Chapter 17

Payout Policy

17-1. What options does a firm have to spend its free cash flow (after it has satisfied all interest
obligations)?
It can retain them and use them to make investments, or hold them in cash. It can pay them out to
equity holders, either by issuing a dividend or by repurchasing shares.

17-4. RFC Corp. has announced a $1.58 dividend. If RFC’s price last price cum-dividend is $17.78,
what should its first ex-dividend price be (assuming perfect capital markets)?
Assuming perfect markets, the first ex-dividend price should drop by exactly the dividend payment.
Thus, the first ex-dividend price should be $16.20 per share. In a perfect capital market, the first price
of the stock on the ex-dividend day should be the closing price on the previous day less the amount of
the dividend.

17-5. EJH Company has a market capitalization of $1.6 billion and 25 million shares outstanding. It
plans to distribute $120 million through an open market repurchase. Assuming perfect capital
markets:
a. What will the price per share of EJH be right before the repurchase?
b. How many shares will be repurchased?
c. What will the price per share of EJH be right after the repurchase?

$ 1.6 billion
a. Price per share= =$ 64
25million

$ 120 million
b. Shares repurchased= =1.875 million shares
$ 64
c. If markets are perfect, then the price right after the repurchase should be the same as the price
immediately before the repurchase. Thus, the price will be $64 per share.

17-6. KMS Corporation has assets with a market value of $500 million, $50 million of which are cash.
It has debt of $200 million, and 10 million shares outstanding. Assume perfect capital markets.
a. What is its current stock price?
b. If KMS distributes $50 million as a dividend, what will its share price be after the dividend
is paid?
c. If instead, KMS distributes $50 million as a share repurchase, what will its share price be
once the shares are repurchased?
d. What will its new market debt-equity ratio be after either transaction?

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248 Berk/DeMarzo, Corporate Finance, Fourth Edition

a. (500 – 200)/10 = 30
b. (450 – 200)/10 = 25
c. (450 – 200)/(10 – 1.667) = 30
d. 200/250 = 0.8

17-7. Natsam Corporation has $250 million of excess cash. The firm has no debt and 350 million
shares outstanding, with a current market price of $20 per share. Natsam’s board has decided to
pay out this cash as a one-time dividend.
a. What is the ex-dividend price of a share in a perfect capital market?
b. If the board instead decided to use the cash to do a one-time share repurchase, in a perfect
capital market what is the price of the shares once the repurchase is complete?
c. In a perfect capital market, which policy, in part a or b, makes investors in the firm better
off?

$ 200 million
a. The dividend payoff is =$ 0.5714 on a per share basis. In a perfect capital
350 million
market the price of the shares will drop by this amount to $19.43.

b. $20.

c. The value of the firm is the same under either policy.

17-8. Now suppose Natsam Corporation has $275 million of excess cash. The firm has no debt and 500
million shares outstanding with a current market price of $19 per share. The board decided to do the
share repurchase in Problem 7 part b, but you, as an investor, would have preferred to receive a
dividend payment. How can you leave yourself in the same position as if the board had elected to
make the dividend payment instead?
If you sell 0.55/19 = 2.89% of one share you receive $0.55 and your remaining shares will be worth
$18.45, leaving you in the same position as if the firm had paid a dividend.

17-11. The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity.
Assume all investors pay a 20% tax on dividends and that there is no capital gains tax. Suppose
that other investments with equivalent risk to HNH stock offer an after-tax return of 12%.
a. What is the price of a share of HNH stock?
b. Assume that management makes a surprise announcement that HNH will no longer pay
dividends but will use the cash to repurchase stock instead. What is the price of a share of
HNH stock now?
a. P = $1.60/0.12 = $13.33
b. P = $2/0.12 = $16.67

17-15. Suppose that all capital gains are taxed at a 26% rate, and that the dividend tax rate is 34%.
Arbuckle Corp. is currently trading for $37, and is about to pay a $5 special dividend.
a. Absent any other trading frictions or news, what will its share price be just after the
dividend is paid?
Suppose Arbuckle made a surprise announcement that it would do a share repurchase rather
than pay a special dividend.
b. What net tax savings per share for an investor would result from this decision?

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c. What would happen to Arbuckle’s stock price upon the announcement of this change?

34 %−26 %
a. Effective dividend tax rate= =10.81 %
( 1−26 % )
Price ex-dividend = $37 – [$5 x (1 – 0.1081)] = $32.54

b. With dividend, tax would be $5 x 34% = $1.70 for dividend, with a tax savings of $5 x 26% =
$1.30 for capital loss, for a net tax from the dividend of $0.40 per share. This amount would be
saved if Arbuckle does a share repurchase instead.

c. Stock price rises to by $0.40 to $37.40 to reflect the tax savings.

17-16. You purchased CSH stock for $40 one year ago and it is now selling for $50. The company has
announced that it plans a $10 special dividend. You are considering whether to sell the stock
now, or wait to receive the dividend and then sell.
a. Assuming 2008 tax rates, what ex-dividend price of CSH will make you indifferent between
selling now and waiting?
b. Suppose the capital gains tax rate is 20% and the dividend tax rate is 40%, what ex-dividend
price would make you indifferent now?
a. In 2008, the capital gains tax rate is 15%, and the dividend tax rate is 15%. The tax on a $10
capital gain is $1.50, and the tax on a $10 special dividend is $1.50. The after-tax income for both
will be $8.50.
b. If the capital gains tax rate is 20%, the tax on a $10 capital gain is $2.00, and the after-tax income
is $8.00. If the dividends tax rate is 40%, then the tax on a $10 special dividend is $4.00, and the
after-tax income is $6.00. The difference in after-tax income is $2.00.

17-21. Clovix Corporation has $50 million in cash, 10 million shares outstanding, and a current share
price of $30. Clovix is deciding whether to use the $50 million to pay an immediate special
dividend of $5 per share, or to retain and invest it at the risk-free rate of 10% and use the $5
million in interest earned to increase its regular annual dividend of $0.50 per share. Assume
perfect capital markets.
a. Suppose Clovix pays the special dividend. How can a shareholder who would prefer an
increase in the regular dividend create it on her own?
b. Suppose Clovix increases its regular dividend. How can a shareholder who would prefer the
special dividend create it on her own?
a. Invest the $5 special dividend, and earn interest of $0.50 per year.
b. Borrow $5 today, and use the increase in the regular dividend to pay the interest of $0.50 per year
on the loan.

17-24. Harris Corporation has $250 million in cash, and 100 million shares outstanding. Suppose the
corporate tax rate is 35%, and investors pay no taxes on dividends, capital gains, or interest
income. Investors had expected Harris to pay out the $250 million through a share repurchase.
Suppose instead that Harris announces it will permanently retain the cash, and use the interest
on the cash to pay a regular dividend. If there are no other benefits of retaining the cash, how
will Harris’ stock price change upon this announcement?
Effective tax disadvantage of retention is t* = 35%. (The reason is that Harris will pay 35% tax on the
interest income it earns.) Thus, stock price falls by 35% × $250m/100m shares = $0.875 per share.

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250 Berk/DeMarzo, Corporate Finance, Fourth Edition

17-26. Raviv Industries has $100 million in cash that it can use for a share repurchase. Suppose instead
Raviv invests the funds in an account paying 10% interest for one year.
a. If the corporate tax rate is 40%, how much additional cash will Raviv have at the end of the
year net of corporate taxes?
b. If investors pay a 20% tax rate on capital gains, by how much will the value of their shares
have increased, net of capital gains taxes?
c. If investors pay a 30% tax rate on interest income, how much would they have had if they
invested the $100 million on their own?
d. Suppose Raviv retained the cash so that it would not need to raise new funds from outside
investors for an expansion it has planned for next year. If it did raise new funds, it would
have to pay issuance fees. How much does Raviv need to save in issuance fees to make
retaining the cash beneficial for its investors? (Assume fees can be expensed for corporate
tax purposes.)
a. 100  10%  (1 – 40%) = $6 m
b. $6  (1 – 0.20) = $4.8 million
c. 100  10%  (1 – 0.30) = $7 million
d. $1 spent on fees = $1  (1 – 0.40)  (1 – 0.20) = $0.48 to investors after corporate and cap gain
tax. To make up the shortfall, fees = (7 – 4.8)/0.48 = $4.583 million.

17-28. Explain under which conditions an increase in the dividend payment can be interpreted as a
signal of the following:
a. Good news
b. Bad news
a. By increasing dividends managers signal that they believe that future earnings will be high enough
to maintain the new dividend payment.
b. Raising dividends signals that the firm does not have any positive NPV investment opportunities,
which is bad news.

17-30. AMC Corporation currently has an enterprise value of $400 million and $100 million in excess
cash. The firm has 10 million shares outstanding and no debt. Suppose AMC uses its excess cash
to repurchase shares. After the share repurchase, news will come out that will change AMC’s
enterprise value to either $600 million or $200 million.
a. What is AMC’s share price prior to the share repurchase?
b. What is AMC’s share price after the repurchase if its enterprise value goes up? What is
AMC’s share price after the repurchase if its enterprise value declines?
c. Suppose AMC waits until after the news comes out to do the share repurchase. What is
AMC’s share price after the repurchase if its enterprise value goes up? What is AMC’s
share price after the repurchase if its enterprise value declines?
d. Suppose AMC management expects good news to come out. Based on your answers to parts
b and c, if management desires to maximize AMC’s ultimate share price, will they undertake
the repurchase before or after the news comes out? When would management undertake the
repurchase if they expect bad news to come out?
e. Given your answer to part d, what effect would you expect an announcement of a share
repurchase to have on the stock price? Why?
a. Because Enterprise Value = Equity + Debt – Cash, AMC’s equity value is

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Equity = EV + Cash = $500 million.

Therefore,
Share price = ($500 million) / (10 million shares) = $50 per share.
b. AMC repurchases $100 million / ($50 per share) = 2 million shares. With 8 million remaining
shares outstanding (and no excess cash) its share price if its EV goes up to $600 million is
Share price = $600/8 = $75 per share.
And if EV goes down to $200 million:
Share price = $200/8 = $25 per share.
c. If EV rises to $600 million prior to repurchase, given its $100 million in cash and 10 million
shares outstanding, AMC’s share price will rise to:
Share price = (600 + 100)/10 = $70 per share.
If EV falls to $200 million:
Share price = (200 + 100)/10 = $30 per share.
The share price after the repurchase will be also be $70 or $30, since the share repurchase itself
does not change the stock price.
Note: the difference in the outcomes for (a) vs (b) arises because by holding cash (a risk-free
asset) AMC reduces the volatility of its share price.
d. If management expects good news to come out, they would prefer to do the repurchase first, so
that the stock price would rise to $75 rather than $70. On the other hand, if they expect bad news
to come out, they would prefer to do the repurchase after the news comes out, for a stock price of
$30 rather than $25. (Intuitively, management prefers to do a repurchase if the stock is
undervalued—they expect good news to come out —but not when it is overvalued because they
expect bad news to come out.)
e. Based on (d), we expect managers to do a share repurchase before good news comes out and after
any bad news has already come out. Therefore, if investors believe managers are better informed
about the firm’s future prospects, and that they are timing their share repurchases accordingly, a
share repurchase announcement would lead to an increase in the stock price.

17-33. Explain why most companies choose to pay stock dividends (split their stock).
Companies use stock splits to keep their stock prices in a range that reduces investor transaction costs.

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