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
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
attraction of companies with specific dividend policies to those investors whose needs
are best served by those policies. Thus, companies with high dividends will have a
Answers and Solutions: 14 – 2
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 date when the
right to the dividend leaves the stock. This date was established by stockbrokers to
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
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 outstanding.
Stock splits usually occur when the stock price is outside of the optimal trading range.
Stock dividends also increase the number of shares outstanding, but at a slower rate
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.
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 capital
budgeting and the residual would increase (other things constant), hence the payout
ratio might increase.
f. Dividends are currently paid out of after-tax dollars, and interest charges from before-
tax dollars. Permission for firms to deduct dividends as they do interest charges would
make dividends less costly to pay than before and would thus tend to increase the
payout ratio.
g. This change would make capital gains less attractive and would lead to an increase in
the payout ratio.
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.
e. True. If a company’s clientele prefers large dividends, the firm is unlikely to adopt a
residual dividend policy. A residual dividend policy could mean low or zero dividends
in some years which would upset the company’s developed clientele.
f. False. If a firm follows a residual dividend policy, all else constant, its dividend payout
will tend to decline whenever the firm’s investment opportunities improve.
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 = ?
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
= $15,000,000 – $7,200,000 = $7,800,000.
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.
Answers and Solutions: 14 – 6
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.
EPS = $10.00/2 = $5.00.
14-8 DPS after split = $1.50.
Equivalent pre-split dividend = $1.50(3/1) = $4.50.
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 million
should be equity. Therefore, the company should pay dividends of:
Answers and Solutions: 14 – 7
14-10 a. 1. 2020 DPS = (2019 Dividends)(1 + LT g)/ # shares
= ($4,000,000)(1 + 0.08) /1,000,000
= $4.32.
3. Equity financing = $7,500,000(1 – 0.34) = $4,950,000.
2020 DPS = (2020 Net income – Equity financing)/(# shares)
=($12,800,000 – $4,950,000)/(1,000,000)
= $7.85
All of the equity financing is done with reinvested retained earnings as long as they
are available.
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.
c. Retained Earnings Available = $11,000,000 – $2.00 (1,000,000)
Retained Earnings Available = $11,000,000 – $2,000,000
Retained Earnings Available = $9,000,000.
e. Capital Budget = $15 million; Dividends = $2 million; NI = $11 million.
Capital Structure = ?
RE Available = $11,000,000 – $2,000,000
= $9,000,000.
Answers and Solutions: 14 – 9
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.
h. The firm can do one of four things:
(1) Cut dividends.
(2) Change capital structure, that is, use more debt.
(3) Cut its capital budget.
(4) Issue new common stock.
Answers and Solutions: 14 – 10
14-12
Prior to
Repurchase
After Repurchase
Value of operations =
(FCF(1+gL))/(WACC-gL) =
$848,000,000.0
$848,000,000.0
$878,000,000.0
$848,000,000.0
$450,000,000.0
$420,000,000.0
# shares repurchased =
(Cash used in repurchase)/Price =
1,000,000
a. $848 million.
b. $450 million.
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
distributions, (2) the form of distributions (dividends or stock repurchases), and (3) the
stability of distributions.