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Answers and Solutions: 14 - 1
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
theoretical sense, but only under strict assumptions, some of which are clearly not
true in the real world. The “bird-in-the-hand” theory assumes that investors value a
dollar of dividends more highly than a dollar of expected capital gains because the
dividend yield component, D1/P0, is less risky than the g component in the total
expected return equation rS = D1/P0 + g. The tax effect theory proposes that
investors prefer capital gains over dividends, because capital gains taxes can be
deferred into the future, but taxes on dividends must be paid as the dividends are
received.
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
income. Similarly, companies with low dividends will attract a clientele with little
need for current income, and who often have high marginal tax rates.
website, in whole or in part.
d. The residual distribution model states that firms should make distributions only when
extra dividend is a dividend paid, in addition to the regular dividend, when earnings
permit. Firms with volatile earnings may have a low regular dividend that can be
maintained even in low-profit (or high capital investment) years, and then supplement
it with an extra dividend when excess funds are available.
the buyer.
If the stock is bought on or after the ex-dividend date, the dividend is paid to the
seller. The date on which a firm actually mails dividend checks is known as the
payment date.
participants. Thus, the company issues stock in lieu of the cash dividend.
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
then referred to as treasury stock. The higher EPS on the now decreased number of
shares outstanding will cause the price of the stock to rise and thus capital gains are
substituted for cash dividends.
website, in whole or in part.
14-2 a. From the stockholders’ point of view, an increase in the personal income tax rate
would make it more desirable for a firm to retain and reinvest earnings.
Consequently, an increase in personal tax rates should lower the aggregate payout
ratio.
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
might be expected to decline. On the other hand, higher interest rates would cause rd,
rs, and firm’s MCCs to rise--that would mean that fewer projects would qualify for
run profit increase.
e. If investment opportunities for firms declined while cash inflows remained relatively
constant, an increase would be expected in the payout ratio.
f. Dividends are currently paid out of after-tax dollars, and interest charges from before-
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
Answers and Solutions: 14 - 4
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.
b. True. If a company’s stock splits 2 for 1, and you own 100 shares, then after the split
you will own 200 shares.
c. True. Dividend reinvestment plans that involve newly issued stock will increase the
amount of equity capital available to the firm.
Answers and Solutions: 14 - 5
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
14-1 60% Debt; 40% Equity; Capital Budget = $5,000,000; NI = $3,000,000;
PO = ?
Payout =
000,000,3$
000,000,1$
= 33.33%.
14-2 The company requires 0.40($1,200,000) = $480,000 of equity financing. If the company
14-3 Equity financing = $12,000,000(0.60) = $7,200,000.
= $7,800,000/$15,000,000 = 52%.
14-4 Vop = (n0 P) − Extra cash = (10,000,000 x $20) − $25,000,000 = $175,000,000.
14-5 P0 = $120; Split = 3 for 2; New P0 = ?
2/3
120$
website, in whole or in part.
14-6 Retained earnings = Net income (1 - Payout ratio)
= $15,000,000(0.70) = $10,500,000.
14-7 Number of shares = 2,000(2) = 4,000.
14-8 DPS after split = $1.50.
Last year’s dividend = $4.50/1.06 = $4.25.
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
website, in whole or in part.
14-10 a. 1. 2017 Dividends = (1.08)(2016 Dividends)
= (1.08)($2,600,000) = $2,808,000.
2017 Dividends = Net income - Equity financing
= $12,600,000 - $4,745,000 = $7,855,000.
Regular dividends = (1.08)($2,600,000) = $2,808,000.
The residual policy calls for dividends of $7,855,000. Therefore, the extra
Implemented properly, it would lead to the correct capital budget and the correct
financing of that budget, and it would give correct signals to investors.
website, in whole or in part.
14-11 a. Capital Budget = $15,000,000; Capital structure = 70% equity, 30% debt.
Retained Earnings Needed = $15,000,000 (0.7) = $10,500,000.
b. According to the residual dividend model, only $500,000 is available for dividends:
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
e. Capital Budget = $15 million; Dividends = $2 million; NI = $11 million.
Capital Structure = ?
000,000,15$
Percentage of Cap. Budget Financed with Debt =
000,000,15$
000,000,6$
= 40%.
website, in whole or in part.
f. Dividends = $2 million; Capital Budget = $15 million; 70% equity, 30% debt; NI =
$11 million.
g. Dividends = $2 million; NI = $11 million; Capital structure = 70% equity, 30% debt.
RE Available = $11,000,000 - $2,000,000
= $9,000,000.
dividend policy.
h. The firm can do one of four things:
(1) Cut dividends.
Answers and Solutions: 14 - 10
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
Total intrinsic value of firm
$878,000,000.0
$848,000,000.0
− Debt
368,000,000.0
368,000,000.0
− Preferred stock
60,000,000.0
60,000,000.0
Intrinsic value of equity
$450,000,000.0
$420,000,000.0
÷ Number of shares
15,000,000
14,000,000
Intrinsic stock price
$30.00
$30.00
# shares repurchased =
(Cash used in repurchase)/Price =
1,000,000
b. $450 million.
c. $30.
