Chapter 14 Payout Policy 403
c. If she sells on the ex-dividend day and the share price only declines by one-half
P14-6. Specialty Chemicals Company (SCC) pays out 50% of its net income as cash dividends
to its shareholders once each quarter. The company plans to do so again this year, during
which SCC earned $100 million in net profits after tax. If the company has 40 million
shares outstanding and pays dividends quarterly, what is the company’s dollar dividend
payment per share each quarter?
A14-6. SCC’s dollar dividend payment per share is $0.3125/share each quarter, or $1.250/per
P14-7. Twilight Company’s stock is selling for $60.25 per share, and the firm’s managers have
just announced a $1.50 per share dividend payment.
a. What should happen to Twilight Company’s stock price on the ex-dividend date,
assuming that investors do not have to pay taxes on dividends or capital gains and do
not incur any transactions costs in trading shares?
b. What should happen to Twilight Company’s stock price on the ex-dividend date,
assuming that it follows the historical performance of U.S. stock prices on ex-
dividend days?
c. If the historical “ex–dividend day price effect” observed in U.S. stock markets was
indeed a tax effect, what should happen to Twilight Company’s stock price on the
ex-dividend date, given the tax changes embodied in the Jobs and Growth Tax Relief
Reconciliation Act of 2003?
A14-7. a. If there are no taxes or transactions costs, Twilight’s stock should decline by the
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P14-8. Global Financial Corporation (GFC) has 10 million shares outstanding, each currently
worth $80 per share. The firm’s managers are considering a plan to split the company’s
stock 2-for-1, but they are concerned about the impact this split announcement will have
on the firm’s stock price.
a. If GFC’s managers announce a 2-for-1 stock split, what exactly will the company do
and what will GFC’s stock price likely be after the split?
b. How many total shares of GFC stock will be outstanding after the stock split?
c. If GFC’s managers believe that the “ideal” stock price for the firm’s shares is $20
per share, what should they do? How many shares would be outstanding after this
action?
d. Why do you think GFC’s managers are considering a stock split?
A14-8. a. If the two-for-one split is approved, GFC will distribute 10 million new shares to
down to a range that would attract more individual investors.
P14-9 The net income for a firm is currently $1,000,000 and is projected to grow annually for the
next four years as follows: $1,200,000, $1,300,000, $1,500,000, and $1,700,000. Assuming
the dividend payout ratio is 20% and there are 1,000,000 shares outstanding, what is the
current dividend per share? Further assuming that the firm does not change its stated
dividend, what is the dividend payout ratio for the next four years? (Note: All figures are in
thousands.)
A14-9. The current dividend per share is: 20% * $1,000,000÷ 1,000,000 = = $200,000 ÷
1,000,000 shares = $0.20/share.
P14-10 A firm’s shares currently sell for $32.48, with 5 million shares outstanding. The firm is
considering a 20% stock dividend, in which 100 shares become 120 shares. After the stock
dividend, at what price will the shareholders’ value be unchanged? (Hint: Consider
shareholder value to be the market capitalization, which equals the number of shares
outstanding multiplied by the stock price.) If the stock price became $27.50 after the stock
dividend, do the shareholders benefit?
A14-10. The price that keeps shareholder value unchanged is: ($32.48 * 5 million shares) ÷ (5
Chapter 14 Payout Policy 405
P14-11 A firm’s shares currently sell for $3.50 with 4 million shares outstanding. The firm plans to
reverse split its stock by combining two shares into one share. If the price after this reverse
split is $6.52, have shareholders gained or lost value? How much value is gained or lost?
(Hint: Consider shareholder value to be the market capitalization, which equals the number
of shares outstanding multiplied by the stock price.)
A14-11. Market capitalization prior to split: $3.50 * 4 million shares = $14 million
P14-12 Sunshine Pageants decides that it will use a Dutch auction to repurchase 2 million shares.
Investors have submitted the following bids on the price and quantity they are willing to
sell shares to the firm:
Price ($)
Shares
24.45
100,000
24.50
200,000
24.60
600,000
24.75
1,100,000
24.95
2,000,000
25.15
2,500,000
25.50
5,000,000
Determine the lowest price at which the firm is able to purchase 2 million shares. (Note: If
the firm is willing to purchase shares for $25.50, then it must purchase all shares at this
price; the goal is to find the lowest price at which the firm can purchase the 2 million
shares.) Given the purchase price of the shares, how much extra money do the shareholders
receive compared to the schedule of acceptable bids?
A14-12 At a price of $24.75, 2 million shares can be purchased according to the schedule.
P14-13 Investor A recognizes $100 in dividend income that is taxed at a rate of 20%. Investor B
also wants to recognize the same after-tax revenue as investor A, but investor B owns stock
that does not pay dividends. If investor B’s stock sells for $12 a share (originally purchased
for $7 a share) and if the capital gains tax is 40%, then how many shares must investor B
sell?
A14-13. Investor A’s after-tax profit on dividends: $100.00 * (1 – 20%) = $80.00
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P14-14. Maggie Fiduciary is a shareholder in the Superior Service Company (SSC). The current
price of SSC’s stock is $33 per share, and there are 1 million shares outstanding. Maggie
owns 10,000 shares, or 1% of the stock, which she purchased one year ago for $30 per
share. Assume that SSC makes a surprise announcement that it plans to repurchase
100,000 shares of its own stock at a price of $35 per share. In response to this
announcement, SSC’s stock price increases $1 per share, from $33 to $34, but this price
is expected to fall back to $33.50 per share after the repurchase is completed. Assume
that Maggie faces marginal personal tax rates of 15% on both dividend income and
capital gains.
a. Calculate Maggie’s (realized) after-tax return from her investment in SSC shares,
assuming that she chooses to participate in the repurchase program and all of the
shares she tenders are purchased at $35 per share.
b. How many shares will Maggie be able to sell if all SSC’s shareholders tender their
shares to the firm as part of this repurchase program and the company purchases
shares on a pro rata basis?
c. What fraction of SSC’s total common equity will Maggie own after the repurchase
program is completed if she chooses not to tender her shares?
A14-14. a. If Maggie is able to sell all of her shares for $35/share, she would earn a pre-tax
profit of $5.00/share ($35/share sale price – $30/share purchase price), or a pre-tax
return of 16.67% ($5.00 profit ÷ $30 purchase price). If she must pay a 15% tax, this
P14-15. Go to the home page for Dogs of the Dow (http://www.dogsofthedow.com), look at the
year-to-date figures, and observe the dividend yields of the thirty stocks of the Dow
Jones Industrial Average. Which industries contain the higher-dividend-yielding stocks,
and which contain the lower-yielding stocks? Are there differences in the growth
prospects between the high- and low-yielding stocks? Is this what you expected?
Explain.
A14-15. Internet problem, so cannot predict exact answer ahead of time. However, the basic
P14-16. Stately Building Company’s shares are selling for $75 each and its dividend yield is
2.0%. What is the amount of Stately’s dividend per share?
Chapter 14 Payout Policy 407
P14-17. The stock of Up-and-Away Inc. is selling for $80 per share and is currently paying a
quarterly dividend of $0.25 per share. What is the dividend yield on Up-and-Away
stock?
A14-17. Our first step is to calculate the annual dividend amount, since yield is calculated as
P14-18. Well-Bred Service Company earned $50,000,000 during 2012 and paid $20,000,000 in
dividends to the holders of its 40 million shares. If the current market price of Well-
Bred’s stock is $31.25, calculate the following: (a) the company’s dividend payout ratio;
(b) the stated dividend per share, assuming Well-Bred pays dividends annually; (c) the
stated dividend per share, assuming Well-Bred pays dividends in four equal quarterly
payments; and (d) the current dividend yield on Well-Bred stock.
A14-18. a. Payout ratio is computed as the dividend paid dividend by the firm’s net income,
either for the firm as a whole or on a per share basis. Since we know total dividends
Dividends in Perfect and Imperfect Worlds
P14-19. It is January 1, 2012, and Boomer Equipment Company (BEC) currently has assets of
$250 million and expects to earn a 10% return on assets during the year. There are 20
million shares of BEC stock outstanding. The firm has an opportunity to invest in a
(minimally) positive-NPV project that will cost $25 million over the course of 2012, and
is trying to determine if it should finance this investment by retaining profits over the
course of the year or by issuing new shares while paying the profits earned as dividends..
Show that the decision is irrelevant in a world of perfect and frictionless markets.
A14-19. There are currently 20 million BEC shares outstanding with a market price of
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P14-20. Swelter Manufacturing Company (SMC) currently has assets of $200 million and a
required return of 10% on its 10 million shares outstanding. The firm has an opportunity
to invest in minimally positive NPV projects that will cost $20 million, and is trying to
determine if it should withhold this amount from dividends payable to finance the
investments or pay out the dividends and issue new shares to finance the investments.
Show that the decision is irrelevant in a world of perfect and frictionless markets. How
is the result affected if a personal income tax of 15% is introduced into the model?
A14-20. There are currently 10 million SMC shares outstanding with a market price of
$20.00/share ($200 million assets ÷ 10 million shares). If the company retains its profits
during the coming year and re-invests these in the new project, the total market value of
SMC at year-end will be $220 million ($200 million + $20 million retained profits +
million shares) and the original shareholders will have earned a 10% return on their
investment during the year, all in the form of dividends received ($2.00/share dividend ÷
$20.00/share initial stock price).
This shows that dividend policy will be irrelevant for SMC under the assumption of
no taxes or transactions costs, because the firm will have the same overall market value
at year-end and investors will earn the same return regardless of whether the company
Chapter 14 Payout Policy 409
P14-21. Assume it is now January 1, 2012, and you are examining two unlevered firms that
operate in the same industry that have identical assets worth $80 million that yield a net
profit of 12.5% per year, and that have 10 million shares outstanding. During 2012 and
all subsequent years, each firm has the opportunity to invest an amount equal to its net
income in (slightly) positive-NPV investment projects. The Beta Company wants to
finance its capital spending through retained earnings. The Gamma Company wants to
pay out 100% of its annual earnings as cash dividends and to finance its investments with
a new share offering each year. There are no taxes or transactions costs to issuing
securities.
a. Calculate the overall and per-share market value of the Beta Company at the end of
2012 and each of the two following years (2013 and 2014). What return on
investment will this firm’s shareholders earn?
A14-21. a. Currently, Beta has assets worth $80 million and 10 million of its shares are
outstanding, so each is now worth $8.00/share. At the end of 2012, Beta’s assets will
grow to $90 million, reflecting $10 million in retained profits (0.125 x $80 million).
Because the number of shares outstanding does not change, Beta will still have 10
million shares at year-end 2012, each of which will be worth $9.00/share ($90
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$8.00/share. It will generate $10 million in profits (0.125 $80 million) during 2012
but, unlike Beta, Gamma plans to distribute all of these profits to shareholders as
c. During 2012, Gamma will pay out all its $10 million in earnings as dividends
($1.00/share) and will need to issue enough shares at the current stock price of
$8.00/share to fund the $10 million investment it will make during the year. Thus it
must issue 1.25 million new shares during 2012. At year-end, Gamma will have
assets worth $90 million ($80 million initial value + $10 million investment +
project NPV [assumed negligible]) and 11.25 million shares outstanding. Each share
will be worth $8.00, and the original shareholders will earn a 12.5% return on their
shares during 2009, all in the form of dividends ($1.00/share dividend ÷ $8.00/share
initial market price).
During 2013, Gamma will pay out all its $11.25 million in earnings (0.125 x $90
million initial asset value) as dividends ($1.00/share) and will thus need to issue
d. If you own 100,000 shares (1%) of Gamma’s stock in early 2012, and do not
purchase any of the new stock issued during 2012, 2013, or 2014, you will own
0.702% of the 14.2383 million shares outstanding at year-end 2014.
P14-22. Investors anticipate that Sweetwater Manufacturing Inc.’s next dividend, due in one year,
A14-22. The Gordon Growth Model determines the current price of a stock (P0) by dividing the
Chapter 14 Payout Policy 411
P14-23. Super-Thrift Pharmaceuticals Company traditionally pays an annual dividend equal to
50% of its earnings. Earnings this year are $30,000,0000. The company has 15 million
shares outstanding. Investors expect earnings to grow at a 5% annual rate in perpetuity,
and they require a return of 12% on their shares.
a. What is Super-Thrift’s current dividend per share? What is it expected to be next
year?
b. Use the Gordon growth model (see Equation 5.4) to calculate Super-Thrift’s stock
price today.
A14-23. a. Super-Thrift currently pays $15,000,000 in dividends ($30 million profits 0.50
P14-24. Casual Construction Corporation (CCC) earned $60,000,000 during 2012. The firm
expects to earn $63,000,000 during 2013, in line with its long-term earnings growth rate.
There are 20 million CCC shares outstanding, and the firm has a policy of paying out
40% of its earnings as cash dividends. Investors require a 10% return on CCC shares.
a. What is CCC’s current dividend per share? What is it expected to be next year?
b. Use the Gordon growth model (see Equation 5.4) to calculate CCC’s stock price
today.
A14-24. a. Since CCC pays out 40% of its earnings as dividends, total dividends for 2012 are
P14-25 Hole Foods Donuts, Inc. has generated profits of $2 per share for many years and has
consistently paid 100% of those profits to shareholders via a dividend. Investors do not
expect Hole Foods Donuts to grow in the future. The company has 200,000 shares of
stock outstanding worth $20 per share. Suppose the firm decides to eliminate its dividend
and instead use the money to repurchase shares.
a. Assuming that there are no taxes and that the repurchase announcement conveys
no new information to investors about the profitability or risk of Hole Foods Donuts,
how do you think the stock price will react to the announcement?
b. How many shares will Hole Foods Donuts repurchase?
c. What stock price would you expect for Hole Foods Donuts one and two years after
this announcement? What would the stock price have been in the next two years if the
company had simply maintained its old dividend policy?
A14-25. a. The stock price should not react to the announcement.
b. The current value of the firm is $20 per share. With 200,000 shares outstanding, this
results in a current market value of $4,000,000.
The current dividend is $2 per share on 200,000 shares for a total of $400,000. If the
P14-26 Jasper Metals, Inc. just announced that it will pay its regular quarterly dividend of $3.50
per share.
a.
Does the stock price fall to reflect this payment on the announcement date, the record
date, the ex-dividend date, or the payment date?
b.Assume that there are no market imperfections. By how much will the stock price fall?
c.
Suppose investors must pay a 38% tax on dividends received but pay nothing on
capital gains. How would this change your answer to part (b)?
d.Now suppose that investors must pay 38% in taxes on both dividends and capital gains.
In this case, how much would you expect the stock price to fall in response to the
dividend?
e.
Suppose that, just prior to the dividend announcement, Jasper Metals stock was worth
$175 per share. Assume once again that there are no taxes. If you own 50 shares, then
what is the value of your investment? How does the dividend payment affect your
wealth? If Jasper Metals cancels the dividend and announces that they will repurchase
2% of their outstanding shares, what effect does that have on your wealth?
A14-26 a. The ex-dividend date.
Chapter 14 Payout Policy 413
P14-27. Go to the home page of Cisco Systems, Inc. (http://www.cisco.com) and link to its
financial reports page. Download the most recent annual report and observe the capital
investment and dividend policies of Cisco Systems. Now, do the same for Chevron
(http://www.chevron.com). Which of the two firms appears to have more high-growth,
positive-NPV investment opportunities? Which pays the higher relative dividend? Do
these results support the agency cost/contracting model? The signaling model?
A14-27.Internet problem, so cannot predict exact answer ahead of time. However, Cisco will
Real-World Influences on Payout Policy
P14-28. Universal Windmill Company (UWC) currently has assets worth $50 million and a
required return of 10% on its 2 million shares outstanding. The firm has an opportunity
to invest in (minimally) positive NPV projects that will cost $5 million. UWC needs to
determine whether it should withhold this amount from dividends payable to finance the
investments or pay out the dividends and issue new shares to finance the investments.
Show that the decision is irrelevant in a world of perfect and frictionless markets. What
happens if a personal income tax of 15% on dividends (but not capital gains) is
introduced into the model?
A14-28. There are currently 2 million UWC shares outstanding with a market price of
$25.00/share ($50 million assets ÷ 2 million shares). If the company retains its profits of
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P14-29. A publicly traded firm announces an increase in its dividend with no other material
information accompanying the announcement. What information is this announcement
likely to convey, and what is the expected stock-price effect, as the market assimilates
this information?
A14-29. Investors will probably interpret the dividend increase as a sign that the firm’s managers
P14-30. Sam Sharp purchased 100 shares of Electric Lighting Inc. (ELI) one year ago for $60 per
share. He also received cash dividends totaling $5 per share over the past twelve months.
Now that ELI’s stock price has increased to $64.50 per share, Sam has decided to sell his
holdings. What is Sam’s gross (pre-tax) and net (after-tax) return on this investment,
assuming that he faces a 15% tax rate on dividends and capital gains?
A14-30. Sam’s pre-tax investment income of $9.50/share is the sum of dividends received
THOMSON ONE Business School Edition: Because P14-31 and 14-32 are based on using a live
data base, answers will vary from moment to moment. For instructions on using Thomson ONE,
refer to the instructions provided with the Thomson ONE problems at the end of Chapters 1–6.
Chapter 14 Payout Policy 415
Answer to MiniCase
Dividend Policy
After working for the past four years as a financial analyst for Nevada Power Corporation, you
receive a well-deserved promotion. You have been appointed to work on special projects for Mr.
Watkins, the chief financial officer (CFO). Your first assignment is to gather information on
dividend theory and policy, because the CFO wants to reassess the firm’s current dividend policy.
Assignment
1. What are the different types of dividend policies? Provide examples of situations in which each
of these dividend policies could be used.
2. Describe the difference between cash dividends, stock dividends, stock splits, and share
repurchases. Provide examples when each of these forms of dividends can be used.
3. Discuss the theory of dividend irrelevance. How do taxes affect the dividend irrelevance
theory?
4. How do managers use dividend policy to convey information to the marketplace? Why is
dividend policy, instead of a press release, used to communicate information?
Answers
1. The different types of dividend policies include; (a) Constant Payout Ratio Policy, (b) Constant
Nominal Payment Policy, and (c) Low-Regular-and -Extra Policy.
With constant payout ratio policy the firm establishes a certain percentage of earnings that
is paid to owners in each dividend period. The problem with this policy is that if the firm’s
2. With a cash dividend excess cash can be distributed to owners allowing owners to put this cash
to better use. Cash dividends are the most common type of dividend.
A stock dividend is the payment to existing owners of a dividend in the form of stock. The
net effect on shareholder wealth is neutral. Shareholders receiving stock dividends also
maintain a constant proportional share in the firm’s equity. In most cases there are no tangible
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3. According to the theory of dividend irrelevance, in a world of frictionless capital markets,
payout policy cannot affect the market value of the firm. Value derives solely from the inherent
profitability of the firm’s assets and the competence of its management team.
4. Managers, who have a better understanding of the firm’s true financial condition than
shareholders do, can convey this information to shareholders through the dividend policy
managers select. Dividend payments have what accountants call “cash validity,” meaning that
these payments are believable and are hard for weaker firms to duplicate. Phrased in economic
terms, in a world that is characterized by informational asymmetries between managers and