CHAPTER 16
DIVIDENDS AND OTHER PAYOUTS
Answers to Concept Questions
1. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid.
2. A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could,
3. The chief drawback to a strict dividend policy is the variability in dividend payments. This is a problem
because investors tend to want a somewhat predictable cash flow. Also, if there is information content
to dividend announcements, then the firm may be inadvertently telling the market that it is expecting
the dividend only if it absolutely has to.
4. Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a holiday,
and the exchanges are closed. Anyone who buys the stock before December 29 is entitled to the
5. No, because the money could be better invested in stocks that pay dividends in cash which benefit the
6. The change in price is due to the change in dividends, not due to the change in dividend policy.
7. The stock price dropped because of an expected drop in future dividends. Since the stock price is the
8. The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on their
own, and the shareholders must pay the taxes on the dividends either way. However, the shareholders
who take the option may benefit at the expense of the ones who don’t (because of the discount). Also
9. If these firms just went public, they probably did so because they were growing and needed the
additional capital. Growth firms typically pay very small cash dividends, if they pay a dividend at all.
This is because they have numerous projects available, and they reinvest the earnings in the firm
10. It would not be irrational to find low-dividend, high-growth stocks. The trust should be indifferent
between receiving dividends or capital gains since it does not pay taxes on either one (ignoring possible
restrictions on invasion of principal, etc.). It would be irrational, however, to hold municipal bonds.
Since the trust does not pay taxes on the interest income it receives, it does not need the tax break
11. The stock price drop on the ex-dividend date should be lower. With taxes, stock prices should drop by
the amount of the dividend, less the taxes investors must pay on the dividends. A lower tax rate lowers
the investors’ tax liability.
12. With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital
gains, which implies stock repurchases are favored. If the dividend tax rate declines, the attractiveness
of dividends increases.
13. Knowing that share price can be expressed as the present value of expected future dividends does not
make dividend policy relevant. Under the growing perpetuity model, if overall corporate cash flows
are unchanged, then a change in dividend policy only changes the timing of the dividends. The PV of
those dividends is the same. This is true because, given that future earnings are held constant, dividend
policy represents a transfer between current and future stockholders.
a firm less risky. If capital spending and investment spending are unchanged, the firm’s overall cash
flows are not affected by the dividend policy.
home-made dividends can be more expensive than dividends directly paid out by the firms. However,
the existence of financial intermediaries, such as mutual funds, reduces the transaction costs for
individuals greatly. Thus, as a whole, the desire for current income shouldn’t be a major factor favoring
high-current-dividend policy.
preference for current income.
homemade dividends can only be constructed under the MM assumptions.
constructing homemade dividends. Also, the Widow may desire the uncertainty resolution which
comes with high dividend stocks.
in low dividend yield stock. Or, if possible, she should keep her high dividend stocks, borrow an
equivalent amount of money and invest that money in a tax-deferred account.
dividends could curtail their investment opportunities. Their other option is to issue stock to pay the
dividend, thereby incurring issuance costs. In either case, the companies and thus their investors are
better off with a zero dividend policy during the firms’ rapid growth phases. This fact makes these
This example demonstrates that dividend policy is relevant when there are issuance costs. Indeed, it
may be relevant whenever the assumptions behind the MM model are not met.
companies are needed for new, potentially profitable investments. These companies are reluctant to
raise outside funds because of flotation costs. As the company grows, internally generated cash flows
are higher than the cash necessary to fund new investments. Keeping the excess cash can result in
agency costs as company management may be tempted to spend this excess cash. Consistent with what
we observe, older, more mature companies make dividend payments. These companies are trading off
dividends are decreased or omitted. A dividend payment also signals to the market that the company
will not be hording cash, and thus, alleviates the agency problem of excess cash. A fixed repurchase
strategy is not the same as a dividend since a company can announce a repurchase and then fail to
make the repurchase. If there were a better monitoring mechanism to ensure that announced
repurchased were in fact made, a fixed repurchase would become more similar to a regular dividend
payment. Additionally, since managers often have information that investors do not have, it may force
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. The aftertax dividend is the pretax dividend times one minus the tax rate, so:
Aftertax dividend = $7.25(1 – .25)
Aftertax dividend = $5.44
The stock price should drop by the aftertax dividend amount, or:
Ex-dividend price = $79 – 5.44
Ex-dividend price = $73.56
2. a. The shares outstanding increases by 10 percent, so:
New shares outstanding = 25,000(1.10)
New shares outstanding = 27,500
New shares issued = 2,500
Common stock ($1 par value)
$ 27,500
Capital surplus
207,500
Retained earnings
712,600
$947,600
New shares outstanding = 25,000(1.25)
New shares outstanding = 31,250
New shares issued = 6,250
Since the par value of the new shares is $1, the capital surplus per share is $29. The total capital
surplus is therefore:
Capital surplus on new shares = 6,250($29)
Capital surplus on new shares = $181,250
Common stock ($1 par value)
$ 31,250
Capital surplus
316,250
Retained earnings
600,100
$947,600
New shares outstanding = 25,000(4/1)
New shares outstanding = 100,000
The equity accounts are unchanged except that the par value of the stock is changed by the ratio
of new shares to old shares, so the new par value is:
New par value = $1(1/4)
New par value = $.25 per share
New shares outstanding = 25,000(1/5)
New shares outstanding = 5,000
The equity accounts are unchanged except that the par value of the stock is changed by the ratio
4. To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares,
a. $91(3/5) = $54.60
b. $91(1/1.15) = $79.13
c. $91(1/1.425) = $63.86
d. $91(7/4) = $159.25
a: 310,000(5/3) = 516,667
b: 310,000(1.15) = 356,500
P0 = $33.47 per share
Ignoring tax effects, the stock price will drop by the amount of the dividend, so:
PX = $33.47 – 1.25
PX = $32.22
The total dividends paid will be:
Shares bought = $9,000/$33.47
Shares bought = 269
Share price = ($241,000 – 9,000)/6,931 shares
Share price = $33.47
P0 = $625,000 equity/28,000 shares
P0 = $22.32 per share
The shares outstanding will increase by 25 percent, so:
New shares outstanding = 28,000(1.25)
New shares outstanding = 35,000
New shares outstanding = 145,600
The capital surplus is the capital paid in excess of par value, which is $1, so:
Capital surplus for new shares = 15,600($61)
Capital surplus for new shares = $951,600
The new capital surplus will be the old capital surplus plus the additional capital surplus for the new
Common stock ($1 par value)
$ 145,600
Capital surplus
1,930,600
Retained earnings
1,898,300
$3,974,500
New par value = $1(1/5)
New par value = $.20 per share.
The total dividends paid this year will be the dividend amount times the number of shares outstanding.
The company had 130,000 shares outstanding before the split. We must remember to adjust the shares
outstanding for the stock split, so:
Total dividends paid this year = $.85(130,000 shares)(5/1 split)
Total dividends paid this year = $552,500
b. If it is not declared, the price will remain at $87.
firm will realize $1,050,000 in net income and it will pay $585,000 (= $9 × 65,000) in dividends,
but the need for financing is immediate. The company must finance $1,800,000 through the sale
of shares worth $87. It must sell $1,800,000/$87 = 20,690 shares.
d. The MM model is not realistic since it does not account for taxes, brokerage fees, uncertainty
Intermediate
11. The price of the stock today is the PV of the dividends, so:
P0 = $1.95/1.15 + $65/1.152
P0 = $50.84
To find the equal two year dividends with the same present value as the price of the stock, we set up
the following equation and solve for the dividend (Note: The dividend is a two-year annuity, so we
could solve with the annuity factor as well):
P1 = $65/1.15
P1 = $56.52
Since you own 1,000 shares, in one year you want:
But you’ll only get:
Thus, in one year you will need to sell additional shares in order to increase your cash flow. The
number of shares to sell in year one is: