Answers and Solutions: 14 – 11
SPREADSHEET PROBLEM
14-13 The detailed solution for the problem is available in the file Ch14 P13 Build a Model
Solution.xlsx on the textbook’s Web site.
Mini Case: 14 – 12
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
(2) A much smaller percentage of companies now pay dividends. When young
companies first begin making distributions, it is usually in the form of repurchases.
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.
some very restrictive assumptions to “prove” it (zero taxes, no flotation or
transactions costs). MM argued that paying out a dollar per share of dividends
reduces the growth rate in earnings and dividends, because new stock will have to be
sold to replace the capital paid out as dividends. Under their assumptions, a dollar of
dividends will reduce the stock price by exactly $1. Therefore, according to MM,
waste and by causing companies to go to the external capital markets more often
(which leads to greater scrutiny and less misuse of resources by managers). If the
bird-in-the-hand theory is true, then investors would regard a firm with a high payout
ratio as being less risky than one with a low payout ratio, all other things equal;
hence, firms with high payout ratios would have higher values than those with low
taxes are not paid on capital gains until the stock is sold. (2) if a stock is held by
someone until he or she dies, no capital gains tax is due at all—the beneficiaries who
receive the stock can use the stock’s value on the death day as their cost basis and
thus escape the capital gains tax.
Mini Case: 14 – 14
a. 3. What do the three theories indicate regarding the actions management should
take with respect to dividend payout?
If the tax effect theory is correct, the firm should set a low payout if it is to maximize
its stock price. Therefore, the theories are in total conflict with one another.
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
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
dividends) with late 2009 and 2011, many companies changed their policies and paid
additional special dividends of over $7 billion. Also, 176 companies moved up
payment dates from the beginning of the next year to late in 2010 and 2012 to avoid
investor protection (where agency costs are most severe) are valued less than low
payout firms, which supports the dividend preference theory.
Mini Case: 14 – 15
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
believes the future is bright, (2) a smaller-than-expected increase, or a dividend
cut, is a negative signal, and (3) if dividends are increased by a “normal” amount,
this is a neutral signal.
2. Different groups, or clienteles, of stockholders prefer different dividend payout
are in high tax brackets and who have no need for current cash income should
prefer low payout stocks.
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
better than another. Still, no one has offered convincing proof that firms can
disregard clientele effects. We know that stockholder shifts will occur if policy is
changed, and since such shifts result in transaction costs and capital gains taxes,
policy changes should not be taken lightly. Further, dividend policy should be
changed slowly, rather than abruptly, in order to give stockholders time to adjust.
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:
maintain the optimal capital structure:
0.357 = 35.7%. DPS would be $50/100 = $0.50.
c. 2. In general terms, how would a change in investment opportunities affect the
payout ratio under the residual payment policy?
website, in whole or in part.
neglect signaling and clientele effects.)
Answer: The primary advantage of the residual policy is that under it the firm makes
maximum use of lower cost retained earnings, thus minimizing flotation costs and
hence the cost of capital. Also, whatever negative signals are associated with stock
effects would lead to a higher required return on equity which would more than offset
the effects of lower flotation costs. Because of these factors, few if any publicly
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)
December 13, 2016:
Ex-dividend date (purchaser on or after this date
doesn’t get dividend)
December 14, 2016:
December 15, 2016:
Holder-of-record date
January 5, 2017:
Payment date