184
© Pearson Education Limited 2008
Dividend Policy
“Contrariwise,” continued Tweedledee, “if it was so, it
might be; and if it were so, it would be; but as it isn’t, it
ain’t. That’s logic.”
LEWIS CAROLL,
THROUGH THE LOOKING GLASS
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
185
© Pearson Education Limited 2008
ANSWERS TO QUESTIONS
1. With a passive dividend-payout policy, the company pays out as cash dividends any
earnings it has left over after funding all worthwhile investment opportunities. It is passive
2. The investor manufactures “homemade” dividends by selling shares of stock if the dividend
paid is less than the investor’s consumption desires and by buying shares if consumption
3. Taxes affect the after-tax return to different investors, which range from tax-free pension
funds to wealthy individuals and corporations that pay taxes at the full rate. As stock price
4. For a company whose growth in assets is great, there typically is a need to finance
externally. In addition to debt, the equity base must be built up – either through retention of
5. Financial signaling implies that concrete actions like a cash dividend increase, a stock
dividend or stock split, and the repurchase of common stock convey positive information to
6. A company with high liquidity and ready access to lines of credit or the public marketplace
7. Neither policy, if strictly interpreted, recognizes variations in the firm’s investment
opportunities or cash flows. While a constant dollar payout gives some recognition to those
Chapter 18: Dividend Policy
186
© Pearson Education Limited 2008
8. A target dividend-payout ratio is a percent of earnings the company pays out over time. The
target might be 30 percent, for example, and the company would endeavor to pay out this
9. A
stock dividend is a payment of additional shares of stock to shareholders. It is often used
in place of or in addition to a cash dividend. A stock split is an increase in the number of
shares outstanding by reducing the par value of the stock. In both cases, the shareholder
10. In theory, stock dividends are not a thing of value. While the stock may respond favorably
to their announcement, it must be remembered that there is an information effect. Usually
11. The reverse stock split will raise share price, but like a straight split the shareholder
12. With full disclosure to the investor of the company’s intentions, it would seem that open-
13. The Internal Revenue Service will not allow the substitution of stock repurchase for regular
14. Companies are reluctant to cut their dividends because of the belief that investors value
15. Dividends represent a reduction in cash which in turn represents a reduced ability of a
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
187
© Pearson Education Limited 2008
16. With a dividend reinvestment plan (DRIP), the company invests the dividend in more shares
of stock in the shareholder’s behalf. The share purchase is subject to full taxation to the
17. Dividend policy is a type of financing decision. Dividends foregone mean, of course, that
SOLUTIONS TO PROBLEMS
1. a. • A 15 percent stock dividend amounts to 150,000 additional shares (1,000,000 × 0.15)
Common stock ($5 par; 1.15 million shares) $ 5,750,000
b. • A 25 percent stock dividend amounts to 250,000 additional shares (1,000,000 × 0.25)
Common stock ($5 par; 1.25 million shares) $ 6,250,000
c.
Common stock ($5 par; 1.25 million shares) $ 5,000,000
2. a. Dividends = $500,000
Chapter 18: Dividend Policy
188
© Pearson Education Limited 2008
3. The answers assume all things are held constant other than the item in question.
a. Low dividend-payout ratio. Highly taxed owners will probably want to realize their
returns through capital gains.
4. We would expect Jumbo to have the higher dividend-payout ratio. As a percent of expected
annual cash flows, the two companies have the following ratios:
Jumbo Giant
Standard deviation 0.60 0.71
Jumbo has a lower relative standard deviation of cash flows, lower relative capital
expenditures, lower relative long-term debt, and greater relative unused bank lines. Its
expected capital expenditures are less than its expected cash flow, which would imply
5. a. The market seems to evaluate both of these stocks in terms of dividend payments. The
average dividend for both firms is approximately the same. Nevertheless, the average
b. Neither of these companies seems to be a growth company. In fact, one would wonder
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
189
© Pearson Education Limited 2008
6. a. $50. The value of the stock adjusts downward on the record date. This sale occurs
before that date.
7. a. 3% × 1,000,000 shares = 30,000 shares
30,000 shares × $5 = $150,000
b. $300,000/1,000,000 = $0.30 $150,000/1,000,000 = $0.15
8. a. (i)
Original Stock
Condition Dividend
Common stock $ 4,800,000 $ 5,376,000
Chapter 18: Dividend Policy
190
© Pearson Education Limited 2008
a) (2)
Original Stock
Condition Dividend
Common stock $ 4,800,000 $ 6,000,000
a) (3)
Original Stock
Condition Dividend
b) (1)
Original Stock
Condition Split
b) (2)
Original Stock
Condition Split
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
191
© Pearson Education Limited 2008
b) (3)
Original Stock
Condition Split
Common stock $ 4,800,000 $ 4,800,000
c. (1)
Original Reverse
Condition Split
c) (2)
Original Reverse
Condition Split
b. If taxes are ignored, it should make little difference other than perhaps if there is a
c. Taxes create an incentive for repurchase, for the reasons illustrated in the chapter.
Chapter 18: Dividend Policy
192
© Pearson Education Limited 2008
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a.
Year
Income Available
For Dividends
(in thousands)
Dividends Per
Share
External Financing
Required
(in thousands)
1 $1,000 $1.00 $ 0
b. (in thousands)
(1) (2) (3) (4)
Year Net Income Dividends
Capital
Expenditures
External Financing
Required
(2) + (3) – (1)
1 $2,000 $1,000 $1,000 0
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
193
© Pearson Education Limited 2008
c.
(1) (2) (3) (4) (5)
Year
Net Income
(in 000s)
Dividends
(in 000s)
Dividends
Per Share
Capital
Expenditures
(in 000s)
External
Financing
Required
(2) + (4) –
(1) (in 000s)
1 $2,000 $1,000 $1.00 $1,000 $ 0
d. Aggregate dividends are highest under Alternative C, which involves a 50 percent
dividend-payout ratio. However, they are only slightly higher than that which occurs
under Alternative B. External financing is minimized under Alternative A, the residual
dividend policy.
2. a.
Year Policy 1 Policy 2 Policy 3
1 $ 0.68 $ 0.80 $ 0.68
2 0.73 0.80 0.68
Other dividend streams are possible under Policy 3. This solution is but one.
Chapter 18: Dividend Policy
194
© Pearson Education Limited 2008
b. Policy 1 and, to a much lesser degree, Policy 2 result in fluctuating dividends over time,
as the company is cyclical. Because of the $0.80 minimum regular dividend, Policy 2
3. a. Present number of shares = $2,000,000/$8 par value = 250,000.
(1) (2) (3)
Stock Dividend Stock Split Reverse Split
Common stock (par) $ 2,200,000 ($8) $ 2,000,000 ($4) $ 2,000,000 ($16)
b. The total market value of the firm before the stock dividend is $60 × 250,000 shares
= $15 million. With no change in the total value of the firm, market price per share after