Chapter 18: Dividend Policy and Retained Earnings
16. Dividend valuation model and wealth maximization (LO18-2) 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 and is reproduced next
(with a slight addition in definition of terms):
01
D
PKg
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 $2.50, Ke is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $3.00 and Ke and g will remain
unchanged.
Under Plan B, D0 will remain at $2.50 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 $3.00 (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 $2.50 (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?
Chapter 18: Dividend Policy and Retained Earnings
17. Stock split and its effects (LO18-4) Wilson Pharmaceuticals’ stock has done very well in
the market during the last three years. It has risen from $55 to $80 per share. The firm’s
current statement of stockholders’ equity is as follows:
Common stock (5 million shares issued
at a par value of $10 per share) ………….
$ 50,000,000
Paid-in capital in excess of par …………….
13,000,000
Retained earnings ……………………………….
57,000,000
Net worth ………………………………………….
$120,000,000
a. How many shares would be outstanding after a two-for-one stock split? What would be
its par value?
b. How many shares would be outstanding after a three-for-one stock split? What would
be its par value?
c. Assume that Wilson earned $11 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 36.36 stays the same.)
e. Should a stock split change the price-earnings ratio for Wilson?
18–17. Solution:
Wilson Pharmaceutical
a. Ten (10) 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
18-17. (Continued)
d. P/E × EPS =Price
Price after 2-1 split = 36.36 × $1.10 = $40.00
18. Stock dividend and its effect (LO18-4) 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:
$12,000,000
5,000,000
23,000,000
$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 $4,800,000 during the year. With 2,400,000 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 70 shares?
Chapter 18: Dividend Policy and Retained Earnings
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.)
18–18. Solution:
Ace Products
a. Common stock (2,640,000 shares at $5 par) $13,200,000
18-18. (Continued)
**$23,000,000 Beginning retained earnings account
– $1,200,000 Transfer to common stock account
Chapter 18: Dividend Policy and Retained Earnings
2
16 mil.
11 mil.
5 mil.
3
12 mil.
6 mil.
6 mil.
4
16 mil.
8 mil.
8 mil.
5
16 mil.
9 mil.
7 mil.
Total cash dividends
$33 mil.
18-22. (Continued)
b.
Year
Net Income
×
Payout Ratio
Dividends
1
$14 mil.
.30
$ 4.2 mil.
2
16 mil.
.30
4.8 mil.
3
12 mil.
.30
3.6 mil.
4
16 mil.
.30
4.8 mil.
5
16 mil.
.30
4.8 mil.
Total cash dividends
$22.2 mil.
c.
Year
Shares
Outstanding
×
Dividends
per Share
Dividends
1
3,000,000
×
$3.40
$ 10,200,000
2
3,300,000
×
3.40
11,220,000
3
3,630,000
×
3.40
12,342,000
4
3,993,000
×
3.40
13,576,200
5
4,392,300
×
3.40
14,933,820
Total cash dividends
$62,272,020
d.
Year
Net
Income
Payout
Ratio
Dividends
Shares
Dividends
per Share
1
$14 mil.
.20
$2.8 mil.
3,000,000
$.93
2
16 mil.
.20
3.2 mil.
3,300,000
.97
Chapter 18: Dividend Policy and Retained Earnings
3
12 mil.
.20
2.4 mil.
3,630,000
.66
4
16 mil.
.20
3.2 mil.
3,993,000
.80
5
16 mil.
.20
3.2 mil.
4,392,300
.73
COMPREHENSIVE PROBLEM
Modern Furniture Company (Dividend payments versus stock repurchases) (LO18-5)
Modern Furniture Company had finally arrived at the point where it had a sufficient excess cash
flow of $4.8 million to consider paying a dividend. It had 3 million shares of stock outstanding
and was considering paying a cash dividend of $1.60 per share. The firm’s total earnings were
$12 million, providing $4.00 in earnings per share. The stock traded in the market at $88.00 per
share.
However, Al Rosen, the chief financial officer, was not sure that paying a cash dividend was the
best route to go. He had recently read a number of articles in The Wall Street Journal about the
advantages of stock repurchases and before he made a recommendation to the CEO and board of
directors, he decided to do a number of calculations.
a. What is the firm’s P/E ratio?
b. If the firm paid the cash dividend, what would be its dividend yield and dividend payout ratio
per share?
c. If a stockholder held 100 shares of stock and received the cash dividend, what would
be the total value of his portfolio (stock plus dividends)?
d. Assume instead of paying the cash dividend, the firm used the $4.8 million of excess funds to
purchase shares at slightly over the current market value of $88 at a price of $89.60. How
many shares could be repurchased? (Round to the nearest share.)
e. What would the new earnings per share be under the stock repurchase alternative? (Round to
three places to the right of the decimal point.)
f. If the P/E ratio stayed the same under the stock repurchase alternative, what would be the
stock value per share? If a stockholder owned 100 shares, what would now be the total value
of his portfolio? (This answer should be approximately the same as the answer to part c.)
CP18-1. Solution:
Modern Furniture Company
a. P/E ratio = Price/EPS
= $88/$4 = 22
Chapter 18: Dividend Policy and Retained Earnings