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Chapter 19: Dividends and Other Payouts 19.1 February 16: Declaration date – the board of directors declares a dividend payment that will be made on March 14. February 24: Ex–dividend date – the shares trade ex dividend on and after this date. Sellers before this date receive the dividend. Purchasers on or after this date do not receive the dividend. February 26: Record date – the declared dividends are distributable to shareholders of record on this date. March 14: 19.5 19.7 Payment date – the checks are mailed. a. The ex–dividend date is Feb. 27, which is two business days before the record date. b. The stock price should drop by $1.76 on the ex–dividend date. a. The price is the PV of the dividends, and there are only 2 more cash flows associated with this stock: D1=$2 and D2=$18.5673. Find the present value of this cash flow series: PV b. $2 $18.5673 $16.31 1.13 1.13 2 The current value of your shares is ($16.31)(460) = $7,502.60. Since you want equal payments, you want an annuity, which solves: $7,502.60 X X 1.13 1.13 2 Solving for X, the cash flows are $4,497.68 each year. However, you will receive $920 in dividends in the first year, so you must sell shares to make up the difference, At the end of the first year, you must sell just enough shares to generate $3,577.68. In order to do that, first you must determine the stock price. At that time, the price will be the PV of the liquidating dividend: $18.5673 $16.43 1.13 And $3,577.68 217.75 shares. $16.43 So you must sell 217.75 shares. Answers to End–of–Chapter Problems B–308 At the end of the 2nd year, the remaining shares will each earn the liquidating dividend. To check your work, note that you will receive $ 4,497.78 [(460 – 217.75) x $18.5673]. (Rounding causes the discrepancy). 19.8 a. Assume that the dividend has yet to be paid. Since the firm has a 100% payout policy, the entire net income, $36,000 will be paid as a dividend. Then, the current value of the firm is the discounted value from 1 year hence, plus the current income: Value $36,000 b. The current price of $166.73 (= 1,500,553.57/9,000) per share will fall by the value of the dividend to $162.73: Pr ice $166.73 c. $1,640,300 $1,500,553.57 1.12 $36,000 $162.73 9,000 shares out tan ding 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 calculations below indicate, the value of the firm is unchanged by their proposal. Therefore, share price will be unchanged. To show this, consider what would happen if the dividend was increased to $4.25. Since only the existing shareholders will get the dividend, the required dollar amount is $4.25 x 9,000 shares = $38,250. Then, the dollars to be raised are: $38,250 required funds – $36,000 net income $2,250 dollars to be raised with sale of new shares Since those new shareholders must also earn 12%, their share of the firm one year from now is 2,250 x 1.12 = $2,520, meaning that the old shareholders' interest falls to $1,640,300 – $2,520 = $1,637,778. Under this scenario, the value of the firm to the old shareholders is Value $38,250 $1,637,780 $1,500,553.57 1.12 Since the value is the same as under a), the change in dividend policy had no effect. ii. The new shareholders are not entitled to receive the current dividend. They will receive only the value of the equity one year hence. The PV of those flows is $1,637,780 $1,462,303.57 1.12 Answers to End–of–Chapter Problems B–309 so the share price will be $1,462,303.57 $162.48 9,000 and shares sold will be $2,250 13.84 share 162.48 19.10 Since the $2,500,000 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 as special dividend in 3 years If the firm invests in T–Bills: If the firm invests in T–bills, the aftertax yield of the T–bills will be: Aftertax corporate yield = 0.05(1 – 0.34) = 0.033 So, the future value of the corporate investment in T–bills will be: FV of investment in T–bills = $2,500,000(1 + 0.033)3 = $2,755,757.34 Since the future value will be paid to shareholders as a dividend, the after-tax cash flow will be: Aftertax cash flow to shareholders = $2,755,757.34 (1 – 0.26) = $2,039,260.43 If the firm invests in preferred stock: 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 = .10($2,500,000) = $250,000 Since 64 percent of the dividends are excluded from tax: Taxable preferred dividends = 0.36($250,000) = $90,000 And the taxes the company must pay on the preferred dividends will be: Taxes on preferred dividends = 0.34($90,000) = $30,600 Answers to End–of–Chapter Problems B–310 So, the aftertax dividend for the corporation will be: Aftertax corporate dividend = $250,000 – 30,600 = $219,400 This means the aftertax corporate dividend yield is: Aftertax corporate dividend yield = $219,400 / $2,500,000 = 0.08776 The future value of the company’s investment in preferred stock will be: FV of investment in preferred stock = $2,500,000(1 + 0.08776)3 = $3,217,653.41 Since the future value will be paid to shareholders as a dividend, the aftertax cash flow will be: Aftertax cash flow to shareholders = $3,217,653.41 (1 – 0.26) = $2,381,063.52 Alternative 2: The firm pays out dividend now, and individuals invest on their own. The aftertax cash received by shareholders now will be: Aftertax cash received today = $2,500,000(1 – 0.26) = $1,850,000 The individuals invest in Treasury bills: If the shareholders invest the current aftertax dividends in Treasury bills, the aftertax individual yield will be: Aftertax individual yield on T–bills = 0.05(1 – 0.26) = 0.037 So, the future value of the individual investment in Treasury bills will be: FV of investment in T–bills = $1,850,000 (1 + 0.037)3 = $2,063,041.66 The individuals invest in preferred stock: : If the individual 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 = .10($1,850,000) = $185,000 And the taxes on the preferred dividends will be: Taxes on preferred dividends = 0.26($185,000) = $48,100 So, the aftertax preferred dividend will be: Aftertax preferred dividend = $185,000 – $48,100 = $136,900 This means the aftertax individual dividend yield is: Answers to End–of–Chapter Problems B–311 Aftertax corporate dividend yield = $136,900/ $1,850,000 = 0.074 The future value of the individual investment in preferred stock will be: FV of investment in preferred stock = $1,700,000(1 + 0.074)3 = $2,106,016.48 The aftertax cash flow for the shareholders is maximized when the firm invests the cash in the preferred stocks and pays a special dividend later. 19.11 a. If TC = T0 =0, then Pb Pe 1 0 1 D 1 0 Pb Pe D So, the stock price will fall by the amount of the dividend. b. If TC = 0 and T0 0 then Pb Pe 1 T0 D Pb Pe D(1 T0 ) So, the stock price will fall by the after–tax proceeds from the dividend. c. There was no tax disadvantage to dividends. Thus, investors are indifferent between buying the stock at Pb and receiving the dividend or waiting, buying the stock at Pe and receiving a subsequent capital gain. When only the dividend is taxed, after–tax proceeds must be equated for investors to be indifferent. Since the after–tax proceeds from the dividend are D (1 – T0), the price will fall by that amount. d. No, Elton and Gruber’s paper is not a prescription for dividend policy. In a world with taxes, a firm should never issue stock to pay a dividend, but the presence of taxes does not imply that firms should not pay dividends from excess cash. The prudent firm, when faced with other financial considerations and legal constraints may choose to pay dividends. 19.15 To minimize her tax burden, your aunt should divest herself of high dividend yield stocks and invest in low dividend yield stock. Or, if possible, she should keep her high dividend stocks, borrow an equivalent amount of money and invest that money in a tax deferred account. 19.16 This is not evidence on investor preferences. A rise in stock price when the current dividend is increased may reflect expectations that future earnings, cash flows, etc. will rise. The better performance of the 115 companies, which raised their payouts, may also reflect a signal by management through the dividends that the firms were expected to do well in the future. 19.18 As the firm has been paying out regular dividends for more than 10 years, the current increase in dividends can cause the shareholders to increase their expectations on current and future cash flows Answers to End–of–Chapter Problems B–312 of the firm. This action can be viewed as a positive “signaling” from the firm of the good prospect. (According to Lintner, this signals that the firm’s “permanent earnings” is increased). It then results in the increase in the stock price. 19.20 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 dividend thereby incurring issuance costs. In either case, the companies and thus their investors are better off with a zero dividend policy during the firms’ rapid growth phases. This fact makes these firms attractive only to low dividend clienteles. This example demonstrates that dividend policy is relevant when there are issuance costs. Indeed, it may be relevant whenever the assumptions behind the MM model are not met. 19.24 a. Since the company has a debt–equity ratio of 3, they can raise $3 in debt for every $1 of equity. The maximum capital outlay with no outside equity financing is: Maximum capital outlay = $180,000 + 3($180,000) = $720,000. b. If planned capital spending is $760,000, then no dividend will be paid and new equity will be issued since this exceeds the amount calculated in a. c. No, they do not maintain a constant dividend payout because, with the strict residual policy, the dividend will depend on the investment opportunities and earnings. As these two things vary, the dividend payout will also vary. Answers to End–of–Chapter Problems B–313