978-1305632295 Chapter 14 Solution Manual Part 2

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Answers and Solutions: 14 – 1

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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

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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

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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

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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)

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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

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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

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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

+ 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

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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

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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.

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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

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