Answers and Solutions: 15 – 15
15-12
Prior to
Repurchase After Repurchase
Value of operations =
(FCF(1+g))/(WACC-g) = $848,000,000.0 $848,000,000.0
+ Value of nonoperating assets 30,000,000.0 0.0
# shares repurchased =
(Cash used in repurchase)/Price = 1,000,000
a. $848 million.
Answers and Solutions: 15 – 16
SPREADSHEET PROBLEM
15-13 The detailed solution for the problem is available in the file Ch15 P13 Build a Model
Mini Case: 15 – 17
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
Mini Case: 15 – 18
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
The dividend preference, or “bird-in-the-hand” theory is identified with Myron
Gordon and John Lintner, who argued that investors perceive a dollar of dividends in
the hand to be less risky than a dollar of potential future capital gains in the bush;
hence, stockholders prefer a dollar of actual dividends to a dollar of retained earnings.
In addition, high payouts mitigate agency costs by depriving managers of cash to
Mini Case: 15 – 19
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
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).. Some evidence shows that high payout firms have
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
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
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: 15 – 21
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
b. If a residual exists–that is, if net income exceeds the amount of equity the
company needs–then it should distribute the residual amount out as either
c. If only $90 million of earnings were available, the residual is $90 – $90 = $0, so
nothing should be paid out as dividends. Thus, the payout ratio would be zero, as
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: 15 – 22
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 19: Board declares a quarterly dividend of $0.50 per share to holders of
record as of December 18.
Mini Case: 15 – 23
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
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
Advantages of repurchases:
1. A repurchase announcement may be viewed as a positive signal that management
believes the shares are undervalued.
Mini Case: 15 – 24
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
3. Selling shareholders may not be fully informed about the repurchase; hence they
may make an uninformed decision and may later sue the company. To avoid this,
firms generally announce repurchase programs in advance.
Mini Case: 15 – 25
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
Mini Case: 15 – 26
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:
Before After Repurchase
Value of operations $1,937.50 $1,937.50
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: 15 – 27
4. A long-term target payout ratio is then determined, based on the residual model
concept. Because of flotation costs and potential negative signaling, the firm will
5. An actual dollar dividend, say $2 per year, will be decided upon. The size of this
dividend will reflect (1) the long-run target payout ratio and (2) the probability
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
It is hard to come up with a convincing rationale for small stock dividends, like 5
percent or 10 percent. No economic value is being created or distributed, yet
stockholders have to bear the administrative costs of the distribution. Further, it is
inconvenient to own an odd number of shares as may result after a small stock
Mini Case: 15 – 28
purchased in round lots, hence at reduced commissions, by most investors. A higher
price would put round lots out of the price range of many small investors, while a
stock price lower than about $20 would convey the image of a stock that is doing
poorly. Thus, most firms try to keep their stock prices within the $20 to $80 range. If
the company prospers, it will split its stock occasionally to hold the price down.
(Also, companies that are doing poorly occasionally use reverse splits to raise their
price.) Many companies do operate outside the $20 to $80 range, but most stay
within it.
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