CHAPTER 17

Dividend Policyand Internal Financing

CHAPTER ORIENTATION

In determining the firm's dividend policy, two issues are important: the dividend payout ratio and the stability of the dividend payment over time. In this regard, the financial manager should consider the investment opportunities available to the firm and any preference that the company's investors have for dividend income or capital gains. Also, stock dividends, stock splits, or stock repurchases can be used to supplement or replace cash dividends.

CHAPTER OUTLINE

I. The trade-offs in setting a firm's dividend policy

A. If a company pays a large dividend, it will therefore:

1. Have a low retention of profits within the firm.

2. Need to rely heavily on a new common stock issue for equity financing.

B. If a company pays a small dividend, it will therefore:

1. Have a high retention of profits within the firm.

2. Will not need to rely heavily on a new common stock issue for equity financing. The profits retained for reinvestment will provide the needed equity financing.

II. Impact of Dividend Policy on Stock Price

A. The importance of a firm's dividend policy depends on the impact of the dividend decision on the firm's stock price. That is, given a firm's capital budgeting and borrowing decisions, what is the impact of the firm's dividend policies on the stock price?

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B. Three views about the importance of a firm's dividend policy.

1. View 1: Dividends do not matter

a. Assumes that the dividend decision does not change the firm's capital budgeting and financing decisions.

b. Assumes perfect capitals markets, which means:

(1) There are no brokerage commissions when investors buy and sell stocks.

(2) New securities can be issued without incurring any flotation costs.

(3) There are no personal or corporate income taxes.

(4) Complete information about the firm is free and equally readily available to all investors.

(5) There are no conflicts of interest between management and stockholders.

(6) Financial distress and bankruptcy costs are nonexistent.

c. Under the foregoing assumptions, it may be shown that the market price of a corporation's common stock is unchanged under different dividend policies. If the firm increases the dividend to its stockholders, it has to offset this increase by issuing new common stock in order to finance the available investment opportunities. If on the other hand, the firm reduces its dividend payment, it has more funds available internally to finance future investment projects. In either policy, the present value of the resulting cash flows to be accrued to the current investors is independent of the dividend policy. By varying the dividend policy, only the type of return is affected (capital gains versus dividend income), not the total return.

2. View 2: High dividends increase stock value

a. Dividends are more predictable than capital gains because management can control dividends, while they cannot dictate the price of the stock. Thus, investors are less certain of receiving income from capital gains than from dividend income. The incremental risk associated with capital gains relative to dividend income should therefore cause us to use a higher required rate in discounting a dollar of capital gains than the rate used for discounting a dollar of dividends. In so doing, we would give a higher value to the dividend income than we would the capital gains.

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b. Criticisms of view 2.

(1) Since the dividend policy has no impact on the volatility of the company's overall cash flows, it has no impact on the riskiness of the firm.

(2) Increasing a firm's dividend does not reduce the basic riskiness of the stock; rather, if dividend payment requires management to issue new stock, it only transfers risk and ownership from the current owners to the new owners.

3. View 3: Low dividends increase value

Stocks that allow us to defer taxes (low dividends-high capital gains) will possibly sell at a premium relative to stocks that require us to pay taxes currently (high dividends-low capital gains). Only then will the two stocks provide comparable after-tax returns, which suggests that a policy to pay low dividends, will result in a higher stock price. That is, high dividends hurt investors, while low dividends-high retention help the firm's investors.

But wait, then came 2003 and Congress again felt the need to change the tax code as it pertained to both dividend income and capital gains income. On May 28 President Bush signed into law the “Jobs and Growth Tax Relief Reconciliation Act of 2003.” Recall that part of the impetus for this Act was the recession 2001.

In a nutshell this 2003 Act lowered the top tax rate on dividend income to 15 percent from a previous top rate of 38.6 percent, and also lowered the top rate paid on realized long-term capital gains to the same 15 percent from a previous 20 percent. Thus, you can see that the so-called investment playing field was (mostly) leveled for dividend income relative to qualifying capital gains. This rather dramatic change in the tax code will immediately remind you of Principle 8: Taxes Bias Business Decisions. In effect, a major portion of the previous bias against paying cash dividends to investors was mitigated. But, not all of it.

C. Additional thoughts about the importance of a firm's dividend policy.

1. Residual dividend theory: Because of flotation costs incurred in issuing new stock, firms must issue a larger amount of securities in order to receive the amount of capital required for investments. As a result, new equity capital will be more expensive than capital raised

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through retained earnings. Therefore, financing investments internally (and decreasing dividends) instead of issuing new stock may be favored. This is embodied in the residual dividend theory, where a dividend would be paid only when any internally generated funds remain after financing the equity portion of the firm's investments.

2. The clientele effect: If investors do in fact have a preference between dividends and capital gains, we could expect them to seek out firms that have a dividend policy consistent with these preferences. They would in essence "sort themselves out" by buying stocks which satisfy their preferences for dividends and/or capital gains. In other words, there would be a "clientele effect," where firms draw a given clientele based on their stated dividend policy. However, unless there is a greater aggregate demand for a particular policy than is being satisfied in the market, dividend policy is still unimportant, in that one policy is as good as the other. The clientele effect only tells us to avoid making capricious changes in a company's dividend policy.

3. Information effect.

a. We know from experience that a large, unexpected change in dividends can have significant impact on the stock price. Despite such "evidence," it is not unreasonable to hypothesize that dividend policy only appears to be important, because we are not looking at the real cause and effect. It may be that investors use a change in dividend policy as a signal about the firm's "true" financial condition, especially its earning power.

b. Some would argue that management frequently has inside information about the firm that it cannot make available to the investors. This difference in accessibility to information between management and investors, called information asymmetry, may result in a lower stock price than would be realized if we had conditions of certainty. Dividends become a means in a risky marketplace to minimize any "drag" on the stock price that might come from differences in the level of information available to managers and investors.

4. Agency costs: Conflicts between management and stockholders may exist, and the stock price of a company owned by investors who are separate from management may be less than the stock value of a closely-held firm. The difference in price is the cost of the conflict to the owners, which has come to be called agency costs. A firm's dividend policy may be perceived by owners as a tool to minimize agency costs. Assuming the payment of a dividend requires management to issue stock to finance new investments, then new investors will be attracted to the company only if management

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provides convincing information that the capital will be used profitably. Thus, the payment of dividends indirectly results in a closer monitoring of management's investment activities. In this case, dividends may provide a meaningful contribution to the value of the firm.

5. Expectations theory: As the time approaches for management to announce the amount of the next dividend, investors form expectations as to how much the dividend will be. When the actual dividend decision is announced, the investor compares the actual decision with the expected decision. If the amount of the dividend is as expected, even if it represents an increase from prior years, the market price of the stock will remain unchanged. However, if the dividend is higher or lower than expected, the investors will reassess their perceptions about the firm and the value of the stock.

D. The empirical evidence about the importance of dividend policy

1. Statistical tests. To test the relationship between dividend payments and security prices, we could compare a firm's dividend yield (dividend/stock price) and the stock's total return, the question being, "Do stocks that pay high dividends provide higher or lower returns to the investors?" Such tests have been conducted using a variety of the most sophisticated statistical techniques available. Despite the use of these extremely powerful analytical tools involving intricate and complicated procedures, the results have been mixed. However, over long periods of time, the results have given a slight advantage to the low-dividend stocks; that is, stocks that pay lower dividends appear to have higher prices. The findings are far from conclusive, however, owing to the relatively large standard errors of the estimates.

2. Reasons for inconclusive results from the statistical tests.

a. To be accurate, we would need to know the amount of dividends investors expect to receive. Since these expectations cannot be observed, we can only use historical data, which may or may not relate to expectations.

b. Most empirical studies have assumed a linear relationship between dividend payments and stock prices. The actual relationship may be nonlinear, possibly even with discontinuities in the relationship.

3. Since our statistical prowess does not provide us with any conclusive evidence, researchers have surveyed financial managers about their perceptions of the relevance of dividend policy. In such surveys, the evidence favors the relevance of dividend policy, but not just overwhelming so. For the most part, managers are divided between believing that dividends are important and having no opinion in the matter.

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E. Conclusions about the importance of dividend policy

1. As a firm's investment opportunities increase, the dividend payout ratio should decrease.

2. The firm's dividend policy appears to be important; however, appearances may be deceptive. The real issue may be the firm's expected earnings power and the riskiness of these earnings.

3. If dividends influence stock price, it probably comes from the investor's desire to minimize and/or defer taxes and from the role of dividends in minimizing agency costs.

4. If the expectations theory has merit, which we believe it does, it behooves management to avoid surprising the investors when it comes to the firm's dividend decision.

III. Dividend policy decisions

A. Other practical considerations

1. Legal restrictions

a. A corporation may not pay a dividend

(l) if the firm's liabilities exceed its assets

(2) if the amount of the dividend exceeds the accumulated profits (retained earnings)

(3) if the dividend is being paid from capital invested in the firm

b. Debtholders and preferred stockholders may impose restrictive provisions on management, such as common dividends not being paid from earnings prior to the payment of interest or preferred dividends.

2. Liquidity position: The amount of a firm's retained earnings and its cash position are seldom the same. Thus, the company must have adequate cash available as well as retained earnings to pay dividends.

3. Absence or lack of other sources of financing: All firms do not have equal access to the capital markets. Consequently, companies with limited financial resources may rely more heavily on internally generated funds.

4. Earnings predictability: A firm that has a stable earnings trend will generally pay a larger portion of its earnings in dividends. If earnings fluctuate significantly, a larger amount of the profits may be retained to ensure that enough money is available for investment projects when needed.

5. Ownership control: For many small firms, and certain large ones, maintaining the controlling vote of common stock is very important. These owners would prefer the use of debt and retained profits to finance new investments rather than to issue new stock.

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6. Inflation: Because of inflation, the cost of replacing equipment has increased substantially Depreciation funds tend to become insufficient. Hence, greater profit retention may be required.

B. Alternative dividend policies

1. Constant dividend payout ratio: The percentage of earnings paid out in dividends is held constant. Therefore, the dollar amount of the dividend fluctuates from year to year.

2. Stable dollar dividend per share: Relatively stable dollar dividend is maintained. The dividend per share is increased or decreased only after careful investigation by the management.

3. Small, regular dividend plus a year-end extra: Extra dividend is paid out in prosperous years. Management's objective is to avoid the connotation of a permanent dividend increase.

C. Basis for stable dividends

1. Stable dividend policy is most common of the three options.

2. Managers were found to be reluctant to change the amount of the dividend, especially when it came to decreasing the amount.

3. Increasing-stream hypothesis of dividend policy states that dividend stability is a smoothing of the dividend stream to minimize the effect of other types of company reversals.

a. Corporate managers attempt to have a gradually increasing dividend over the long-term.

b. If dividend reduction is necessary, it should be large enough to reduce the probability of future cuts.

D. Dividend policy and corporate strategy: Things will change—even dividend policy.

1. The recessions of 1990 to 1991 and 2001 induced a large number of American corporations to revisit their broadest corporate strategies, including adjusting dividend policies.

2. One firm that altered its dividend policy in response to new strategies was the W.R. Grace & Co., headquartered in Columbia, Maryland.

3. Table 17-5 in the text reviews W.R. Grace’s actual dividend policies over the 1992 to 1996 time frame. The firm’s payout ratio and the absolute amount of the cash dividend paid per share declined in a significant fashion over this period.

IV. Dividend payment procedures

A. Dividends are generally paid quarterly.

B. The declaration date is the date on which the firm's board of directors announces the forthcoming dividends.

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C. The date of record designates when the stock transfer books are to be closed. Investors who own stock on this date are entitled to the dividend.

D Brokerage firms terminate the right of ownership to the dividend two working days prior to the date of record. This date is called the ex-dividend date.

E. Dividend checks are mailed on the payment date.

V. Stock dividends and stock splits

A. Both a stock dividend and a stock split involve issuing new shares of stock to current stockholders.

B. The investor’s percentage ownership in the firm remains unchanged. The investor is neither better nor worse off than before the stock split/dividend.

C. On an economic basis there is no difference between a stock dividend and a stock split.

D. For accounting purposes, the stock split has been defined as a stock dividend exceeding 25 percent of the number of shares currently outstanding.

E. Accounting treatment

1. For a stock dividend, the dollar amount of the dividend is transferred from retained earnings to the capital accounts (par and paid-in capital).

2. In the case of a split, the dollar amounts of the capital accounts do not change. Only the number of shares is increased while the par value of each share is decreased proportionately.

F. Rationale for a stock dividend or split

1. Shareholders benefit because the price of stock may not fall precisely in proportion to the share increase; thus, the stockholders' value is increased.

2. If a company is encountering cash problems, it can substitute a stock dividend for a cash dividend. Investors will probably look beyond the stock dividend to determine the underlying reasons for conserving cash.

VI. Stock repurchases

A. A number of benefits exist justifying stock repurchases instead of dividend payments. Included in these are:

1. to provide an internal investment opportunity

2. to modify the firm's capital structure

3. to impact earnings per share, thus increasing stock price

B. Share repurchase as a dividend decision

1. A firm may decide to repurchase its shares, increasing the earnings per share, which should be reflected in a higher stock price.

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2. The investor's choice

a. For tax purposes, the investor may prefer the firm to repurchase stock in lieu of a dividend. Dividends formerly were taxed as ordinary income, whereas any price appreciation resulting from the stock repurchase would be taxed as a capital gain, and can be deferred until the gain is realized.

b. The investor may prefer dividend payment because

(l) Dividends are viewed as being more dependable than stock repurchases.

(2) The price the firm must pay for its stock may be too high.

(3) Riskiness of the firm's capital structure may increase, lowering the P/E ratio and thus the stock price.

C. Financing or investment decision

1. A stock repurchase effectively increases the debt-equity ratio towards higher debt, thus repurchase is viewed as a financing decision.

2. When buying its own stock at depressed prices, a firm may consider the repurchase as an investment decision. However, this action is not a true investment opportunity; buying its own stock does not provide the expected returns as other investments do.

D. The repurchase procedure

1. A public announcement should be made detailing the amount, purpose and procedure for the stock repurchase.

2. Open market purchase – stock is bought at the current market price.

3. Tender offer - more formal offer where offer for stock is at a specified price, usually above current market price.

4. Negotiated basis - repurchasing from specific, major shareholders at a negotiated price.

VII. The Multinational firm: The Case of Low Dividend Payments

A. During economic prosperity, multinational firms look to international markets for high net present value projects.

1. This provides diversification of country-related economic risks.

2. Firm can achieve cost advantages over its competitors.

B. U.S. multinational firms favor the UK and Canada for direct investments.

C. U.S. multinational firms concentrate investments in manufacturing industries when investing internationally.

1. Firms can achieve lower labor costs by employing workers in a foreign country.

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2. Lower labor costs improve a firm’s competitive position.

VIII. How Financial Managers Use This Material

A. In the text, actual examples of dividend policy in action are presented that deal with Coca-Cola and the Walt Disney Company.

B. And we are reminded that the differential tax treatment of cash dividends as opposed to capital gains can give investors a preferential tax advantage when shares are repurchased, as the capital gains can be deferred. This is not possible with the receipt of cash dividends. The income tax has to be paid in the year that the dividends are actually received by the investor.

ANSWERS TOEND-OF-CHAPTER QUESTIONS

17-1. The dividend payout ratio indicates the amount of dividends paid relative to the earnings available to common stockholders, or dividend-per-share divided by earnings-per-share.

17-2. A firm's net profits are used to pay dividends and/or to finance new investments. As larger dividends are paid, the retained earnings available for reinvestment are reduced. Conversely, as a larger amount of profits is reinvested, the capital available for common stockholders' dividends is reduced.

17-3. (a) In a perfect market, there are no brokerage commissions, no flotation costs, no taxes, no information content assigned to a particular dividend policy, complete information about a firm is available to every investor, no conflicts of interest between management and stockholders and financial distress and bankruptcy costs are nonexistent..

(b) A firm's dividend policy is irrelevant in a perfect market. Management may choose between retaining profits and paying dividends without affecting the value of the firm's security. Therefore, the only wealth-creating activities in a perfect market are management's investment and financing decisions.

17-4. The existence of flotation costs eliminates the indifference between financing by internal capital and new stock. Financing investments through retained earnings will be preferred to avoid flotation costs and capital leakage. If no other perfect market assumptions have been relaxed, new stock would be issued only after internally generated funds have been exhausted.

17-5. (a) According to the residual dividend theory, dividends are paid only if retained earnings are available after financing all acceptable investments.

(b) This theory may not be feasible in the short term because the year-to-year variability in dividend payments is undesirable. The theory can be used in the long term if management projects financing needs for several years. A target dividend payout ratio for this planning horizon can be established that will distribute the residual capital smoothly over the period.

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17-6. Taxes on dividend income are paid when the dividend is received, while taxes on capital gains are deferred until the stock is actually sold.

17-7. Statutory restrictions prevent a corporation from paying dividends if its liabilities exceed its assets, the amount of the dividend exceeds retained earnings, or the dividend is being paid from capital invested in the firm.

The restrictions in debt and preferred stock contracts may also limit dividends. These contract provisions may stipulate that dividends are not to be paid from earnings prior to the debt payment. Also, a certain amount of working capital may be required. Finally, if any preferred dividends have gone unpaid, a provision may restrict payment of common dividends.

17-8. Dividends are paid with cash. If there is little or no cash available, the firm will be unable to pay dividends.

17-9. For many smaller companies, maintaining voting control of the common stock is very important. Issuing new stock is unattractive to these firms if it results in a dilution of the control of the current stockholders. Financing by debt and through profits will be preferred. Thus, the firm's growth is limited to the amount of debt capital available and the company's ability to generate profits.

17-10. (a) Corporate managers are reluctant to change dividends without being confident that the change is reflective of the company's long-term earnings prospects. This is why most managers avoid a change in dividends in response to temporary fluctuations in earnings and are especially reluctant to make a dividend cut. They would prefer instead to develop a gradually increasing dividend series over time. This smoothing of the dividend stream is done in an effort to minimize the effect of other types of company reversals.

(b) Investors also prefer a stable dividend policy because they perceive a change in the dividend payment to reflect management's view of the firm's long-term earnings prospects. Also, many investors rely upon dividends for current income, and this need is best satisfied by the stable dividend. Another reason for the popularity of the stable dividend is the requirement of many states that financial institutions invest only in companies with a regular dividend payment.

17-11. The declaration date is the date that the dividend is formally authorized by the board of directors. Investors shown to own the stock on the date of record receive the dividends. The ex-dividend date is two days prior to the record date. This date was set by stock brokerage companies as the date when the right of ownership to the dividend is terminated.

17-12. The stockholder is benefited only if the price of the stock does not fall in direct proportion to the number of new shares issued. An advantage to the corporation is the conservation of cash for investment opportunities.

17-13. A stock repurchase might be used by a firm to provide an alternative to cash dividends, to provide an "internal" investment opportunity, to alter the firm's capital structure, or any of a variety of other reasons stemming from a reduction of the number of shares outstanding.

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SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

17-1A. Dividend Policiesa. Constant payout ratio of 40%

Year $ Dividend Profits × payout/shares1 0.40 1,000,000 × 0.4 / 1,000,0002 0.80 2,000,000 × 0.4 / 1,000,0003 0.64 1,600,000 × 0.4 / 1,000,0004 0.36 900,000 × 0.4 / 1,000,0005 1.20 3,000,000 × 0.4 / 1,000,000

b. Stable target payout of 40%

Target dividend = = 0.68

c. Small regular dividend of $0.50 plus year-end extra

Base profits: 1,500,000

% of extra profits: 50%

Year $ Dividend Payout Calculation1 0.50 0.502 0.75 0.5 + [(2,000,000 – 1,500 000 * 0.5 / 1,000,000]3 0.55 0.5 + [(1,600,000 -,1,500,000) * 0.5 / 1,000,000]4 0.50 0.505 1.25 0.5 + [(3,000,000 – 1,500,000) * 0.5 / 1,000,000]

17-2A. Number of shares to be issued:

= 95,238 shares

Dollar size of the issue:

95,238 shares x $120 = $11,428,560

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17-3A. Flotation Costs and Issue Size

Flotation costs 0.18Stock price $85.00Net to firm $5,800,000

Dollar issue size = $ 7,073,171 = $5,800,000/(1-.18)

Number of shares = $ 7,073,171 ÷ $85/share83,214 shares

17-4A. Terra Cotta - Residual Dividend Theory

Total financing needed $640,000Retained earnings $400,000Debt ratio 0.4Equity ratio 0.6Equity financing needed $384,000 = $640,000(.6)Dividends $ 16,000 = $400,000 - $384,000

17-5A. RCB - Stock Dividend

Before dividendShares outstanding 2,000,000Net income $ 550,000Price/Earnings 10Stock dividend 20%Investor's share 100

Current price $ 2.75= P/E x EPS = 10 ×

Value before dividend $ 275.00 = $2.75 x 100 shares

After dividendShares outstanding 2,400,000 = 2,000,000 x (1 + 0.2)New price $2.29 = P/E x EPS=10 x

Investor's shares 120 = 100 x 1.2Value after dividend $ 275.00 = 120 x $2.29

Change $ 0.00 = $275 (before)- $275 (after)

The value of the investors' holdings does not change because the price of the stock reacted fully to the increase in the shares outstanding.

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17-6A. Harris, Inc. - Dividends in Perfect Markets

Dividend PlansYear Plan A Plan B1996 $ 2.50 $ 4.251997 $ 2.50 $ 4.751998 $45.75 $40.66

Required rate of return 0.18

Value stock A $31.76 =

Value stock B $31.76 =

a. There is no effect on the value of the common stock.b. An investor's preference for current income, tax consequences, informational

content, and transaction costs may change your answer.

17-7A. Stetson Manufacturing, Inc. - Long Term Dividend Policy

Debt ratio 0.35Equity ratio 0.65Shares outstanding 100,000

(A) (B) (C)Equity

Funds Available ContributionYear Investment Internally (A x .65)

1 $ 350,000 $ 250,000 $ 227,5002 475,000 450,000 308,7503 200,000 600,000 130,0004 980,000 650,000 637,0005 600,000 390,000 390,000

$2,340,000 $1,693,250a. Residual Dividend

Year Dividend =

1 $0.2252 $1.413 $4.704 $0.135 $0.00

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b. Target Dividend = $1.29 =

c. The target dividend allows for consistency of income to the stockholder and income in all years whereas the year-to-year dividend would not pay a dividend in year five.

17-8A. Trexco Corporation - Stock Split

Market price $ 98.00Split multiple 2Shares outstanding 25,000

a. You own 0.05 x 25,000Investor's shares = 1,250Position before split $122,500 = 1,250 Shares x $98 per share

Price after split $ 49.00 = $98 ÷ 2Your shares after split 2,500 = 1,250 x 2Position after split $122,500 = 2,500 shares x $49 per shareNet gain $ 0

b. Price fall 0.4Price after split $ 58.80 = $98.00 (1 - .4)Position after split $147,000 = 2,500 Shares x $58.80 per shareNet gain $ 24,500 = $147,000 - $122,500

17-9A. Crystal Cargo, Inc. - Dividend Policies

Year Profits After Taxes1 $1,400,0002 2,000,0003 1,860,0004 900,0005 2,800,000

Total Profits After Taxes $8,960,000

Shares Outstanding 1,000,000

a. Constant Payout Ratio of 50%

Year Dividend = Profits x Payout Ratio ÷ Shares1 $0.70 = $1,400,000 (.5) ÷ 1,000,0002 $1.00 = $2,000,000 (.5) ÷ 1,000,0003 $0.93 = $1,860,000 (.5) ÷ 1,000,0004 $0.45 = $ 900,000 (.5) ÷ 1,000,0005 $1.40 = $2,800,000 (.5) ÷ 1,000,000

b. Stable target payout of 50%

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Target dividend = $0.90 =

c. Small regular dividend of $0.50 plus year-end extra

Base profits $1,500,000% of extra profits 50%

Year Dividend1 0.502 0.75 = .50+[($2,000,000-$1,500,000)(.5)/1,000,000]3 0.68 = .50+[($1,860,000-$1,500,000)(.5)/1,000,000]4 0.505 1.15 = .50+[($2,800,000-$1,500,000)(.5)/1,000,000]

17-10A. Dunn Corporation - Repurchase of Stock

Proposed dividend $ 500,000Shares outstanding 250,000Earnings per share $ 5.00Ex-dividend price $ 50.00Proposed dividend/share $2.00

a. Repurchase price $ 52.00 = $50 + $2

b. Number of shares repurchased 9,615 = $500,000 ÷ ($50 + $2)

c. The capital gains to be received by the stockholder would not be equal to the intended dividend, thus resulting in a dollar benefit or loss to the stockholders.

d. Unless you have a need for current income, you would probably prefer the stock repurchase plan.

17-11A. Number of shares to be issued

= 163,743 share

Dollar size of the issue

163,743 shares x $95 = $15,555,585

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17-12A. Martinez, Inc. - Residual Dividend Theory

Total financing needed $1,200,000Retained earnings $450,000Debt ratio 0.70Equity ratio 0.30Equity financing needed $360,000 = $1,200,000 (0.30)**Dividends** $ 90,000 = $450,000 - $360,000

Thus, the firm would pay $90,000 dividends.

17-13A. Rainy Corporation - Stock Split

Market price $ 86.00Split multiple 2Shares outstanding 80,000

a. You own 16,000 shares = .20 x 80,000Position before split $1,376,000 = 16,000 Shares x $86 per share

Price after split $ 43.00 = $86 ÷ 2Your shares after split 32,000 = 16,000 x 2Position after split $1,376,000 = 32,000 shares x $43 per shareNet gain $ 0

b. Price fall 0.45Price after split $ 47.30 = $86.00 (1 - .45)Position after split $1,513,600 = 32,000 Shares x $47.30 per shareNet gain $ 137,600 = $1,513,600 - $1,376,000

SOLUTION TO INTEGRATIVE PROBLEM

Burns’ main argument is that dividends are more important in some periods and less important in others. His discussion certainly gives us the impression that “dividend policy matters.” He also sounds like he believes the “bird in the hand is worth two in the bush” theory. However, he fails to prove that a shareholder’s value is greater whether a dividend is paid or whether it is not paid. Obviously, he is correct in saying that in some years more of an investor’s returns come in the form of dividends, and in other years more is in the form of capital gains. But that does not prove that a dividend payment is inherently good or bad. It is simply a tradeoff between one form of return and another. Also of great importance, he fails to acknowledge the fact that dividends (or any form of distribution to shareholders) should be paid when the firm cannot earn its cost of capital and retained when it can earn more than the cost of capital. Retaining profits and investing them in negative NPV projects destroys shareholder value – period. Thus, the more important question is what can be done with the money within the firm versus what the shareholder can do with the money apart from the company, and not how much dividends contribute to a shareholder’s total returns in a given year.

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Solutions to Problem Set B17-1B. Number of shares to be issued:

= 122,449 shares

Dollar size of the issue:122,449 shares x $115 = $14,081,635

17-2B. Flotation Costs and Issue Size

Flotation costs 0.14Stock price $76.00Net to firm $6,100,000

Dollar issue size = $7,093,023 = $6,100,000/(1-.14)

Number of shares = 93,329 shares ($7,093,023 ÷ $76/share)

17-3B. Steven Miller - Residual Dividend Theory

Total financing needed $650,000Retained earnings $375,000Debt ratio 0.35Equity ratio 0.65Equity financing needed $422,500 = $650,000(.65)Dividends ($47,500) = $375,000 - $422,500

Thus, the firm would pay no dividends and would also have to issue $47,500 in stock.

17-4B. DCA - Stock DividendBefore dividendShares outstanding 2,500,000Net income $ 600,000Price/Earnings 10Stock dividend 18%Investor's shares 120

Current price $ 2.40 = P/E x EPS=10 x

Value before dividend $ 288.00 = $2.40 x 120 sharesAfter dividendShares outstanding 2,950,000 = 2,500,000 x (1+.18)

New price $ 2.03 = P/E x EPS = 10 x

Investor's shares 141.6 = 120 (1.18)Value after dividend $ 288.00 = 141.6 x $2.03

Change $ 0.00 = $288(before)- $288 (after)

The value of the investors' holdings does not change because the price of the stock reacted fully to the increase in the shares outstanding.

17-5B. Montford, Inc. - Dividends in Perfect Markets

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Dividend PlansYear Plan A Plan B1997 $ 2.55 $ 4.351998 $ 2.55 $ 4.701999 $45.60 $40.62

Required rate of return 0.17

Value stock A $32.51 =

Value stock B $32.51 =

a. There is no effect on the value of the common stock.

b. An investor's preference for current income, tax consequences, informational content, and transaction costs might change our conclusion.

17-6B. Wells Manufacturing, Inc. - Long Term Dividend Policy

Debt ratio 0.40Equity ratio 0.60Shares outstanding 125,000

(A) (B) (C)Equity

Funds Available ContributionYear Investment Internally (A x .60)

1 $ 360,000 $225,000 $ 216,0002 450,000 440,000 270,0003 230,000 600,000 138,0004 890,000 650,000 534,0005 600,000 400,000 360,000

$2,315,000 $1,518,000a. Residual Dividend

Year Dividend =

1 $0.072 $1.363 $3.704 $0.935 $0.32

b. Target Dividend = $1.28 =

c. The target dividend allows for consistency of income to the stockholder and income in all years whereas the year-to-year dividend would result in wide year-to-year variations.

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17-7B. Standlee Corporation - Stock Split

Market price $ 98.00Split multiple 2Shares outstanding 30,000

a. You own 0.08 x 30,000Investor's shares = 2,400Position before split $235,200 = 2,400 Shares x $98 per share

Price after split $ 49.00 = $98 ÷ 2Your shares after split 4,800 = 2,400 x 2Position after split $235,200 = 4,800 shares x $49 per shareNet gain $ 0

b. Price fall 0.45Price after split $ 53.90 = $98.00 (1 - .45)Position after split $258,720 = 4,800 Shares x $53.90 per share

Net gain $ 23,520 = $258,720 - $235,200

17-8B. Carlson Cargo, Inc. - Dividend Policies

Year Profits After Taxes1 $1,500,0002 2,000,0003 1,750,0004 950,0005 2,500,000

Total Profits After Taxes $8,700,000

Shares Outstanding 1,000,000

a. Constant Payout Ratio of 40%

Year Dividend = Profits x Payout Ratio ÷ Shares1 $0.60 = $1,500,000 (.4) ÷ 1,000,0002 $0.80 = $2,000,000 (.4) ÷ 1,000,0003 $0.70 = $1,750,000 (.4) ÷ 1,000,0004 $0.38 = $ 950,000 (.4) ÷ 1,000,0005 $1.00 = $2,500,000 (.4) ÷ 1,000,000

b. Stable target payout of 40%

Target dividend = $0.70 =

c. Small regular dividend of $0.50 plus year-end extra

Base profits 1,500,000% of extra profits 50%

Year Dividend

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1 0.502 0.75 = .50+[($2,000,000-$1,500,000)(.5)/1,000,000]3 0.63 = .50+[($1,750,000-$1,500,000)(.5)/1,000,000]4 0.505 1.00 = .50+[($2,500,000-$1,500,000)(.5)/1,000,000]

17-9B. B. Phillips Corporation - Repurchase of Stock

Proposed dividend $ 550,000Shares outstanding 275,000Earnings per share $ 6.00Ex-dividend price $ 45.00Proposed dividend/share $2.00

a. Repurchase price $ 47.00 = $45 + $2

b. Number of shares repurchased 11,702 = $550,000 ÷ ($45 + $2)

c. The capital gains to be received by the stockholder would not be equal to the intended dividend, thus resulting in a dollar benefit or loss to the stockholders.

d. Unless you have a need for current income, you would probably prefer the stock repurchase plan.

17-10B. Number of shares to be issued

= 181,819 share

Dollar size of the issue

181,818 shares x $100 = $18,181,800

17-11B. Maness, Inc. - Residual Dividend Theory

Total financing needed $ 1,500,000Retained earnings $ 525,000Debt ratio 0.65Equity ratio 0.35Equity financing needed $ 525,000 = $1,500,000 (0.35)Dividends $ 0 = $525,000 - $525,000

Thus, the firm would pay no dividend, but it would also not have to issue any stock.

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17-12B. Star Corporation - Stock Split

Market price $ 90Split multiple 2Shares outstanding 90,000

a. You own 22,500 shares = 0.25 x 90,000

Position before split $2,025,000 = 22,500 shares x $90 per share

Price after split $ 45.00 = $90 ÷ 2

Your shares after split 45,000 = 22,500 x 2

Position after split $2,025,000 = 45,000 shares x $45 per share

Net gain $ 0

b. Price fall 0.45

Price after split $ 49.50 = $90 (1 - .45)

Position after split $2,227,500 = 45,000 Shares x $49.50 per share

Net gain $ 202,500 = $2,227,500 - $2,025,000

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