CHAPTER 17
DIVIDENDS AND DIVIDEND POLICY
Answers to Concepts Review and Critical Thinking 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. Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a
4. No, because the money could be better invested in stocks that pay dividends in cash which benefit
5. The change in price is due to the change in dividends, not due to the change in dividend policy.
6. The stock price dropped because of an expected drop in future dividends. Since the stock price is the
7. The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on
8. If these firms just went public, they probably did so because they were growing and needed the
9. The stock price drop on the ex-dividend date should be lower. With taxes, stock prices should drop
10. With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital
Solutions to Questions and Problems
CHAPTER 17 – 2
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:
The stock price should drop by the aftertax dividend amount, or:
2. a. Since the par value is $.50 and the common stock account is $25,000, there are 50,000 shares
outstanding. The shares outstanding increases by 10 percent, so:
Since the par value of the new shares is $.50, the capital surplus per share is $31.50. The total
capital surplus is therefore:
b. The shares outstanding increases by 25 percent, so:
Since the par value of the new shares is $.50, the capital surplus per share is $31.50. The total
capital surplus is therefore:
CHAPTER 17 – 3
3. a. To find the new shares outstanding, we multiply the current shares outstanding times the ratio
of new shares to old shares, so:
The equity accounts are unchanged except the par value of the stock is changed by the ratio of
new shares to old shares, so the new par value is:
b. To find the new shares outstanding, we multiply the current shares outstanding times the ratio
of new shares to old shares, so:
The equity accounts are unchanged except the par value of the stock is changed by the ratio of
new shares to old shares, so the new par value is:
4. To find the new stock price, we multiply the current stock price by the ratio of old shares to new
shares, so:
a. $68(3/5) = $40.80
b. $68(1/1.15) = $59.13
e. To find the new shares outstanding, we multiply the current shares outstanding times the ratio
of new shares to old shares, so:
a: 530,000(5/3) = 883,333
5. The stock price is the total market value of equity divided by the shares outstanding, so:
CHAPTER 17 – 4
Ignoring tax effects, the stock price will drop by the amount of the dividend, so:
The total dividends paid will be:
6. Repurchasing the shares will reduce cash and shareholders’ equity by $18,200. The shares
repurchased will be the total purchase amount divided by the stock price, so:
And the new shares outstanding will be:
After repurchase, the new stock price is:
The repurchase is effectively the same as the cash dividend because you either hold a share worth
7. The stock price is the total market value of equity divided by the shares outstanding, so:
The shares outstanding will increase by 25 percent, so:
The new stock price is the market value of equity divided by the new shares outstanding, so:
8. With a stock dividend, the shares outstanding will increase by one plus the dividend amount, so:
CHAPTER 17 – 5
The capital surplus is the capital paid in excess of par value, which is $1, so:
The new capital surplus will be the old capital surplus plus the additional capital surplus for the new
shares, so:
The new equity portion of the balance sheet will look like this:
Common stock ($1 par value) $ 281,750
9. The only equity account that will be affected is the par value of the stock. The par value will change
by the ratio of old shares to new shares, so:
The total dividends paid this year will be the dividend amount times the number of shares
The dividends increased by 10 percent, so the total dividends paid last year were:
And to find the dividends per share, we divide this amount by the shares outstanding last year. Doing
so, we get:
Intermediate
10. The price of the stock today is the PV of the dividends, so:
CHAPTER 17 – 6
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):
We now know the cash flow per share we want in each of the next two years. We can find the price
of the stock in one year, which will be:
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 1 is:
At Year 2, your cash flow will be the dividend payment times the number of shares you still own, so
the Year 2 cash flow is:
11. If you only want $1,500 in Year 1, you will buy:
at Time 1. Your dividend payment in Year 2 will be:
Note, the present value of each cash flow stream is the same. Below we show this by finding the
present values as:
CHAPTER 17 – 7
12. 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:
If the shareholder lets their shares be repurchased, they will have $64 in cash. If the shareholder
keeps their shares, they are still worth $64.
b. If the company pays dividends, the current EPS is $1.89, 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 $64 per share, so the PE ratio is:
c. A share repurchase would seem to be the preferred course of action. Only those shareholders
Challenge
13. Assuming no capital gains tax, the aftertax return for the Gordon Company is the capital gains
Solving for g, we get:
CHAPTER 17 – 8
The equivalent pretax return for Gordon Company is:
Pretax return = g + D
14. Using the equation for the decline in the stock price ex-dividend for each of the tax rate
policies, we get:
a. P0 – PX = D(1 – 0)/(1 – 0)
b. P0 – PX = D(1 – .15)/(1 – 0)
c. P0 – PX = D(1 – .15)/(1 – .30)
d. With this tax policy, we need to multiply the corporate 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,
15. Since the $4,000,000 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 to shareholders as a special
dividend in three years.
So, the future value of the corporate investment in T-bills will be:
CHAPTER 17 – 9
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:
Since 70 percent of the dividends are excluded from tax:
And the taxes the company must pay on the preferred dividends will be:
So, the aftertax dividend for the corporation will be:
This means the aftertax corporate dividend yield is:
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 out dividend now, and individuals invest on their own. The aftertax cash received by
shareholders now will be:
CHAPTER 17 – 10
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:
So, the aftertax preferred dividend will be:
CHAPTER 17 – 11
This means the aftertax individual dividend yield is:
The future value of the individual investment in preferred stock will be:
The aftertax cash flow for the shareholders is maximized when the firm invests the cash in the
preferred stocks and pays a special dividend later.
16. a. Let x be the ordinary income tax rate. The individual receives an aftertax dividend of:
which she invests in Treasury bonds. The Treasury bond will generate aftertax cash flows to the
investor of:
If the firm invests the money, its proceeds are:
And the proceeds to the investor when the firm pays a dividend will be:
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
CHAPTER 17 – 12
c. Since both investors will receive the same pretax return, you would expect the same answer as
in part a. Yet, because Carlson enjoys a tax benefit from investing in stock (70 percent of
$1,000(1 – x)[1 + .06(1 – x)] = (1 – x)($1,000{1 + .06[.70 + (1 – .70)(1 – .35)]})
CHAPTER 26 – 13