Chapter 14
Distributions to Shareholders:
Dividends and Repurchases
ANSWERS TO END-OF-CHAPTER QUESTIONS
14-1 a. The optimal distribution policy is one that strikes a balance between dividend yield
and capital gains so that the firm’s stock price is maximized.
b. The dividend irrelevance theory holds that dividend policy has no effect on either the
price of a firm’s stock or its cost of capital. The principal proponents of this view are
Merton Miller and Franco Modigliani (MM). They prove their position in a
c. The signaling hypothesis holds that investors regard dividend changes as “signals” of
management forecasts.
Thus, when dividends are raised, this is viewed by investors as recognition by
management of future earnings increases. Therefore, if a firm’s stock price increases
d. The residual distribution model states that firms should make distributions only when
more earnings are available than needed to support the optimal capital budget. An
e. The declaration date is the date on which a firm’s directors issue a statement declaring
a dividend. If a company lists the stockholder as an owner on the holder-of-record
date, then the stockholder receives the dividend. The ex-dividend date is the date
If the stock is bought on or after the ex-dividend date, the dividend is paid to the
f. Dividend reinvestment plans allow stockholders to automatically purchase shares of
common stock of the paying corporation in lieu of receiving cash dividends. There
g. In a stock split, current shareholders are given some number (or fraction) of shares for
each stock owned. Thus, in a 3-for-1 split, each shareholder would receive 3 new
shares in exchange for each old share, thereby tripling the number of shares
14-2 a. From the stockholders’ point of view, an increase in the personal income tax rate
b. If the depreciation allowances were raised, cash flows would increase. With higher
cash flows, payout ratios would tend to increase. On the other hand, the change in
c. If interest rates were to increase, the increase would make retained earnings a
relatively attractive way of financing new investment. Consequently, the payout ratio
d. A permanent increase in profits would probably lead to an increase in dividends, but
not necessarily to an increase in the payout ratio. If the aggregate profit increase were
f. Dividends are currently paid out of after-tax dollars, and interest charges from
g. This change would make capital gains less attractive and would lead to an increase in
the payout ratio.
14-3 The difference is largely one of accounting. In the case of a split, the firm simply
increases the number of shares and simultaneously reduces the par or stated value per
14-4 The residual distribution policy is based on the premise that, since new common stock is
14-5 a. True. When investors sell their stock they are subject to capital gains taxes.
retain earnings rather than those that pay large dividends.
dividends in some years which would upset the company’s developed clientele.
payout will tend to decline whenever the firm’s investment opportunities improve.
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
14-1 60% Debt; 40% Equity; Capital Budget = $5,000,000; NI = $3,000,000;
PO = ?
Equity retained for capital budget = 0.4($5,000,000) = $2,000,000.
14-3 Equity financing = $12,000,000(0.60) = $7,200,000.
Dividends = Net income – Equity financing
Dividend payout ratio = Dividends/Net income
14-5 P0 = $120; Split = 3 for 2; New P0 = ?
P0 New =
2/3
120$
= $80.
14-6 Retained earnings = Net income (1 – Payout ratio)
= $8,000,000(0.45) = $3,600,000.
External equity needed:
Total equity required = (New investment)(1 – Debt ratio)
14-7 Number of shares = 2,000(2) = 4,000.
14-8 DPS after split = $1.50.
14-9 Capital budget should be $6 million since the company will accept all independent
projects whose IRR exceeds the project’s cost of capital. We know that 65% of the $6
million should be equity. Therefore, the company should pay dividends of:
Dividends = Net income – needed equity
2017 Dividends = Net income – Equity financing
All of the equity financing is done with retained earnings as long as they are
available.
4. The regular dividends would be 8% above the 2016 dividends:
The residual policy calls for dividends of $7,855,000. Therefore, the extra
dividend, which would be stated as such, would be
An even better use of the surplus funds might be a stock repurchase.
b. Policy 4, based on the regular dividend with an extra, seems most logical.
b. According to the residual dividend model, only $500,000 is available for dividends:
NI – Retained earnings needed for cap. projects = Residual dividend.
c. Retained Earnings Available = $11,000,000 – $2.00 (1,000,000)
d. No. If the company maintains its $2.00 DPS, only $9 million of retained earnings
will be available for capital projects. However, if the firm is to maintain its current
Capital Structure = ?
000,000,15$
000,000,6$
RE Available = $11,000,000 – $2.00(1,000,000)
g. Dividends = $2 million; NI = $11 million; Capital structure = 70% equity, 30% debt.
We’re forcing the RE Available = Required Equity to find the new capital budget.
Required Equity = Capital Budget (Target Equity Ratio)
Therefore, if Reynolds cuts its capital budget from $15 million to $12.86 million, it
h. The firm can do one of four things:
(1) Cut dividends.
Realize that each of these actions is not without consequences to the company’s
cost of capital, stock price, or both.
14-12
Prior to
Repurchase After Repurchase
Value of operations =
(FCF(1+g))/(WACC-g) = $848,000,000.0 $848,000,000.0
+ Value of nonoperating assets 30,000,000.0 0.0
a. $848 million.
b. $450 million.
MINI CASE
Integrated Waveguide Technologies (IWT) is a 6-year old company founded by Hunt
Jackson and David Smithfield to exploit metamaterial plasmonic technology to develop and
manufacture miniature microwave frequency directional transmitters and receivers for use
in mobile Internet and communications applications. The technology, although
highly-advanced, is relatively inexpensive to implement and their patented manufacturing
techniques require little capital in comparison to many electronics fabrication ventures.
Because of the low capital requirement, Jackson and Smithfield have been able to avoid
issuing new stock and thus own all of the shares. Because of the explosion in demand for its
mobile Internet applications, IWT must now access outside equity capital to fund its
growth and Jackson and Smithfield have decided to take the company public. Until now,
Jackson and Smithfield have paid themselves reasonable salaries but routinely reinvested
all after-tax earnings in the firm, so dividend policy has not been an issue. However, before
talking with potential outside investors, they must decide on a dividend policy.
Your new boss at the consulting firm Flick and Associates, which has been retained
to help IWT prepare for its public offering, has asked you to make a presentation to
Jackson and Smithfield in which you review the theory of dividend policy and discuss the
following issues.
a. 1. What is meant by the term “distribution policy”? How have dividend payouts
versus stock repurchases changed over time?
Answer: Distribution policy is defined as the firm’s policy with regard to (1) the level of
In terms of payouts, here are some facts. (1) The percent of total payouts to net
income has been stable at around 26%-28%, but dividend payout rates have fallen
a. 2. The terms “irrelevance,” “bird-in-the-hand,” and “tax effect” have been used to
describe three major theories regarding the way dividend payouts affect a firm’s value.
Explain what these terms mean, and briefly describe each theory.
Answer: Dividend irrelevance refers to the theory that investors are indifferent between
The dividend irrelevance theory was proposed by MM, but they had to make
some very restrictive assumptions to “prove” it (zero taxes, no flotation or
The dividend preference, or “bird-in-the-hand” theory is identified with Myron
Gordon and John Lintner, who argued that investors perceive a dollar of dividends in
the hand to be less risky than a dollar of potential future capital gains in the bush;
MM opposed the Gordon-Lintner theory, arguing that a firm’s risk is dependent
The tax effect theory recognizes that there are two tax-related reasons for
believing that investors might prefer a low dividend payout to a high payout: (1)