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Chapter 15 Distributions to Shareholders: Dividends and Share Repurchases

Answers to End-of-Chapter Questions


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 being equal. The disadvantage is that such a policy might decrease corporate flexibility. However, the announced policy would possibly include elements of flexibility. On balance, it would appear desirable for directors to announce their policies. While it is true that the cost of outside equity is higher than that of retained earnings, it is not necessarily irrational for a firm to pay dividends and sell stock in the same year. The reason is that if the firm has been paying a regular dividend, and then cuts it in order to obtain equity capital from retained earnings, there might be an unfavorable effect on the firm 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. #ogic suggests that stockholders like stable dividends$many of them depend on dividend income, and if dividends were cut, this might cause serious hardship. !f a firm s earnings are temporarily depressed or if it needs a substantial amount of funds for investment, then it might well maintain its regular dividend using borrowed funds to tide it over until things returned to normal. Of course, this could not be done on a sustained basis$it would be appropriate only on relatively rare occasions. a" "" argue that dividend policy has no effect on rs, thus no effect on firm 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 r s 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 efficient 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 different dividend policies, "" could argue that one policy is as good as another. 'ut, if the clienteles are of differing si(es or economic means, the clienteles might not be equal, and one dividend policy could be preferential to another.

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Chapter 15: Distributions to Shareholders

Answers and Solutions

15-5

a" )rom the stockholders point of view, an increase in the personal income tax rate would make it more desirable for a firm to retain and reinvest earnings. *onsequently, an increase in personal tax rates should lower the aggregate payout ratio. b" !f the depreciation allowances were raised, cash flows would increase. With higher cash flows, 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 financing new investment. *onsequently, the payout ratio might be expected to decline. On the other hand, higher interest rates would cause rd, rs, and firms "**s to rise$that would mean that fewer pro,ects would qualify for capital budgeting and the residual would increase -other things constant., hence the payout ratio might increase. d" / permanent increase in profits would probably lead to an increase in dividends, but not necessarily to an increase in the payout ratio. !f the aggregate profit increase were a cyclical increase that could be expected to be followed by a decline, then the payout ratio might fall, because firms do not generally raise dividends in response to a short+run profit increase. e" !f investment opportunities for firms declined while cash inflows remained relatively constant, an increase would be expected in the payout ratio. f" 0ividends are currently paid out of after+tax dollars, and interest charges from before+tax dollars. 1ermission for firms 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.

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a" The residual dividend policy is based on the premise that, since new common stock is more costly than retained earnings, a firm 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 firm s investment opportunities. &ee Table 23+4 in the text for an illustration. b" 5es. / more shallow plot implies that changes from the optimal capital structure have little effect on the firm s cost of capital, hence value. !n this situation, dividend policy is less critical than if the plot were 6+shaped.

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!t is true that executives salaries are more highly correlated with the si(e of the firm than with profitability. This being the case, it might be in management s own best interest -assuming that management does not have a substantial ownership position in the firm. to see the si(e of the firm increase whether or not this is optimal from stockholders point of view. The larger the investment during any given year, the larger the firm will become. /ccordingly, a firm whose management is interested in maximi(ing firm si(e rather than the value of the existing common stock might push Answers and Solutions Chapter 15: Distributions to Shareholders

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. !f the firm 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 benefits from the higher retained earnings -due to the firm being larger., 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-& The difference is largely one of accounting. !n the case of a split, the firm 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 firms, a 2778 stock dividend and a 4+for+2 stock split accomplish exactly the same thing9 hence, investors may choose either one. !t is sometimes argued that there is an optimum price for a stock9 that is, a price at which W/** will be minimi(ed, giving rise to a maximum price for any given earnings. !f a firm can use stock dividends or stock splits to keep its shares selling at this price -or in this price range., then stock dividends and:or splits will have helped maintain a high 1:; 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 effect of keeping 1:; 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.

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15-1( a" True. When investors sell their stock they are sub,ect to capital gains taxes. b" True. !f a company s stock splits 4 for 2, and you own 277 shares, then after the split you will own 477 shares. c" True. 0ividend reinvestment plans that involve newly issued stock will increase the amount of equity capital available to the firm. d" )alse. The Tax *ode, through the tax deductibility of interest, encourages firms 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 firms who retain earnings rather than those that pay large dividends. e" True. !f a company s clientele prefers large dividends, the firm is unlikely to adopt a residual dividend policy. / residual dividend policy could mean low or (ero dividends in some years, which would upset the company s developed clientele. f" )alse. !f a firm follows a residual dividend policy, all else constant, its dividend payout will tend to decline whenever the firm s investment opportunities improve.

Chapter 15: Distributions to Shareholders

Answers and Solutions

Solutions to End-of-Chapter )roble*s

15-1

<78 0ebt9 =78 ;quity9 *apital budget > ?=,777,7779 @! > ?4,777,7779 1O > A ;quity retained > 7.=-?=,777,777. > ?B77,777. @! C /dditions to D; ;arnings remaining 1ayout >
?2,277,777 > 338. ?4,777,777

?4,777,777 B77,777 ?2,277,777

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17 > ?B79 &plit > = for 49 @ew 17 > A


?B7 > ?E7. =: 4

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@! > ?4,777,7779 &hares > 2,777,7779 17 > ?=49 Depurchase > 4789 @ew 17 > A Depurchase > 7.4 2,777,777 > 477,777 shares. Depurchase amount > 477,777 ?=4 > ?E,F77,777. ;1&Old >
?4,777,777 @! > > ?4.77. 2,777,777 &hares

1:; >

?=4 > 2E. ?4 ?4,777 ,777 ?4,777,777 > > ?4.37. G77,777 2,777 ,777 477 ,777

;1&@ew >

1rice@ew > ;1&@ew 1:; > ?4.37-2E. > ?F7. 15-! 01& after split > ?7.<3. ;quivalent pre+split dividend > ?7.<3-3. > ?=.<3. @ew equivalent dividend > #ast year s dividend-2.7B. ?=.<3 > #ast year s dividend-2.7B. #ast year s dividend > ?=.<3:2.7B > ?=.FF. 15-5 ! Detained earnings > @et income -2 C 1ayout ratio. Chapter 15: Distributions to Shareholders

Answers and Solutions

> ?3,777,777-7.33. > ?4,<37,777. ;xternal equity neededH Total equity required > -@ew investment.-2 C 0ebt ratio. > ?27,777,777-7.E7. > ?E,777,777. @ew external equity needed > ?E,777,777 C ?4,<37,777 > ?=,437,777. 15-$ &tep 2H 0etermine the capital budget by selecting those pro,ects whose returns are greater than the pro,ect s risk+ad,usted cost of capital. 1ro,ects H and # should be chosen because !DD I W/**, so the firm s capital budget > ?27 million. &tep 4H 0etermine how much of the capital budget will be financed with equity. *apital 'udget ;quity 8> ;quity required. ?27,777,777 7.3 > ?3,777,777. &tep =H 0etermine dividends through residual model. ?<,4G<,377 C ?3,777,777 > ?4,4G<,377. &tep FH *alculate payout ratio. ?4,4G<,377:?<,4G<,377 > 7.=2=B > =2.=B8. 15-% a" Total dividends7B > @et income7B 1ayout ratio > ?2,G77,777 7.F7 > ?<47,777. 01&7B > 0ividends7B:&hares outstanding > ?<47,777:377,777 > ?2.FF. b" 0ividend yield > 01&:17 > ?2.FF:?FG.77 > =8. c" Total dividends7G > @et income7G 1ayout ratio > ?2,377,777 7.F > ?E77,777. 01&7G > 0ividends7G:&hares outstanding > ?E77,777:377,777 > ?2.47. d" 1ayout ratio > 0ividends:@et income > ?E77,777:?2,G77,777 > 7.==== > ==2:=8. Chapter 15: Distributions to Shareholders Answers and Solutions 5

e" &ince the company would like to avoid transactions costs involved in issuing new equity, it would be best for the firm to maintain the same per+share dividend. This will provide a stable dividend to investors, yet allow the firm to expand operations without significantly affecting the dividend. / constant dividend payout ratio would cause serious fluctuations 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 firm s stock price to decline -because investors prefer a more stable dividend policy.. 15-& a" 'efore finding the long+run growth rate, the dividend payout ratio must be determined. 0ividend payout ratio > 01&:;1& > ?7.<3:?4.43 > 7.====. The firmJs long+run growth rate can be found by multiplying the portion of a firmJs earnings that are retained times the firmJs return on equity. g > DO; Detention ratio > -@et !ncome:;quity *apital. -2 C 0ividend payout ratio. > 2G8 -2 C 7.====. > 248. b" The required return can be calculated using the 0*) approach. rs > > > > 02:17 K g ?7.<3:?24.37 K 7.24 7.7E K 7.24 7.2G or 2G8.

c" The new payout ratio can be calculated asH ?2.37:?4.43 > 7.EEE<. The new long+run growth rate can now be calculated asH g > DO; -2 C 0ividend payout ratio. > 2G8 -2 C 7.EEE<. > E8. The firmJs required return would beH rs > > > > 02:17 K g ?2.37:?24.37 K 7.7E 7.24 K 7.7E 7.2G or 2G8.

d" The firmJs original plan was to issue a dividend equal to ?7.<3 per share, which equates to a total dividend of ?7.<3 times the number of shares outstanding. &o, first the number of shares outstanding must be determined from the ;1&. /mount of equity capital > Total assets ;quity ratio > ?27 million 7.E > ?E million.

Answers and Solutions

Chapter 15: Distributions to Shareholders

@et income > ;quity capital DO; > ?E million 7.2G > ?2.7G million. ;1& > @et income:@umber of shares ?4.43 > ?2.7G million:@umber of shares @umber of shares> FG7,777. With FG7,777 shares outstanding, the total dividend that would be paid would be ?7.<3 FG7,777 shares > ?=E7,777. The firmJs current market capitali(ation is ?E.7 million, determined by FG7,777 shares at ?24.37 per share. -'6 > "6 per problem.. !f the stock dividend is implemented, it shall account for E8 of the firmJs current market capitali(ation -?=E7,777:?E,777,777 > 7.7E.. e" !f the total amount of value to be distributed to shareholders is ?=E7,777, at a price of ?24.37 per share, then the number of new shares issued would beH @umber of new shares > 0ividend value:1rice per share > ?=E7,777:?24.37 > 4G,G77 shares. The stock dividend will leave the firmJs net income unchanged9 therefore, the firmJs new ;1& is its net income divided by the new total number of shares outstanding. @ew ;1& > @et income:-Old shares outstanding K @ew shares outstanding. > ?2,7G7,777:-FG7,777 K 4G,G77. > ?4.244E. The dilution of earnings per share is the difference between old ;1& and new ;1&. 0ilution of ;1& > Old ;1& C @ew ;1& > ?4.43 C ?4.244E > ?7.24<F L ?7.2= per share. 15-' a" 2. 477B 0ividends > -2.27.-477G 0ividends. > -2.27.-?=,E77,777. > ?=,BE7,777. 4. 477G 1ayout > ?=,E77,777:?27,G77,777 > 7.==== > == 2:=8. 477B 0ividends > -7.====.-477B @et income. > -7.====.-?2F,F77,777. > ?F,G77,777. -@oteH !f the payout ratio is rounded off to ==8, 477B dividends are then calculated as ?F,<34,777.. =. ;quity financing > ?G,F77,777-7.E7. > ?3,7F7,777. 477B 0ividends > @et income C ;quity financing > ?2F,F77,777 C ?3,7F7,777 > ?B,=E7,777. /ll of the equity financing is done with retained earnings as long as they are available.

Chapter 15: Distributions to Shareholders

Answers and Solutions

F. The regular dividends would be 278 above the 477G dividendsH Degular dividends > -2.27.-?=,E77,777. > ?=,BE7,777. The residual policy calls for dividends of ?B,=E7,777. Therefore, the extra dividend, which would be stated as such, would be ;xtra dividend > ?B,=E7,777 C ?=,BE7,777 > ?3,F77,777. /n even better use of the surplus funds might be a stock repurchase. b" 1olicy F, based on the regular dividend with an extra, seems most logical. !mplemented properly, it would lead to the correct capital budget and the correct financing of that budget, and it would give correct signals to investors. c" rs > d"

02 ?B,777,777 Kg> K 278 > 238. ?2G7,777,7 77 17

g > Detention rate-DO;. 7.27 > M2 C -?=,E77,777:?27,G77,777.N-DO;. DO; > 7.27:7.EEE< > 7.23 > 238.

e" / 477B dividend of ?B,777,777 may be a little low. The cost of equity is 238, and the average return on equity is 238. However, with an average return on equity of 238, 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 -say 278. on existing assets yet have extremely profitable investment opportunities this year -say averaging =78. for an expected overall average DO; of 238. &till, if this year s pro,ects are like those of past years, then the payout appears to be slightly low.

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Answers and Solutions

Chapter 15: Distributions to Shareholders

Co*prehensive+Spreadsheet )roble*

Note to Instructors: ,he solution to this proble* is not provided to students at the bac- of their te.t" /nstructors can access the Excel file on the te.tboo-0s web site or the /nstructor0s Resource CD" 15-1( a" *apital budget > ?27,777,7779 *apital structure > E78 equity, F78 debt9 *ommon shares outstanding > 2,777,777. Detained earnings needed > ?27,777,777-7.E. > ?E,777,777. b" /ccording to the residual dividend model, only ?4 million is available for dividends. @! C Detained earnings needed for capital pro,ects > Desidual dividend ?G,777,777 C ?E,777,777 > ?4,777,777. 01& > ?4,777,777:2,777,777 > ?4.77. 1ayout ratio > ?4,777,777:?G,777,777 > 438. c" Detained earnings available > ?G,777,777 C ?=.77-2,777,777. > ?3,777,777. d" @o. !f the company maintains its ?=.77 01&, only ?3 million of retained earnings will be available for capital pro,ects. However, if the firm is to maintain its current capital structure ?E million of equity is required. This would necessitate the company having to issue ?2 million of new common stock. e" *apital budget > ?27 million9 0ividends > ?= million9 @! > ?G million9 *apital structure > A D; available > ?G,777,777 C ?=,777,777 > ?3,777,777. 1ercentage of capital budget financed with D; >
?3,777,777 > 378. ?27,777,77 7 ?3,777,777 > 378. ?27,777,77 7

1ercentage of capital budget financed with debt >

f" 0ividends > ?= million9 *apital budget > ?27 million9 E78 equity, F78 debt9 @! > ?G million. ;quity needed > ?27,777,777-7.E. > ?E,777.777. D; available > ?G,777,777 C ?=.77-2,777,777. > ?3,777,777.

Chapter 15: Distributions to ShareholdersComprehensive/Spreadsheet Problem

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;xternal -@ew. equity needed > ?E,777,777 C ?3,777,777 > ?2,777,777. #" 0ividends > ?= million9 @! > ?G million9 *apital structure > E78 equity, F78 debt. D; available > ?G,777,777 C ?=,777,777 > 3,777,777. We re forcing the D; available > Dequired equity to fund the new capital budget. Dequired equity > *apital budget-Target equity ratio. ?3,777,777 > *apital budget-7.E. *apital budget > ?G,===,===. Therefore, if 'uena Terra cuts its capital budget from ?27 million to ?G.== million, it can maintain its ?=.77 01&, its current capital structure, and still follow the residual dividend policy. h" The firm can do one of four thingsH -2. -4. -=. -F. *ut dividends. *hange capital structure, that is, use more debt. *ut its capital budget. !ssue new common stock.

Deali(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 sufficient to fund its capital budget, then the firm must issue new common stock if it does not want to forgo any investment opportunities. However, this will raise the firm s cost of debt ratio, so as to increase its retained earnings breakpoint$which will allow it to use retained earnings rather than new common equity to fund its capital budget. The effect on W/** would be negligible. The firm could also forgo investment opportunities9 however, this would result in not maximi(ing the firm s value. )inally, the firm could reduce dividends$which would increase the firm s retained earnings. However, dividends are OstickyP so this would also have a negative impact on the firm s W/** -increasing it.. The ObestP alternative to the firm is probably Oad,ustingP its debt ratio as this probably has the least impact on the firm s W/**.

1( Comprehensive/Spreadsheet Problem Shareholders

Chapter 15: Distributions to

/nte#rated Case
15-11

Southeastern Steel Co*pan1 Dividend Policy


Southeastern Steel Co*pan1 2SSC3 was for*ed 5 1ears a#o to e.ploit a new continuous castin# process" SSC0s founders4 Donald 5rown and 6ar#o 7alencia4 had been e*plo1ed in the research depart*ent of a *a8or inte#rated-steel co*pan19 but when that co*pan1 decided a#ainst usin# the new process 2which 5rown and 7alencia had developed34 the1 decided to stri-e out on their own" :ne advanta#e of the new process was that it re;uired relativel1 little capital co*pared to the t1pical steel co*pan14 so 5rown and 7alencia have been able to avoid issuin# new stoc- and thus own all of the shares" <owever4 SSC has now reached the sta#e in which outside e;uit1 capital is necessar1 if the fir* is to achieve its #rowth tar#ets 1et still *aintain its tar#et capital structure of $(= e;uit1 and !(= debt" ,herefore4 5rown and 7alencia have decided to ta-e the co*pan1 public" >ntil now4 5rown and 7alencia have paid the*selves reasonable salaries but routinel1 reinvested all after-ta. earnin#s in the fir*9 so dividend polic1 has not been an issue" <owever4 before tal-in# with potential outside investors4 the1 *ust decide on a dividend polic1" Assu*e that 1ou were recentl1 hired b1 Arthur Ada*son ? Co*pan1 2AA34 a national consultin# fir*4 which has been as-ed to help SSC prepare for its public offerin#" 6artha 6illon4 the senior AA consultant in 1our #roup4 has as-ed 1ou to *a-e a presentation to 5rown and 7alencia in which 1ou review the theor1 of dividend polic1 and discuss the followin# ;uestions"

Chapter 15: Distributions to Shareholders

Inte rated Case

11

A"

213 @hat is *eant b1 the ter* dividend polic1A

Answer: BShow S15-1 and S15-2 here"C Dividend polic1 is defined as the fir*0s polic1 with re#ard to pa1in# out earnin#s as dividends versus retainin# the* for reinvest*ent in the fir*" Dividend polic1 reall1 involves three -e1 issues: 213 <ow *uch should be distributedA 223 Should the distribution be as cash dividends4 or should the cash be passed on to shareholders b1 bu1in# bac- so*e of the stoc- the1 holdA 2 3 <ow stable should the distribution be4 that is4 should the funds paid out fro* 1ear to 1ear be stable and dependable4 which stoc-holders would probabl1 prefer4 or be allowed to var1 with the fir*0s cash flows and invest*ent re;uire*ents4 which would probabl1 be better fro* the fir*0s standpointA A" 223 E.plain briefl1 the dividend irrelevance theor1 that was put forward b1 6odi#liani and 6iller" @hat were the -e1 assu*ptions underl1in# their theor1A Answer:BShow S15- here"C Dividend irrelevance refers to the theor1 that investors are indifferent between dividends and capital #ains4 *a-in# dividend polic1 irrelevant with re#ard to its effect on the value of the fir*" ,he dividend irrelevance theor1 was proposed b1 664 but the1 had to *a-e so*e ver1 restrictive assu*ptions to DproveE it" ,hese assu*ptions include4 a*on# other thin#s4 that no ta.es are paid on dividends4 that stoc-s can be bou#ht and sold with no transactions costs4 and that ever1oneFinvestors and *ana#ers ali-eFhas the sa*e infor*ation re#ardin# fir*s0 future earnin#s" 66 ar#ued
12 Inte rated Case Chapter 15: Distributions to Shareholders

that pa1in# out a dollar per share of dividends reduces the #rowth rate in earnin#s and dividends4 because new stocwill have to be sold to replace the capital paid out as dividends" >nder their assu*ptions4 a dollar of dividends will reduce the stoc- price b1 e.actl1 G1" ,herefore4 accordin# to 664 stoc-holders should be indifferent between dividends and capital #ains" A" 2 3 @h1 do so*e investors prefer hi#h-dividend-pa1in# stoc-s4 while other investors prefer stoc-s that pa1 low or none.istent dividendsA Answer: BShow S15-! and S15-5 here"C /nvestors *i#ht prefer dividends to capital #ains because the1 *a1 re#ard dividends as less ris-1 than potential future capital #ains" /f this were so4 then investors would value hi#h-pa1out fir*s *ore hi#hl1Fthat is4 a hi#h-pa1out stoc- would have a hi#h price" /nvestors *i#ht prefer low-pa1out fir*s or capital #ains to dividends because the1 *a1 want to avoid transactions costsFthat is4 havin# to reinvest the dividends and incurrin# bro-era#e costs4 not to *ention ta.es" ,he *a.i*u* ta. rate on dividends is the sa*e as it is for capital #ains9 however4 ta.es on dividends are due in the 1ear the1 are received4 while ta.es on capital #ains are due whenever the stoc- is sold" /n addition4 if an investor holds a stoc- until his+her death4 the beneficiaries can use the date of the death as the cost-basis date and escape all previousl1 accrued capital #ains"

Chapter 15: Distributions to Shareholders

Inte rated Case

5"

Discuss 213 the infor*ation content4 or si#nalin#4 h1pothesis9 223 the clientele effect9 and 2 3 their effects on dividend polic1"

Answer: BShow S15-$ and S15-% here"C 1" /t has lon# been reco#niHed that the announce*ent of a dividend increase often results in an increase in the stoc- price4 while an announce*ent of a dividend cut t1picall1 causes the stoc- price to fall" :ne could ar#ue that this observation supports the pre*ise that investors prefer dividends to capital #ains" <owever4 66 ar#ued that dividend announce*ents are si#nals throu#h which *ana#e*ent conve1s infor*ation to investors" /nfor*ation as1**etries e.istF*ana#ers -now *ore about their fir*s0 prospects than do investors" Iurther4 *ana#ers tend to raise dividends onl1 when the1 believe that future earnin#s can co*fortabl1 support a hi#her dividend level4 and the1 cut dividends onl1 as a last resort" ,herefore4 213 a lar#er-than-nor*al dividend increase Dsi#nalsE that *ana#e*ent believes the future is bri#ht4 223 a s*allerthan-e.pected increase4 or a dividend cut4 is a ne#ative si#nal4 and 2 3 if dividends are increased b1 a Dnor*alE a*ount4 this is a neutral si#nal" 2" Different #roups4 or clienteles4 of stoc-holders prefer different dividend pa1out policies" Ior e.a*ple4 *an1 retirees4 pension funds4 and universit1 endow*ent funds are in a low 2or Hero3 ta. brac-et4 and the1 have a need for current cash inco*e" ,herefore4 this #roup of
1! Inte rated Case Chapter 15: Distributions to Shareholders

stoc-holders *i#ht prefer hi#h-pa1out stoc-s" ,hese investors could4 of course4 sell so*e of their stoc-4 but this would be inconvenient4 transactions costs would be incurred4 and the sale *i#ht have to be *ade in a down *ar-et" Conversel14 investors in their pea- earnin#s 1ears who are in hi#h-ta. brac-ets and who have no need for current cash inco*e should prefer low-pa1out stoc-s" " Clienteles do e.ist4 but the real ;uestion is whether there are *ore *e*bers of one clientele than another4 which would affect what a chan#e in its dividend polic1 would do to the de*and for the fir*0s stoc-" ,here are also costs 2ta.es and bro-era#e3 to stoc-holders who would be forced to switch fro* one stoc- to another if a fir* chan#es its dividend polic1" ,herefore4 we cannot sa1 whether a dividend polic1 chan#e to appeal to one particular clientele or another would lower or raise a fir*0s cost of e;uit1" 66 ar#ued that one clientele is as #ood as another4 so in their view the e.istence of clienteles does not i*pl1 that one dividend polic1 is better than another" Still4 no one has offered convincin# proof that fir*s can disre#ard clientele effects" @e -now that stoc-holder shifts will occur if dividend polic1 is chan#ed4 and since such shifts result in transactions costs and capital #ains ta.es4 dividend polic1 chan#es should not be ta-en li#htl1" Iurther4 dividend polic1 should be chan#ed slowl14 rather than abruptl14 in order to #ive stoc-holders ti*e to ad8ust"

Chapter 15: Distributions to Shareholders

Inte rated Case

15

C"

213 Assu*e that SSC has an G&((4((( capital bud#et planned for the co*in# 1ear" Jou have deter*ined that its present capital structure 2$(= e;uit1 and !(= debt3 is opti*al4 and its net inco*e is forecasted at G$((4(((" >se the residual dividend *odel approach to deter*ine SSC0s total dollar dividend and pa1out ratio" /n the process4 e.plain how the residual dividend *odel wor-s" ,hen e.plain what would happen if net inco*e was forecasted at G!((4((( and at G&((4((("

Answer: BShow S15-& throu#h S15-11 here"C @e *a-e the followin# points: 1" Kiven the opti*al capital bud#et and the tar#et capital structure4 we *ust now deter*ine the a*ount of e;uit1 needed to finance the pro8ects" :f the G&((4((( re;uired for the capital bud#et4 ("$2G&((4(((3 L G!&(4((( *ust be raised as e;uit1 and ("!2G&((4(((3 L G 2(4((( *ust be raised as debt if we are to *aintain the opti*al capital structure: Debt E;uit1 2" G 2(4((( !&(4((( G&((4((( !(= $(= 1((=

/f a residual e.istsFthat is4 if net inco*e e.ceeds the a*ount of e;uit1 the co*pan1 needsFthen it should pa1 the residual a*ount out in dividends" Since G$((4((( of earnin#s is available4 and onl1 G!&(4((( is needed4 the residual is G$((4((( M G!&(4((( L G12(4(((4 so this is the a*ount that should be paid out as dividends" ,hus4 the pa1out ratio would be G12(4(((+G$((4((( L ("2( L 2(="

1$

Inte rated Case

Chapter 15: Distributions to Shareholders

"

/f onl1 G!((4((( of earnin#s were available4 the fir* would still need G!&(4((( of e;uit1" /t should then retain all of its earnin#s and also sell G&(4((( of new stoc-" ,he residual polic1 would call for a Hero dividend pa1*ent"

!"

/f G&((4((( of earnin#s were available4 the dividend would be increased to G&((4((( M G!&(4((( L G 2(4(((4 and the pa1out ratio would rise to G 2(4(((+G&((4((( L !(="

C"

223 /n #eneral ter*s4 how would a chan#e in invest*ent opportunities affect the pa1out ratio under the residual pa1*ent polic1A

Answer: BShow S15-12 here"C A chan#e in invest*ent opportunities would lead to an increase 2if invest*ent opportunities were #ood3 or a decrease 2if invest*ent opportunities were not #ood3 in the a*ount of e;uit1 needed" /f invest*ent opportunities were #ood then the residual a*ount would be s*aller than if invest*ent opportunities were bad" C" 2 3 @hat are the advanta#es and disadvanta#es of the residual polic1A 2<int: Don0t ne#lect si#nalin# and clientele effects"3 Answer: BShow S15-1 here"C ,he pri*ar1 advanta#e of the residual polic1 is that under it the fir* *a-es *a.i*u* use of lowercost retained earnin#s4 thus *ini*iHin# flotation costs and hence the cost of capital" Also4 whatever ne#ative si#nals are associated with stoc- issues would be avoided" <owever4 if it were applied e.actl14 the residual *odel would result in dividend pa1*ents that fluctuated
Chapter 15: Distributions to Shareholders Inte rated Case 1%

si#nificantl1 fro* 1ear to 1ear as capital re;uire*ents and internal cash flows fluctuated" ,his would 213 send investors conflictin# si#nals over ti*e re#ardin# the fir*0s future prospects4 and 223 since no specific clientele would be attracted to the fir*4 it would be an Dorphan"E ,hese si#nalin# and clientele effects would lead to a hi#her re;uired return on e;uit1 that would *ore than offset the effects of lower flotation costs" 5ecause of these factors4 few if an1 publicl1-owned fir*s follow the residual *odel on a 1ear-to-1ear basis" Even thou#h the residual approach is not used to set the annual dividend4 it is used when fir*s establish their lon#run dividend polic1" /f Dnor*aliHedE cost of capital and invest*ent opportunit1 conditions su##est that in a Dnor*alE 1ear the co*pan1 should pa1 out about $(= of its earnin#s4 this fact will be noted and used to help deter*ine the fir*0s lon#-run dividend polic1" D" @hat is a dividend reinvest*ent plan 2DR/)34 and how does it wor-A Answer: BShow S15-1! throu#h S15-1$ here"C >nder a dividend reinvest*ent plan 2DR/)34 shareholders have the option of auto*aticall1 reinvestin# their dividends in shares of the fir*0s co**on stoc-" /n an open *ar-et purchase plan4 a trustee pools all the dividends to be reinvested and then bu1s shares on the open *ar-et" Shareholders use the DR/) for three reasons: 213 bro-era#e costs are reduced b1 the volu*e purchases4 223 the DR/) is a convenient wa1 to invest

1&

Inte rated Case

Chapter 15: Distributions to Shareholders

e.cess funds4 and 2 3 the co*pan1 #enerall1 pa1s all ad*inistrative costs associated with the operation" /n a new stoc- plan4 the fir* issues new stoc- to the DR/) *e*bers in lieu of cash dividends" No fees are char#ed4 and *an1 co*panies even offer the stoc- at a 5= discount fro* the *ar-et price on the dividend date on the #rounds that the fir* avoids flotation costs that would otherwise be incurred" :nl1 fir*s that need new e;uit1 capital use new stoc- plans4 while fir*s with no need for new stoc- use an open *ar-et purchase plan" E" Describe the series of steps that *ost fir*s ta-e in settin# dividend polic1 in practice" Answer: BShow S15-1% here"C Iir*s establish dividend polic1 within the fra*ewor- of their overall financial plans" ,he steps in settin# polic1 are listed below: 1" ,he fir* forecasts its annual capital bud#et and its annual sales4 alon# with its wor-in# capital needs4 for a relativel1 lon#-ter* plannin# horiHon4 often 5 1ears" 2" ,he tar#et capital structure4 presu*abl1 the one that *ini*iHes the @ACC while retainin# sufficient reserve borrowin# capacit1 to provide Dfinancin# fle.ibilit14E will also be established" " @ith its capital structure and invest*ent re;uire*ents in *ind4 the fir* can esti*ate the appro.i*ate a*ount of debt and e;uit1 financin# re;uired durin# each 1ear over the plannin# horiHon"

Chapter 15: Distributions to Shareholders

Inte rated Case

1'

!"

A lon#-ter* tar#et pa1out ratio is then deter*ined4 based on the residual *odel concept" 5ecause of flotation costs and potential ne#ative si#nalin#4 the fir* will not want to issue co**on stoc- unless this is absolutel1 necessar1" At the sa*e ti*e4 due to the clientele effect4 the fir* will *ove cautiousl1 fro* its past dividend polic14 if a new polic1 appears to be warranted4 and it will *ove toward an1 new polic1 #raduall1 rather than in one #iant step"

5"

An actual dollar dividend4 sa1 G2 per 1ear4 will be decided upon" ,he siHe of this dividend will reflect 213 the lon#-run tar#et pa1out ratio and 223 the probabilit1 that the dividend4 once set4 will have to be lowered4 or4 worse 1et4 o*itted" /f there is a #reat deal of uncertaint1 about cash flows and capital needs4 then a relativel1 low initial dollar dividend will be set4 for this will *ini*iHe the probabilit1 that the fir* will have to either reduce the dividend or sell new co**on stoc-" ,he fir* will run its corporate plannin# *odel so that *ana#e*ent can see what is li-el1 to happen with different initial dividends and pro8ected #rowth rates under different econo*ic scenarios"

I"

@hat are stoc- repurchasesA Discuss the advanta#es and disadvanta#es of a fir*0s repurchasin# its own shares"

Answer: BShow S15-1& throu#h S15-2( here"C A fir* *a1 distribute cash to stoc-holders b1 repurchasin# its own stoc- rather than pa1in# out cash dividends" Stoc- repurchases can be used 213 so*ewhat routinel1 as an alternative to re#ular
2( Inte rated Case Chapter 15: Distributions to Shareholders

dividends4 223 to dispose of e.cess 2nonrecurrin#3 cash that ca*e fro* asset sales or fro* te*poraril1 hi#h earnin#s4 and 2 3 in connection with a capital structure chan#e in which debt is sold and the proceeds are used to bu1 bacand retire shares" Advanta#es of repurchases: 1" A repurchase announce*ent *a1 be viewed as a positive si#nal that *ana#e*ent believes the shares are undervalued" 2" Stoc-holders have a choiceFif the1 want cash4 the1 can tender their shares4 receive the cash4 and pa1 the ta.es4 or the1 can -eep their shares and avoid ta.es" :n the other hand4 one *ust accept a cash dividend and pa1 ta.es on it" " /f the co*pan1 raises the dividend to dispose of e.cess cash4 this hi#her dividend *ust be *aintained to avoid adverse stoc- price reactions" A stoc- repurchase4 on the other hand4 does not obli#ate *ana#e*ent to future repurchases" !" Repurchased stoc-4 called treasur1 stoc-4 can be used later in *er#ers4 when e*plo1ees e.ercise stocoptions4 when convertible bonds are converted4 and when warrants are e.ercised" ,reasur1 stoc- can also be resold in the open *ar-et if the fir* needs cash" Repurchases can re*ove a lar#e bloc- of stoc- that is Doverhan#in#E the *ar-et and -eepin# the price per share down"

Chapter 15: Distributions to Shareholders

Inte rated Case

21

5"

Repurchases can be varied fro* 1ear to 1ear without #ivin# off adverse si#nals4 while dividends *a1 not"

$"

Repurchases can be used to produce lar#e-scale chan#es in capital structure"

Disadvanta#es of repurchases: 1" A repurchase could lower the stoc-0s price if it is ta-en as a si#nal that the fir* has relativel1 few #ood invest*ent opportunities" :n the other hand4 thou#h4 a repurchase can si#nal stoc-holders that *ana#ers are not en#a#ed in De*pire buildin#4E where the1 invest funds in low-return pro8ects" 2" /f the /RS establishes that the repurchase was pri*aril1 to avoid ta.es on dividends4 then penalties could be i*posed" Such actions have been brou#ht a#ainst closel1-held fir*s4 but to our -nowled#e char#es have never been brou#ht a#ainst publicl1-held fir*s" " Sellin# shareholders *a1 not be full1 infor*ed about the repurchase9 hence4 the1 *a1 *a-e an uninfor*ed decision and *a1 later sue the co*pan1" ,o avoid this4 fir*s #enerall1 announce repurchase pro#ra*s in advance" !" ,he fir* *a1 bid the stoc- price up and end up pa1in# too hi#h a price for the shares" /n this situation4 the sellin# shareholders would #ain at the e.pense of the re*ainin# shareholders" ,his could occur if a tender offer were *ade and the price was set too hi#h4 or if the repurchase was *ade in the open *ar-et and bu1in# pressure drove the price above its e;uilibriu* level"
22 Inte rated Case Chapter 15: Distributions to Shareholders

K"

@hat are stoc- dividends and stoc- splitsA @hat are the advanta#es and disadvanta#es of stoc- dividends and stocsplitsA

Answer: BShow S15-21 throu#h S15-2 here"C @hen it uses a stocdividend4 a fir* issues new shares in lieu of pa1in# a cash dividend" Ior e.a*ple4 in a 5= stoc- dividend4 the holder of 1(( shares would receive an additional 5 shares" /n a stocsplit4 the nu*ber of shares outstandin# is increased 2or decreased in a reverse split3 in an action unrelated to a dividend pa1*ent" Ior e.a*ple4 in a 2-for-1 split4 the nu*ber of shares outstandin# is doubled" A 1((= stocdividend and a 2-for-1 stoc- split would produce the sa*e effect4 but there would be differences in the accountin# treat*ents of the two actions" 5oth stoc- dividends and stoc- splits increase the nu*ber of shares outstandin# and4 in effect4 cut the pie into *ore4 but s*aller4 pieces" /f the dividend or split does not occur at the sa*e ti*e as so*e other event that would alter perceptions about future cash flows4 such as an announce*ent of hi#her earnin#s4 then one would e.pect the price of the stoc- to ad8ust such that each investor0s wealth re*ains unchan#ed" Ior e.a*ple4 a 2-for-1 split of a stoc- sellin# for G5( would result in the stoc- price bein# halved4 to G25" /t is hard to co*e up with a convincin# rationale for s*all stoc- dividends4 li-e 5= or 1(=" No econo*ic value is bein# created or distributed4 1et stoc-holders have to bear the ad*inistrative costs of the distribution" Iurther4 it is inconvenient to own an odd nu*ber of shares as *a1 result
Chapter 15: Distributions to Shareholders Inte rated Case 2

after a s*all stoc- dividend" ,hus4 *ost co*panies toda1 avoid s*all stoc- dividends" :n the other hand4 there is a #ood reason for stocsplits or lar#e stoc- dividends" Specificall14 there is a widespread belief that an opti*al price ran#e e.ists for stoc-s" ,he ar#u*ent #oes as follows: if a stoc- sells for about G2(-G&(4 then it can be purchased in round lots4 hence at reduced co**issions4 b1 *ost investors" A hi#her price would put round lots out of the price ran#e of *an1 s*all investors4 while a stoc- price lower than about G2( would conve1 the i*a#e of a stoc- that is doin# poorl1" ,hus4 *ost fir*s tr1 to -eep their stoc- prices within the G2( to G&( ran#e" /f the co*pan1 prospers4 it will split its stococcasionall1 to hold the price down" 2Also4 co*panies that are doin# poorl1 occasionall1 use reverse splits to raise their price"3 6an1 co*panies do operate outside the G2( to G&( ran#e4 but *ost sta1 within it" Another factor that *a1 influence stoc- splits and dividends is the belief that the1 si#nal *ana#e*ent0s belief that the future is bri#ht" /f a fir*0s *ana#e*ent would be inclined to split the stoc- or pa1 a stoc- dividend onl1 if it anticipated i*prove*ents in earnin#s and dividends4 then a split+dividend action could provide a positive si#nal and thus boost the stoc- price" <owever4 if earnin#s and cash dividends did not subse;uentl1 rise4 the price of the stocwould fall bac- to its old level4 or even lower4 because *ana#ers would lose credibilit1" /nterestin#l14 one of the *ost astute investors of the 2(th Centur14 @arren 5uffett4 chair*an of 5er-shire<athawa14 has never split his fir*0s stoc-" 5er-shire
2! Inte rated Case Chapter 15: Distributions to Shareholders

currentl1 2:ctober 2((&3 sells for G11541(( per share4 and its perfor*ance over the 1ears has been absolutel1 spectacular" /t *a1 be that 5er-shire0s *ar-et value would be hi#her if it had a 14! ':1 stoc- split4 or it *a1 be that the conventional wisdo* is wron#"

Chapter 15: Distributions to Shareholders

Inte rated Case

25