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.
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
with a dividend increase, the reason may not be investor preference for dividends, but
expectations of higher future earnings. Conversely, a dividend reduction may signal
that management is forecasting poor earnings in the future. The clientele effect is the
maintained even in low-profit (or high capital investment) years, and then supplement
it with an extra dividend when excess funds are available.
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
other involves newly issued stock. In the first type, the dividends of all participants
are pooled and the stock is purchased on the open market. Participants benefit from
lower transaction costs. In the second type, the company issues new shares to the
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
Answers and Solutions: 14 – 3
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.
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
capital budgeting and the residual would increase (other things constant), hence the
payout ratio might increase.
e. If investment opportunities for firms declined while cash inflows remained relatively
constant, an increase would be expected 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
share. In the case of a stock dividend, there must be a transfer from retained earnings to
capital stock. For most firms, a 100 percent stock dividend and a 2-for-1 split accomplish
exactly the same thing; hence, investors may choose either one.
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
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
14-1 60% Debt; 40% Equity; Capital Budget = $5,000,000; NI = $3,000,000;
PO = ?
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.
Dividends = Net income – Equity financing
14-4 Vop = (n0 P) − Extra cash = (10,000,000 x $20) − $25,000,000 = $175,000,000.
n = Vop / P = $175,000,000 / $20 = 8,750,000.
14-5 P0 = $120; Split = 3 for 2; New P0 = ?
14-6 Retained earnings = Net income (1 – Payout ratio)
= $8,000,000(0.45) = $3,600,000.
14-7 Number of shares = 2,000(2) = 4,000.
14-8 DPS after split = $1.50.
Equivalent pre-split dividend = $0.75(3/1) = $4.50.
New equivalent dividend = Last year’s dividend(1.06)
$4.50 = Last year’s dividend(1.06)
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
14-10 a. 1. 2014 Dividends = (1.08)(2013 Dividends)
= (1.08)($2,600,000) = $2,808,000.
2. 2013 Payout = $2,600,000/$9,800,000 = 0.2653 = 26.53%.
3. Equity financing = $7,300,000(0.65) = $4,745,000.
2014 Dividends = Net income – Equity financing
4. The regular dividends would be 8% above the 2013 dividends:
Regular dividends = (1.08)($2,600,000) = $2,808,000.
The residual policy calls for dividends of $7,855,000. Therefore, the extra
Answers and Solutions: 14 – 8
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:
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, $10.5 million of equity is required. This would necessitate the
company having to issue $1.5 million of new common stock.
Answers and Solutions: 14 – 9
f. Dividends = $2 million; Capital Budget = $15 million; 70% equity, 30% debt; NI =
$11 million.
Equity Needed = $15,000,000(0.7) = $10,500,000.
g. Dividends = $2 million; NI = $11 million; Capital structure = 70% equity, 30% debt.
RE Available = $11,000,000 – $2,000,000
= $9,000,000.
h. The firm can do one of four things:
(1) Cut dividends.
(2) Change capital structure, that is, use more debt.
Answers and Solutions: 14 – 10
14-12
Prior to
Repurchase
Value of operations =
(FCF(1+g))/(WACC-g) =
$848,000,000.0
+ Value of nonoperating assets
30,000,000.0
# shares repurchased =
(Cash used in repurchase)/Price =
1,000,000
a. $848 million.
b. $450 million.
$878,000,000.0
$848,000,000.0
368,000,000.0
60,000,000.0
$450,000,000.0
$420,000,000.0
Answers and Solutions: 14 – 11
SPREADSHEET PROBLEM
Mini Case: 14 – 12
MINI CASE
Integrated Waveguide Technologies, Inc. (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
distributions, (2) the form of distributions (dividends or stock repurchases), and (3)
Mini Case: 14 – 13
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
dividends and capital gains, making dividend policy irrelevant with regard to its
effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of
Mini Case: 14 – 14
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
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
b. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele
effect, and (3) their effects on distribution policy.
Answer: 1. Different groups, or clienteles, of stockholders prefer different dividend payout
policies. For example, many retirees, pension funds, and university endowment
2. 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
and brokerage) to stockholders who would be forced to switch from one stock to
3. 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
typically causes the stock price to fall. One could argue that this observation
supports the premise that investors prefer dividends to capital gains. However,
Mini Case: 14 – 16
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
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
Mini Case: 14 – 17
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
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
d. 1. Describe the procedures a company follows when it make a distribution through
dividend payments.
Answer: November 14: Board declares a quarterly dividend of $0.50 per share to holders of
record as of December 13.
Mini Case: 14 – 18
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
an alternative to regular dividends, (2) to dispose of excess (nonrecurring) cash that
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
an alternative to regular dividends, (2) to dispose of excess (nonrecurring) cash that
came from asset sales or from temporarily high earnings, and (3) in connection with a
capital structure change in which debt is sold and the proceeds are used to buy back
and retire shares.
Advantages of repurchases:
1. A repurchase announcement may be viewed as a positive signal that management
Mini Case: 14 – 19
Disadvantages of repurchases:
1. A repurchase could lower the stock’s price if it is taken as a signal that the firm
has relatively few good investment opportunities. On the other hand, though, a
repurchase can signal stockholders that managers are not engaged in “empire
building,” where they invest funds in low-return projects.
Mini Case: 14 – 20
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
$1,937.50
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
$1,987.50
$1,937.50
$1,600.00
$1,550.00
$1,987.50
$1,600.00
Mini Case: 14 – 21
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)
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:
1. The firm forecasts its annual capital budgets and its annual sales, along with its
working capital needs, for a relatively long-term planning horizon, often 5 years.
Mini Case: 14 – 22
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
receive an additional 5 shares. In a stock split, the number of shares outstanding is
increased (or decreased in a reverse split) in an action unrelated to a dividend
Mini Case: 14 – 23
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
open market purchase plan, a trustee pools all the dividends to be reinvested and then