Review Questions: Titman 11ed Chapter 16 Dividend Policy

16.1 How Do Firms Distribute Cash to Their Shareholders?

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1) Why has the popularity of stock repurchases been growing faster than the cash dividends as a method for companies to distribute cash to their stockholders. Stock repurchases allow investors to tailor the timing of cash flows to their individual needs and tax situations. An investor with high current income can refuse the distribution, thereby reinvesting the money, postponing taxes, and avoiding transaction fees. An investor who wants or needs the income can sell shares back to the firm with no or very low transaction fees and often at a price that is slightly higher than the market value. !rom the firm"s point of view, the effect on stock price of omitting a dividend is often devastating, while there seems to be no e#uivalent penalty for not offering to repurchase shares. $) %xplain the significance of each of the following& a. announcement date b. ex'dividend date c. record date d. payment date a. announcement date& (ate at which the )oard of (irectors announces that a dividend will be paid. b. ex'dividend& date (ate after which the stock trades ex'dividend. *nvestors who buy the stock on or after the ex'dividend date do not receive the dividend. +he previous owner does. c. record date& (ate on which the company examines its records to determine who is entitled to the dividend. d. payment date& +he date at which cash is actually distributed to eligible shareholders ,those who purchased before the ex'dividend date.) on!Cash Distributions" Stoc# Dividends and Stoc# Splits -) What are the effects of stock splits and stock dividends. Why are they popular. %conomically, the only effect of a stock split or stock dividend is to increase the number of shares in existence. Since these shares bring no additional cash into the firm, it is obvious that neither book e#uity nor market e#uity increase as a result. /f necessity, the price per share must fall to ad0ust for the number of additional shares. A company whose shares sell for a relatively high price, say 1$22, might decide to split the shares 3 for 1 creating 3 shares valued at 142 for every 1 share in existence. +his action is based on the belief that investors will prefer the lower price because a typical 122 share round lot would then be more affordable. *t also assumes that the price of a stock is influenced by supply and demand for the stock rather than 0ust future cash flows. *n view of the importance of large institutional investors who are not concerned with whether they buy 122,222 142 shares or 42,222 1122 shares, this argument seems dubious. *t is also possible that managers use stock splits to hint at future good news concerning the company"s cash flows. 3) 567 8orporation has 322,222 shares of common stock outstanding, a 9:% ratio of ;, and 1422,222 available for common stockholders. +he board of directors has 0ust voted a -'$ stock split. a. *f you had 122 shares of stock before the split, how many shares will you have after the split. b. What was the total value of your investment in 567 stock before the split. c. What should be the total value of your investment in 567 stock after the split. d. *n view of your answers to ,b) and ,c) above, why would a firm"s management want to have a stock split. a. b. c. <umber of shares after split = -:$ > 122 = 142 %9S before split = ,1422,222:322,222) = 11.$4 i. 9rice per share before split = ; > 11.$4 = 112 ii. +otal value of investment = 112 > 122 = 11,222 +otal number of shares after split = -,322,222:$) = ?22,222 i. %9S after split = ,1422,222:?22,222) = 1.;--ii. 9rice per share after split = ; > 1.;-- = 1?.?@ iii. +otal value of investment after split = 1?.?@ > 142 = 11,222 ,1) Stock splits are believed to have favorable information content. Splits are often associated with growth companies. 1 8opyright A $211 9earson %ducation, *nc.

d.

Review Questions: Titman 11ed Chapter 16 Dividend Policy

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,$) Splits can conserve corporate cash if the firm has cash flow problems or needs additional funds for attractive investment opportunities. 4) Belly owns 12,222 shares in Cc8ormick Spices, which currently has 422,222 shares outstanding. +he stock sells for 1;? on the open market. Cc8ormick"s management has decided on a $'1 split. a. Will Belly"s financial position alter after the split, assuming that the stocks will fall proportionately. b. Assuming only a -4D fall on each stock, what will be Belly"s value after the split. Eiven& Cc8ormick Spices 8orporation ' Stock Split Carket price 1;?.22 Split multiple $ Shares outstanding 422,222 a. *nvestor"s shares = 12,222 9osition before split 1;?2,222 = 12,222 shares > 1;? per share 9rice after split 13-.22 = 1;?:$ Belly"s shares after split $2,222 = 12,222 > $ 9osition after split 1;?2,222 = $2,222 shares > 13- per share <et gain 12 b. 9rice fall 2.-4 9rice after split 144.F2 = 1;?.22,1 ' .-4) 9osition after split 11,11;,222 = $2,222 shares > 144.F2 per share <et gain 1$4;,222 = 11,11;,222 ' 1;?2,222 16.$ Does Dividend Policy %atter? ?) Gnder what conditions would the Codigliani and Ciller dividend indifference theorem be literally true. +he Codigliani and Ciller dividend indifference theorem re#uires that investors be able to buy and sell stock without incurring any transaction costs, such as brokerage costs. *n addition, companies can issue stock without incurring any cost in doing so. *t assumes that there are no personal or corporate taxes. 8omplete information about the firm is readily available, and there are no conflicts of interest between management and stockholders. Hastly, financial distress and bankruptcy costs are nonexistent. @) Hist the benefits of a firm repurchasing its own stock. Stock repurchases can be very advantageous to a firm. !irst, repurchases are a means for providing an internal investment opportunity as well as an approach for modifying a firm"s capital structure. *n general, repurchases create a favorable impact on %9S. %limination of a minority ownership group of stockholders can be achieved as well. +he firm can minimiIe the dilution in %9S associated with mergers and can reduce the costs associated with servicing small stockholders. ;) Eeorges )iIet owns 12,222 shares of 9earl 8o. purchased at an average price of 114 per share. +he tax rate on both dividends and capital gains is 14D. Would )iIet prefer a 1$.22 per share dividend or to sell 1,222 shares back to the company at 1$2 per share. 8ompute his after'tax income from each option. *f )iIet receives the dividend, Jis tax will be 1$2,222 > .14 = 1-,222 and Je would have 11@,222 in after'tax income. *f the company repurchases the share, he will have a capital gain of 1$2 ' 114=14 per share. /f the 1$2,222 he receives by selling back the shares, only 14,222 would be taxable. Jis tax would be 14,222 > .14 = 1@42, so his after'tax income would be 1$2,222 ' 1@42 = 11F,$42. Je would be better off by 1$,$42. F) )ecause money has a time value investors should prefer that dividends be paid sooner rather than later. Agree or disagree. %xplain your answer with a numerical example. $ 8opyright A $211 9earson %ducation, *nc.

Review Questions: Titman 11ed Chapter 16 Dividend Policy

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When investors buy a company"s shares, they assume that the company will earn a rate of return on e#uity that e#uals or exceeds their re#uired rate of return. *f an investor re#uires a 12D rate of return and the company decides to defer a 1122 dividend for a year, the company will reinvest the 1122 at its K/% and it will grow to 1112. Keinvesting the money will allow the firm to pay a later dividend that is large enough to provide the investor with her re#uired rate of return. *n other words, if an investor re#uires 12D, she should be indifferent between a 1122 dividend now and a 1112 dividend a year from now. <ote that the 12D includes compensation for the risk of the future cash flow, the same risk the investor was willing to take when she bought the stock. Some investors purchase stocks with a record of paying stable dividends as a higher yielding alternative to bonds or certificates of deposits. Such investors could be retirees or institutions who need the dividends for their operating budgets. /ther investors prefer that the company reinvest all available funds in growth and would rather not receive dividends. +hese investors are often high income individuals who would have to pay high taxes. Such investors prefer to build wealth for the future rather than increase their current income. 12) 9ettry, *nc. expects %9S this year to be 14.$4. *f %9S grows at an average annual rate of 12D, and if 9ettry pays ?2D of its earnings as dividends, what will the expected dividend per share be in 12 years. 14.$4 ,1 L 2.12)12 = 1-.?$ = %9S in 12 years 11-.?$ > 2.? = 1;.1@ = %xpected dividends per share 11) 6ou are considering the stock of two firms to add to your portfolio. +he companies differ only with respect to their dividend policies. !or both firms, investors expect %9S for each of the next two years to be 1@ and dividends and ending price for each of the next two periods to be& (1 ($ 9$ !irm A 1$ 1$ 1?2.@2 !irm ) 3 3 4?.3$ +he re#uired rate of return for the stock of !irm A is 13D. *gnore taxes or transaction fees. a. Jow much would investors pay for the stock of !irm A. b. Jow much would investors pay for the stock of !irm ). c. !or a less'than'perfect world, provide an argument for each of the following& ,1) *nvestors prefer the dividend policy of !irm A. ,$) *nvestors prefer the dividend policy of !irm ). ,-) !irms prefer the dividend policy of !irm A. a. b. 9o = ,1$.22:1.13) L M,1$.22 L 1?2.@$):,1.13)$N a. 9o = 142 %xactly the same in the perfect capital market environment. a. 9o = ,13.22:1.13) L ,,13.22 L 14?.3$):,1.13)$) b. 9o = 142 ,1) *nvestors can pay a lower capital gains tax on the growth. ,$) *nvestors in this firm may need current income. ,-) !irms need additional e#uity to finance growth.

c.

1$) <oblesville Auto Supply 8ompany"s stock is trading ex'dividend at 14 per share. +he company 0ust paid a 12D stock dividend. +he 9:% ratio for the stock is 12. What was the price of the stock prior to trading ex'dividend. %9S after stock dividend = ,14.22:12.22) = 1.42 %9S after stock dividend = ,%9S before stock dividend):,1.12) ,1.42),1.12) = 1.44 = %9S before stock dividend Stock price prior to stock dividend = ,12),1.44) = 14.42 16.& Cash Distribution Policies in Practice 1-) 8ompare management"s motives for preferring either stock repurchases or cash dividends. 8ash dividends and repurchase offers are both ways to return cash to shareholders and both tend to convey positive information about the company"s stock price and future earnings. /nce a company begins paying cash dividends, it is under considerable pressure to at least match and preferably increase dividends each year. 8opyright A $211 9earson %ducation, *nc.

Review Questions: Titman 11ed Chapter 16 Dividend Policy

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Kepurchase offers put less pressure on management to pay out cash each year. +hey are more like the residual dividend policy in that the company only needs to pay out cash when all other demands have been met. 13) 8ompare the Stable (ividend 9ayout to the Kesidual (ividend 9olicy. A stable dividend payout policy tries to avoid unpleasant surprises to the company"s shareholder clientele who may depend on the dividends to meet their income needs. 8ompanies who follow this policy consider the predictability of dividends more important than the siIe or payout ratio and only increase dividends when they are #uite certain that they can maintain the increased payout. A company that followed a residual dividend policy would only pay a dividend after all operational and investment needs had been met. Such a policy would lead to large year to year fluctuations in the dollar amount of dividends. +he residual dividend policy is much less popular with investors and therefore with managers as well. 1'( Company )*s +uture earnin,s +or the ne-t +our years are predicted below. )ssumin, there are '../... shares outstandin,/ what will the yearly dividend per share be i+ the dividend policy is as +ollows? a. ) constant payout ratio o+ 0.1 b. Stable dollar dividend tar,eted at 0.1 o+ the avera,e earnin,s over the +our!year period c. Small/ re,ular dividend o+ 2..3' plus a year!end e-tra o+ 0.1 o+ pro+its e-ceedin, 21 million 8o. A future earnings 6ear 1 1 F22,222 6ear $ 1,$22,222 6ear - ;42,222 6ear 3 1,-42,222 a. .32,1F22,222):422,222 = 12.@$ .32,11,$22,222):422,222 = 12.F? .32,1;42,222):422,222 = 12.?; .32,11,-42,222):422,222 = 11.2; 6ear 1 12.@4 = 12.@4 6ear $ 12.@4 L .32,11.$m'11.2m):422,222 = 12.@4L12.1? = 12.F1 6ear - 12.@4 = 12.@4 6ear 3 12.@4 L .32,11.-4m'11.2m):422,222 = 12.@4L12.$; = 11.2-

b. .32,11,2@4,222) = 13-2,222:422,222 = 12.;? c.

1?) 8ompany ) needs to raise 114 million. Assuming that the market price of the firmOs stock is 11$2 and flotation costs are expected to be 1$2 per share a. <umber of shares to be issued

114,222,222 11$2 1$2

= 142,222 shares

b. Palue ,siIe of the issue in dollars) 142,222 shares x 11$2 = 11; million 1@) 8ompany 8 finances new ac#uisitions with ?2 percent debt and the rest in e#uity. +he firm needs 1$.3 million for a new ac#uisition. Ketained earnings available for reinvestment = 1F?2,222 a. %#uity financing needed = 1$,322,222 ,2.32) = 1F?2,222 According to the residual dividend theory, how much money will be available for dividends. +otal financing needed 1 $.322,222 Ketained earnings 1 F?2,222 (ebt ratio 2.?2 %#uity ratio 2.32 %#uity financing needed 1 F?2,222 = 1$,322,222 ,2.32) (ividends 12 = 1F?2,222 ' 1F?2,222 +hus, the firm would pay no dividend, but it would also not have to issue any stock. 1;) 8ompany ( has $.2 million shares of common stock outstanding. <et income is 1422,222, and the 9:% ratio for the stock is 12. Canagement is planning a $2 percent stock dividend. 3 8opyright A $211 9earson %ducation, *nc.

Review Questions: Titman 11ed Chapter 16 Dividend Policy

a. %9S before the stock dividend& 1422,222 %9S = = .$4 1$,222,222 +he current price before the stock dividend is computed as& 8urrent price = 9:% x %9S = 12 > .$4= 1 $.42

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b. c.

*f an investor owns 122 shares prior to the stock dividend, the value of his shares is computed as& Palue before dividend = 1$.42 x 122 shares = 1 $42.22 $,222,222 1 422,222 12 $2D 122 1 $.42 = 9:% x %9S = 12 >

/K )efore dividend Shares outstanding <et income 9rice:%arnings Stock dividend *nvestor"s share d. e. 8urrent price

1422,222 1$,222,222 Palue before dividend 1 $42.22 = 1$.42 x 122 shares After the stock dividend , the no. of shares outstanding is& Shares outstanding = $,222,222 x ,1L.$2) = $,322,222

f. g. h.

%9S after the stock dividend& 1422,222 %9S = = .$2; 1$,322,222 8urrent ,new) price after the stock dividend is computed as& <ew price = 9:% x %9S = 12 > .$2;= 1 $.2; +he investor owning 122 shares prior to the stock dividend now has the no. of shares computed as& *nvestor"s shares = 122 ,1.$2) = 1$2 !or an investor owning 122 shares prior to the stock dividend, the value of his shares after the dividend is now computed as& After dividend Shares outstanding $,322,222 = $,222,222 x ,1L.$2) <ew price 1 $.2; = 9:% x %9S = 12 x .$2; *nvestor"s shares 1$2 = 122 ,1.$2) Palue after dividend 1 $42.22 = $.2; x 1$2 = 1$42,before) ' 1$42 ,after) *f an investor owns 122 shares before the stock dividend, does the total value of his or her shares change. +he value of the investors" holdings does not change because the price of the stock reacted fully to the increase in the shares outstanding. 8hange 1 2.22

i.

1F) 6ou own 12 percent of 8ompany %Os common stock, which most recently sold for 1122 before a planned two' for'one stock split announcement. )efore the split there are $4,222 shares of common stock outstanding. a. 6our financial position before the split, i.e. the value of your common stock is computed as& Carket price 1 122.22 Split multiple $ Shares outstanding $4,222 6ou own 2.12 x $4,222 *nvestor"s shares = $,422 9osition before split 1$42,222 = $,422 Shares x 1122 per share 6our financial position after the split is computed as& 9rice after split 1 42.22 = 1F; Q $ 4 8opyright A $211 9earson %ducation, *nc.

b.

Review Questions: Titman 11ed Chapter 16 Dividend Policy

c. 6our shares after split 9osition after split 4,222 = $,422 x $ 1$42,222 = 4,222 shares x 142 per share

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d.

Kelative to now, what will be your financial position after the stock split, i.e. what will be your net gain. ,Assume the stock price falls proportionately.) 9osition before split 1$42,222 = $,422 Shares x 1122 per share 9osition after split 1$42,222 = 4,222 shares x 142 per share <et gain 1 2 *f it is believed that the price will only fall -4 percent after the split what will be your net gain. 9rice fall 2.-4 9rice after split 1 ?4.22 = 1122.22 ,1 ' .-4) 9osition after split 1-$4,222 = 4,222 Shares x 1?4 per share <et gain 1 @4,222 = 1-$4,222 ' 1$42,222

$2) 8ompany ! is planning to pay dividends of 1?22,222. +here are -22,222 shares outstanding, with earnings per share of 14. +he stock should sell for 142 after the ex'dividend date. *f instead of paying a dividend, management decides to repurchase stock& a. What should be the repurchase price. 9roposed dividend:share = 1$.22 = 1 ?22,222:-22,222 b. Kepurchase price 1 4$.22 = Jow many shares should be repurchased. <umber of shares repurchased 11,4-; 142 L 1$ = 1?22,222 Q ,14$)

$1) 8ompany E is considering two dividend policies for the years $22@ and $22;, one and two years away shown below. +he re#uired rate of return for the common stockholders is 14 percent. Canagement is concerned about the effect of the two dividend streams on the value of the common stock. (ividend 9lans 6ear 9lan A 9lan ) $22@ 1 $.22 1 4.22 $22; 1 $.22 1 4.22 $22F 13F.F4 13$.4-$4 Ke#uired rate of return a. 14D +he value of stock A is computed as& Palue stock A b. 1-?.2F =

1$.22 1$.22 13F.F4 + + $ ,1 + .14) ,1 + .14) ,1 + .14) 14.22 14.22 13$.4-$4 + + $ ,1 + .14) ,1 + .14) ,1 + .14) -

+he value of stock ) is computed as& Palue stock ) 1-?.2F =

c.

Assuming perfect markets, what would be the effect on the value of the common stock. +here is no effect on the value of the common stock.

? 8opyright A $211 9earson %ducation, *nc.