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Department
Economics
Course
ECN 104
Professor
Vikraman Baskaran
Semester
Fall

Description
CHAPTER17 DIVIDENDS AND DIVIDEND POLICY Learning Objectives LO1 Dividend types and how dividends are paid. LO2 The issues surrounding dividend policy decisions. LO3 The difference between cash and stock dividends. LO4 Why share repurchases are an alternative to dividends. Answers to Concepts Review and Critical Thinking Questions 1. (LO2) Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend policy is irrelevant when the timing of dividend payments doesn’t affect the present value of all future dividends. 2. (LO4) A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could, if desired, use excess cash to reduce debt instead. This is a capital structure decision. 3. (LO2) The chief drawback to a strict residual dividend policy is the variability in dividend payments. This is a problem because investors tend to want a somewhat predictable cash flow. Also, if there is information content to dividend announcements, then the firm may be inadvertently telling the market that it is expecting a downturn in earnings prospects when it cuts a dividend, when in reality its prospects are very good. In a compromise policy, the firm maintains a relatively constant dividend. It increases dividends only when it expects earnings to remain at a sufficiently high level to pay the larger dividends, and it lowers the dividend only if it absolutely has to. 4. (LO1) Friday, December 29 is the ex-dividend day. Because of the weekend and the holiday on January 1, shares will settle on January 4 and not be entitled to the dividend. Anyone who buys the stock before December 29 is entitled to the dividend, assuming they do not sell it again before December 29. 5. (LO1) No, because the money could be better invested in stocks that pay dividends in cash that will benefit the fundholders directly. 6. (LO2) The change in price is due to the change in dividends, not to the change in dividend policy. Dividend policy can still be irrelevant without a contradiction. 7. (LO2) The stock price dropped because of an expected drop in future dividends. Since the stock price is the present value of all future dividend payments, if the expected future dividend payments decrease, then the stock price will decline. 8. (LO2) The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on their own, and the shareholders must pay the taxes on the dividends either way. However, the shareholders who take the option may benefit at the expense of the ones who don’t (because of the discount). Also as a result of the plan, the firm will be able to raise equity by paying a 10% flotation cost (the discount), which may be a smaller discount than the market flotation costs of a new issue for some companies. 9. (LO2) If these firms just went public, they probably did so because they were growing and needed the additional capital. Growth firms typically pay very small cash dividends, if they pay a dividend at all. This is because they have numerous projects available, and they reinvest the earnings in the firm instead of paying cash dividends. 17-1 10. (LO2) It would not be irrational to find low-dividend, high-growth stocks. The University should be indifferent between receiving dividends or capital gains since it does not pay taxes on either one (ignoring possible restrictions on invasion of principal, etc.). The University would not be averse to holding preferred shares since neither the income nor any capital gain would be taxable. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. (LO2) The aftertax dividend is the pretax dividend times one minus the tax rate, so: Aftertax dividend = $4.60(1 – .15) = $3.91 The stock price should drop by the aftertax dividend amount, or: Ex-dividend price = $80.37 – 3.91 = $76.46 For the 1st printing of the textbook, please note the following amendment to the question printed in the textbook: 2.‘Common stock’ should read ‘Common stock ($1 par value)’. 2. (LO3) a. The shares outstanding increases by 10 percent, so: New shares outstanding = 30,000(1.10) = 33,000 New shares issued = 3,000 Since the par value of the new shares is $1, the capital surplus per share is $29. The total capital surplus is therefore: Capital surplus on new shares = 3,000($29) = $87,000 Common stock ($1 par value) $ 33,000 Capital surplus 87,000 Retained earnings 844,180 $964,180 b. The shares outstanding increases by 25 percent, so: New shares outstanding = 30,000(1.25) = 37,500 New shares issued = 7,500 17-2 Since the par value of the new shares is $1, the capital surplus per share is $29. The total capital surplus is therefore: Capital surplus on new shares = 7,500($29) = $217,500 Common stock ($1 par value) $ 37,500 Capital surplus 217,500 Retained earnings 709,180 $964,180 3. (LO3) a. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: New shares outstanding = 30,000(4/1) = 120,000 The equity accounts are unchanged except the par value of the stock is changed by the ratio of new shares to old shares, so the new par value is: New par value = $1(1/4) = $0.25 per share. b. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: New shares outstanding = 30,000(1/5) = 6,000. The equity accounts are unchanged except the par value of the stock is changed by the ratio of new shares to old shares, so the new par value is: New par value = $1(5/1) = $5.00 per share. 4. (LO3) To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares, so: a. $90(3/5) = $54.00 b. $90(1/1.15) = $78.26 c. $90(1/1.425) = $63.16 d. $90(7/4) = $157.50 e. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so: a: 350,000(5/3) = 583,333 b: 350,000(1.15) = 402,500 c: 350,000(1.425) = 498,750 d: 350,000(4/7) = 200,000 5. (LO1) The stock price is the total market value of equity divided by the shares outstanding, so: P = $308,500 equity/8,000 shares = $38.56 per share 0 17-3 Ignoring tax effects, the stock price will drop by the amount of the dividend, so: PX= $38.56 – 1.30 = $37.26 The total dividends paid will be: $1.30 per share(8,000 shares) = $10,400 The equity and cash accounts will both decline by $10,400. 6. (LO4) Repurchasing the shares will reduce cash and shareholders’ equity by $10,400. The shares repurchased will be the total purchase amount divided by the stock price, so: Shares bought = $10,400/$38.56 = 269.69 And the new shares outstanding will be: New shares outstanding = 8,000 – 269.69 = 7,730.31 After repurchase, the new stock price is: Share price = ($308,500 – 10,400)/7,730.31 shares = $38.56 The repurchase is effectively the same as the cash dividend because you either hold a share worth $38.56, or a share worth $37.26 and $1.30 in cash. Therefore, if you participate in the repurchase according to the dividend payout percentage; you are unaffected. 7. (LO3) The stock price is the total market value of equity divided by the shares outstanding, so: P0= $471,000 equity/12,000 shares = $39.25 per share The shares outstanding will increase by 25 percent, so: New shares outstanding = 12,000(1.25) = 15,000 The new stock price is the market value of equity divided by the new shares outstanding, so: PX= $471,000/15,000 shares = $31.40 8. (LO3) With a stock dividend, the shares outstanding will increase by one plus the dividend amount, so: New shares outstanding = 406,000(1.15) = 466,900 The capital surplus is the capital paid in excess of par value, which is $1, so: Capital surplus for new shares = 60,900($34) = $2,070,600 The new capital surplus will be the old capital surplus plus the additional capital surplus for the new shares, so: Capital surplus = $1,340,000 + 2,070,600 = $3,410,600 17-4 The new equity portion of the balance sheet will look like this: Common stock ($1 par value) $ 466,900 Capital surplus 3,410,600 Retained earnings 1,295,500 $5,173,000 9. (LO3) The only equity account that will be affected is the par value of the stock. The par value will change by the ratio of old shares to new shares, so: New par value = $1(1/4) = $0.25 per share. The total dividends paid this year will be the dividend amount times the number of shares outstanding. The company had 406,000 shares outstanding before the split. We must remember to adjust the shares outstanding for the stock split, so: Total dividends paid this year = $0.85(406,000 shares)(4/1 split) = $1,380,400 The dividends increased by 10 percent, so the total dividends paid last year were: Last year’s dividends = $1,380,400/1.10 = $1,254,909.09 And to find the dividends per share, we simply divide this amount by the shares outstanding last year. Doing so, we get: Dividends per share last year = $1,254,909.09/406,000 shares = $3.09 10. (LO2) The equity portion of capital outlays is the retained earnings. Subtracting dividends from net income, we get: Equity portion of capital outlays = $1,200 – 480 = $720 Since the debt-equity ratio is 1.00, we can find the new borrowings for the company by multiplying the equity investment by the debt-equity ratio, so: New borrowings = 1.00($720) = $720 And the total capital outlay will be the sum of the new equity and the new debt, which is: Total capital outlays = $720 + 720 =$1,440. 11. (LO2) a. The payout ratio is the dividend per share divided by the earnings per share, so: Payout ratio = $0.80/$8 Payout ratio = .10 or 10.0% b. Under a residual dividend policy, the additions to retained earnings, which is the equity portion of the planned capital outlays, is the retained earnings per share times the number of shares outstanding, so: Equity portion of capital outlays = 7M shares ($8 – .80) = $50.4M The debt-equity ratio is the new borrowing divided by the new equity, so: D/E ratio = $18M/$50.4M = .3571 17-5 12. (LO2) a. Since the company has a debt-equity ratio of 2, they can raise $2 in debt for every $1 of equity. The maximum capital outlay with no outside equity financing is: Maximum capital outlay = $180,000 + 2($180,000) = $540,000. b. If planned capital spending is $760,000, then no dividend will be paid and new equity will be issued since this exceeds the amount calculated in a. c. No, they do not maintain a constant dividend payout because, with the strict residual policy, the dividend will depend on the investment opportunities and earnings. As these two things vary, the dividend payout will also vary. 13 . (LO2) a. We can find the new borrowings for the company by multiplying the equity investment by the debt- equity ratio, so we get: New debt = 3($56M) = $168M Adding the new retained earnings, we get: Maximum investment with no out
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