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Chapter 18: Dividend Policy and Retained Earnings
18-11
10. Dividend yield (LO1) The stock of North American Dandruff Company is selling at $80
per share. The firm pays a dividend of $2.50 per share.
a. What is the dividend yield?
b. If the firm has a payout rate of 50 percent, what is the firm’s P/E ratio?
18-10. Solution:
North American Dandruff Company
a. Annual dividend yield = cash dividend/price
b. Earnings per share = cash dividends/payout ratio
P/E ratio = Price/earnings per share
11. Dividend yield (LO1) The shares of Charles Darwin Fitness Centers sell for $60. The firm
has a P/E ratio of 20. Forty percent of earnings are paid out in dividends. What is the firm’s
dividend yield?
18-11. Solution:
Charles Darwin Fitness Centers
Earnings per share = Stock price/price-earnings ratio
Dividends per share = Earnings per share × payout ratio
Dividend yield = Dividends per share/price
Chapter 18: Dividend Policy and Retained Earnings
18-12
12. Ex-dividends date and stock price (LO1) The Ohio Freight Company’s common stock is
selling for $40 the day before the stock goes ex-dividend. The annual dividend yield is 6.7
percent, and dividends are distributed quarterly. Based solely on the impact of the cash
dividend, by how much should the stock go down on the ex-dividend date? What will the
new price of the stock be?
18-12. Solution:
Ohio Freight Company
Annual dividend = Dividend yield × stock price
13. Stock dividend and cash dividend (LO4) The Western Pipe Company has the following
capital section in its balance sheet. Its stock is currently selling for $5 per share.
Common stock (50,000 shares at $1 par) ......... $ 50,000
Capital in excess of par ................................... 50,000
Retained earnings ............................................ 100,000
$200,000
The firm intends to first declare a 10 percent stock dividend and then pay a 20-cent cash
dividend (which also causes a reduction of retained earnings). Show the capital section of
the balance sheet after the first transaction and then after the second transaction.
18-13. Solution:
Western Pipe Co.
After 1st transaction
Chapter 18: Dividend Policy and Retained Earnings
18-13
Capital in excess of par ..................................... 70,000
After 2nd transaction
Common stock (55,000 shares at $1 par) .......... $ 55,000
14. Cash dividend policy (LO1) Phillips Rock and Mud is trying to determine the maximum
amount of cash dividends it can pay this year. Assume its balance sheet is as follows:
Assets
Cash ............................................................. $ 312,500
Accounts receivable ..................................... 800,000
Fixed assets .................................................. 987,500
Total assets .......................................... $2,100,000
Liabilities and Stockholders’ Equity
Accounts payable ......................................... $ 445,000
Long-term payable ....................................... 280,000
Common stock (250,000 shares at $2 par) .... 500,000
Retained earnings ......................................... 875,000
Total liabilities and stockholders’ equity ... $2,100,000
a. From a legal perspective, what is the maximum amount of dividends per share the firm
could pay? Is this realistic?
b. In terms of cash availability, what is the maximum amount of dividends per share the
firm could pay?
Chapter 18: Dividend Policy and Retained Earnings
18-14
c. Assume the firm earned an 16 percent return on stockholders’ equity last year. If the
board wishes to pay out 60 percent of earnings in the form of dividends, how much will
dividends per share be? (Round to two places to the right of the decimal point.)
18-14. Solution:
Phillips Rock and Mud
a. From a legal viewpoint, the firm can pay cash dividends
equal to retained earnings of $875,000. On a per share
basis, this represents $3.50 per share.
Retained earnings $875,000 $3.50
Shares 250,000
==
balance.
18-14. (Continued)
b.
Cash $312,500 $1.25
Shares 250,000
==
c. Stockholders’ equity = common stock + retained earnings
$1,375,000 = $500,000 + $875,000
Chapter 18: Dividend Policy and Retained Earnings
18-15
Dividends $132,000 $.53
Shares 250,000
==
15. Dividends and stockholder wealth maximization (LO2) The Warner Corporation has
earnings of $750,000 with 300,000 shares outstanding. Its P/E ratio is 16. The firm is
holding $400,000 of funds to invest or pay out in dividends. If the funds are retained, the
aftertax return on investment will be 15 percent, and this will add to present earnings. The
15 percent is the normal return anticipated for the corporation, and the P/E ratio would
remain unchanged. If the funds are paid out in the form of dividends, the P/E ratio will
increase by 10 percent because the stockholders have a preference for dividends over
retained earnings. Which plan will maximize the market value of the stock?
18-15. Solution:
Warner Corp.
Retain
Incremental earnings = 15% × $400,000 = $60,000
$750,000 + $60,000 $810,000
Earnings per share = $2.70
300,000 300,000
==
Price of stock = P/E × EPS
Payout
New P/E = 1.10% × 16 = 17.6
Earnings per share =
$750,000 $2.50
300,000 =
Price of stock = P/E × EPS
= 17.6 × $2.50 = $44.00
Chapter 18: Dividend Policy and Retained Earnings
18-16
16. Dividend valuation model and wealth maximization (LO2) Omni Telecom is trying to
decide whether to increase its cash dividend immediately or use the funds to increase its
future growth rate. It will use the dividend valuation model originally presented in Chapter
10 for purposes of analysis. The model was shown as Formula 10–9 on page 300 and is
reproduced below (with a slight addition in definition of terms).
D1
P0Kg
e
=
−
P0 = Price of the stock today
D1 = Dividend at the end of the first year
D0 × (1 + g)
D0 = Dividend today
Ke = Required rate of return
g = Constant growth rate in dividends
D0 is currently $2.00, Ke is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $2.20 and Ke and g will remain
unchanged.
Under Plan B, D0 will remain at $2.00 but g will go up to 6 percent and Ke will remain
unchanged.
a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 × (1 +
g) or $2.20 (1.05). Ke will equal 10 percent and g will equal 5 percent.
b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 × (1 +
g) or $2.00 (1.06). Ke will be equal to 10 percent and g will be equal to 6 percent.
c. Which plan will produce the higher value?
18-16. Solution:
Omni Telecom
Chapter 18: Dividend Policy and Retained Earnings
1
o
e
D
PKg
=
−
Then compute the stock price
Chapter 18: Dividend Policy and Retained Earnings
18-18
rate, will produce a higher value.
17. Stock split and its effects (LO4) Wilson Pharmaceuticals’ stock has done very well in the
market during the last three years. It has risen from $45 to $70 per share. The firm’s current
statement of stockholders’ equity is as follows:
Common stock (4 million shares issued
at par value of $10 per share) ...............
$ 40,000,000
Paid-in capital in excess of par ...............
15,000,000
Retained earnings ...................................
45,000,000
Net worth ...............................................
$100,000,000
a. What changes would occur in the statement of stockholders’ equity after a two-for-one
stock split?
b. What changes would occur in the statement of stockholders’ equity after a three-for-one
stock split?
c. Assume that Wilson earned $14 million. What would its earnings per share be before
and after the two-for-one stock split? After the three-for-one stock split?
d. What would be the price per share after the two-for-one stock splits? After the three-
for-one stock split? (Assume that the price-earnings ratio of 20 stays the same.)
e. Should a stock split change the price-earnings ratio for Wilson?
18-17. Solution:
Wilson Pharmaceutical
a. Eight (8) million shares would be outstanding at a par value
of $5 per share. Everything else will be the same.
Chapter 18: Dividend Policy and Retained Earnings
18-19
18-17. (Continued)
d. P/E × EPS =Price
Price after 2-1 split = 20 × $1.75 = $35.00
Price after 3-1 split = 20 × $1.17 = $23.40
on the P/E ratio.
18. Stock dividend and its effect (LO4) Ace Products sells marked playing cards to blackjack
dealers. It has not paid a dividend in many years, but is currently contemplating some kind
of dividend. The capital accounts for the firm are as follows:
Common stock (2,000,000 shares at $5 par) ......
$10,000,000
Capital in excess of par* ....................................
6,000,000
Retained earnings ..............................................
24,000,000
Net worth .......................................................
$40,000,000
*The increase in capital in excess of par as a result of a stock dividend
is equal to the new shares created times (Market price – Par Value).
The company’s stock is selling for $20 per share. The company had total earnings
of $4,000,000 during the year. With 2,000,000 shares outstanding, earnings per share
were $2.00. The firm has a P/E ratio of 10.
a. What adjustments would have to be made to the capital accounts for a 10 percent stock
dividend? Show the new capital accounts.
b. What adjustments would be made to EPS and the stock price? (Assume the P/E ratio
remains constant.)
c. How many shares would an investor end up with if he or she originally had 100 shares?
Chapter 18: Dividend Policy and Retained Earnings
18-20
d. What is the investor’s total investment worth before and after the stock dividend if the
P/E ratio remains constant? (There may be a $1 to $2 difference due to rounding.)
e. Has Ace Products pulled a magic trick, or has it given the investor something of value?
Explain.
18-18. Solution:
Ace Products
a. Common stock (2,200,000 shares at $5 par) $11,000,000
*Capital in excess of par 9,000,000
18-18. (Continued)
**$24,000,000 beginning Retained earnings account
– $1,000,000 transfer to Common stock account
$20,000,000 ending Retained earnings account
b. EPS after stock dividend = $4,000,000/$2,200,000 = $1.82
