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1 CHAPTER FIVE Qualitative Questions Question 1 Shareholders prefer to have cash dividends paid to them now rather than waiting for potential payments in the future. Future cash flows from retained earnings are riskier than current dividends. Investors will be willing to pay more for high-dividend-paying firms than low-dividendpaying firms. If all else is equal, investors demand a higher rate of return when the dividend payout is reduced. Question 2 In perfect markets, taxes and transaction costs are zero. Value depends on a firm s asset investment policy rather than on how earnings are split between dividends and retained earnings. Retaining earnings increases share value and investors who desire cash for consumption can sell a portion of their holdings. If a dividend payment requires management to issue new shares, it only transfers the risk and ownership from current owners to new owners. Question 3 Investors who are not happy with the firm s dividend policy will trade securities to create homemade dividends. Transaction costs make homemade dividends expensive. A firm can pay dividends and, at the same time, sell shares to raise funds for investment. The existence of flotation costs makes the cost of raising funds from the market more expensive than retained earnings. Question 4 Capital gains are generally taxed at a lower effective rate than dividend income and the investor has the ability to defer capital gains. Low-dividend-paying stocks provide more capital gains and less dividend income than stocks paying high dividends. The impact of taxes is complicated by the existence of tax-exempt institutional investors and individual investors who prefer capital gains. The clientele effect suggests that investors will invest in shares that suit their tax needs. Question 5 Changes in dividends are considered to signal useful information to investors concerning a company s future prospects. The quality of the information contained in dividend changes depends on the pattern of dividends established by a firm. An increase in the current dividend payout is viewed as a message that management anticipates a permanently higher level of cash flows from investment. An increase in dividend is often accompanied by an increase in share price. 47

2 Question 6 Different groups of shareholders prefer different dividend policies. Management s reluctance to alter established dividend policies provides a possible explanation for clientele effects. If a dividend announcement is as expected, the market price remains unchanged. Question 7 Legal restrictions may be imposed by legislative authorities. Investors may impose restrictive constraints in the form of protective covenants included in debt and preferred share contracts. There may be restrictions on cash distributions because of the lack of liquidity. The volatility of a firm s earnings may constrain the firm from increasing dividends. Question 8 Regular cash dividends Extra or special cash dividends Stock dividends Question 9 Corporations often set their dividend payments lower than expected earnings. Firms resist cutting dividends to avoid conveying negative signals about their prospects. Regular and predictable payments tend to occur on a quarterly basis. Firms avoid paying dividends during the early stages of their life cycles. Question 10 According to the residual strategy, the firm pays any cash not needed for financing profitable internal projects. Under the constant payout ratio policy, the firm pays a constant proportion of earnings in dividends. Under the constant dollar dividend policy, the firm pays a constant amount quarterly. Firms may pay extra and special dividends. Question 11 Announcement date Record date Ex-dividend date Dividend-on date Payment date Question 12 Stock dividends are additional shares of stock distributed to existing shareholders in place of cash dividends. Often, firms maintain the cash dividend per share following a stock dividend. A stock split increases the number of shares outstanding without issuing new shares and selling them in the market. Often, stock splits are accompanied by an increase in total dividends. 48

3 Question 13 Share repurchases decrease the number of shares outstanding and lead to a higher market price per share. Shareholders who wish to receive cash can sell a portion of their holdings to substitute for the cash dividend. Share repurchases are perfect substitutes for cash dividends when markets are perfect. Shareholders who pay more taxes on dividends than on capital gains prefer stock repurchases to dividends. Question 14 In an open market purchase, the firm acquires shares at the going market price. In an offer to purchase, shareholders tender their shares at a premium within a particular time period. In a negotiated purchase, the firm purchases a large block of shares from one or more holders on a negotiated basis. Qualitative Multiple Choice Questions Question 1 iii) Constant dollar dividend policy Question 2 i) The firm acquires the shares from stockbrokers at the going market price. Question 3 ii) Shareholders have a choice with a share repurchase they can tender their shares or they can refuse to tender. Question 4 i) January 29, 2003 Question 5 ii) Tax-exempt institutions are willing to pay a premium for shares that pay high dividends, but this will not affect share prices, as long as the existence of tax clienteles can be predicted and as long as there are enough investors in each tax situation. Question 6 iv) Pay out dividends as a residual, after financing all positive NPV investment projects Question 7 ii) The existence of tax clienteles implies that each firm will attract a specific group of investors, depending on their dividend policy. Question 8 ii) Perfect market view Question 9 iv) Shareholders solve the problem of reinvesting small amounts of cash. Question 10 iv) The dividend paid each period is a function of current earnings and current investment opportunities. 49

4 Question 11 iv) The cash account Question 12 ii) Shareholders have a choice with share repurchases. Quantitative Multiple Choice Questions Question 1 ii) $1.96 Standard deviation of DPS = standard deviation of EPS dividend payout ratio Question 2 ii) $17,589 = $5.60 (0.35) = $1.96 Dividends received = 10,000(2.25) = $22,500 Dividend income, after tax = $22,5000 $22,5000(1.45) ( )(1.5) = $22,500 $4,911 = $17,589 Question 3 ii) 20% Equity needed to finance budget = 0.6 $5 million = $3 million Net income $3.75 million Less: equity retained: $3 million Thus, dividends payable $0.75 million Question 4 iii) $29.40 Number of shares purchased = 250, Payout ratio = $0.75 million $3.75 million = 20% = 10,000 $126 million Current EPS = = $2.52 per share 50 million shares P/E ratio = $26.46 = 10.5 times $2.52 $126 million EPS after repurchase = = $2.80 per share 45 million shares Expected market price after repurchase = 10.5 $2.80 = $ = $29.40 Quantitative Problems Problem 1 In this question, a firm is implementing a residual dividend policy. A stock dividend and a stock split must also be described, as these are potential alternatives for the firm, for the current year. 50

5 a) Calgina follows a residual dividend policy, and it maintains a 55% debt-to-equity ratio. It must finance $3,500,000 for the four new projects with this debt-to-equity ratio. D 0.55 =, so D = 0.55E E E = $3,500,000 = $2,258, This $2,258,065 is the amount of the investment outlays that will be financed from current earnings attributable to common shareholders. The remaining $1,241,935 will be raised by issuing new debt. To confirm: 1,241,935 $2,258,065 = 55% An alternative calculation of debt and equity proportion: D = 0.55 E = 1.0 V = 1.55 D + E = 1.55 D V = E V = b) The firm has $2,500,000 current earnings available to common shareholders and requires $2,258,065 of equity financing for its new investments. The remainder can be paid out as dividends: $2,500,000 $2,258,065 = $241,935 c) i) If no dividends are paid and all $2,500,000 of earnings available to common shareholders is invested in new projects, then the total amount of investment could be: $2,500,000 (or $2,500,000(1.55)) = $3,875, ii) New debt of $1,3750,000 ($2,500, ) would be required to maintain a 55% debt-to-equity ratio. d) A stock dividend is the distribution of additional shares to existing shareholders. There is no cash involved; instead, there is an accounting transfer or capitalization from the retained earnings account to the common share account. The number of outstanding shares increases, but there is no change in the total value of equity it is just distributed proportionately to its existing shareholders. e) A stock split is an action taken to increase the number of shares outstanding without issuing new shares. A firm issues new shares and distributes them to current shareholders in proportion to shareholders ownership in the original shares. The book value of shares is split to reflect the new number of shares. Total shareholders wealth and firm value are unaffected. Problem 2 a) i) 2008 dividends = (1.07)(2007 dividends) = (1.07)($7,200,000) = $7,704,000 ii) 2007 payout ratio = $7,200,000 $18,000,000 = 40% 2008 dividends = (40%)($28,800,000) = $11,520,000 51

6 iii) Equity financing = $16,800,000(0.7) = $11,760, dividends = net income - equity financing = $28,800,000 - $11,760,000 = $17,040,000 All of the equity financing is done with earnings as long as they are available. iv) The regular dividends would be the 2007 dividends plus a 7% growth: Regular dividends = (1.07)($7,200,000) = $7,704,000 The residual policy calls for dividends of $17,040,000. Therefore, the extra dividend would be: Extra dividend = $17,040,000 - $7,704,000 = $9,336,000 b) Policy iv), based on the regular dividend with an extra dividend, seems most logical. If implemented properly, it would lead to correct capital budgeting and correct financing decisions, and it would convey correct signals to investors. c) Cost of equity = D 1 P 0 + g = $18,000,000 $360,000, % = 12% d) Other possible forms of remuneration are stock dividends, stock splits, and share repurchases. Cases Case 1: Antibury Inc. a) Under the cash dividend policy, Antibury Inc. will pay out 70% of earnings as dividends. Earnings are projected to be $3,257,143 and there are 1,500,000 shares outstanding. Total cash dividends = 0.70 ($3,257,143) = $2,280,000 Dividend per share = $2,280,000 1,500,000 = $1.52 Therefore, a holder of 200 shares will receive $ The cash dividends will reduce retained earnings to $15,000,000 - $2,280,0000 = $12,720,000 Total-debt-to-total-equity = (4,700, ,000,000) (1,500, ,720,000) = b) i) If all cash is retained and a 30% stock dividend is paid, then the number of common shares outstanding will increase to 1,500,000 (1.3) = 1,950,000 shares. A holder of 200 shares will receive 60 additional common shares. ii) There will be a transfer from the retained earnings account to the common shares account, equal to 30% of the market value of all outstanding shares: 0.30($15)(1,500,000) = $6,750,000 The new balance of common shares = 1,500,000 6,750,000 = $8,250,000 The new balance of retained earnings = 15,000,000 6,750,000 = $8,250,000 (4,700, ,000,000) Total-debt-to-total-equity ratio = (8,250, ,250,000) = 9,700,000 16,500,000 =

7 iii) Next year, if earnings remain at $3,257,143 and the payout remains at 70%, the firm will pay out cash dividends of $2,280,000 to holders of the 1,950,000 shares: Dividend per share = $2,280,000 = $1.169 L $1.17 1,950,000 For 260 shares, dividend = $ c) i) If the firm opts for a share repurchase, with a payout of $2,280,000, and if the share $2,280,000 price remains at $15, the firm can repurchase $15 = 152,000 shares. ii) Remaining shares outstanding = 1,500, ,000 = 1,348,000 shares iii) If earnings and payout remain unchanged in the following year, the per-share dividend will be: Earnings(0.7) new number of shares = $3,257,143(0.7) = $2,280,000 1,348,000 1,348,000 = $1.69 For 180 shares,* dividend = $ * Note: % ownership before = 1,500,000 = % ownership after must remain the same; 1,348,000( ) = shares. d) The policies differ on a variety of dimensions. If tax differences are not present, a cash dividend is equivalent to a share repurchase. The capital structure of the firm, as measured by the debt-to-equity ratio, is affected by dividend payout policy. Also, if there is a link between investment opportunities and dividend payout policies, firms should restrict cash dividends so as to enable them to undertake positive NPV projects, as implied in part b). Case 2: JoliBrand Corp. In a world that is perfect, except for the existence of corporate taxes, a firm is considering changing its capital structure. The impetus for the change is the realization that the firm has a capital structure inconsistent with others in the industry. Using the M&M with corporate taxes model, students must identify the new level of debt required to achieve the desired target capital structure. The analysis continues by determining how many common shares to repurchase with the new debt, and then by considering the impact on the dividend payout of the firm under alternative dividend payout policies. Overall impact on the cash flows of the firm can then be calculated, since interest payments will increase while dividend payments to common shareholders will fall. This integrative problem incorporates capital structure, dividend policy, and cash management. a) As JBC changes its capital structure, its value will change due to the interest tax shields on additional debt. This must be taken into account when identifying the required amount of additional debt, since the target capital structure is defined in terms of the total debt to total market value ratio. New value = old value + tax rate amount of additional debt Old value = $81,000,000 + $22,000,000 + $48,000,000 = $151,000,000 $70,000,000 $151,000,000 JBC now has a total debt to market value ratio of = 46.36%, which is below the industry norm. JBC should issue more debt to achieve its objective. The new total debt to market value ratio is to be the industry norm of 60%: (New firm value)(60%) = $70 million existing debt + value of new debt (151,000, new debt)(0.60) = $70,000,000 + new debt 90,600, new debt = 70,000,000 + new debt 90,600,000 70,000,000 = new debt 53

8 New debt = 20,600, = $25,879,397 required to be issued To verify: 1 Alternative solution Value without debt: New firm value = 151,000, (25,879,397) New debt-to-market-value ratio = V B = V A + BT C 151,000 = V A + 70,000(0.34) V A = 127,200 Value with 60% debt V B = 127, (0.60)V B V B = 127, V B V B = 159,798,995 = 151,000, ,798,995 = 159,798,995 1 b) Before the change in capital structure, JBC had 10,000,000 shares outstanding with a total market value of $81,000,000 so the share price was $8.10 each. Every current shareholder can expect to receive a fair share of the new higher firm value after the proposed change in capital structure. The increase in firm value of $6,120,000 ($18,000, ) is therefore shared among all 10,000,000 shares: New share value = (70,000, ,879,397) 159,798,995 ($81,000,000 + $6,120,000) 10,000,000 = 95,879, ,798,995 = 60% = $8.712 Shares to be repurchased = a $18,000,000 b = 2,066,116 shares $8.712 Shares remaining outstanding = 10,000,000-2,066,116 = 7,933,884 $8.712 each c) The increase in firm value of $6,800,000 ($20,000, ) is therefore shared among all 10,000,000 shares: ($81,000,000 + $6,800,000) New share value = = $ ,000,000 Shares to be repurchased = $20,000,000 = 2,277,904 shares $8.78 Shares remaining outstanding = 10,000,000-2,277,904 = 7,722,096 $8.78 each If JBC continues its policy of paying common shareholders an annual dividend of $2 per share, it will pay out $4,555,808 less in dividends as a consequence of the change in capital structure. New debt yielding 10% with a value of $20,000,000 will require interest payments of $2,000,000 ($20,000, ). After tax, the interest expense will be $1,320,000 [$2,000,000 (1-0.34)]. The net effect is a reduction in cash outflows of $4,555,808 - $1,320,000 = $3,235,

9 d) JBC could adopt a constant dividend payout percentage. Annual earnings would be multiplied by this percentage to identify total cash dividends for the year. Per-share dividends would be this total amount divided by the number of shares outstanding. Under this policy, per-share dividends fluctuate from year to year, with earnings. Shareholders do not have the stable cash flows they receive under the current constant-dollar dividend policy. JBC could also adopt a residual dividend payout policy. Dividends would then be paid only after all positive NPV projects had been undertaken. That is, only residual funds are paid out and the rest is retained in the firm for reinvestment. Under this policy, annual dividends fluctuate with annual investment opportunities, with given levels of earnings. Again, shareholders are unlikely to have the stability of dividends that they enjoy under the current policy. CHAPTER SIX Qualitative Questions Question 1 Sponsors guarantee that the project will be completed on time and will meet certain specifications or quality tests. Sponsors guarantee the supply of raw materials to the project during or after completion. Sponsors guarantee purchasing part or all of the output from or services of a project. Sponsors effectively guarantee the project against default. Question 2 Calculate the cash flows obtained from the project assuming the project will be financed with all equity (unlevered project). Determine the cost of capital assuming an all-equity firm. Discount the unlevered cash flows by the unlevered cost of equity. Question 3 Calculate the base-case NPV (all equity). Calculate the incremental cash flows obtained if the firm uses a source other than equity to finance the project. Determine the after-tax cost of debt for the firm. Determine the interest tax shield. Discount the present value of incremental cash flows at the after-tax cost of debt. Add the present value of the finance-related benefits and costs to present value from the base-case NPV. Question 4 Leasing uses up the firm s debt capacity in the same manner as debt. Lease payments magnify the variability of the net cash flows to shareholders. Leasing allows the lessee to avoid the investment outlays that would be required to purchase. Leasing requires periodic cash outflows similar to those required to service debt. Question 5 The entire periodic lease payment can be claimed as a tax-deductible expense. Lessees cannot claim capital cost allowances on the leased equipment. The lessee loses the advantages derived from the asset s residual value. 55