ASSIGNMENT

DIVIDEND POLICY: Dividends are Irrelevant

Course: Advance Corporate Finance

Course Code: FIN 5103

Submitted to
Dr. Md. Monzur Morshed Bhuiya
Professor
Faculty of Business Studies (FBS)
Jagannath University

Submitted by: Group-04

Khadiza Akter Lima ID: 2022331011

Tasmiah Binte Noor ID: 2022331015
Rifat Ibna Lokman ID: 2022331020
Ulfat Murshed Tamanna ID: 2022331022
Bushra Emdad ID: 2022331040

Batch- MBA 2020

Department of Business Administration in Finance and Banking
Bangladesh University of Professionals

Date of Submission
28th October, 2020
 Member Details

Seria
Name ID Marks
l

1 Khadiza Akter Lima 2022331011

2 Tasmiah Binte Noor 2022331015

3 Rifat Ibna Lokman 2022331020

4 Ulfat Murshed Tamanna 2022331022

5 Bushra Emdad 2022331040

Question: 09

Which types of companies would you expect to distribute a relatively high or low proportion of
current earnings? Which would you expect to have a relatively high or low price-earnings ratio?

a. High-risk companies.

b. Companies that have experienced an unexpected decline in profits.

c. Companies that expect to experience a decline in profits.

d. Growth companies with valuable future investment opportunities.

Answer:

a. High-risk companies distribute a low proportion of current earnings to offset fluctuations in

operational cash flow. These companies will have lower price-earnings ratio.

Risky companies may have lack of earnings to pay shareholders. The P/E ratio implicitly
incorporates the risk of a company's future earnings. Low P/E ratio is associated with high risk
and lower payouts ratios.

b. Companies that have experienced an unexpected decline in profits distribute a relatively high
proportion of current earnings since the decline is unexpected. These companies will have higher
price-earnings ratio.

c. Companies that expect to experience a decline in profits distribute a relatively low proportion
of current earnings in order to offset anticipated decline in earnings. These companies will have
lower price-earnings ratio.

d. Growth companies with valuable future investment opportunities distribute a relatively low
proportion of current earnings in order to fund expected growth. These companies will have
higher price-earnings ratio.

For the firm that has valuable growth opportunities, the higher the growth opportunities, the
lower the earnings–price ratio and the higher the price–earnings ratio. Thus the high price–
earnings ratios observed for growth companies imply that investors forecast future earnings
growth and are willing to pay more for them. But Growth stocks are often higher in volatility and
this puts a lot of pressure on companies to do more to justify their higher valuation. So
shareholders of a “growth stock,” expect that the company will retain earnings so as to fund
growth internally.

Question: 10

Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is
expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected
to grow by 5% a year in perpetuity. Thus, the expected dividend is $1.05 million in year 2,
$1.105 million in year 3, and so on.

a. At what price will the new shares be issued in year 1?

b. How many shares will the firm need to issue?

c. What will be the expected dividend payments on these new shares, and what therefore will be
paid out to the old shareholders after year 2?

Answer:

a. At t = 0 each share is worth $20. This value is based on the expected stream of dividends: $1
at t = 1, and increasing by 5% in each subsequent year. Thus, we can find the appropriate
discount rate for this company as follows:

DI V 1
P 0=
r −g

1
$ 20=
r −0.05
 r = 0.10 = 10.0%
Beginning at t = 2, each share in the company will enjoy a perpetual stream of growing dividends:
$1.05 at t = 2, and increasing by 5% in each subsequent year. Thus, the total value of the shares at t
= 1 (after the t = 1 dividend is paid and after N new shares have been issued) is given by:

$ 1.05 million
V 1= =$ 21million
0.10−0.05

If P1 is the price per share at t = 1, then:

V1 = P1  (1,000,000 + N) = $21,000,000
And,
 P1  N = $1,000,000
From the first equation:

(1,000,000  P1) + (N  P1) = $21,000,000

Substituting from the second equation:

(1,000,000  P1) + $1,000,000 = $21,000,000

so that P1 = $20.00.
b. With P1 equal to $20 the firm will need to sell 50,000 new shares to raise $1,000,000.
c. The expected dividends paid at t = 2 are $1,050,000, increasing by 5% in each subsequent
year. With 1,050,000 shares outstanding, dividends per share are: $1 at t = 2, increasing by 5%
in each subsequent year. Thus, total dividends paid to old shareholders are: $1,000,000 at t =
2, increasing by 5% in each subsequent year.
Question:11

We stated in Section 16-5 that MM’s proof of dividend irrelevance assumes that new shares are
sold at a fair price. Look back at problem 10. Assume that new shares are issued in year 1 at $10
a share. Show who gains and who loses. Is dividend policy still irrelevant? Why or why not?

Answer:

From Question No. 10, the fair issue price is $20 per share. If these shares are instead issued at
$10 per share, then the new shareholders are getting a bargain, which means that the new
shareholders win and the old shareholders lose.

As pointed out in the text, any increase in cash dividend must be offset by a stock issue if the
firm’s investment and borrowing policies are to be held constant. The old stockholders can also
raise cash by selling their shares. Thus, the old shareholders can cash in either by persuading the
management to pay a higher dividend or by selling some of their shares. In either case there will
be a transfer of value from old to new shareholders. The only difference is that in the former case
this transfer is caused by a dilution in the value of each of the firm’s shares, and in the latter case
it is caused by a reduction in the number of shares held by the old shareholders.
Because investors do not need dividends to earn cash, they will not pay higher prices for the
shares of firms with high payouts. So, the firm ought not to worry about dividend policy.
Question: 18
Formaggio Vecchio has just announced its regular quarterly cash dividend of $1 per share.
a. When will the stock price fall to reflect this dividend payment- on the record date, the ex-
dividend date, or the payment date?
b. Assume that there are no taxes. By how much is the stock price likely to fall?
c. Now assume that all investors pay tax of 30% on dividends and nothing on capital gains.
What is the likely fall in the stock price?
d. Suppose, finally, that everything is the same as in part (c), except that security dealers
pay tax on both dividends and capital gains. How would you expect your answer to (c) to
change? Explain.
Answer:
a) The stock price will fall to reflect this dividend payment on the ex-dividend date.

b) The stock price will fall by $1.

c) The stock price will fall by the after-tax dividend, i.e., by $1 (1-0.3) = $0.70, so that the after-
tax return on dividends and capital gains are the same. To see this more clearly, suppose the
stock price is 10 before the dividends is paid. If you buy the stock right before the dividend is
paid and sell it right after, your net profit should be essentially zero since you have held the stock
for a small amount of time. Here are your cash flows:
 buy now: -10.00
 dividend: + 1.00
 tax on dividend: -0.30
 sell after dividend: S (to be found)

So, the sum of all these cash flows should be zero:

-10+1-0.30+S=0

S= 9.30

The stock price fell by $10.00-$9.30= $0.70.

d) In this case, there should be no tax effects, i.e., the stock price will fall by $1. To better see
this, suppose you buy the stock (for $10, say) right before the dividend is paid, and sell it right
after the dividend is paid. Because you hold the stock for a small amount of time (a second, say),
your net profit should be zero. You pay $10 for the stock; you receive $1 as a dividend which is
taxed at 30%; then you sell it for S (To be found) and pay taxes of 30%*(S-10) on your capital
gains (which are going to be negative here).

So, your net profit is,

-10+ (1-0.30) +S-0.30 (S-10) =0

Solving for S, we find S=9. So, the change in S is $10-$9=$1

Question 20

Firms A and B are both unlevered. The shares of both companies are currently trading at $100,
and both offer an annual pre-tax return of 10%. In the case of firm A, the return is entirely in the
form of a dividend yield (i.e., the company pays a regular annual dividend of $10 a share). In the
case of firm B, the return comes entirely as capital gain (the shares appreciate by 10% a year).
Suppose that an investor buys a share of each firm today, and plans to sell them in 10 years.
Suppose that dividends and capital gains are both taxed at 30%.

a. What is the annual after-tax yield (rate of return) on firm A’s share over the 10-year period?

b. What is the annual after-tax yield (rate of return) on firm B’s share over the 10-year period?

Answer:

a. Every year, the investor receives $10, which is taxed at 30%. So, after taxes, the investor
receives $7 each year. At the end of year 10, the investor will sell his share of firm A for
$100, and so will not have any capital gain. His annual after-tax return on his $100, is
therefore 7/100=7%
b. The investor will not receive any money until year 10, at which point he will sell his
share of firm B for 100(1.1010 ¿ = 259.37. The capital gains of 259.37-100 = 159.37 will
then be taxed at 30%. Therefore, the annual after-tax rate of return r satisfies

259.37−0.30 (159.37 )
( 1+r )10=
100

 r = 7.781%