Download Chapter 19

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