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CHAPTER 13 DIVIDEND POLICY ANSWERS

13-1

a.Dividend policy refers to the decision to pay out earnings or to retain and reinvest them in the firm. There are three elements to dividend policy: (1) what fraction of earnings should be paid out, on average, over time; (2) whether the firm should maintain a stable dividend growth rate or vary its dividend payments from year to year based on its internal needs for cash; and (3) the dollar amount the firm should pay in current dividends. b. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm's stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world. c. The "bird-in-the-hand" theory assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains because the dividend yield component, D1/P0, is less risky than the g component in the total expected return equation ^s = D1/P0 + g. k d. The tax preference theory proposes that investors prefer capital gains over dividends, because capital gains taxes can be deferred into the future and are taxed at a maximum rate of 28 percent, while taxes on dividends must be paid as the dividends are received and are taxed at rates as high as 39.6 percent. e. The residual dividend model states that firms should pay dividends only when more earnings are available than needed to support the optimal capital budget. f. Constraints on dividend policy are those factors, uncontrollable by the firm, that restrict the firm's dividend policy. Five major constraints are (1) bond indentures, (2) impairment of capital rule, (3) cash availability, (4) the penalty tax on improperly accumulated earnings, and (5) preferred stock restrictions. g. The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low dividends will attract a clientele with little need for current income, and who often have high marginal tax rates. h. The information content of dividends is a theory which holds that investors regard dividend changes as "signals" of management forecasts. Thus, when dividends are raised, this is viewed by investors as recognition by management of future earnings increases. Therefore, if a firm's stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. i. An extra dividend is a dividend paid, in addition to the regular dividend, when earnings permit. Firms with volatile earnings may have a low regular dividend that can be maintained even in low-profit (or high capital investment) years, and then supplement it with an extra dividend when excess funds are available. j. The ex-dividend date is the date when the right to the dividend leaves the stock. This date was established by stockbrokers to avoid confusion and is 4 business days prior to the holder of record date. If the stock sale is made prior to the ex-dividend date, the dividend is paid to the buyer. If the stock is bought on or after the ex-dividend date, the dividend is paid to the seller. k. Dividend reinvestment plans allow stockholders to automatically purchase shares of common stock of the paying corporation in lieu of receiving cash dividends. There are two types of plans--one involves only stock that is already outstanding, while the other involves newly issued stock. In the first type, the dividends of all participants are pooled and the stock is purchased on the open market. Participants benefit from lower transaction costs. In the second type, the company issues new shares to the participants. Thus, the company issues stock in lieu of the cash dividend. l. In a stock split, current shareholders are given some number (or fraction) of shares for each stock owned. Thus, in a 3-for-1 split, each shareholder would receive 3 new shares in exchange for each old share, thereby tripling the number of shares outstanding. Stock splits usually occur when the stock price is outside of the

Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 13 - 1

m.

optimal trading range. Stock dividends also increase the number of shares outstanding, but at a slower rate than splits. In a stock dividend, current shareholders receive additional shares on some proportional basis. Thus, a holder of 100 shares would receive 5 additional shares at no cost if a 5 percent stock dividend were declared. Stock repurchases occur when a firm repurchases its own stock. These shares of stock are then referred to as treasury stock. The higher EPS on the now decreased number of shares outstanding will cause the price of the stock to rise and thus capital gains are substituted for cash dividends.

13-2

The way this question is worded, the decision would have to be made on an individual basis. In our opinion, investors who intend to invest in companies that maintain a relatively high payout are probably seeking income and would prefer to receive a stable dollar dividend per share. Investors who are not seeking current income would probably, over the long run, seek companies that retain a relatively large percentage of their earnings. These investors would probably not be particularly concerned about whether or not the company paid a stable dividend. They would, of course, be concerned with earnings and the trend in earnings.

13-3

a.From the stockholders' point of view, an increase in the personal income tax would make it more desirable for a firm to retain and reinvest earnings. Consequently, an increase in personal tax rates should lower the aggregate payout ratio. An increase in the corporate tax rate would, other factors held constant, reduce the amount of after-tax earnings available for dividends. Even though the amount of dividends would decrease, the payout ratio would probably remain constant, or even increase if management does not reduce the dividend amount in proportion to the reduction in after-tax earnings. b. If the depreciation charges were raised, the rise would tend to reduce reported profits vis-à-vis cash flows, because most firms set up a reserve for deferred taxes, that is, "normalize" reported profits. 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, reduce redundant cash flows, 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. If interest rates were to increase, the increase would make retained earnings a relatively attractive way of financing new investment. Consequently, the payout ratio might be expected to decline. d. A permanent increase in profits would probably lead to an increase in dividends, but not necessarily to an increase in the payout ratio. If 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. If investment opportunities for firms declined while cash inflows remained relatively constant, the payout ratio would most likely increase. f. A lowering of the capital gains tax rate would make capital gains more attractive to tax-paying investors. Thus, aggregate payout ratios would probably decline.

13-4

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 capitalization rates (required returns) 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, for example, a regular dividend plus extras. On balance, it would appear desirable for directors to announce their policies.

13-5

It is sometimes argued that there is an optimum price for a stock, that is, a price at which ks will be minimized, giving rise to a maximum price for any given earnings. If a

__________________________________________________ Chapter 13 - 2 ANSWERS __________________________________________________ Copyright © 1996 by The Dryden Press. All rights reserved.

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 P/E ratio. Others argue that stockholders simply like stock dividends and/or splits for psychological or some other reasons. If stockholders do like stock dividends, using them would have the effect of keeping P/E ratios high. Finally, it has been argued (by Barker) that increases in the number of shareholders accompany stock dividends and stock splits. One could, of course, argue that no causation is shown in this relationship. In other words, it could be that growth in ownership and stock splits are both functions of yet another variable.

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The difference is largely one of accounting. In the case of a split, the firm simply increases the number of shares and simultaneously reduces the par or stated value (if one is given) per share. In the case of a stock dividend, there must be a transfer from earned surplus to capital stock. For most firms, a 100 percent stock dividend and a 2-for-1 split accomplish exactly the same thing; hence, investors may choose either one.

13-7

While it is true that the cost of outside equity is generally 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 price of the firm's stock because investors may view the cut as a negative signal from management. If investors lived in the world of certainty and rationality postulated by Miller and Modigliani, then the statement in the question would be true, but it is not necessarily true in an uncertain world.

13-8

Logic suggests that stockholders like stable, or steadily increasing, dividends--many of them depend on dividend income, and if dividends were cut, this might cause serious hardship. If 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.

13-9

If a firm is retaining earnings, then presumably these retained earnings are reinvested and provide for growth in earnings and dividends. If the firm cuts prices or increases wages (and thus reduces profits) sufficiently and eliminates retained earnings, then certainly the price of the stock would fall. So while it could finance growth by selling new stock, this new stock would necessarily be sold at lower prices; hence, the old stockholders would suffer severe economic losses. Accordingly, it does not follow that, simply because a firm retains earnings, its profits are too high. Of course, profits could be too high in the sense that the firm could be earning a monopoly profit, but the determination of that fact is not necessarily related to dividends and retained earnings.

13-10

It is true that executives' salaries are more highly correlated with size of 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 size of the firm increase whether or not this is optimal from the stockholders' point of view. In terms of text Figure 13-3, the further down the IOS schedule the firm goes, the larger the investment during any given year, so the larger the firm will become. Accordingly, a firm whose management is interested in maximizing the size of the firm rather than the value of the existing common stock might push investments down the IOS schedule past the point where it intersects the cost of capital schedule. In other words, management might invest to a point where the marginal return on new investment is less than the marginal cost of capital. If the firm does invest to a point where the return on investment is less than the cost of capital, the price of the stock must fall below what it otherwise would have been.

Copyright © 1996 by The Dryden Press. All rights reserved. Chapter 13 - 3

Stockholders would be given additional benefits from the higher retained earnings, and this might well push up the price of the stock, 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.

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A high dividend payout policy may reduce agency costs incurred by the firm's investors, because it forces the firm's management to go to the capital markets more often, thus exposing them to periodic outside scrutiny by investment bankers, rating agencies, and security analysts.

SOLUTIONS

a.MM argue that dividend policy has no effect on ks, and hence no effect on firm value and cost of capital. On the other hand, GL argue that investors view current dividends as being less risky than potential future capital gains. Thus, GL claim that ks is inversely related to dividend payout. See text Figure 13-2 for a graphic representation of the two positions.

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b. The tax preference model supports the view that since capital gains are effectively taxed at lower rates than dividend income, investors value capital gains more highly than dividends. Thus, the tax preference model states that ks is directly related to dividend payout. Unfortunately, empirical tests have failed to offer overwhelming support for any one of the three dividend theories. MM 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 ks. MM'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 prices, as well as raise them, depending on how well the dividend increase matches expectations. Thus, a bias towards price increases with dividend increases supports GL. Since there are clienteles which prefer different dividend policies, MM could argue that one policy is as good as another. But, if the clienteles are of differing sizes or economic means, the clienteles might not be equal, and one dividend policy may be preferential to another.

c. d.

e.

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a.The residual dividend model 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 model, is a function of the firm's investment opportunities. See Figure 13-5 in the text for a graphical depiction. b. No. The residual model implies that the dividend payout will be zero in some years. Thus, to support any dividend at all, the firm would have to increase its external financing, thus negating the lower cost of the residual model. c. A more shallow plot implies that changes from the optimal capital structure have little effect on the firm's cost of capital, and hence value. In this situation, dividend policy is less critical than if the plot were V-shaped; thus, a firm with a shallow cost of capital plot should be more inclined to use the residual dividend model. d. The steeper the slope of the IOS, the more costly is a failure to follow the residual model. Thus, the firm that reduced its annual dividend (followed the residual model) had the steeper IOS.

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________________________________________ Chapter 13 - 4 _________________________________________ SPREADSHEET APPLICATIONS Copyright © 1996 by The Dryden Press. All rights reserved.

Stock prices rose significantly in 1983; thus, many firms' stock prices rose above the "optimal" $20-$80 range. Firms were then inclined to use stock splits or dividends to return stock prices to the range where firm value is supposedly maximized.

13-4

a. Projected net income $2,000,000 Less: Projected capital investments800,000 _________ Available residual $1,200,000 Shares outstanding 200,000 DPS = $1,200,000/200,000 shares = $6 = D1. EPS = $2,000,000/200,000 shares = $10. Payout ratio = DPS/EPS = $6/$10 = 60%, or Total dividends/NI = $1,200,000/$2,000,000 = 60%.

b.

c.

$6 $6 D1 = ^ = = $66.67. 0 P0 = ks - g 0.14 - 0.05 0.09

Under the former circumstances, D1 would be equal to the 20 percent payout on $10 EPS, or $2. With ks = 14% and g = 12%, the intrinsic value is $100 per share:

$2 $2 D1 ^ = = = $100.00. 0 P0 = ks - g 0.14 - 0.12 0.02

Although the firm has suffered a severe setback, its existing assets will continue to provide a good income stream. More of these earnings should now be passed on to the shareholders, as the slowed internal growth has reduced the need for funds. However, the net result is a 33 percent decrease in the value of the shares.

13-5

$16,500,000(0.5) = $8,250,000 available for dividends:

$8,250,000 = $4 /share . 0 2,062,500 shares

Assuming no repurchase: Value = $32 + $4 = $36/share.

Assuming repurchase of 187,500 shares from Greg Beaumont: $32(187,500 shares) = $6,000,000. Dividends:$8,250,000 - $6,000,000 = $2,250,000.

$2,250,000 = $1.20 /share . 0 1,875,000

New EPS: $16,500,000/1,875,000 = $8.80. P/E = Price per share/$8.80 = 4. 4($8.80) = $35.20/share. Value = $35.20 + $1.20 = $36.40/share. The firm should purchase Beaumont's stock because the stockholders will be $0.40 better off.

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SPREADSHEET APPLICATIONS Copyright © 1996 by The Dryden Press. All rights reserved.

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