1. Comment on Joe Skandis suggestion of not paying any dividend.

What are the

pros and cons of such a policy?

Joes suggestion of not paying any dividend in order for the firm to use the cash for a
planned project is indeed a good idea. However, dividends do have a higher cost as
compared to the after-tax cost of debt. Its considered the opportunity cost to
stockholders. Furthermore, it is not clever for them to not give dividends given
their successful performance and the stockholders expecting to receive dividends after a
long period of not giving one. Pros and cons of such policy include but not limited to the
following;

Advantages of not paying any dividends

1. Tax advantage for high-tax bracket investors
2. Good source of internal funds without having to pay flotation costs
3. Less of a negative price effect on stock.

Disadvantages of not paying any dividends

1. Can have a negative effect on stock price, if most investors are in lower tax
brackets, retired, etc.
2. The discounted value of near dividends is higher than the present worth of
distant dividends.
3. Payment of dividends resolves some uncertainty regarding performance of the
firm in the minds of investors.
4. Some investors have a desire for current income.

2. Critically evaluate Jim Bakers argument that shareholders are expecting a
dividend and if not paid one the share price will suffer. Does he have a point?
Please explain.

The company is known for having a history of not paying dividends. Having said that, Jim
Bakers argument is partially correct. Shareholders will be expecting dividends anytime
soon. Whether the stock price will suffer or not depends on the desires of the majority of
shareholders, however. Furthermore, if shareholders see that their money is being
invested wisely, the share price will not suffer.

3. What did Janet Long mean when she said, those shareholders who dont like our
dividend policy can create homemade dividends. How can one make homemade
dividends? Assume you are a shareholder who owns 1000 shares and are
expecting the company to pay at least $0.25 per share. If the company decides to
retain all its earnings, how can you create homemade dividends?

The investor could sell off shares equivalent to the value of the dividends that he or she
was expecting to receive, and reinvest the money into alternative investments

At $0.25 per share, the investor would be expecting $250 on 1000 shares. He or she
could sell off ($250/$8) = 32 shares, leaving him or her with 968 shares.

4. What does the composition of shareholder groups within a corporation have to do
with dividend policy? Based on the majority shareholding groups and their
relative proportions of ownership in the company, what sort of dividend policy
should New Wave adopt?

One of the main arguments affecting dividend policy is the tax disadvantage associated
with dividends being taxed at a higher rate than capital gains. However, different groups
of shareholders have different tax rates and exemptions. Hence, it is argued that it is the
majority shareholder groups desires that should be met by a firm when making dividend
policy decisions. From the breakdown given in Table 1, it seems as if individual
shareholders dominate the scene. But within the individual shareholders group, the
composition of investors preferences would differ as well. Thus, there isnt enough
information to state what sort of dividend policy would be best suited for New Wave.

5. How does a residual dividend policy work? Based on a residual dividend policy
how much dividend per share can the company afford to pay? Assume that the
companys bonds are trading at par value.

Under a residual dividend policy, the firm pays dividends only after meeting its investment
needs while maintaining a desired debt-equity ratio.

In the case of New Wave Corporation:

The investment need = $1,000,000

Market Value of Debt = $3,350,000 (from Balance Sheet, bonds trading at par)
Market Value of Equity= $8,000,000 (1,000,000 shares @ $8 per share)
Total market value = 11,350,000

Target Capital Structure
Debt = $3.35m/$11.35m = 29.5%
Equity = $8m/$11.35m = 70.5%

Net Income available for dividends = $960,000

Equity portion of needed investment based on target capital structure = 0.705* $1,000,000
= $705,000

Net income available for dividend under residual approach = 960,000 - 705,000 =
$255,000

Dividends per share = 255,000/1,000,000 = 26 cents per share

6. What are some of the drawbacks of following a strict residual dividend policy?
What do firms typically do in practice?

A strict residual dividend policy can make the dividend payout ratio fluctuate significantly
each quarter leading to a very unstable dividend policy. Dividend cuts due to lower net
income and/or increased investment opportunities can have long-term negative effects on
stock prices. In practice firms tend to follow a compromise policy based on adhering to a
long-term constant debt-equity ratio and allowing the proportions to vary in the short-run.
Some firms try to avoid drastic changes in dividend payout ratios by creating two types of
dividends: regular and extra. Extra dividends are paid during good periods as a bonus
thereby creating little or no disruption during not so good periods. Other firms use share
repurchases as a way of returning capital to the stockholders.


7. Critically evaluate Eds suggestion of following a residual dividend policy
accompanied by a repurchase of stock at $8 per share. What are the pros and
cons of using a stock repurchase option instead of a cash dividend to distribute
returns to shareholders?

According to Eds suggestion the firm would use $705,000 of the $960,000 net income for
its investment (i.e. 70.5% of the required $1,000,000 investment). It would then offer to
buy back $255,000/$8 = 31,875 shares from the current shareholders instead of paying
out a dividend.


The advantage of the buyback method is that the number of shares outstanding would go
down (968,125 shares) and the EPS would go up from $0.96 to $0.99 per share.
Moreover, the shareholders in higher tax brackets would not have to pay the higher taxes
on dividend income. Besides, a proportional drop in price normally accompanies cash
dividends on the ex-dividend date, unlike stock buybacks.

8. Comment on the dividend policy debate at the New Wave Corporation. In your
opinion should they pay dividends at all? Why or why not? If they decide to pay
dividends, what kind of dividend policy should they adopt? Please explain.

Each director has brought out some valid issues related to dividend policy. Dividend
policy, like capital structure is one of the unanswered questions in Corporate Finance.
Given the performance of New Wave and its history of not paying dividends, I think it
would be a good idea for them to use a residual dividend method accompanied by a stock
buyback. Many companies have used stock buybacks as positive NPV decisions. Since
New Waves stock is fairly cheap at $8 per share, they could justify the buyback to the IRS
and it would help boost their EPS.