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420
Integrated Case
Chapter 15: Distributions to Shareholders
A. (2) Explain briefly the dividend irrelevance theory that was put forward
by Modigliani and Miller. What were the key assumptions underlying
their theory?
Answer: [Show S15-3 here.] Dividend irrelevance refers to the theory that
investors are indifferent between dividends and capital gains, making
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A. (3) Why do some investors prefer high-dividend-paying stocks, while
other investors prefer stocks that pay low or nonexistent dividends?
Answer: [Show S15-4 and S15-5 here.] Investors might prefer dividends to
capital gains because they may regard dividends as less risky than
B. Discuss (1) the information content, or signaling, hypothesis; (2) the
clientele effect; (3) catering theory; and (4) their effects on dividend
policy.
Answer: [Show S15-6 through S15-8 here.] It has long been recognized that
the announcement of a dividend increase often results in an increase
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C. (1) Assume that SSC has an $800,000 capital budget planned for the
coming year. You have determined that its present capital structure
(60% equity and 40% debt) is optimal, and its net income is
forecasted at $600,000. Use the residual dividend model to
determine SSC’s total dollar dividend and payout ratio. In the
process, explain how the residual dividend model works. Then
explain what would happen if expected net income was $400,000 or
$800,000.
Answer: [Show S15-9 through S15-12 here.] We make the following points:
1. Given the optimal capital budget and the target capital
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C. (2) In general terms, how would a change in investment opportunities
affect the payout ratio under the residual dividend model?
Answer: [Show S15-13 here.] A change in investment opportunities would
lead to an increase (if investment opportunities were good) or a
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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: [Show S15-14 here.] The primary advantage of the residual policy is
that the firm makes maximum use of lower-cost retained earnings,
thus minimizing flotation costs and hence the cost of capital. Also,
D. Describe the series of steps that most firms take in setting dividend
policy in practice.
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Integrated Case
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Answer: [Show S15-15 here.] 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 budget and its annual sales,
4. A long-term target payout ratio is then determined, based on
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E. What is a dividend reinvestment plan (DRIP), and how does it work?
Answer: [Show S15-16 through S15-18 here.] Under a dividend reinvestment
F. What are stock dividends and stock splits? What are the advantages
and disadvantages of stock dividends and stock splits?
Answer: [Show S15-19 through S15-21 here.] When it uses a stock dividend,
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G. What are stock repurchases? Discuss the advantages and
disadvantages of a firm’s repurchasing its own shares.
Answer: [Show S15-22 through S15-24 here.] A firm may distribute cash to
stockholders by repurchasing its own stock rather than paying out
Advantages of repurchases:
1. A repurchase announcement may be viewed as a positive signal
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
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2. If the IRS establishes that the repurchase was primarily to avoid
3. Selling shareholders may not be fully informed about the
4. The firm may bid up the stock price resulting in the firm paying
