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
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 consequence,
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
differ just with respect to payout).
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
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
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 issues would be
avoided.
d. 1. Describe the procedures a company follows when it make a distribution through
dividend payments.
Answer:
November 16, 2019:
Declaration date
Holder-of-record date
Payment date
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
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
$1,987.50
$1,600.00
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
387.50
$1,600.00
$1,550.00
÷ Number of shares
100.00
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)
nPost = 100 − ($50/$16)
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:
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
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