Chapter 18: Dividend Policy and Retained Earnings
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benefits have taken place.
19. Stock dividend and cash dividend (LO4) Health Systems, Inc. is considering a 15 percent
stock dividend. The capital accounts are as follows:
Common stock (3,000,000 shares at $10 par) ……
$30,000,000
Capital in excess of par* ……………………………….
15,000,000
Retained earnings …………………………………………
45,000,000
Net worth …………………………………………………
$90,000,000
*The increase in capital in excess of par as a result of a stock dividend
is equal to the shares created times (Market price – Par value).
The company’s stock is selling for $35 per share. The company had total earnings of
$7,500,000 with 3,000,000 shares outstanding and earnings per share were $2.50. The firm
has a P/E ratio of 14.
a. What adjustments would have to be made to the capital accounts for a 15 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 have if he or she originally had 100?
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 slight difference due to rounding.)
e. Assume Mr. Heart, the president of Health Systems, wishes to benefit stockholders by
keeping the cash dividend at a previous level of $1.05 in spite of the fact that the
stockholders how have 15 percent more shares. Because the cash dividend is not
reduced, the stock price is assumed to remain at $35.
What is an investor’s total investment worth after the stock dividend if he/she had
100 shares before the stock dividend?
f. Under the scenario described in part e, is the investor better off?
g. As a final question, what is the dividend yield on this stock under the scenario
described in part e?
Chapter 18: Dividend Policy and Retained Earnings
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18–19. Solution:
Health Systems, Inc.
a. Common stock (3,450,000 shares at $10 par) . $34,500,000
18–19. (Continued)
*450,000 shares × ($35 market price – $10 stock price)
= 450,000 × 25 = 11,250,000
b. EPS after the stock dividend = $7,500,000/3,450,000 = $2.17
d. Before After
Chapter 18: Dividend Policy and Retained Earnings
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($6.30 rounding difference)
e. After
f. Yes. As a result of keeping the cash dividend constant, the
stockholder not only received more cash dividends, but the
portfolio value goes up by $525 as a result of having 15
more shares still worth $35 a share.
g.
Divided Cash dividend $1.05 3%
Yield Market price $35.00
= = =
20. Reverse stock split (LO4) Double Vision Optical Company has had a lot of complaints
from customers of late and its stock price is now only $2 per share. It is going to employ a
one-for-six reverse stock split to increase the stock value. Assume Johnnie Walker owns
120 shares.
a. How any shares will he own after the reverse stock split?
b. What is the anticipated price of the stock after the reverse stock split?
c. Because investors often have a negative reaction to a revere stock split, assume the
stock only goes up to 80 percent of the value computed in part b. What will the stock’s
price be?
d. How has the total value of Johnnie Walker’s holdings changed from before the reverse
stock split to after the reverse stock split (based on the stock value computed in part c)?
To get the total value before and after the split, multiply the shares held times the stock
price.
18–20. Solution:
Double Vision Optical Company
a. Number of shares after reverse stock split
= Original shares divided by the reverse split ratio
Chapter 18: Dividend Policy and Retained Earnings
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b. Anticipated stock price
= Original stock price × reverse split ratio
c. Actual stock price based on the 80% assumption
18–20. (Continued)
d. Johnnie Walker’s total holdings
Before reverse stock split
After reverse stock split
21. Cash dividend versus stock repurchase (LO5) The Carlton Corporation has $4 million in
earnings after taxes and 1 million shares outstanding. The stock trades at a P/E of 20. The
firm has $3 million in excess cash.
a. Compute the current price of the stock.
b. If the $3 million is used to pay dividends, how much will dividends per share be?
c. If the $3 million is used to repurchase shares in the market at a price of $83 per share,
how many shares will be acquired? (Round to the nearest share.)
d. What will the new earnings per share be? (Round to two places to the right of the
decimal.)
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e. If the P/E ratio remains constant, what will the price of the securities be? By how much,
in terms of dollars, did the repurchase increase the stock price?
f. Has the stockholder’s total wealth changed as a result of the stock repurchase as
opposed to receiving the cash dividend?
g. What are some reasons a corporation may wish to repurchase its own shares in the
market?
18–21. Solution:
Carlton Corporation
a. Price = P/E × EPS
EPS = $4 mil. in earnings/1 mil. shares = $4
Price = 20 × $4 = $80
18–21. (Continued)
f. No. With the cash dividend:
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term capital gains.
Also, the corporation may think its shares are underpriced
in the market. The purchase may stave off further decline
and perhaps even trigger a rally. Reacquired shares may
company.
22. Retaining funds versus paying them out (LO1) The Hastings Sugar Corporation has the
following pattern of net income each year, and associated capital expenditure projects. The
firm can earn a higher return on the projects than the stockholders could earn if the funds
were paid out in the form of dividends.
Net Income
Profitable Capital
Expenditure
$10 million
$ 7 million
15 million
11 million
9 million
6 million
12 million
7 million
14 million
8 million
The Hastings Corporation has 2 million shares outstanding (the following questions are
separate from each other).
a. If the marginal principle of retained earnings is applied, how much in total cash
dividends will be paid over the five years?