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CHAPTER 19
DIVIDENDS AND OTHER PAYOUTS
Answers to Concepts Review and Critical Thinking Questions
1. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid.
3. The chief drawback to a strict dividend policy is the variability in dividend payments. This is a problem
because investors tend to want a somewhat predictable cash flow. Also, if there is information content
4. Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a holiday,
5. No, because the money could be better invested in stocks that pay dividends in cash which benefit the
fundholders directly.
7. The stock price dropped because of an expected drop in future dividends. Since the stock price is the
8. The plan will probably have little effect on shareholder wealth. The shareholders can reinvest on their
own, and the shareholders must pay the taxes on the dividends either way. However, the shareholders
9. If these firms just went public, they probably did so because they were growing and needed the
additional capital. Growth firms typically pay very small cash dividends, if they pay a dividend at all.
10. It would not be irrational to find low-dividend, high-growth stocks. The trust should be indifferent
between receiving dividends or capital gains since it does not pay taxes on either one (ignoring possible
11. The stock price drop on the ex-dividend date should be lower. With taxes, stock prices should drop by
12. With a high tax on dividends and a low tax on capital gains, investors, in general, will prefer capital
gains. If the dividend tax rate declines, the attractiveness of dividends increases.
13. Knowing that share price can be expressed as the present value of expected future dividends does not
make dividend policy relevant. Under the growing perpetuity model, if overall corporate cash flows
are unchanged, then a change in dividend policy only changes the timing of the dividends. The PV of
14. The bird-in–the-hand argument is based upon the erroneous assumption that increased dividends make
15. This argument is theoretically correct. In the real world, with transaction costs of security trading,
homemade dividends can be more expensive than dividends directly paid out by the firms. However,
16. a. Cap’s past behavior suggests a preference for capital gains, while Sarah exhibits a preference for
current income.
17. To minimize her tax burden, your aunt should divest herself of high dividend yield stocks and invest
18. The capital investment needs of small, growing companies are very high. Therefore, payment of
dividends could curtail their investment opportunities. Their other option is to issue stock to pay the
19. Unless there is an unsatisfied high dividend clientele, a firm cannot improve its share price by
switching policies. If the market is in equilibrium, the number of people who desire high dividend
20. This finding implies that firms use initial dividends to “signal” their potential growth and positive
NPV prospects to the stock market. The initiation of regular cash dividends also serves to convince
the market that their high current earnings are not temporary.
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
1. The aftertax dividend is the pretax dividend times one minus the tax rate, so:
Aftertax dividend = $7.25(1 – .15)
2. a. The shares outstanding increase by 10 percent, so:
New shares outstanding = 25,000(1.10)
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b. The shares outstanding increases by 25 percent, so:
New shares outstanding = 25,000(1.25)
New shares outstanding = 31,250
3. a. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of
new shares to old shares, so:
New shares outstanding = 25,000(4/1)
New shares outstanding = 100,000
4. To find the new stock price, we multiply the current stock price by the ratio of old shares to new shares,
so:
a. $108(3/5) = $64.80
b. $108(1/1.15) = $93.91
5. The stock price is the total market value of equity divided by the shares outstanding, so:
P0 = $503,000 equity/12,000 shares
6. Repurchasing the shares will reduce shareholders’ equity by $22,800. The shares repurchased will be
the total purchase amount divided by the stock price, so:
Shares bought = $22,800/$41.92
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And the new shares outstanding will be:
7. The stock price is the total market value of equity divided by the shares outstanding, so:
P0 = $695,000 equity/25,000 shares
P0 = $27.80 per share
8. With a stock dividend, the shares outstanding will increase by one plus the dividend amount, so:
New shares outstanding = 305,000(1.15)
New shares outstanding = 350,750
The capital surplus is the capital paid in excess of par value, which is $1, so:
9. The only equity account that will be affected is the par value of the stock. The par value will change
by the ratio of old shares to new shares, so:
New par value = $1(1/5)
New par value = $.20 per share
10. a. If the dividend is declared, the price of the stock will drop on the ex-dividend date by the value
of the dividend, $4. It will then trade for $103.
b. If it is not declared, the price will remain at $107.
11. The price of the stock today is the PV of the dividends, so:
P0 = $2.90/1.14 + $59/1.142
P0 = $47.94
To find the equal two-year dividends with the same present value as the price of the stock, we set up
the following equation and solve for the dividend (Note: The dividend is a two-year annuity, so we
12. If you only want $500 in Year 1, you will buy:
Shares to buy at Year 1 = ($2,900 – 500)/$51.75
Shares to buy at Year 1 = 46.37 shares
at Year 1. Your dividend payment in Year 2 will be:
13. a. If the company makes a dividend payment, we can calculate the wealth of a shareholder as:
Dividend per share = $6,675/1,500 shares
Dividend per share = $4.45
The stock price after the dividend payment will be:
b. If the company pays dividends, the current EPS is $2.80, and the PE ratio is:
PE = $62.55/$2.80
PE = 22.34
If the company repurchases stock, the number of shares will decrease. The total net income is the
EPS times the current number of shares outstanding. Dividing net income by the new number of
shares outstanding, we find the EPS under the repurchase is:
14. a. Since the firm has a 100 percent payout policy, the entire net income, $135,000 will be paid as a
dividend. The current value of the firm is the discounted value one year from now, plus the
current income, which is:
b. The current stock price is the value of the firm, divided by the shares outstanding, which is:
Stock price = $1,907,321.43/30,000
Stock price = $63.58
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c. i. According to MM, it cannot be true that the low dividend is depressing the price. Since
dividend policy is irrelevant, the level of the dividend should not matter. Any funds not
distributed as dividends add to the value of the firm, hence the stock price. These directors
merely want to change the timing of the dividends (more now, less in the future). As the
Dollars raised = $52,500
This money can only be raised with the sale of new equity to maintain the all-equity
financing. Since those new shareholders must also earn 12 percent, their share of the firm
one year from now is:
New shareholder value in one year = $52,500(1.12)
the value of the equity one year hence. The present value of those flows is:
Present value = $1,926,200/1.12
Present value = $1,719,821.43
And the current share price will be:
Current share price = $1,719,821.43/30,000
15. a. The current price is the current cash flow of the company plus the present value of the expected
cash flows, divided by the number of shares outstanding. So, the current stock price is:
b. To achieve a zero dividend payout policy, he can invest the dividends back into the company’s
stock. The dividends per share will be:
Dividends per share = [($1,100,000)(.50)]/525,000
Dividends per share = $1.05
16. a. Using the formula from the text proposed by Lintner:
Div1 = Div0 + s(t EPS1 – Div0)
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b. Now we use an adjustment rate of .60, so the dividend next year will be:
Div1 = Div0 + s(t EPS1 – Div0)
17. Assuming no capital gains tax, the aftertax return for the Gordon Company is the capital gains growth
rate, plus the dividend yield times one minus the tax rate. Using the constant growth dividend model,
we get:
18. Using the equation for the decline in the stock price ex-dividend for each of the tax rate policies,
we get:
(P0 – PX)/D = (1 – TP)/(1 – TG)
a. P0 – PX = D(1 – 0)/(1 – 0)
19. Since the $4,900,000 cash is after corporate tax, the full amount will be invested. So, the value of each
alternative is:
Alternative 1:
The firm invests in T-bills or in preferred stock and then pays out a special dividend in 3 years.
If the firm invests in T-Bills:
If the firm invests in preferred stock, the assumption would be that the dividends received will be
reinvested in the same preferred stock. The preferred stock will pay a dividend of:
Preferred dividend = .05($4,900,000)
Preferred dividend = $245,000
Since 70 percent of the dividends are excluded from tax:
Aftertax corporate dividend yield = .0469, or 4.69%
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The future value of the company’s investment in preferred stock will be:
FV of investment in preferred stock = $4,900,000(1 + .0469)3
FV of investment in preferred stock = $5,621,464.24
will be:
Aftertax individual yield on T-bills = .03(1 – .31)
Aftertax individual yield on T-bills = .0207, or 2.07%
So, the future value of the individual investment in Treasury bills will be:
FV of investment in T-bills = $4,165,000(1 + .0207)3
Aftertax preferred dividend = $208,250 – 64,557.50
Aftertax preferred dividend = $143,692.50
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This means the aftertax individual dividend yield is:
Aftertax individual dividend yield = $143,692.50/$4,165,000
20. a. Let x be the ordinary income tax rate. The individual receives an aftertax dividend of:
Aftertax dividend = $1,000(1 – x)
which she invests in Treasury bonds. The Treasury bond will generate aftertax cash flows to the
investor of:
Aftertax cash flow from Treasury bonds = $1,000(1 – x)[1 + .07(1 – x)]
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c. Since both investors will receive the same pretax return, you would expect the same answer as
in part a. Yet, because the company enjoys a tax benefit from investing in stock (70 percent of
income from stock is exempt from corporate taxes), the tax rate on ordinary income which
induces indifference, is much lower. Again, set the two equations equal and solve for x: