978-1259709685 Chapter 19 Solution Manual Part 2

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CHAPTER 19 –

13. a. If the company makes a dividend payment, we can calculate the wealth of a shareholder as:

The stock price after the dividend payment will be:

The shareholder will have a stock worth $46.80 and a $4.20 dividend for a total wealth of $51.

If the company makes a repurchase, the company will repurchase:

b. If the company pays dividends, the current EPS is $2.60, and the PE ratio is:

If the company repurchases stock, the number of shares will decrease. The total net income is

the EPS times the current number of shares outstanding. Dividing net income by the new

number of shares outstanding, we find the EPS under the repurchase is:

The stock price will remain at $51 per share, so the PE ratio is:

c. A share repurchase would seem to be the preferred course of action. Only those shareholders

14. a. Since the firm has a 100 percent payout policy, the entire net income, $85,000 will be paid as a

dividend. The current value of the firm is the discounted value one year from now, plus the

b. The current stock price is the value of the firm, divided by the shares outstanding, which is:

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Since the company has a 100 percent payout policy, the current dividend per share will be the

company’s net income, divided by the shares outstanding, or:

The stock price will fall by the value of the dividend to:

c. i. According to MM, it cannot be true that the low dividend is depressing the price. Since

dividend policy is irrelevant, the level of the dividend should not matter. Any funds not

distributed as dividends add to the value of the firm, hence the stock price. These directors

To show this, consider what would happen if the dividend were increased to $4.60. Since

only the existing shareholders will get the dividend, the required dollar amount to pay the

dividends is:

To fund this dividend payment, the company must raise:

This money can only be raised with the sale of new equity to maintain the all-equity

financing. Since those new shareholders must also earn 12 percent, their share of the firm

one year from now is:

This means that the old shareholders’ interest falls to:

Under this scenario, the current value of the firm is:

Since the firm value is the same as in part a, the change in dividend policy had no effect.

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ii. The new shareholders are not entitled to receive the current dividend. They will receive

only the value of the equity one year hence. The present value of those flows is:

15. a. The current price is the current cash flow of the company plus the present value of the expected

cash flows, divided by the number of shares outstanding. So, the current stock price is:

b. To achieve a zero dividend payout policy, he can invest the dividends back into the company’s

stock. The dividends per share will be:

And the stockholder in question will receive:

The new stock price after the dividends are paid will be:

So, the number of shares the investor will buy is:

16. a. Using the formula from the text proposed by Lintner:

b. Now we use an adjustment rate of .60, so the dividend next year will be:

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c. The lower adjustment factor in part a is more conservative. The lower adjustment factor will

Challenge

17. Assuming no capital gains tax, the aftertax return for the Gordon Company is the capital gains

growth rate, plus the dividend yield times one minus the tax rate. Using the constant growth dividend

model, we get:

The equivalent pretax return for Gordon Company is:

18. Using the equation for the decline in the stock price ex-dividend for each of the tax rate

policies, we get:

b. P0 – PX = D(1 – .15) / (1 – 0)

c. P0 – PX = D(1 – .15) / (1 – .20)

d. With this tax policy, we need to multiply the personal tax rate times one minus the dividend

exemption percentage, so:

e. Since different investors have widely varying tax rates on ordinary income and capital gains,

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19. Since the $4,500,000 cash is after corporate tax, the full amount will be invested. So, the value of

each alternative is:

Alternative 1 :

The firm invests in T-bills or in preferred stock and then pays out a special dividend in 3 years.

So, the future value of the corporate investment in T-bills will be:

FV of investment in T–bills = $4,500,000(1 + .0195)3

FV of investment in T–bills = $4,768,416.74

Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be:

If the firm invests in preferred stock:

If the firm invests in preferred stock, the assumption would be that the dividends received will be

reinvested in the same preferred stock. The preferred stock will pay a dividend of:

And the taxes the company must pay on the preferred dividends will be:

Taxes on preferred dividends = .35($67,500)

Taxes on preferred dividends = $23,625

So, the aftertax dividend for the corporation will be:

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The future value of the company’s investment in preferred stock will be:

Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be:

Alternative 2:

The firm pays the dividend now and individuals invest on their own. The aftertax cash received by

shareholders now will be:

The individuals invest in Treasury bills:

If the shareholders invest the current aftertax dividends in Treasury bills, the aftertax individual yield

will be:

So, the future value of the individual investment in Treasury bills will be:

The individuals invest in preferred stock:

If the individual invests in preferred stock, the assumption would be that the dividends received will

be reinvested in the same preferred stock. The preferred stock will pay a dividend of:

And the taxes on the preferred dividends will be:

This means the aftertax individual dividend yield is:

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The future value of the individual investment in preferred stock will be:

20. a. Let x be the ordinary income tax rate. The individual receives an aftertax dividend of:

Aftertax dividend = $1,000(1 – x)

which she invests in Treasury bonds. The Treasury bond will generate aftertax cash flows to the

investor of:

To be indifferent, the investor’s proceeds must be the same whether she invests the aftertax

dividend or receives the proceeds from the firm’s investment and pays taxes on that amount. To

find the rate at which the investor would be indifferent, we can set the two equations equal, and

solve for x. Doing so, we find:

Note that this argument does not depend upon the length of time the investment is held.

b. Yes, this is a reasonable answer. She is only indifferent if the aftertax proceeds from the $1,000

c. Since both investors will receive the same pretax return, you would expect the same answer as

in part a. Yet, because the company enjoys a tax benefit from investing in stock (70 percent of

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d. It is a compelling argument, but there are legal constraints which deter firms from investing