CHAPTER 18 DIVIDENDS AND DIVIDEND POLICY(ANSWER KEY TO PROBLEMS IN HO # 6)

Assignment: Critical Thinking Questions: pg. 617, nos. 1, 2; pg. 618, nos. 3, 4, 6; Problems: pg. 619, nos. 2, 3, 4; pg. 620, nos. 5 o 10; pg. 621, 11 o 13, 16.
Ans!"#s o Con$"p s %"&'"! (n) C#' '$(* +,'n-'ng ./"s 'ons 1. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend policy is irrelevant when the timing of dividend payments doesnt affect the present value of all future dividends. 2. 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. The chief drawback to a strict 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. n a compromise policy, the firm maintains a relatively constant dividend. t 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. !riday, December "# is the ex$dividend day. %emember not to count &anuary ' because it is a holiday, and the exchanges are closed. Anyone who buys the stock before December "# is entitled to the dividend, assuming they do not sell it again before December "#. 5. (o, because the money could be better invested in stocks that pay dividends in cash which benefit the fundholders directly. 6. The change in price is due to the change in dividends, not due to the change in dividend policy. Dividend policy can still be irrelevant without a contradiction. 7. The stock price dropped because of an expected drop in future dividends. )ince 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. 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. *owever, the shareholders who take the option may benefit at the expense of the ones who dont +because of the discount,. Also as a result of the plan, the firm will be able to raise equity by paying a '-. flotation cost +the discount,, which may be a smaller discount than the market flotation costs of a new issue for some companies. 9. f these firms /ust went public, they probably did so because they were growing and needed the additional capital. 0rowth firms typically pay very small cash dividends, if they pay a dividend at all. This is because they have numerous pro/ects available, and they reinvest the earnings in the firm instead of paying cash dividends. 1*A2T3% '4 5$6-' 10. t would not be irrational to find low$dividend, high$growth stocks. The trust should be indifferent between receiving dividends or capital gains since it does not pay taxes on either one +ignoring possible restrictions on invasion of principal, etc.,. t would be irrational, however, to hold municipal bonds. )ince the trust does not pay taxes on the interest income it receives, it does not need the tax break associated with the municipal bonds. Therefore, it should prefer to hold higher yield, taxable bonds. 11. The stock price drop on the ex$dividend date should be lower. 7ith taxes, stock prices should drop by the amount of the dividend, less the taxes investors must pay on the dividends. A lower tax rate lowers the investors tax liability. 12. 7ith a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital gains. f the dividend tax rate declines, the attractiveness of dividends increases. So*/ 'ons o ./"s 'ons (n) P#o0*"1s NOTE: All end of chapter problems were sol ed using a spreadsheet! "any problems re#uire multiple steps! $ue to space and readability constraints% when these intermediate steps are included in this solutions manual% rounding may appear to ha e occurred! &owe er% the final answer for each problem is found without rounding during any step in the problem! 'asic 1. The aftertax dividend is the pretax dividend times one minus the tax rate, so8 Aftertax dividend 9 :;.--+' < .';, 9 :=."; The stock price should drop by the aftertax dividend amount, or8

3x$dividend price 9 :#-."; < =."; 9 :4>.-2. a! The shares outstanding increases by '- percent, so8 (ew shares outstanding 9 "-,---+'.'-, 9 "",--(ew shares issued 9 ",--)ince the par value of the new shares is :', the capital surplus per share is :"=. The total capital surplus is therefore8 1apital surplus on new shares 9 ",---+:"=, 9 :=4,--1ommon stock +:' par value, : "",--1apital surplus "=6,--%etained earnings =4?,=-:?;",=-5$6-" )@ABT @() b! The shares outstanding increases by "; percent, so8 (ew shares outstanding 9 "-,---+'.";, 9 ";,--(ew shares issued 9 ;,--)ince the par value of the new shares is :', the capital surplus per share is :"=. The total capital surplus is therefore8 1apital surplus on new shares 9 ;,---+:"=, 9 :'"-,--1ommon stock +:' par value, : ";,--1apital surplus 6';,--%etained earnings ='",=-:?;",=-3. a! To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so8 (ew shares outstanding 9 "-,---+=C', 9 4-,--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 is8 (ew par value 9 :'+'C=, 9 :-."; per share. b! To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so8 (ew shares outstanding 9 "-,---+'C;, 9 =,---. 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 is8 (ew par value 9 :'+;C', 9 :;.-- per share. 4. To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares, so8 a! :?;+6C;, 9 :=;.-b! :?;+'C'.';, 9 :>;."" c! :?;+'C'.=";, 9 :;".>6 d! :?;+?C=, 9 :'6'."; 1*A2T3% '4 5$6-6 e! To find the new shares outstanding, we multiply the current shares outstanding times the ratio

of new shares to old shares, so8 a: ";-,---+;C6, 9 ='>,>>? b: ";-,---+'.';, 9 "4?,;-c: ";-,---+'.=";, 9 6;>,";d: ";-,---+=C?, 9 '=",4;? 5. The stock price is the total market value of equity divided by the shares outstanding, so8 2- 9 :"';,--- equityC;,--- shares 9 :=6.-- per share gnoring tax effects, the stock price will drop by the amount of the dividend, so8 2D 9 :=6.-- < '."- 9 :='.4The total dividends paid will be8 :'."- per share+;,--- shares, 9 :>,--The equity and cash accounts will both decline by :>,---. 6. %epurchasing the shares will reduce shareholders equity by :>,---. The shares repurchased will be the total purchase amount divided by the stock price, so8 )hares bought 9 :>,---C:=6.-- 9 '6#.;6 And the new shares outstanding will be8 (ew shares outstanding 9 ;,--- < '6#.;6 9 =,4>-.=? After repurchase, the new stock price is8 )hare price 9 +:"';,--- < >,---,C=,4>-.=? shares 9 :=6.-The repurchase is effectively the same as the cash dividend because you either hold a share worth :=6.--, or a share worth :='.4- and :'."- in cash. Therefore, you participate in the repurchase according to the dividend payout percentageE you are unaffected. 5$6-= )@ABT @() 7. The stock price is the total market value of equity divided by the shares outstanding, so8 2- 9 :==-,--- equityC';,--- shares 9 :"#.66 per share The shares outstanding will increase by "; percent, so8 (ew shares outstanding 9 ';,---+'.";, 9 '4,?;The new stock price is the market value of equity divided by the new shares outstanding, so8 2D 9 :==-,---C'4,?;- shares 9 :"6.=? 8. 7ith a stock dividend, the shares outstanding will increase by one plus the dividend amount, so8 (ew shares outstanding 9 6;-,---+'.';, 9 =-",;-The capital surplus is the capital paid in excess of par value, which is :', so8 1apital surplus for new shares 9 ;",;--+:'#, 9 :##?,;-The new capital surplus will be the old capital surplus plus the additional capital surplus for the new shares, so8 1apital surplus 9 :',>;-,--- F ##?,;-- 9 :",>=?,;-The new equity portion of the balance sheet will look like this8 1ommon stock +:' par value, : =-",;-1apital surplus ",>=?,;-%etained earnings ',#;-,--:;,---,---

9. 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, so8 (ew par value 9 :'+'C;, 9 :-."- per share. The total dividends paid this year will be the dividend amount times the number of shares outstanding. The company had 6;-,--- shares outstanding before the split. 7e must remember to ad/ust the shares outstanding for the stock split, so8 Total dividends paid this year 9 :-.#-+6;-,--- shares,+;C' split, 9 :',;?;,--The dividends increased by '- percent, so the total dividends paid last year were8 Aast years dividends 9 :',;?;,---C'.'- 9 :',=6',4'4.'4 1*A2T3% '4 5$6-; And to find the dividends per share, we simply divide this amount by the shares outstanding last year. Doing so, we get8 Dividends per share last year 9 :',=6',4'4.'4C6;-,--- shares 9 :=.-# 10. The equity portion of capital outlays is the retained earnings. )ubtracting dividends from net income, we get8 3quity portion of capital outlays 9 :',;-- < 6#- 9 :','')ince the debt$equity ratio is '."-, we can find the new borrowings for the company by multiplying the equity investment by the debt$equity ratio, so8 (ew borrowings 9 '."-+:',''-, 9 :',66" And the total capital outlay will be the sum of the new equity and the new debt, which is8 Total capital outlays 9 :',''- F ',66" 9 :",==" 11. a! The payout ratio is the dividend per share divided by the earnings per share, so8 2ayout ratio 9 :-.4-C:>.=2ayout ratio 9 .'";- or '".;-. b! Bnder a residual dividend policy, the additions to retained earnings, which is the equity portion of the planned capital outlays, is the retained earnings per share times the number of shares outstanding, so8 3quity portion of capital outlays 9 ?,---,--- shares +:>.=- < .4-, 9 :6#,"--,--The debt$equity ratio is the new borrowing divided by the new equity, so8 DC3 ratio 9 :'4,---,---C:6#,"--,--- 9 .=;#" 12. a! )ince the company has a debt$equity ratio of ".;, they can raise :".;- in debt for every :' of equity. The maximum capital outlay with no outside equity financing is8 Gaximum capital outlay 9 :'#-,--- F ".;-+:'#-,---, 9 :>>;,--b! f planned capital spending is :?>-,---, then no dividend will be paid and new equity will be issued since this exceeds the amount calculated in a. c! (o, 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. 5$6-> )@ABT @() 13. a! 7e can find the new borrowings for the company by multiplying the equity investment by the debt$equity ratio, so we get8 (ew debt 9 '.;+:?;,---,---, 9 :''",;--,--Adding the new retained earnings, we get8 Gaximum investment with no outside equity financing 9 :?;,---,--- F :''",;--,---, Gaximum investment with no outside equity financing 9 :'4?,;--,--b! A debt$equity ratio of '.; implies capital structure is '.;C".; debt and 'C".; equity. The equity portion of the planned new investment will be8 3quity portion of investment funds 9 'C".;+:?",---,---, 9 :"4,4--,--This is the addition to retained earnings, so the total available for dividend payments is8 %esidual 9 :?;,---,--- < "4,4--,--- 9 :=>,"--,--This makes the dividend per share8 Dividend per share 9 :=>,"--,---C'",---,--- shares 9 :6.4; c! The borrowing will be8 5orrowing 9 :?",---,--- < "4,4--,--- 9 :=6,"--,--Alternatively, we could calculate the new borrowing as the weight of debt in the capital structure times the planned capital outlays, so8 5orrowing 9 '.;C".;+:?",---,---, 9 :=6,"--,--The addition to retained earnings is :"4,4--,---, which we calculated in part b. d! f the company plans no capital outlays, no new borrowing will take place. The dividend per share will be8 Dividend per share 9 :?;,---,---C'",---,--- shares 9 :>."; 1*A2T3% '4 5$6-? (ntermediate 14. The price of the stock today is the 2H of the dividends, so8 2- 9 :'.;-C'.'; F :=;C'.';" 9 :6;.66 To find the equal two year dividends with the same present value as the price of the stock, we set up the following equation and solve for the dividend +(ote8 The dividend is a two year annuity, so we could solve with the annuity factor as well,8 :6;.66 9 DC'.'; F DC'.';" D 9 :"'.?6 7e now know the cash flow per share we want each of the next two years. 7e can find the price of stock in one year, which will be8 2' 9 :=;C'.'; 9 :6#.'6 )ince you own ',--- shares, in one year you want8 1ash flow in Iear one 9 ',---+:"'.?6, 9 :"',?6".;> 5ut youll only get8

Dividends received in one year 9 ',---+:'.;-, 9 :',;-Thus, in one year you will need to sell additional shares in order to increase your cash flow. The number of shares to sell in year one is8 )hares to sell at time one 9 +:"',?6".;> < ',;--,C:6#.'6 9 ;'?.-; shares At Iear ", you cash flow will be the dividend payment times the number of shares you still own, so the Iear " cash flow is8 Iear " cash flow 9 :=;+',--- < ;'?.-;, 9 :"',?6".;> 15. f you only want :"-- in Iear ', you will buy8 +:',;-- < "--,C:6#.'6 9 66."" shares at time '. Iour dividend payment in Iear " will be8 Iear " dividend 9 +',--- F 66."",+:=;, 9 :=>,=#;.-5$6-4 )@ABT @() (ote, the present value of each cash flow stream is the same. 5elow we show this by finding the present values as8 2H 9 :"--C'.'; F :=>,=#;C'.';" 9 :6;,66-.4' 2H 9 ',---+:'.;-,C'.'; F ',---+:=;,C'.';" 9 :6;,66-.4' 16. a! f the company makes a dividend payment, we can calculate the wealth of a shareholder as8 Dividend per share 9 :';,---C',--- shares 9 :';.-The stock price after the dividend payment will be8 2D 9 :=4 < '; 9 :66 per share The shareholder will have a stock worth :66 and a :'; dividend for a total wealth of :=4. f the company makes a repurchase, the company will repurchase8 )hares repurchased 9 :';,---C:=4 9 6'".;- shares f the shareholder lets their shares be repurchased, they will have :=4 in cash. f the shareholder keeps their shares, theyre still worth :=4. b! f the company pays dividends, the current 32) is :'."-, and the 2C3 ratio is8 2C3 9 :66C:'."- 9 "?.;f the company repurchases stock, the number of shares will decrease. The total net income is the 32) times the current number of shares outstanding. Dividing net income by the new number of shares outstanding, we find the 32) under the repurchase is8 32) 9 :'."-+',---,C+',--- J 6'".;-, 9 :'.?; The stock price will remain at :=4 per share, so the 2C3 ratio is8 2C3 9 :=4C:'.?; 9 "?.;c! A share repurchase would seem to be the preferred course of action. @nly those shareholders who wish to sell will do so, giving the shareholder a tax timing option that he or she doesnt get with a dividend payment. 1*A2T3% '4 5$6-# Challenge

17. Assuming no capital gains tax, the aftertax return for the 0ordon 1ompany is the capital gains growth rate, plus the dividend yield times one minus the tax rate. Bsing the constant growth dividend model, we get8 Aftertax return 9 g F D+' < t, 9 .'; )olving for g, we get8 .'; 9 g F .-;+' < .6;, g 9 .''?; The equivalent pretax return for 0ecko 1ompany, which pays no dividend, is8 2retax return 9 g F D 9 .''?; F .-; 9 .'>?; or '>.?;. 18. Bsing the equation for the decline in the stock price ex$dividend for each of the tax rate policies, we get8 +2- < 2D,CD 9 +' < T2,C+' < T0, a! 2- < 2D 9 D+' < -,C+' < -, 2< 2D 9 D b! 2- < 2D 9 D+' < .';,C+' < -, 2< 2D 9 .4;D c! 2- < 2D 9 D+' < .';,C+' < .6-, 2< 2D 9 '."'=6D d! 7ith this tax policy, we simply need to multiply the personal tax rate times one minus the dividend exemption percentage, so8 2< 2D 9 DK' < +.6;,+.6-,LC+' < .>;, 2< 2D 9 '.6??D e! )ince different investors have widely varying tax rates on ordinary income and capital gains, dividend payments have different after$tax implications for different investors. This differential taxation among investors is one aspect of what we have called the clientele effect.