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. 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 (1,000,000 shares) After (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 30 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 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 http://money.canoe.ca/stocks/ Problems 18-1. Eastern Telecom a. P0 = D1 $3.40 $3.40 = = = $68.00 K e − g 0.10 − 0.05 .05 b. P0 = D1 $3.00 $3.00 = = = $75.00 K e − g 0.10 − 0.06 .04 c. Plan B produces the higher value because of the higher growth rate. 18-2. Midnight Express Ltd. Year Dividends PV@12% 1 2 3 $ 5.00 7.50 10.00 $ 4.46 5.98 7.12 $17.56 The suggested current value for Midnight Express Ltd. is $17.56. 18-3. Midnight Express (continued) a. Year 1 2 3 Dividends FV@14% $ 5.00 7.50 10.00 $ 6.50 8.55 10.00 $25.05 Investor’s require 12% PV (N = 3, %I/Y = 12) $17.83 Ltd. The suggested current value for Midnight Express Ltd. is $17.83. b. Year 1 2 3 Dividends PV@12% $ 5.00 7.50 10.00 $ 6.27 8.40 10.00 $24.67 Investor’s require 12% PV (n = 3, %I/Y = 12) $17.56 The suggested current value for Midnight Express Ltd. is $17.56. c. Year 1 2 3 Dividends PV@10% $ 5.00 7.50 10.00 $ 6.05 8.25 10.00 $24.30 Investor’s require 12% PV (n = 3, %I/Y = 12) $17.30 The suggested current value for Midnight Express Ltd. is $17.30. 18-4. Gallagher Parades Payout ratio = 18-5. Dividend per share $0.75 = = 0.250 = 25.0% Earnings per share $3.00 Sewell Enterprises Dividends = (earnings – retained funds) = $160 million – $100 million = $60 million Payout ratio = Dividends $60 million = = 0.375 = 37.5% Earnings $160 million 18-6. Auction.com Dividends ? = = 0.35 = 35.0% Earnings $420 million Dividends = Earnings × payout ratio = $420 million × 0.35 = $147 million Payout ratio = Addition to retained earnings = earnings – dividends = $420 million – $147 million = $273 million 18-7. Springsteen Music Company a. Dividends ? = = 0.20 = 20.0% Earnings $820 million Dividends = Earnings × payout ratio = $820 million × 0.20 Payout ratio = = $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 yield = Dividend per share $1.64 = = 0.0328 = 3.28% Market share price $50 18-8. Barry’s Knot Farm a. Dividend yield = Dividend per share $1.50 = = 0.0375 = 3.75% Market share price $40 b. Dividends per share $1.50 = = 0.60 = 60.0% ? Earnings per share Dividends per share $1.50 = = $2.50 Earnings per share = Payout ratio 0.60 Payout ratio = P/E ratio = 18-9. Market share price $40 = = 16.0 × Earnings per share $2.50 Maple Leaf Blowers Company a. Dividend yield = Dividend per share $0.88 = = 0.04 = 4% Market share price $22 b. Dividends per share $0.88 = = 0.40 = 40.0% ? Earnings per share Dividends per share $0.88 = = $2.20 Earnings per share = Payout ratio 0.40 Payout ratio = P/E ratio = Market share price $22 = = 10.0 × Earnings per share $2.20 18-10. Dyer Drilling Co. Market share price $60 = = 25.0 ? Earnings per share Market share price $60 = = $2.40 Earnings per share = P/E ratio 25 P/E ratio = Dividends per share ? = = 0.25 = 25.0% Earnings per share $2.40 Dividends per share = Earnings per share × Payout ratio = $2.40 × 0.25 = $0.60 Payout ratio = Dividend yield = 18-11. Dividend per share $0.60 = = 0.010 = 1.0% Market share price $60 Martin Shipping Limited Market share price $51 = = 17.0 ? Earnings per share Market share price $51 = = $3.00 Earnings per share = P/E ratio 17 P/E ratio = Dividends per share ? = = 0.34 = 34.0% Earnings per share $3.00 Dividends per share = Earnings per share × Payout ratio = $3.00 × 0.34 = $1.02 Payout ratio = Dividend yield = Dividend per share $1.02 = = 0.020 = 2.0% Market share price $51 18-12. Alert Radio Annual dividend = Share price × dividend yield = $80 × 0.045 = $3.60 Quarterly dividend = $3.60/ 4 =$0.90 The share price would be expected to decline by $0.90 other things being equal. Due to tax factors the decline will be somewhat less than $0.90. The new share price would be = $80.00 ─ $0.90 = $79.10 18-13. Nunavut Freight Company Annual dividend = Share price × dividend yield = $40 × 0.067 = $2.68 Quarterly dividend = $2.68/ 4 =$0.67 The share should decline by approximately $0.67 to $39.33. Due to tax factors the decline will be somewhat less than $0.67. 18-14. Dawson Corporation a. Plan A: ($1.50 + 1.50 + 1.50 + 1.60 + 1.60) = Plan B: ($0.50 + 2.00 + 0.20 + 4.00 + 1.70) = b. Plan A Dividend per share 1 $1.50 2 1.50 3 1.50 4 1.60 5 1.60 Present value of future dividends $ 7.70 $ 8.40 PV @ 10% $1.36 1.24 1.13 1.09 0.99 $5.81 Plan B Dividend per share PV @ 12% 1 $0.50 $0.45 2 2.00 1.59 3 0.20 0.14 4 4.00 2.54 5 1.70 0.96 Present value of future dividends $5.68 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. 18-16. Farrah Faucet and Plumbing Company a. Judy Andrews (24.08% combined marginal tax rate) $2.40 × 24.08% $ 0.58 Cash dividend Marginal tax rate Combined taxes payable b. Sound Corporation No tax on inter-corporate dividends. 18-17. The Greek Letter Companies a. Payout ratios Year Gamma 1 50% 2 50% 3 50% 4 50% 5 50% Omega 50.0% 47.6% 41.7% 35.7% 40.0% Delta 50.0% 35.7% 41.7% 53.6% 33.3% b. Gamma has a constant payout ratio which could imply stability of earnings and sales, and steady growth patterns and financing needs. Gamma appears to have a planned dividend payout while Delta uses dividends as a residual. Omega 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 $1.20 in the last year). c. Gamma 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. 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). 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). 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 Shares 250,000 b. This would not be realistic in light of the firm's cash balance. Dividend (maximum) = c. Shareholder's equity $1,375,000 Cash $312,500 = = $1.25 Shares 250,000 = 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 Dividend per share = Total dividends $132,000 = = $0.53 Shares 250,000 18-22. Adams Corporation Retain Incremental earnings Earnings per share = = 15% × $400,000 = $60,000 Earnings $750,000 + $60,000 = = $2.70 Shares 300,000 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) × EPS = 8.8 × $2.50 = $22.00 The payout option provides the maximum market value. 18-23. West Coast Telecom a. Plan A – increase cash dividend immediately Po = D1 Ke − g First Compute D 1 D1 = = D 0 (1 + g) $3.40 (1.05) = $3.57 Then Compute the share price D 1 = $3.57, K e = .10, g = .05 Po = $3.57 $3.57 = = $71.40 .10 − .05 .05 b. Plan B – increase growth rate First Compute D 1 D1 = = D0 (1 + g) $3.00 (1.06) = $3.18 Then Compute the share price D 1 = $3.18, K e = .10, g = .06 Po = $3.18 $3.18 = = $79.50 .10 − .06 .04 c. Plan B, which calls for using funds to increase the growth rate, will produce a higher value. 18-24. Wilson Pharmaceuticals’ a. Eight (8) million shares would be outstanding. Everything else will be the same. b. Twelve (12) million shares would be outstanding. Everything else will be the same. c. EPS before = $14,000,000/ 4,000,000 shares = $3.50 e.p.s. EPS after 2:1 split = $14,000,000/ 8,000,000 shares = $1.75 e.p.s EPS after 3-1 split =$14,000,000/ 12,000,000 shares = $1.17 e.p.s d. Current P/E ratio = Price $70 = = 20 × EPS $3.50 P/E × EPS = Price Price after 2-1 split Price after 3-1 split = 20 × $1.75 = $35.00 = 20 × $1.17 = $23.40 e. Probably not. A stock split should not change the price-earnings ratio unless it is combined with a change in dividends to the shareholders. Generally speaking, nothing of real value has taken place. Only to the limited extent that new information content from this split increased investor's expectations would the stock split possibly have an impact on the P/E ratio. 18-25. Vegas Products a. Common stock (220,000)* Retained earnings Net worth $5,800,000 4,200,000 $10,000,000 *20,000 shares × $40 = $800,000 $5,000,000 + $800,000 = $5,800,000 b. Earnings = $0.60 × 150,000 = $90,000 EPS after stock dividend = $400,000/ 220,000 = $1.82 Price = P/E ratio × EPS = 20 × $1.82 = $36.40 c. (100 × 1.10) = 110 shares after the stock dividend d. Before 100 × $40 = $400 After 110 × $36.40 = $400.40 e. Generally speaking, nothing of real value has taken place. Only to the limited extent that total cash dividends might have increased or information been provided could small benefits have taken place. 18-26. Matrix Corp. Inc. a. Common stock (4,450,000 shares) .................. $64,000,000* Retained earnings............................................... 36,000,000 Net worth .............................................. $100,000,000 *4,000,000 × 15% = 600,000 600,000 shares × ($40 market price) = 600,000 × $40 = $24,000,000 ** $60,000,000 beginning Retained earnings account – 24,000,000 transfer to Common stock account $36,000,000 ending Retained earnings account b. EPS after the stock dividend = $12,000,000/4,600,000 = $2.61 Price = P/E ratio × EPS = 13.33 × $2.61 = $34.79 c. 100 + (100 × 15%) = 115 shares after the stock dividend d. Before 100 × $40 = $4,000 After 115 × $34.79 = $4,000.85 ($0.85 rounding difference) e. After 115 × $40 = $4,600 f. Yes. As a result of keeping the cash dividend constant, the shareholder not only received more cash dividends, but the portfolio value goes up by $600 as a result of having 15 more shares still worth $40 a share. Dividend cash dividend $1.05 = = = 0.0263 = 2.6% Yield market price $40.00 18-27. Worst Buy a. Number of shares after reverse stock split = Original shares divided by the reverse split ratio = 140/5 = 28 shares b. Anticipated share price = Original stock price x reverse split ratio = $2 × 5 = $10 c. Actual share price based on the 80% assumption $10 Anticipated stock price 80% Assumption $8.00 Actual stock price d. Dean Smith’s total holdings Before reverse stock split 140 shares × $2 = $280 After reverse stock split 28 shares × $8.00 = $224 Dean’s holding have decreased by $56 ($280 - $224) 18-28. a. Price EPS Price Belton Corporation = P/E × EPS = $5 mil. / 1 mil. = $5 = 10 × $5 = $50 b. $4 mil. / 1 mil. = $4 dividends per share c. $4,000,000/ $54 = 74,074 shares reacquired d. Shares outstanding after repurchase 1,000,000 – 74,074 = 925,926 EPS = $5,000,000/ 925,926 = $5.40 e. Price = P/E × EPS = 10 × $5.40 = $54 The stock price has increased by $4. f. No. With the cash dividend: Market value per share Cash dividend per share Total value With the repurchase of stock: Total value per share $50 4 $54 $54 g. No. The effective tax rate on capital gains versus a cash dividend is lower for high income earners, although the effective rates are similar for mid-range earners. (Each tax situation is different). As well capital gains can be deferred until realized. h. The corporation may think its shares are underpriced in the market. The purchase may stave off further decline and perhaps even trigger a rally. Reacquired shares may also be used for employee stock options or as part of a tender offer in a merger or an acquisition. Firms may also reacquire part of their shares as a protective device against being taken over as a merger candidate. 18-29. Stanley Truck / Blanche Carr a. and b. together Investment A Dividend income Marginal combined rate Taxes payable Net dividend after tax Stanley Truck (mid bracket) Blanche Carr (top bracket) $2,800.00 7.52% 210.56 $2,589.44 $2,800.00 23.96% 670.88 $2,129.12 Investment B Capital gain $2,800.00 Taxable capital gain (50%) Marginal combined rate 15.58% Taxes payable 436.24 Net dividend after tax $2,363.76 $2,800.00 23.20% 649.60 $2,150.40 c. Investment A: $2,589.44 –$2,129.12 = $460.32 d. Investment B: $2,363.76 – $2,150.40 = $213.36 e. The major reason is that the dividend tax credit is equally valuable to tax payers in high and low tax brackets, while the capital gains savings are rate dependent. 18-30. Hasting Sugar Corporation a. Dividends represent what is left over after profitable capital expenditures are undertaken. Profitable Capital Year Net Income Expenditures (millions) – (millions) 1 $10 – $ 7 2 15 – 11 3 9 – 6 4 12 – 7 5 14 – 8 Total cash dividends Dividends (millions) $3 4 3 5 6 $21 b. Net income Year (millions) 1 $10 2 15 3 9 4 12 5 14 Dividends Payout ratio (millions) × .40 $ 4.0 × .40 6.0 × .40 3.6 × .40 4.8 × .40 5.6 × Total cash dividends $24.0 c. Year 1 2 3 4 5 Shares Dividends outstanding per share 2,000,000 × $2.40 2,200,000 × 2.40 2,420,000 × 2.40 2,662,000 × 2.40 2,928,200 × 2.40 Total cash dividends Dividends $4,800,000 5,280,000 5,808,000 6,388,800 7,027,680 $29,304,480 d. Year 1 2 3 4 5 Net income Payout Dividends Shares Dividends (millions) ratio (millions) (millions) per share $10 .30 $3.0 2.0000 $1.50 15 .30 4.5 2.4000 1.88 9 .30 2.7 2.8800 0.94 12 .30 3.6 3.4560 1.04 14 .30 4.2 4.1472 1.01 Comprehensive Problem 18-31. Lyle Communications Share price $64 = = 16.0 × eps $4 a. P/E ratio = b. Dividend yield = Payout ratio = c. Dividend per share $1.20 = = 0.01875 = 1.875% Market share price $64 Dividends per share $1.20 = = 0.300 = 30.0% Earnings per share $4.00 Portfolio value: Shares: 100 × $64 = Cash (from dividends): 100 × $1.20 = d. Repurchase = e. EPS = f. Share price $6,400 120 $6,520 Excess cash $2.4 million = = 36,810 shares Share price $65.20 Total earnings $8 million = = $4.075 # of shares $2 million − 36,810 = P/E × EPS = 16 × $4.075 = $65.20 Portfolio value: Shares: 100 × $65.20 = $6,520 MINI CASE Montgomery Corporation (Dividend policy) Purpose: The key issue is whether the firm's cash dividend should be considered an active or residual variable in setting the actual payment. There is enough bickering between the directors and officers of the firm to give the student plenty of insight into the issue. There is information on comparable industry dividend policies. The student is asked to use the dividend valuation model, to consider capital structure issues, and also to evaluate the suitability of a stock dividend versus a cash dividend. a. From Figure 1, we note that dividends per share for the years 2006 – 2012 were: 2006 2007 2008 2009 2010 2011 2012 $1.36 $1.36 $1.48 $1.70 $1.76 $1.76 $1.96 The firm is following a constant dividend policy with increases as the company grows. Note that the total amount committed to common dividends has increased each year, but it's the dividend per share figure that counts. Given the increasing number of shares outstanding each year, the directors each year have ensured that DPS has remained constant or increased slightly. b. In Figure 2, we see that all of Montgomery's competitors are either following the same policy that Montgomery is, or they are striving to increase the dividend every year. The Lake held to a $0.20 dividend in 2012 even though EPS decreased over 75% in 2010! In 2010 The Lake actually increased the dividend by over 17% in spite of the decrease in EPS. Clearly, dividend stability and growth are perceived as important in the retailing industry. Even National Wheels, a growing company which might be expected to emphasize capital growth over dividends, follows the general trend. (It is interesting to note that Montgomery generally has the highest average payout ratio in the industry. That’s to be expected of an old firm that has been paying, and increasing dividends for many years). c. Given that D 1 = $2.10, g = 7.1%, and P 0 = $35, k e , the expected return to the common shareholders is: D $2.10 + 0.071 = 0.06 + 0.071 = 0.1310 = 13.10% Ke = 1 + g = P0 $35 d. If Don's proposal is adopted, and next year's dividend is zero, but g rises to 14%, the expected return to the shareholders is: D $0 + 0.14 = 0.00 + 0.14 = 0.1400 = 14.00% Ke = 1 + g = $35 P0 It appears that if Montgomery adopted Don's suggestion, the shareholders would realize a 0.9% increase in their expected return. By this calculation alone, we might conclude that Don's idea is a good one: adopt a residual dividend policy. However, the shareholders would only realize Don's 14% gain if they sell their shares, while the firm's current dividend policy gives the shareholders 13.1%. Given that situation, and the fact that there is little advantage of a capital gain over dividends, one might well argue that the shareholders are better off under current policy. Further, note that the shareholders only appear to be better off under the new policy if g does, in fact, rise to 14%, which is speculative at best. If g turns out to be less than 13.1%, for example, the old policy will appear to be superior. It is reasonable to assume that if the dividend is retained and invested, g will increase, and intuitively we believe it should increase sufficiently to produce a total return greater than before, but there is no hard evidence that it will do so. e. Don's argument rests on the principle that the capital budget, as well as the dividend, must be paid for solely out of net income for the current year, and, of course, this is not so. It is the amount of cash available that is the limiting factor. Referring to figure 1, we see that Montgomery's cash balance for 2012 is $3.235 million, so that is the maximum size that the capital budget plus dividend payment can be without selling off assets or seeking outside financing. (This is an excellent point). We often speak of financing the capital budget, or indeed, paying dividends out of retained earnings. We tend to speak of retained earnings as if they were cash. They are not, of course; only claims on assets, of which cash is but one. If retained earnings were to be entirely used up in financing the capital budget, then some of the firm's assets would have to be sold in the process. f. The cost of internal equity financing is, of course, 13.1%, which was computed in question (c), above. The cost of external equity financing would be slightly higher due to flotation costs. g. Given that the firm can sell bonds priced to yield 13%, the aftertax cost of debt is 13% × (1 – .25) = 9.75% h. This might throw the debt/equity mix out of proportion. Excessive use of debt might out only increase the cost of debt financing, but all other sources of financing as well. i. Mr. Autry's comments strike at the heart of the residual dividend policy. That policy presumes that the shareholders have no preferences about the form of repayment they receive from their investment-only that the highest possible return be achieved. If, on the other hand the shareholders do have a preference, then the residual policy may not be the best. There is no hard and fast rule on establishing whether or not the shareholders have a preference, or how strong it might be. Strong cases can be argued for either point of view and the subject remains controversial. From Figure 2, it appears that managers of firms in the retailing business do believe that their shareholders have a preference for current income in the form of dividends. j. The firm could pay a stock dividend in place of the cash dividend, and some shareholders might be satisfied with that. However, the majority would probably recognize that they had not received anything at all. A stock dividend is merely a paper entry creating more shares. It would only be perceived as beneficial if total shareholders’ cash dividends increased as a result. (However this would defeat the proposed purpose of the stock dividend: to conserve funds). k. As mentioned in (i), there is no universal agreement on this question, as some argue that dividends do not matter and some argue that they do. Most agree, however, that if the firm does pay taxes, if there are flotation costs associated with outside equity financing, and if there are costs associated with bankruptcy, then capital structure does matter, and dividend policy matters. Intuitively, and in the face of the obvious custom in the retailing industry, we would view a decision by a mature firm such Montgomery to go to a residual dividend policy with some misgivings. Such a policy is perhaps best left to a younger firm.
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