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Answers and Solutions: 14 - 1
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
a. 3. What do the three theories indicate regarding the actions management should
take with respect to dividend payout?
Answer: If the dividend irrelevance theory is correct, then dividend payout is of no
consequence, and the firm may pursue any dividend payout. If the bird-in-the-hand
a. 4. What results have empirical studies of the dividend theories produced? How
does all this affect what we can tell managers about dividend payouts?
Answer:
Unfortunately, empirical tests of the theories have been mixed (because firms don’t
Some evidence shows that high payout firms have higher required stock return,
Research shows that in countries with relatively low dividend tax penalties: (1)
In countries with relatively high dividend tax penalties, more companies
This evidence doesn’t directly support the tax effect hypothesis, but it does show
In 2010 and 2012 here was fear of tax increases on dividends. When comparing
late 2010 and 2012 (periods with great uncertainty regarding future tax rates on
This evidence doesn’t directly support the tax effect hypothesis, but it does show
However, other research shows that high payout firms in countries with poor
b. Discuss the effects on distribution policy consistent with: (1) the signaling
hypothesis (also called the information content hypothesis) and (2) the clientele
effect.
Answer: 1. It has long been recognized that the announcement of a dividend increase often
results in an increase in the stock price, while an announcement of a dividend cut
Answers and Solutions: 14 - 2
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
typically causes the stock price to fall. One could argue that this observation
2. Different groups, or clienteles, of stockholders prefer different dividend payout
policies. For example, many retirees, pension funds, and university endowment
3. Clienteles do exist, but the real question is whether there are more members of
one clientele than another, which would affect what a change in its dividend
policy would do to the demand for the firm’s stock. There are also costs (taxes
Answers and Solutions: 14 - 3
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
c. 1. Assume that IWT has a $112.5 million capital budget planned for the coming
year. You have determined its present capital structure (80% equity and 20%
debt) is optimal, and its net income is forecasted at $140 million. Use the residual
distribution model approach to determine IWT’s total dollar distribution.
Assume for now that the distribution is in the form of a dividend. IWT has 100
million shares. What is the forecasted dividend payout ratio? What is the
forecasted dividend per share? What would happen to the payout ratio and DPS
if net income were forecasted to decrease to $90 million? To increase to $160
million?
Answer: We make the following points:
a. Given the optimal capital budget and the target capital structure, we must now
determine the amount of equity needed to finance the projects. Of the $112.5
b. If a residual exists--that is, if net income exceeds the amount of equity the
company needs--then it should distribute the residual amount out as either
c. If only $90 million of earnings were available, the residual is $90 - $90 = $0, so
d. If $160 million of earnings were available, the residual is $160 - $90 = $70
c. 2. In general terms, how would a change in investment opportunities affect the
payout ratio under the residual payment policy?
Answer: A change in investment opportunities would lead to an increase (if investment
Answers and Solutions: 14 - 4
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
c. 3. What are the advantages and disadvantages of the residual policy? (Hint: don’t
neglect signaling and clientele effects.)
Answer: The primary advantage of the residual policy is that under it the firm makes
However, if it were applied exactly, the residual model would result in dividend
payments which fluctuated significantly from year to year as capital requirements and
Even though the residual approach is not used to set the annual dividend, it is used
when firms establish their long-run dividend policy. If “normalized” cost of capital
d. 1. Describe the procedures a company follows when it make a distribution through
dividend payments.
Answer:
November 16, 2016: Declaration date
December 12, 2016: Dividend goes with stock (owner on this day will
get dividend)
Answers and Solutions: 14 - 5
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
d. (2) What is a stock repurchase? Describe the procedures a company follows when it
make a distribution through a stock repurchase.
Answer: A firm may distribute cash to stockholders by repurchasing its own stock rather than
paying out cash dividends. Stock repurchases can be used (1) somewhat routinely as
A company announces intent to purchase a dollar amount of its own stock during a
specific period. The announcement is not binding; in fact, companies often don’t
e. Discuss the advantages and disadvantages of a firm’s repurchasing its own
shares.
Answer: A firm may distribute cash to stockholders by repurchasing its own stock rather than
paying out cash dividends. Stock repurchases can be used (1) somewhat routinely as
Advantages of repurchases:
1. A repurchase announcement may be viewed as a positive signal that management
believes the shares are undervalued.
2. Stockholders have a choice--if they want cash, they can tender their shares,
3. If the company raises the dividend to dispose of excess cash, this higher dividend
4. Repurchased stock, called treasury stock, can be used later in mergers, when
Answers and Solutions: 14 - 6
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
5. Repurchases can be varied from year to year without giving off adverse signals,
while dividends may not.
Disadvantages of repurchases:
1. A repurchase could lower the stock’s price if it is taken as a signal that the firm
2. If the IRS establishes that the repurchase was primarily to avoid taxes on
3. Selling shareholders may not be fully informed about the repurchase; hence they
4. The firm may bid the stock price up and end up paying too high a price for the
Answers and Solutions: 14 - 7
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
f. 1. Suppose IWT has decided to distribute $50 million, which it presently is holding
in very liquid short-term investments. IWT’s value of operations is estimated to
be about $1,937.5 million. IWT has $387.5 million in debt (it has no preferred
stock). As mentioned previously, IWT has 100 million shares of stock
outstanding. Assume that IWT has not yet made the distribution. What is IWT’s
intrinsic value of equity? What is its intrinsic per share stock price?.
Answer:
Value of operations
$1,937.5
0
+ Value of nonoperating assets 50.00
$1,987.5
f. (2) Now suppose that IWT has just made the $50 million distribution in the form of
dividends. What is IWT’s intrinsic value of equity? What is its intrinsic per
share stock price?
Answer:
Before After Dividend
Value of operations $1,937.50 $1,937.50
Answers and Solutions: 14 - 8
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
f. (3) Suppose instead that IWT has just made the $50 million distribution in the form
of a stock repurchase. Now what is IWT’s intrinsic value of equity? How many
shares did IWT repurchase? How many shares remained outstanding after the
repurchase? What is its intrinsic per share stock price after the repurchase?
Answer:
nPost = nPrior − (CashRep/PPrior)
Before After Repurchase
Value of operations $1,937.50 $1,937.50
+ Value of nonoperating assets 50.00 0.00
g. Describe the series of steps that most firms take in setting dividend policy in
practice.
Answer: Firms establish dividend policy within the framework of their overall financial plans.
The steps in setting policy are listed below:
2. The target capital structure, presumably the one which minimizes the WACC
3. With its capital structure and investment requirements in mind, the firm can
Answers and Solutions: 14 - 9
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
4. A long-term target payout ratio is then determined, based on the residual model
concept. Because of flotation costs and potential negative signaling, the firm will
5. An actual dollar dividend, say $2 per year, will be decided upon. The size of this
dividend will reflect (1) the long-run target payout ratio and (2) the probability
that the dividend, once set, will have to be lowered, or, worse yet, omitted. If
h. What are stock dividends and stock splits? What are the advantages and
disadvantages of stock dividends and stock splits?
Answer: When it uses a stock dividend, a firm issues new shares in lieu of paying a cash
dividend. For example, in a 5 percent stock dividend, the holder of 100 shares would
Both stock dividends and stock splits increase the number of shares outstanding
and, in effect, cut the pie into more, but smaller, pieces. If the dividend or split does
It is hard to come up with a convincing rationale for small stock dividends, like 5
percent or 10 percent. No economic value is being created or distributed, yet
On the other hand, there is a good reason for stock splits or large stock dividends.
Specifically, there is a widespread belief that an optimal price range exists for stocks.
Answers and Solutions: 14 - 10
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Another factor that may influence stock splits and dividends is the belief that they
signal management’s belief that the future is bright. If a firm’s management would be
Interestingly, one of the most astute investors of the 20th century, Warren Buffett,
chairman of Berkshire-Hathaway, has never split his firm’s stock. Berkshire currently
i. What is a dividend reinvestment plan (drip), and how does it work?
Answer: Under a dividend reinvestment plan (DRIP), shareholders have the option of
automatically reinvesting their dividends in shares of the firm’s common stock. In an
In a new stock plan, the firm issues new stock to the DRIP members in lieu of
cash dividends. No fees are charged, and many companies even offer the stock at a 5
Answers and Solutions: 14 - 11
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
