Chapter 18 Dividend Policy and Retained Earnings Discussion Questions 18-1. How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on funds associated with retained earnings. Thus, we must consider what the stockholders can earn on other investments. 18-2. Discuss the difference between a passive and an active dividend policy. 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, stockholder preference for cash dividends is considered very early in the decision process. 18-3. How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some stockholders may say that the dividends are relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the immediate income tax. 18-4. Explain the relationship between a company’s growth possibilities and its dividend policy. 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 four-year growth rates for selected U.S. corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm. 18-5. Since initial contributed capital theoretically belongs to the stockholders, why are there legal restrictions on paying out the funds to the stockholders? Creditors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place. 18-6. Discuss how desire for control may influence a firm’s willingness to pay dividends. Management’s desire for control 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 stockholders happy. 18-7. If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 18-8. How is a stock split (versus a stock dividend) treated on the financial statements of a corporation? For a stock split, there is no transfer of funds, but merely a reduction in par value and a proportionate increase in the number of shares outstanding. Impact of a Stock Split Before After Common stock (1,000,000 shares at $10 par) (2,000,000 shares at $5 par) 18-9. Why might a stock dividend or a stock split be of limited value to an investor? The asset base remains the same and the stockholders’ 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 the growth of the company. A stock split may have some functionality in placing the company into a lower “stock price” trading range. 18-10. Does it make sense for a corporation to repurchase its own stock? Explain. 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 as the shares decline, and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as if a cash dividend was paid. Because the benefits are in the format of capital gains, 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. What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders 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. Chapter 18 Problems 1. Payout ratio (LO18-1) Moon and Sons Inc. earned $120 million last year and retained $72 million. What is the payout ratio? 18-1. Solution: Moon and Sons Inc. Dividends = Earnings – Retained funds = $120 mil. – $72 mil. = $48 mil. Payout ratio = Dividends/Earnings = $48 mil./$120 mil. = 40.0% 2. Payout ratio (LO18-1) Ralston Gourmet Foods Inc. earned $360 million last year and retained $252 million. What is the payout ratio? 18-2. Solution: Ralston Gourmet Foods Inc. Dividends = Earnings – Retained funds = $360 mil. – $252 mil. = $108 mil. Payout ratio = Dividends/Earnings = $180 mil./$360 mil. = 30% 3. Payout ratio (LO18-1) Swank Clothiers earned $640 million last year and had a 30 percent payout ratio. How much did the firm add to its retained earnings? 18-3. Solution: Swank Clothiers Addition to retained earnings = Earnings – Dividends Dividends = 30% × $640,000,000 = $192,000,000 Addition to retained earnings = $640,000,000 – $192,000,000 = $448,000,000 4. Dividends, retained earnings, and yield (LO18-1) Polycom Systems earned $553 million last year and paid out 25 percent of earnings in dividends. a. By how much did the company’s retained earnings increase? b. With 100 million shares outstanding and a stock price of $101, what was the dividend yield? (Hint: First compute dividends per share.) 18-4. Solution: Polycom Systems a. Addition to retained earnings= Earnings – Dividends Dividends = 25% × $553,000,000 Dividends = $138,250,000 Earnings – Dividends = $553,000,000 – $138,250,000 Addition to retained earnings = $414,750,000 b. Dividends/Shares = $138,250,000/100,000,000 = $1.38 Dividend yield = Dividend per share/Stock price = $1.38/$101 = 1.37 percent 5. Growth and dividend policy (LO18-2) The following companies have different financial statistics. What dividend policies would you recommend for them? Explain your reasons. Turtle Co. Hare Corp. Growth rate in sales and earnings 22% 4% Cash as a percentage of total assets 5 20 18-5. Solution: Turtle is growing very fast and needs its cash for reinvestment in assets. For this reason, Turtle should have a low payout ratio. Hare is not growing very fast so it doesn’t need cash for growth unless it desires to change its policies. Assuming it doesn’t, hare should have a high dividend payout. 6. Limits on dividends (LO18-3) Planetary Travel Co. has $240,000,000 in stockholders’ equity. Eighty million dollars is listed as common stock and the balance is in retained earnings. The firm has $500,000,000 in total assets and 2 percent of this value is in cash. Earnings for the year are $40,000,000 and are included in retained earnings. a. What is the legal limit on current dividends? b. What is the practical limit based on liquidity? c. If the company pays out the amount in part b, what is the dividend payout ratio? (Compute this based on total dollars rather than on a per share basis because the number of shares is not given.) Payout ratio = Dividends/Earnings 18-6. Solution: Planetary Travel Co. a. The legal limit is equal to retained earnings Retained earnings = Stockholder’s equity – Common stock = $240,000,000 – 80,000,000 = $160,000,000 b. The practical limit based on liquidity is equal to the cash balance. Cash = Cash percentage × Total assets = 2% × $500,000,000 = $10,000,000 c. Payout ratio = Dividends/Earnings = $10,000,000/40,000,000 = 25% 7. Life cycle growth and dividends (LO18-2) A financial analyst is attempting to assess the future dividend policy of Environmental Systems by examining its life cycle. She anticipates no payout of earnings in the form of cash dividends during the development stage (I). During the growth stage (II), she anticipates 12 percent of earnings will be distributed as dividends. As the firm progresses to the expansion stage (III), the payout ratio will go up to 35 percent, and eventually reach 58 percent during the maturity stage (IV). a. Assuming earnings per share will be as follows during each of the four stages, indicate the cash dividend per share (if any) during each stage. Stage I $ .10 Stage II 1.80 Stage III 2.80 Stage IV 3.70 b. Assume in Stage IV that an investor owns 325 shares and is in a 15 percent tax bracket. What will be the investor’s aftertax income from the cash dividend? c. In what two stages is the firm most likely to utilize stock dividends or stock splits? 18-7. Solution: Environmental Systems a. Earnings Payout Ratio Dividends Stage I $ .10 0 0 Stage II 1.80 12% $ .22 Stage III 2.80 35% $. 98 Stage IV 3.70 58% $2.15 b. Total Dividends = Shares × Dividends per share = 325 × $2.15 = $698.75 After tax income = Total dividends × (1 – T) = $698.75 × (1 – .15) = $698.75 × (.85) = $593.94 c. Stock dividends or stock splits are most likely to be utilized during stage II (growth) or stage III (expansion). 8. Stock split and stock dividend (LO18-4) Squash Delight Inc. has the following balance sheet: Assets Cash $ 100,000 Accounts receivable 300,000 Fixed assets 600,000 Total assets $1,000,000 Liabilities Accounts payable $ 150,000 Notes payable 50,000 Common stock (50,000 shares @ $2 par) 100,000 Capital in excess of par 200,000 Retained earnings 500,000 $1,000,000 The firm’s stock sells for $10 a share. a. Show the effect on the capital account(s) of a two-for-one stock split. b. Show the effect on the capital accounts of a 10 percent stock dividend. Part b is separate from part a. In part b, do not assume the stock split has taken place. c. Based on the balance in retained earnings, which of the two dividend plans is more restrictive on future cash dividends? 18-8. Solution: Squash Delight Inc. a. 2 for 1 stock split * Common stock (100,000 shares @ $1 par) $100,000 Capital excess of par 200,000 Retained earnings 500,000 * The only account affected b. 10 percent stock dividend Common stock (55,000 shares @ $2 par) $110,000 * Capital in excess of par 245,000 ** Retained earnings 445,000 * $200,000 + 5,000 ($10 – $1) = $200,000 + $45,000 = $245,000 ** $500,000 – 10,000 – 45,000 = $500,000 – $55,000 = $445,000 c. The stock dividend. Cash dividends cannot exceed the balance in retained earnings and the balance is lower with the stock dividend ($445,000 versus $500,000). 9. Policy on payout ratio (LO18-1) In doing a five-year analysis of future dividends, the Dawson Corporation is considering the following two plans. The values represent dividends per share. Year Plan A Plan B 1 $1.70 $ .60 2 1.70 2.50 3 1.70 .30 4 1.90 5.00 5 1.90 1.30 a. How much in total dividends per share will be paid under each plan over five years? b. Mr. Bright, the Vice-President of Finance, suggests that stockholders often prefer a stable dividend policy to a highly variable one. He will assume that stockholders apply a lower discount rate to dividends that are stable. The discount rate to be used for Plan A is 11 percent; the discount rate for Plan B is 14 percent. Compute the present value of future dividends. Which plan will provide the higher present value for the future dividends? (Round to two places to the right of the decimal point.) 18-9. Solution: Dawson Corporation a. Plan A ($1.70 + 1.70 + 1.70 + 1.90 + 1.90) = $8.90 Plan B ($.60 + 2.50 + .30 + 5.00 + 1.30) = $9.70 b. Plan A Dividend per Share × PVIF (11%) PV 1 $1.70 .901 $1.53 2 1.70 .812 1.38 3 1.70 .731 1.24 4 1.90 .659 1.25 5 1.90 .593 1.13 Present value of future dividends $6.53 Plan B Dividend per Share × PVIF (14%) PV 1 $ .60 .877 $ .53 2 2.50 .769 1.92 3 .30 .675 .20 4 5.00 .592 2.96 5 1.30 .519 .67 Present value of future dividends $6.28 Plan A will provide the higher present value of future dividends. Shareholders generally prefer certainty to uncertainty and Plan A provides more predictability than Plan B. This is reflected in the higher discount rate for B. 10. Dividend yield (LO18-1) The stock of Pills Berry Company is currently selling at $60 per share. The firm pays a dividend of $1.80 per share. a. What is the annual dividend yield? b. If the firm has a payout rate of 50 percent, what is the firm’s P/E ratio? 18-10. Solution: Pills Berry Company a. Annual dividend yield = Cash dividends/Price = $1.80/$60 = 3.00% b. Earnings per share = Cash dividends/.5 = $1.80/.5 = $3.60 P/E ratio = Price/Earnings per share = $60/$3.60 = 16.67x 11. Dividend yield (LO18-1) The shares of the Dyer Drilling Co. sell for $60. The firm has a P/E ratio of 15. Forty percent of earnings is paid out in dividends. What is the firm’s dividend yield? 18-11. Solution: Dyer Drilling Company Earnings per share = Stock price/Price – Earnings ratio = $60/15 = $4.00 Dividends per share = Earnings per share × .40 = $4.00 × .40 = $1.60 Dividend yield = Dividends per share/Price = $1.60/$60 = 2.67% 12. Ex-dividends date and stock price (LO18-1) Peabody Mining Company’s common stock is selling for $50 the day before the stock goes ex-dividend. The annual dividend yield is 5.6 percent, and dividends are distributed quarterly. Based solely on the impact of the cash dividend, by how much should the stock go down on the ex-dividend date? What will the new price of the stock be? 18-12. Solution: Peabody Mining Company Annual dividend = 5.6% × $50 = $2.80 Quarterly dividend = $2.80/4 = $.70 The stock should go down by $.70 to $49.30. 13. Stock dividend and cash dividend (LO18-4) The Western Pipe Company has the following capital section in its balance sheet. Its stock is currently selling for $6 per share. Common stock (50,000 shares at $2 par) $ 100,000 Capital in excess of par 100,000 Retained earnings 250,000 $450,000 The firm intends to first declare a 15 percent stock dividend and then pay a 25-cent cash dividend (which also causes a reduction of retained earnings). Show the capital section of the balance sheet after the first transaction and then after the second transaction. 18-13. Solution: Western Pipe Co. After first transaction Common stock (57,500 shares at $2 par) $ 115,000 Capital in excess of par* 130,000 Retained earnings 205,000 $450,000 *Capital in excess of par = 100,000 + 7500($6 – $4) =130,000 *Retained earnings = 250,000 – 7500($6) = 205,000 The cash dividend of 25¢ per share causes retained earnings to be reduced by $14,375 (57,500 × 25¢). After second transaction Common stock (57,500 shares at $2 par) $ 110,000 Capital in excess of par 130,000 Retained earnings* 190,625 $435,625 * The cash dividend of 25¢ per share causes retained earnings to be reduced by $14,375 (57,500 × 25¢). 14. Cash dividend policy (LO18-1) Phillips Rock and Mud is trying to determine the maximum amount of cash dividends it can pay this year. Assume its balance sheet is as follows: Assets Cash $ 386,000 Accounts receivable 836,000 Fixed assets 1,048,000 Total assets $2,270,000 Liabilities and Stockholders’ Equity Accounts payable $ 459,000 Long-term payable 371,000 Common stock (295,000 shares at $1 par) 295,000 Retained earnings 1,145,000 Total liabilities and stockholders’ equity $2,270,000 a. From a legal perspective, what is the maximum amount of dividends per share the firm could pay? b. In terms of cash availability, what is the maximum amount of dividends per share the firm could pay? c. Assume the firm earned an 18 percent return on stockholders’ equity last year. If the board wishes to pay out 50 percent of earnings in the form of dividends, how much will dividends per share be? (Round to two places to the right of the decimal point.) 18-14. Solution: Phillips Rock and Mud a. From a legal viewpoint, the firm can pay cash dividends equal to retained earnings of $1,145,000. On a per share basis, this represents $3.88 per share. This would not be realistic in light of the firm’s cash balance. 18-14. (Continued) b. c. Stockholders’ equity = Common stock + Retained earnings $1,440,000 = $295,000 + $1,145,000 Return on equity = 18% × $1,440,000 = $259,200 Dividends = 50% × Return on equity = 50% × $259,200 = $129,600 15. Dividends and stockholder wealth maximization (LO18-2) The Vinson Corporation has earnings of $500,000 with 250,000 shares outstanding. Its P/E ratio is 20. The firm is holding $300,000 of funds to invest or pay out in dividends. If the funds are retained, the after tax return on investment will be 15 percent, and this will add to present earnings. The 15 percent is the normal return anticipated for the corporation, and the P/E ratio would remain unchanged. If the funds are paid out in the form of dividends, the P/E ratio will increase by 10 percent because the stockholders in this corporation have a preference for dividends over retained earnings. Which plan will maximize the market value of the stock? 18-15. Solution: Vinson Corporation Retained Earnings Incremental earnings = 15% × $300,000 = $45,000 Price of stock = P/E × EPS = 20 × $2.18 = $43.60 Payout Earnings New P/E = 1.10% × 20 = 22 Earnings per share = Price of stock = P/E × EPS = 22 × $2.00 = $44.00 The payout option provides the maximum market value. 16. Dividend valuation model and wealth maximization (LO18-2) Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate. It will use the dividend valuation model originally presented in Chapter 10 for purposes of analysis. The model was shown as Formula 10-9 and is reproduced next (with a slight addition in definition of terms). P0 = Price of the stock today D1 = Dividend at the end of the first year D0 × (1 + g) D0 = Dividend today Ke = Required rate of return g = Constant growth rate in dividends D0 is currently $2.50, Ke is 10 percent, and g is 5 percent. Under Plan A, D0 would be immediately increased to $3.00 and Ke and g will remain unchanged. Under Plan B, D0 will remain at $2.50 but g will go up to 6 percent and Ke will remain unchanged. a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 × (1 + g) or $3.00 (1.05). Ke will equal 10 percent, and g will equal 5 percent. b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 × (1 + g) or $2.50 (1.06). Ke will be equal to 10 percent, and g will be equal to 6 percent. c. Which plan will produce the higher value? 18-16. Solution: Omni Telecom a. Plan A – Increase cash dividend immediately First compute D1. D1 = D0 (1 + g) = $3.00 (1.05) = $3.15 Then, compute the stock price: D1 = $3.15, Ke = .10, g = .05 b. Plan B – Increase growth rate First, compute D1. D1 = D0 (1 + g) = $2.50 (1.06) = $2.65 Then, compute the stock price. D1 = $2.65, Ke = .10, g = .06 c. Plan B, which calls for using funds to increase the growth rate, will produce a higher value. 17. Stock split and its effects (LO18-4) Wilson Pharmaceuticals’ stock has done very well in the market during the last three years. It has risen from $55 to $80 per share. The firm’s current statement of stockholders’ equity is as follows: Common stock (5 million shares issued at a par value of $10 per share) $ 50,000,000 Paid-in capital in excess of par 13,000,000 Retained earnings 57,000,000 Net worth $120,000,000 a. How many shares would be outstanding after a two-for-one stock split? What would be its par value? b. How many shares would be outstanding after a three-for-one stock split? What would be its par value? c. Assume that Wilson earned $11 million. What would its earnings per share be before and after the two-for-one stock split? After the three-for-one stock split? d. What would be the price per share after the two-for-one stock splits? After the three-for-one stock split? (Assume that the price-earnings ratio of 36.36 stays the same.) e. Should a stock split change the price-earnings ratio for Wilson? 18-17. Solution: Wilson Pharmaceutical a. Ten (10) million shares would be outstanding at a par value of $5 per share. Everything else will be the same. b. Fifteen (15) million shares would be outstanding at a par value of $3.33 per share. Everything else will be the same. c. EPS before split = $11,000,000/5,000,000 shares = $2.20 EPS EPS after 2-1 split = $11,000,000/10,000,000 shares = $1.10 EPS EPS after 3-1 split = $11,000,000/15,000,000 shares = $.73 EPS 18-17. (Continued) d. P/E × EPS =Price Price after 2-1 split = 36.36 × $1.10 = $40.00 Price after 3-1 split = 36.36 × $.73 = $26.54 e. Probably not. A stock split should not change the price-earnings ratio unless it is combined with a change in dividends to the stockholders. Generally speaking, nothing of real value has taken place. Only to the limited extent that new information content from this split increased investors’ expectations would the stock split possibly have an impact on the P/E ratio. 18. Stock dividend and its effect (LO18-4) Ace Products sells marked playing cards to blackjack dealers. It has not paid a dividend in many years, but is currently contemplating some kind of dividend. The capital accounts for the firm are as follows: Common stock (2,400,000 shares at $5 par) $12,000,000 Capital in excess of par* 5,000,000 Retained earnings 23,000,000 Net worth $40,000,000 *The increase in capital in excess of par as a result of a stock dividend is equal to the new shares created times (Market price – Par value). The company’s stock is selling for $20 per share. The company had total earnings of $4,800,000 during the year. With 2,400,000 shares outstanding, earnings per share were $2.00. The firm has a P/E ratio of 10. a. What adjustments would have to be made to the capital accounts for a 10 percent stock dividend? Show the new capital accounts. b. What adjustments would be made to EPS and the stock price? (Assume the P/E ratio remains constant.) c. How many shares would an investor end up with if he or she originally had 70 shares? d. What is the investor’s total investment worth before and after the stock dividend if the P/E ratio remains constant? (There may be a $1 to $2 difference due to rounding.) 18-18. Solution: Ace Products a. Common stock (2,640,000 shares at $5 par) $13,200,000 *Capital in excess of par 8,600,000 **Retained earnings 18,200,000 Net worth $40,000,000 *240,000 shares × ($20 market price – $5 par value) = 240,000 × $15 = $3,600,000 $ 5,000,000 Beginning capital in excess of par account + $ 3,600,000 Additional capital in excess of par $ 8,600,000 Ending capital in excess of par account 18-18. (Continued) **$23,000,000 Beginning retained earnings account – $1,200,000 Transfer to common stock account – $3,600,000 Transfer to capital in excess of par account $18,200,000 Ending retained earnings account b. EPS after stock dividend = $4,800,000/$2,640,000 = $1.82 Price = P/E ratio × EPS = 10 × 1.82 = $18.20 c. 70 + (70 × 10%) = 77 shares after the stock dividend d. Before After 70 × $20 = $1,400 77 × $18.20 = $1,401 19. Stock dividend and cash dividend (LO18-4) Health Systems Inc. is considering a 15 percent stock dividend. The capital accounts are as follows: Common stock (6,000,000 shares at $10 par) $60,000,000 Capital in excess of par* 35,000,000 Retained earnings 75,000,000 Net worth $170,000,000 *The increase in capital in excess of par as a result of a stock dividend is equal to the shares created times (Market price – Par value). The company’s stock is selling for $32 per share. The company had total earnings of $19,200,000 with 6,000,000 shares outstanding and earnings per share were $3.20. The firm has a P/E ratio of 10. a. What adjustments would have to be made to the capital accounts for a 15 percent stock dividend? Show the new capital accounts. b. What adjustments would be made to EPS and the stock price? (Assume the P/E ratio remains constant.) c. How many shares would an investor have if he or she originally had 80? d. What is the investor’s total investment worth before and after the stock dividend if the P/E ratio remains constant? (There may be a slight difference due to rounding.) e. Assume Mr. Heart, the president of Health Systems, wishes to benefit stockholders by keeping the cash dividend at a previous level of $1.25 in spite of the fact that the stockholders now have 15 percent more shares. Because the cash dividend is not reduced, the stock price is assumed to remain at $32. What is an investor’s total investment worth after the stock dividend if he/she had 80 shares before the stock dividend? f. Under the scenario described in part e, is the investor better off? g. As a final question, what is the dividend yield on this stock under the scenario described in part e? 18-19. Solution: Health Systems Inc. a. Common stock (6,900,000 shares at $10 par) $69,000,000 *Capital in excess of par 54,800,000 **Retained earnings 46,200,000 Net worth $170,000,000 18-19. (Continued) *900,000 shares × ($32 Market price – $10 Stock price) = 900,000 × 22 = 19,800,000 $35,000,000 Beginning capital in excess of par account + $19,800,000 Additional capital in excess of par $54,800,000 Ending capital in excess or par account **$75,000,000 Beginning retained earnings account – 9,000,000 Transfer to common stock account – 19,800,000 Transfer to capital in excess of par account $ 46,200,000 Ending retained earnings account b. EPS after the stock dividend = $19,200,000/6,900,000 = $2.78 price = P/E ratio × EPS = 10 × $2.78 = $27.80 c. 80 + (80 × 15%) = 92 shares after the stock dividend d. Before After 80 × $32 = $2,560 92 × $27.80 = $2,557.60 ($2.40 rounding difference) e. After 92 × $32 = $2,944 f. Yes. As a result of keeping the cash dividend constant, the stockholder not only received more cash dividends, but the portfolio value goes up by $384 as a result of having 12 more shares still worth $32 a share. g. 20. Reverse stock split (LO18-4) Worst Buy Company has had a lot of complaints from customers of late and its stock price is now only $2 per share. It is going to employ a one-for-five reverse stock split to increase the stock value. Assume Dean Smith owns 140 shares. a. How many shares will he own after the reverse stock split? b. What is the anticipated price of the stock after the reverse stock split? c. Because investors often have a negative reaction to a revere stock split, assume the stock only goes up to 80 percent of the value computed in part b. What will the stock’s price be? d. How has the total value of Dean Smith’s holdings changed from before the reverse stock split to after the reverse stock split (based on the stock value computed in part c)? To get the total value before and after the split, multiply the shares held times the stock price. 18-20. Solution: Worst Buy Company a. Number of shares after reverse stock split = Original shares divided by the reverse split ratio = 140/5 = 28 shares b. Anticipated stock price = Original stock price × Reverse split ratio = $2 × 5 = $10 c. Actual stock price based on the 80 percent 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 His holdings have decreased by $56 ($280 – $224) 21. Cash dividend versus stock repurchase (LO18-5) The Carlton Corporation has $5 million in earnings after taxes and 2 million shares outstanding. The stock trades at a P/E of 20. The firm has $4 million in excess cash. a. Compute the current price of the stock. b. If the $4 million is used to pay dividends, how much will dividends per share be? c. If the $4 million is used to repurchase shares in the market at a price of $54 per share, how many shares will be acquired? (Round to the nearest share.) d. What will the new earnings per share be? (Round to two places to the right of the decimal.) e. If the P/E ratio remains constant, what will the price of the securities be? By how much, in terms of dollars, did the repurchase increase the stock price? f. Has the stockholder’s total wealth changed as a result of the stock repurchase as opposed to receiving the cash dividend? g. What are some reasons a corporation may wish to repurchase its own shares in the market? 18-21. Solution: Carlton Corporation a. Price = P/E × EPS EPS = $5 mil. in earnings/2 mil. shares = $2.50 Price = 20 × $2.50 = $50 b. $4 mil./2 mil. = $2 dividends per share c. $4,000,000/$54 = 74,074 shares reacquired d. Shares outstanding after repurchase 2,000,000 – 74,074 = 1,925,926 EPS = $5,000,000/1,925,926 = $2.60 e. Price = P/E × EPS = 20 × $2.60 = $52.00 $52 – $50 = $2 18-21. (Continued) f. No. With the cash dividend: Market value per share $50 Cash dividend per share 2 Total value $52 With the repurchase of stock: Total value per share $52 g. The (potential) appreciation in value associated with a stock repurchase defers the capital gains tax until the stock is sold, whereas dividends are taxed when received. Current tax law taxes long-term capital gains and dividends equally at 15 percent, but tax law continually changes. In previous times, dividends were taxed at a higher marginal rate than long-term capital gains. Also, 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. The reduction in shares also reduces the total cash dividend paid out by the company. 22. Retaining funds versus paying them out (LO18-1) The Hastings Sugar Corporation has the following pattern of net income each year, and associated capital expenditure projects. The firm can earn a higher return on the projects than the stockholders could earn if the funds were paid out in the form of dividends. Year Net Income Profitable Capital Expenditure 1……… $14 million $ 7 million 2……… 16 million 11 million 3……… 12 million 6 million 4……… 16 million 8 million 5……… 16 million 9 million The Hastings Corporation has 3 million shares outstanding (the following questions are separate from each other). a. If the marginal principle of retained earnings is applied, how much in total cash dividends will be paid over the five years? b. If the firm simply uses a payout ratio of 30 percent of net income, how much in total cash dividends will be paid? c. If the firm pays a 10 percent stock dividend in years 2 through 5, and also pays a cash dividend of $3.40 per share for each of the five years, how much in total dividends will be paid? d. Assume the payout ratio in each year is to be 20 percent of net income and the firm will pay a 10 percent stock dividend in years 2 through 5. How much will dividends per share for each year be? (Assume cash dividend is paid after the stock dividend). 18-22. Solution: Hastings Sugar Corporation a. Dividends represent what is left over after profitable capital expenditures are undertaken. Year Net Income – Profitable Capital Expenditures Dividends 1 $14 mil. $ 7 mil. $ 7 mil. 2 16 mil. 11 mil. 5 mil. 3 12 mil. 6 mil. 6 mil. 4 16 mil. 8 mil. 8 mil. 5 16 mil. 9 mil. 7 mil. Total cash dividends $33 mil. 18-22. (Continued) b. Year Net Income × Payout Ratio Dividends 1 $14 mil. .30 $ 4.2 mil. 2 16 mil. .30 4.8 mil. 3 12 mil. .30 3.6 mil. 4 16 mil. .30 4.8 mil. 5 16 mil. .30 4.8 mil. Total cash dividends $22.2 mil. c. Year Shares Outstanding × Dividends per Share Dividends 1 3,000,000 × $3.40 $ 10,200,000 2 3,300,000 × 3.40 11,220,000 3 3,630,000 × 3.40 12,342,000 4 3,993,000 × 3.40 13,576,200 5 4,392,300 × 3.40 14,933,820 Total cash dividends $62,272,020 d. Year Net Income Payout Ratio Dividends Shares Dividends per Share 1 $14 mil. .20 $2.8 mil. 3,000,000 $.93 2 16 mil. .20 3.2 mil. 3,300,000 .97 3 12 mil. .20 2.4 mil. 3,630,000 .66 4 16 mil. .20 3.2 mil. 3,993,000 .80 5 16 mil. .20 3.2 mil. 4,392,300 .73 COMPREHENSIVE PROBLEM Modern Furniture Company (Dividend payments versus stock repurchases) (LO18-5) Modern Furniture Company had finally arrived at the point where it had a sufficient excess cash flow of $4.8 million to consider paying a dividend. It had 3 million shares of stock outstanding and was considering paying a cash dividend of $1.60 per share. The firm’s total earnings were $12 million, providing $4.00 in earnings per share. The stock traded in the market at $88.00 per share. However, Al Rosen, the chief financial officer, was not sure that paying a cash dividend was the best route to go. He had recently read a number of articles in The Wall Street Journal about the advantages of stock repurchases and before he made a recommendation to the CEO and board of directors, he decided to do a number of calculations. a. What is the firm’s P/E ratio? b. If the firm paid the cash dividend, what would be its dividend yield and dividend payout ratio per share? c. If a stockholder held 100 shares of stock and received the cash dividend, what would be the total value of his portfolio (stock plus dividends)? d. Assume instead of paying the cash dividend, the firm used the $4.8 million of excess funds to purchase shares at slightly over the current market value of $88 at a price of $89.60. How many shares could be repurchased? (Round to the nearest share.) e. What would the new earnings per share be under the stock repurchase alternative? (Round to three places to the right of the decimal point.) f. If the P/E ratio stayed the same under the stock repurchase alternative, what would be the stock value per share? If a stockholder owned 100 shares, what would now be the total value of his portfolio? (This answer should be approximately the same as the answer to part c.) CP18-1. Solution: Modern Furniture Company a. P/E ratio = Price/EPS = $88/$4 = 22 b. Dividend yield = Dividend per share/price = $1.60/$88 = 1.82% Dividend payout ratio = Dividend per share/Earnings per share = $1.60/$4.00 = 40% c. Portfolio value Stock (100 shares × $88) $8,800 Dividends (100 shares × $1.60) 160 $8,960 d. $4,800,000/$89.60 = 53,371 shares e. EPS = Total earnings/Total shares = $12,000,000/(3,000,000 – 53,371) = $12,000,000/2,946,629 = $4.072 f. Stock price = P/E × EPS = 22 × $4.072 = $89.58 Portfolio value Stock (100 shares × $89.58) $8,958 Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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