-# and S15-5 here$G 6nvestors -i'ht preer
dividends to capital 'ains because the* -a* re'ard
dividends as less ris5* than potential uture capital 'ains$ 6
this were so+ then investors would value hi'h-pa*out 7r-s
-ore hi'hl*Kthat is+ a hi'h-pa*out stoc5 would have a hi'h
price$
6nvestors -i'ht preer low-pa*out 7r-s or capital 'ains
to dividends because the* -a* want to avoid transactions
costsKthat is+ havin' to reinvest the dividends and incurrin'
bro5era'e costs+ not to -ention ta,es$ 4he -a,i-u- ta,
rate on dividends is the sa-e as it is or capital 'ains
(althou'h this -a* chan'e on &13&13"&13)< however+ ta,es
on dividends are due in the *ear the* are received+ while
ta,es on capital 'ains are due whenever the stoc5 is sold$ 6n
addition+ i an investor holds a stoc5 until his3her death+ the
bene7ciaries can use the date o the death as the cost-basis
date and escape all previousl* accrued capital 'ains$
9$ Discuss (1) the inor-ation content+ or si'nalin'+
h*pothesis< (") the clientele eCect< (3) caterin' theor*< and
(#) their eCects on dividend polic*$
Answer: FShow S15-. throu'h S15-0 here$G 6t has lon' been
reco'niMed that the announce-ent o a dividend increase
oten results in an increase in the stoc5 price+ while an
announce-ent o a dividend cut t*picall* causes the stoc5
price to all$ =ne could ar'ue that this observation supports
the pre-ise that investors preer dividends to capital 'ains$
?owever+ )) ar'ued that dividend announce-ents are
si'nals throu'h which -ana'e-ent conve*s inor-ation to
investors$ 6nor-ation as*--etries e,istK-ana'ers 5now
-ore about their 7r-s8 prospects than do investors$
Nurther+ -ana'ers tend to raise dividends onl* when the*
believe that uture earnin's can co-ortabl* support a
hi'her dividend level+ and the* cut dividends onl* as a last
resort$ 4hereore+ (1) a lar'er-than-nor-al dividend increase
Isi'nalsJ that -ana'e-ent believes the uture is bri'ht+ (")
a s-aller-than-e,pected increase+ or a dividend cut+ is a
ne'ative si'nal+ and (3) i dividends are increased b* a
Inor-alJ a-ount+ this is a neutral si'nal$
DiCerent 'roups+ or clienteles+ o stoc5holders preer
diCerent dividend pa*out policies$ Nor e,a-ple+ -an*
retirees+ pension unds+ and universit* endow-ent unds are
in a low (or Mero) ta, brac5et+ and the* have a need or
current cash inco-e$ 4hereore+ this 'roup o stoc5holders
-i'ht preer hi'h-pa*out stoc5s$ 4hese investors could+ o
course+ sell so-e o their stoc5+ but this would be
inconvenient+ transactions costs would be incurred+ and the
1# Interated Case Chapter 15: Distributions to Shareholders
sale -i'ht have to be -ade in a down -ar5et$ Conversel*+
investors in their pea5 earnin's *ears who are in hi'h-ta,
brac5ets and who have no need or current cash inco-e
should preer low-pa*out stoc5s$
Clienteles do e,ist+ but the real >uestion is whether
there are -ore -e-bers o one clientele than another+
which would aCect what a chan'e in its dividend polic*
would do to the de-and or the 7r-8s stoc5$ 4here are also
costs (ta,es and bro5era'e) to stoc5holders who would be
orced to switch ro- one stoc5 to another i a 7r- chan'es
its dividend polic*$ 4hereore+ we cannot sa* whether a
dividend polic* chan'e to appeal to one particular clientele
or another would lower or raise a 7r-8s cost o e>uit*$ ))
ar'ued that one clientele is as 'ood as another+ so in their
view the e,istence o clienteles does not i-pl* that one
dividend polic* is better than another$ Still+ no one has
oCered convincin' proo that 7r-s can disre'ard clientele
eCects$ De 5now that stoc5holder shits will occur i
dividend polic* is chan'ed+ and since such shits result in
transactions costs and capital 'ains ta,es+ dividend polic*
chan'es should not be ta5en li'htl*$ Nurther+ dividend polic*
should be chan'ed slowl*+ rather than abruptl*+ in order to
'ive stoc5holders ti-e to ad;ust$
Caterin' theor* su''ests that investors8 preerence or
dividends varies over ti-e and that corporations adapt their
dividend polic* to cater to the current desires o investors$
4his theor* su''ests that corporate -ana'ers acco--odate
the shitin' preerences o investors+ and are -ore li5el* to
initiate dividends when dividend-pa*in' stoc5s are in avor
with investors+ and are -ore li5el* to o-it dividends when
investors de-onstrate a 'reater preerence or capital
'ains$
C$ (1) Assu-e that SSC has an L0&&+&&& capital bud'et planned or
the co-in' *ear$ Oou have deter-ined that its present
capital structure (.&@ e>uit* and #&@ debt) is opti-al+ and
its net inco-e is orecasted at L.&&+&&&$ Ase the residual
dividend -odel to deter-ine SSC8s total dollar dividend and
pa*out ratio$ 6n the process+ e,plain how the residual
dividend -odel wor5s$ 4hen e,plain what would happen i
e,pected net inco-e was L#&&+&&& or L0&&+&&&$
Answer: FShow S15-1 throu'h S15-1" here$G De -a5e the ollowin'
points:
1$ Piven the opti-al capital bud'et and the tar'et capital
structure+ we -ust now deter-ine the a-ount o e>uit*
needed to 7nance the pro;ects$ = the L0&&+&&&
re>uired or the capital bud'et+ &$.(L0&&+&&&) Q
L#0&+&&& -ust be raised as e>uit* and &$#(L0&&+&&&) Q
L3"&+&&& -ust be raised as debt i we are to -aintain
the opti-al capital structure:
Debt L3"&+&&& #&@
E>uit* #0&+&&& .&@
L0&&+&&& 1&&@
"$ 6 a residual e,istsKthat is+ i net inco-e e,ceeds the
a-ount o e>uit* the co-pan* needsKthen it should pa*
the residual a-ount out in dividends$ Since L.&&+&&& o
earnin's is available+ and onl* L#0&+&&& is needed+ the
residual is L.&&+&&& R L#0&+&&& Q L1"&+&&&+ so this is
the a-ount that should be paid out as dividends$ 4hus+
1. Interated Case Chapter 15: Distributions to Shareholders
the pa*out ratio would be L1"&+&&&3L.&&+&&& Q &$"& Q
"&@$
3$ 6 onl* L#&&+&&& o earnin's were available+ the 7r-
would still need L#0&+&&& o e>uit*$ 6t should then
retain all o its earnin's and also sell L0&+&&& o new
stoc5$ 4he residual polic* would call or a Mero dividend
pa*-ent$
#$ 6 L0&&+&&& o earnin's were available+ the dividend
would be increased to L0&&+&&& R L#0&+&&& Q L3"&+&&&+
and the pa*out ratio would rise to L3"&+&&&3L0&&+&&& Q
#&@$
C$ (") 6n 'eneral ter-s+ how would a chan'e in invest-ent
opportunities aCect the pa*out ratio under the residual
dividend -odelE
Answer: FShow S15-13 here$G A chan'e in invest-ent opportunities
would lead to an increase (i invest-ent opportunities were
'ood) or a decrease (i invest-ent opportunities were not
'ood) in the a-ount o e>uit* needed$ 6 invest-ent
opportunities were 'ood then the residual a-ount would be
s-aller than i invest-ent opportunities were bad$
C$ (3) Dhat are the advanta'es and disadvanta'es o the residual
polic*E (?int: Don8t ne'lect si'nalin' and clientele eCects$)
Answer: FShow S15-1# here$G 4he pri-ar* advanta'e o the residual
polic* is that the 7r- -a5es -a,i-u- use o lower-cost
retained earnin's+ thus -ini-iMin' Hotation costs and hence
the cost o capital$ Also+ whatever ne'ative si'nals are
associated with stoc5 issues would be avoided$
Chapter 15: Distributions to Shareholders Interated Case 1/
?owever+ i it were applied e,actl*+ the residual -odel
would result in dividend pa*-ents that Huctuated
si'ni7cantl* ro- *ear to *ear as capital re>uire-ents and
internal cash Hows Huctuated$ 4his would (1) send investors
conHictin' si'nals over ti-e re'ardin' the 7r-8s uture
prospects+ and (") since no speci7c clientele would be
attracted to the 7r-+ it would be an Iorphan$J 4hese
si'nalin' and clientele eCects would lead to a hi'her
re>uired return on e>uit* that would -ore than oCset the
eCects o lower Hotation costs$ 9ecause o these actors+ ew
i an* publicl*-owned 7r-s ollow the residual -odel on a
*ear-to-*ear basis$
Even thou'h the residual approach is not used to set the
annual dividend+ it is used when 7r-s establish their lon'-
run dividend polic*$ 6 Inor-aliMedJ cost o capital and
invest-ent opportunit* conditions su''est that in a
Inor-alJ *ear the co-pan* should pa* out about .&@ o its
earnin's+ this act will be noted and used to help deter-ine
the 7r-8s lon'-run dividend polic*$
D$ Describe the series o steps that -ost 7r-s ta5e in settin'
dividend polic* in practice$
Answer: FShow S15-15 here$G Nir-s establish dividend polic* within
the ra-ewor5 o their overall 7nancial plans$ 4he steps in
settin' polic* are listed below:
1$ 4he 7r- orecasts its annual capital bud'et and its
annual sales+ alon' with its wor5in' capital needs+ or a
relativel* lon'-ter- plannin' horiMon+ oten 5 *ears$
10 Interated Case Chapter 15: Distributions to Shareholders
"$ 4he tar'et capital structure+ presu-abl* the one that
-ini-iMes the DACC while retainin' suScient reserve
borrowin' capacit* to provide I7nancin' He,ibilit*+J will
also be established$
3$ Dith its capital structure and invest-ent re>uire-ents
in -ind+ the 7r- can esti-ate the appro,i-ate a-ount
o debt and e>uit* 7nancin' re>uired durin' each *ear
over the plannin' horiMon$
#$ A lon'-ter- tar'et pa*out ratio is then deter-ined+
based on the residual -odel concept$ 9ecause o
Hotation costs and potential ne'ative si'nalin'+ the 7r-
will not want to issue co--on stoc5 unless this is
absolutel* necessar*$ At the sa-e ti-e+ due to the
clientele eCect+ the 7r- will -ove cautiousl* ro- its
past dividend polic*+ i a new polic* appears to be
warranted+ and it will -ove toward an* new polic*
'raduall* rather than in one 'iant step$
5$ An actual dollar dividend+ sa* L" per *ear+ will be
decided upon$ 4he siMe o this dividend will reHect (1)
the lon'-run tar'et pa*out ratio and (") the probabilit*
that the dividend+ once set+ will have to be lowered+ or+
worse *et+ o-itted$ 6 there is a 'reat deal o
uncertaint* about cash Hows and capital needs+ then a
relativel* low initial dollar dividend will be set+ or this
will -ini-iMe the probabilit* that the 7r- will have to
either reduce the dividend or sell new co--on stoc5$
4he 7r- will run its corporate plannin' -odel so that
-ana'e-ent can see what is li5el* to happen with
diCerent initial dividends and pro;ected 'rowth rates
under diCerent econo-ic scenarios$
E$ Dhat is a dividend reinvest-ent plan (DR62)+ and how does
it wor5E
Answer: FShow S15-1. throu'h S15-10 here$G Ander a dividend
reinvest-ent plan (DR62)+ shareholders have the option o
auto-aticall* reinvestin' their dividends in shares o the
7r-8s co--on stoc5$ 6n an open -ar5et purchase plan+ a
trustee pools all the dividends to be reinvested and then
bu*s shares on the open -ar5et$ Shareholders use the DR62
or three reasons: (1) bro5era'e costs are reduced b* the
volu-e purchases+ (") the DR62 is a convenient wa* to invest
e,cess unds+ and (3) the co-pan* 'enerall* pa*s all
ad-inistrative costs associated with the operation$
6n a new stoc5 plan+ the 7r- issues new stoc5 to the
DR62 -e-bers in lieu o cash dividends$ To ees are
char'ed+ and -an* co-panies even oCer the stoc5 at a 5@
discount ro- the -ar5et price on the dividend date on the
'rounds that the 7r- avoids Hotation costs that would
otherwise be incurred$ =nl* 7r-s that need new e>uit*
capital use new stoc5 plans+ while 7r-s with no need or
new stoc5 use an open -ar5et purchase plan$
N$ Dhat are stoc5 dividends and stoc5 splitsE Dhat are the
advanta'es and disadvanta'es o stoc5 dividends and stoc5
splitsE
Answer: FShow S15-11 throu'h S15-"1 here$G Dhen it uses a stoc5
dividend+ a 7r- issues new shares in lieu o pa*in' a cash
dividend$ Nor e,a-ple+ in a 5@ stoc5 dividend+ the holder o
"& Interated Case Chapter 15: Distributions to Shareholders
1&& shares would receive an additional 5 shares$ 6n a stoc5
split+ the nu-ber o shares outstandin' is increased (or
decreased in a reverse split) in an action unrelated to a
dividend pa*-ent$ Nor e,a-ple+ in a "-or-1 split+ the
nu-ber o shares outstandin' is doubled$ A 1&&@ stoc5
dividend and a "-or-1 stoc5 split would produce the sa-e
eCect+ but there would be diCerences in the accountin'
treat-ents o the two actions$
9oth stoc5 dividends and stoc5 splits increase the
nu-ber o shares outstandin' and+ in eCect+ cut the pie into
-ore+ but s-aller+ pieces$ 6 the dividend or split does not
occur at the sa-e ti-e as so-e other event that would alter
perceptions about uture cash Hows+ such as an
announce-ent o hi'her earnin's+ then one would e,pect
the price o the stoc5 to ad;ust such that each investor8s
wealth re-ains unchan'ed$ Nor e,a-ple+ a "-or-1 split o a
stoc5 sellin' or L5& would result in the stoc5 price bein'
halved+ to L"5$
6t is hard to co-e up with a convincin' rationale or
s-all stoc5 dividends+ li5e 5@ or 1&@$ To econo-ic value is
bein' created or distributed+ *et stoc5holders have to bear
the ad-inistrative costs o the distribution$ Nurther+ it is
inconvenient to own an odd nu-ber o shares as -a* result
ater a s-all stoc5 dividend$ 4hus+ -ost co-panies toda*
avoid s-all stoc5 dividends$
=n the other hand+ there is a 'ood reason or stoc5
splits or lar'e stoc5 dividends$ Speci7call*+ there is a
widespread belie that an opti-al price ran'e e,ists or
stoc5s$ 4he ar'u-ent 'oes as ollows: i a stoc5 sells or
about L"&-L0&+ then it can be purchased in round lots+ hence
Chapter 15: Distributions to Shareholders Interated Case "1
at reduced co--issions+ b* -ost investors$ A hi'her price
would put round lots out o the price ran'e o -an* s-all
investors+ while a stoc5 price lower than about L"& would
conve* the i-a'e o a stoc5 that is doin' poorl*$ 4hus+ -ost
7r-s tr* to 5eep their stoc5 prices within the L"& to L0&
ran'e$ 6 the co-pan* prospers+ it will split its stoc5
occasionall* to hold the price down$ (Also+ co-panies that
are doin' poorl* occasionall* use reverse splits to raise their
price$) )an* co-panies do operate outside the L"& to L0&
ran'e+ but -ost sta* within it$
Another actor that -a* inHuence stoc5 splits and
dividends is the belie that the* si'nal -ana'e-ent8s belie
that the uture is bri'ht$ 6 a 7r-8s -ana'e-ent would be
inclined to split the stoc5 or pa* a stoc5 dividend onl* i it
anticipated i-prove-ents in earnin's and dividends+ then a
split3dividend action could provide a positive si'nal and thus
boost the stoc5 price$ ?owever+ i earnin's and cash
dividends did not subse>uentl* rise+ the price o the stoc5
would all bac5 to its old level+ or even lower+ because
-ana'ers would lose credibilit*$
6nterestin'l*+ one o the -ost astute investors o the
"&th Centur*+ Darren 9uCett+ chair-an o 9er5shire
?athawa*+ had lon' resisted the use o stoc5 splits+ but he
recentl* shited 'ears in earl* "&1&$ Ater 9er5shire
?athawa* ac>uired 9urlin'ton Torthern Santa Ne+ the
co-pan* announced a 5&-1 split or its Class 9 shares$ 2rior
to the announce-ent+ the stoc5 traded around L3+5&& per
share$ Ater the split+ the stoc5 traded around L/& per
share+ and in =ctober "&11 the stoc5 was tradin' around
L/. per share$
"" Interated Case Chapter 15: Distributions to Shareholders
P$ Dhat are stoc5 repurchasesE Discuss the advanta'es and
disadvanta'es o a 7r-8s repurchasin' its own shares$
Answer: FShow S15-"" throu'h S15-"# here$G A 7r- -a* distribute
cash to stoc5holders b* repurchasin' its own stoc5 rather
than pa*in' out cash dividends$ Stoc5 repurchases can be
used (1) so-ewhat routinel* as an alternative to re'ular
dividends+ (") to dispose o e,cess (nonrecurrin') cash that
ca-e ro- asset sales or ro- te-poraril* hi'h earnin's+
and (3) in connection with a capital structure chan'e in
which debt is sold and the proceeds are used to bu* bac5
and retire shares$
Advanta'es o repurchases:
1$ A repurchase announce-ent -a* be viewed as a
positive si'nal that -ana'e-ent believes the shares are
undervalued$
"$ Stoc5holders have a choiceKi the* want cash+ the* can
tender their shares+ receive the cash+ and pa* the ta,es+
or the* can 5eep their shares and avoid ta,es$ =n the
other hand+ one -ust accept a cash dividend and pa*
ta,es on it$
3$ 6 the co-pan* raises the dividend to dispose o e,cess
cash+ this hi'her dividend -ust be -aintained to avoid
adverse stoc5 price reactions$ A stoc5 repurchase+ on
the other hand+ does not obli'ate -ana'e-ent to uture
repurchases$
#$ Repurchased stoc5+ called treasur* stoc5+ can be used
later in -er'ers+ when e-plo*ees e,ercise stoc5
options+ when convertible bonds are converted+ and
when warrants are e,ercised$ 4reasur* stoc5 can also
be resold in the open -ar5et i the 7r- needs cash$
Repurchases can re-ove a lar'e bloc5 o stoc5 that is
Ioverhan'in'J the -ar5et and 5eepin' the price per
share down$
5$ Repurchases can be varied ro- *ear to *ear without
'ivin' oC adverse si'nals+ while dividends -a* not$
.$ Repurchases can be used to produce lar'e-scale chan'es
in capital structure$
Disadvanta'es o repurchases:
1$ A repurchase could lower the stoc58s price i it is ta5en
as a si'nal that the 7r- has relativel* ew 'ood
invest-ent opportunities$ =n the other hand+ thou'h+ a
repurchase can si'nal stoc5holders that -ana'ers are
not en'a'ed in Ie-pire buildin'+J where the* invest
unds in low-return pro;ects$
"$ 6 the 6RS establishes that the repurchase was pri-aril*
to avoid ta,es on dividends+ then penalties could be
i-posed$ Such actions have been brou'ht a'ainst
closel*-held 7r-s+ but to our 5nowled'e char'es have
never been brou'ht a'ainst publicl*-held 7r-s$
3$ Sellin' shareholders -a* not be ull* inor-ed about the
repurchase< hence+ the* -a* -a5e an uninor-ed
decision and -a* later sue the co-pan*$ 4o avoid this+
7r-s 'enerall* announce repurchase pro'ra-s in
advance$
#$ 4he 7r- -a* bid up the stoc5 price resultin' in the 7r-
pa*in' too hi'h a price or the shares$ 6n this situation+
"# Interated Case Chapter 15: Distributions to Shareholders
the sellin' shareholders would 'ain at the e,pense o
the re-ainin' shareholders$ 4his could occur i a tender
oCer were -ade and the price was set too hi'h+ or i the
repurchase was -ade in the open -ar5et and bu*in'
pressure drove the price above its e>uilibriu- level$

15 Answers To All Problems

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

15 Answers To All Problems

Încărcat de

Drepturi de autor:

Formate disponibile

Chapter 15 (13E)

Distributions to Shareholders: Dividends and

S-ar putea să vă placă și