FFM 10Ce SM Chapter 18 PDF

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Chapter 18 Discussion Questions 18-1. The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the shareholders can earn the most on funds associated with retained earnings. Thus, we must consider what the shareholders can earn on other investments. 18-2. A passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at alternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, shareholder preference for cash dividends is considered very early in the decision process. 18-3. The shareholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some shareholders may say that the dividends are relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the income tax imposed on cash dividends. 18-4. The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show growth rates for selected corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm. 18-5. Factors influencing a firm’s willingness and desire to pay dividends include: a. Internal investment opportunities: determined by corporate opportunities for investment and the life cycle of the firm. b. Shareholders’ investment opportunities and tax position. c. Legal rules disallowing dividend payments from capital contributions to the firm. d. The cash position of the firm. e. The corporation’s access to capital markets. f. Management’s desire for control, which could imply that a closely held firm should avoid dividends to minimize the need for outside financing. For a larger firm, management may have to pay dividends in order to maintain their current position through keeping shareholders happy. 18-6. No, the old shareholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 18-7. The shareholder must pay a tax on dividends received, before funds can be reinvested. To the extent a shareholder is in a high tax bracket, he or she may prefer that the funds be reinvested in the corporation with the hope for future capital appreciation. 18-8. For a stock dividend, there is an accounting transfer between retained earnings and common stock (retained earnings is capitalized). The transfer takes place at the market value of the stock.

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Chapter 18 Common stock

+

Retained earnings

–

For a stock split, there is no transfer of funds, but merely a proportionate increase in the number of shares outstanding. Before Common stock

After

(1,000,000 shares)

(2,000,000 shares)

18-9. The asset base remains the same and the shareholders' proportionate interest is unchanged (everyone got the same new share). Earnings per share will go down by the exact proportion that the number of shares increases. If the P/E ratio remains constant, the total value of each shareholder's portfolio will not increase. The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value is when dividends per share remain constant and total dividends go up, or where substantial information is provided about a growth company. A stock split may have some functionality in placing the company into a lower ‘stock price’ trading range. 18-10. A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the shareholder will receive the same dollar benefit as through a cash dividend. Because the benefits are in the format of capital gains, the tax rate will be lower and the tax may be deferred until the stock is sold. A corporation also may justify the repurchase of its own stock because it is at a very low price, or to maintain constant demand for the shares. Reacquired shares may be used for employee options or as a part of a tender offer in a merger or acquisition. Firms may also reacquire part of their stock as protection against a hostile takeover. 18-11. The faster a firm grows, the more money it needs for investment and the less money it can pay out in dividends. In the early periods of growth, no dividends may be paid out because the firm needs all its earnings for reinvestment. In many cases there may be no earnings in the early periods of growth and alternative sources of external funds are not readily available. As the firm moves along the life cycle curve, growth slows, external funds become more available, earnings stabilize, and internal sources of funds are not all needed for reinvestment, resulting in an increasing payout ratio as the firm approaches maturity. 18-12. Currently 50% of capital gains are taxable when realized for an effective top marginal rate of around 20%. The dividend tax credit means that low income investors will pay very little tax on dividends with high income investors paying about 20 percent. 18-13. Dividend reinvestment plans allow corporations to raise funds continually from present shareholders. This reduces the need for some external funds. These plans allow shareholders to reinvest dividends at low costs and to buy fractional shares, neither of which can be easily accomplished in the market by an individual. The strategy of Foundations of Fin. Mgt. 10Ce

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Chapter 18 dividend reinvestment plans allows for the compounding of dividends and the accumulation of common stock over time. 18-14. Market efficiency suggests that all financial assets are bought and sold based on a proper return for the risk assumed. Prices have all information impounded into them to assure no abnormal returns and that the NPV of all financial transactions is zero. A corporation should be making investments in capital assets where it is likely that positive NPVs can be realized. By making purchases in a corporation’s own shares, management is suggesting that share purchases are better investments than replenishing capital assets. The financial investment in a corporation’s own shares has a positive NPV. This further suggests that the market has inefficiently priced the corporation’s shares and that management knows better. 18-15. A share repurchase will deplete cash resources and the equity in the firm. This will increase debt to equity ratios. There will be less shares outstanding but the assets (particularly cash) held by the firm will be decreased. In an efficient market (without taxes) the share price should be unaffected. There may however be a signaling effect that accompanies the repurchase announcement. 18-16. This question can require some research. It is suggested that Inco paid the dividend to recapitalize the corporation and make it less attractive as a takeover target. At the time Inco had enjoyed huge cash flows due to the high price of nickel and over $1/2 billion in cash sat on the balance sheet. This represented a valued prize of any takeover. By declaring the dividend Inco not only gave this cash to shareholders, but increased its debt to equity becoming a less attractive takeover target. Interestingly Inco had attempted to find a worthwhile acquisition before this decision but apparently was unsuccessful. This suggests that Inco could not find investments with a positive NPV and thus was returning money to the shareholders. Perhaps the shareholders could locate worthwhile investments. 18-17. Corporate executives believe a stable divided policy is important because the conventional wisdom says it should be stable. To alter that policy they believe would convey to shareholders that something has changed and shareholders may believe that as well. 18-18. It shouldn’t matter unless the new dividend signals greater potential for the company’s products. Is management conveying some new information about the future to the market?

Internet Resources and Questions 1. www.tmx.com 2. as above 3. as above

www.reuters.com/finance/markets

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Chapter 18 Problems 18-1.

Omni Telecom

a.

b.

P0 =

D1 $ 1. 80 $ 1 . 80 = = =$ 30 .00 K e−g 0 .10−0 . 04 . 06

P0 =

D1 $ 1 .50 $ 1 .50 =$ 37 . 50 = = K e−g 0 .10 −0 . 06 . 04

c. Plan B produces the higher value because of the higher growth rate.

18-2.

Roget’s Search Engine Limited Year

Dividends

PV@10%

1 2 3

$ 2.00 3.50 20.25

$ 1.82 2.89 15.21 $19.92

The suggested current value for Roget’s is $19.92. 18-3.

Roget’s Revisited a.

Year

Dividends

FV@8%

1 2 3

$ 2.00 3.50 20.25

$ 2.33 3.78 20.25 $26.36

Investor’s require 10% PV (N = 3, %i = 10)

$19.80

The suggested current value for Roget’s is $19.80.

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Chapter 18 b. Year 1 2 3

Dividends

FV@10%

$ 2.00 3.50 20.25

$ 2.42 3.85 20.25 $26.52

Investor’s require 10% PV (N = 3, %i = 10)

$19.92

The suggested current value for Roget’s is $19.92. c. Year 1 2 3

Dividends

FV@12%

$ 2.00 3.50 20.25

$ 2.51 3.92 20.25 $26.68

Investor’s require 10% PV (N = 3, %i = 10)

$20.05

The suggested current value for Roget’s is $20.05.

18-4.

Gallagher Parades

Dividend per share $ 0 . 75 = =0 .250=25 . 0 % Payout ratio= Earnings per share $ 3 . 00 18-5.

Sewell Enterprises Dividends

= (earnings – retained funds) = $160 million – $100 million = $60 million

Dividends $ 60 million =0 .375=37 .5 % = Payout ratio= Earnings $ 160 million Foundations of Fin. Mgt. 10Ce

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Chapter 18 18-6.

Auction.com

Dividends ? =0 . 35=35 . 0 % Payout ratio= = Earnings $ 420 million Dividends= Earnings×payout ratio =$ 420 million ×0 .35 =$ 147 million Addition to retained earnings = earnings – dividends = $420 million – $147 million = $273 million

18-7.

Springsteen Music Company a.

Dividends ? =0 . 20=20 . 0 % Payout ratio= = $ 820 million Earnings Dividends= Earnings×payout ratio =$ 820 million ×0 .20 =$ 164 million Addition to retained earnings = earnings – dividends = $820 million – $164 million = $656 million

b.

Dividend per share=

Dividends $ 164 million =$ 1 . 64 = # of shares 100 million

Dividend per share $ 1 .64 =0 . 0328=3 . 28 % Dividend yield= = $ 50 Market share price

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Chapter 18 18-8.

Pills Berry Corporation

Dividend yield= a.

Dividend per share $ 1 . 80 =0 .03=3 % = $ 60 Market share price

b.

Dividends per share $ 1. 80 =0 .50 =50 .0 % = Payout ratio= Earnings per share ? Dividends per share $ 1 .80 = =$ 3 .60 Earnings per share= Payout ratio 0. 50 Market share price $ 60 =16 .67 = P/E ratio= Earnings per share $ 3 . 60 18-9.

Raptor BB Ranch

Dividend yield= a.

Dividend per share $ 1 .25 = =0 .05=5 % Market share price $ 25

b.

Dividends per share $ 1. 25 = =0 .50 =50 .0 % Payout ratio= Earnings per share ? Dividends per share $ 1 .25 = Earnings per share= =$ 2. 50 Payout ratio 0. 50 Market share price $ 25 =10 . 0 = P/E ratio= Earnings per share $ 2 .50

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Chapter 18 18-10.

Dyer Drilling Co.

Market share price $ 60 P/E ratio= = =25 . 0 Earnings per share ? Market share price $ 60 Earnings per share= = =$ 2. 40 P/E ratio 25

Dividends per share ? =0 . 25=25 . 0 % Payout ratio= = Earnings per share $ 2. 40 Dividends per share= Earnings per share × Payout ratio =$ 2 . 40× 0. 25 =$ 0. 60 Dividend per share $ 0 . 60 = =0 . 010=1 . 0 % Dividend yield= Market share price $ 60 . 18-11.

Chrétien Golf Links Limited

Market share price $ 50 P/E ratio= = =20 . 0 Earnings per share ? Market share price $ 50 = =$ 2 . 50 Earnings per share= P/E ratio 20

Dividends per share ? =0 .30=30 .0 % Payout ratio= = Earnings per share $ 2. 50 Dividends per share= Earnings per share × Payout ratio =$ 2 .50 ×0 . 30=$ 0 .75

Dividend yield=

Dividend per share $ 0 . 75 = =0 . 0150=1 .50 % Market share price $ 50

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Chapter 18 18-12.

Resolute Bay Shipping News Annual dividend = Quarterly dividend =

$65 × 0.055 = $3.575 $3.575/ 4 = $0.89375

The share should decline by approximately $0.89 to $64.11. Due to tax factors the decline will be somewhat less than $0.89.

18-13.

Peabody Mining Company Annual dividend = Quarterly dividend =

$50 × 0.056 = $2.80 $2.80/ 4 = $0.70

The share should decline by approximately $0.70 to $49.30. Due to tax factors the decline will be somewhat less than $0.70.

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Chapter 18 18-14.

Newell Labs, Inc.

a. Plan A: ($2.50 + 2.55 + 2.50 + 2.65 + 2.65) = Plan B: ($0.80 + 3.30 + 0.35 + 2.80 + 6.60) =

$ 12.85 $ 13.85

b. Plan A 1 2 3 4 5

Dividend per share $2.50 2.55 2.50 2.65 2.65 Present value of future dividends

PV @ 10% $2.27 2.11 1.88 1.81 1.65 $9.72

Plan B Dividend per share 1 $0.80 2 3.30 3 0.35 4 2.80 5 6.60 Present value of future dividends

PV @ 12% $0.71 2.63 0.25 1.78 3.75 $9.12

Plan A will provide the higher present value of future dividends.

18-15.

Turtle Co./ Hare Corp. Turtle is not growing very fast so it doesn’t need cash for growth unless it desires to change its policies. Assuming it doesn’t, Turtle should have a high payout ratio. Hare is growing very fast and needs its cash for reinvestment in assets. For this reason, Aaron should have a low dividend payout.

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Chapter 18 18-16.

Goren Bridge Construction Co.

a. Ms. Queen $3.80 31% $ 1.18

Cash dividend Marginal tax rate Taxes

b. Ace Corporation No tax on inter-corporate dividends. 18-17.

Alpha, Beta, Delta

a. Payout ratios Year Alpha 1 50% 2 50% 3 50% 4 50% 5 50%

Beta 50.0% 47.6% 41.7% 35.7% 38.3%

Delta 50.0% 35.7% 41.7% 53.6% 33.3%

b. Alpha has a constant payout ratio which could imply stability of earnings and sales, and steady growth patterns and financing needs. Alpha appears to have a planned dividend payout while Delta uses dividends as a residual. Beta seems to have a stepwise dividend policy in that they do not raise dividends until they are sure that even in a downturn they can be supported. (Note: They went to $2.30 in the last year). c. Alpha has a constant payout ratio, a larger dividend stream over the period, and these may be considered desirable. The earnings of the companies are all the same so that a true investment decision would have to include an analysis of more than the dividend policy, including the shareholder’s marginal tax rate. Other information that would be helpful in the decision would be corporate growth rates, ratio information, and a detailed analysis of the financial statements.

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Chapter 18 18-18.

Interactive Technology

a.

Earnings

Payout ratio

$0.20 2.00 2.80 3.00

0 10% 40% 60%

Stage 1 Stage II Stage III Stage IV b. Total dividends

Dividend income = Taxes @ 31.33% = Aftertax income

Dividends 0 $0.20 1.12 1.80

= shares × dividends per share = 425 × $1.80 = $765.00 $765.00 239.67 $525.33

c. Stock dividends or stock splits are most likely to be utilized during Stage II (growth) or Stage III (expansion).

18-19.

Squash Delight Inc. a. 2 for 1 stock split * Common stock (200,000 shares) Retained earnings * The only account affected b. 10% stock dividend * Common stock (110,000 shares) ** Retained earnings * $300,000 + 10,000 ($10) = $400,000 ** $500,000 – $100,000 = $400,000

$300,000 500,000

$400,000 400,000

c. The stock dividend. Cash dividends cannot exceed the balance in retained earnings and the balance is lower with the stock dividend ($400,000 versus $500,000). Foundations of Fin. Mgt. 10Ce

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Chapter 18 18-20.

Western Pipe Company After 1st transaction Common stock (55,000 shares) Retained earnings

After 2nd transaction Common stock (55,000 shares) Retained earnings*

$125,000 75,000 $200,000

$125,000 64,000 $189,000

*The cash dividend of $0.20 per share causes retained earnings to be reduced by $11,000 (55,000  $0.20).

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Chapter 18 18-21.

Philips Rock and Mud

a. From a legal viewpoint, the firm can pay cash dividends equal to retained earnings of $875,000. On a per share basis, this represents $3.50 per share.

Dividend ( maximum )=

Retained earnings $ 875 ,000 =$ 3 . 50 = 250 , 000 Shares

This is not realistic as the cash available is only $312,500.

b. In terms of cash availability, maximum amount the firm can pay is $1.25 per share. To pay more would require borrowing.

$ 312 ,500 Cash =$ 1 .25 = Dividend ( maximum ) = Shares 250 ,000 c. Shareholder's equity $1,375,000

= common stock + retained earnings = $500,000 + $875,000

Return on equity

= 16%  $1,375,000 = $220,000

Dividends

= 60%  return on equity = 60%  $220,000 = $132,000

Total dividends $ 132 , 000 =$ 0 .53 = Dividend per share= 250 , 000 Shares Foundations of Fin. Mgt. 10Ce

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Chapter 18 18-22.

Adams Corporation Retain Incremental earnings

Earnings per share=

= 15%  $400,000 = $60,000

Earnings $ 750 ,000+$ 60 , 000 =$ 2 .70 = 300 , 000 Shares

Market price of share = P/E ratio (earnings multiplier)  EPS = 8  $2.70 = $21.60

Payout New P/E

Earnings per share=

= 1.10  8 = 8.8

Earnings $ 750 ,000 =$ 2 . 50 = Shares 300 , 000

Market price of share = P/E ratio (earnings multiplier...