Chaper 10: The Deerminans of Dividend Policy 1. True True False 2. This means ha firms generally prefer no o change dividends, paricularly downwards. One explanaion for his is he clienele hypohesis. Tha is, firms end o have a cerain class of shareholders who depend upon he firm s dividend policy o obain funds for consumpion on a regular basis. When he firm lowers is dividends frequenly or unexpecedly, hese shareholders have o sell some of heir shares and incur ransacions coss in order o obain funds for consumpion purposes. If he firm increases dividends, hey have o incur ransacions coss when hey reinves hese funds. (However, see he answer o he nex quesion as well.) 3. Markes inerpre decreased dividends as signals ha he firm is no expecing o do well, which of course sends he sock price lower. Increased dividends on he oher hand generally send sock prices higher. Hence firms are less reicen abou increasing dividends provided hey can mainain he higher level of dividends. 4. The Modigliani-Miller argumen assumes: There are no ransacions coss in convering dividends ino sock and vice-versa. I is no cosly for a firm o issue new sock. The invesmen decisions of he firm are unaffeced by is dividend policy. Managers of firms ha pay very low dividends relaive o free cash flow do no misuse he funds. There is no ax advanage or disadvanage o dividends. Firms wih significan holdings by insiuional invesors such as pension funds, who are ax exemp migh mee hese condiions. Firs, hey do no bear any ax penaly by receiving dividends. Second, hese shareholders migh have greaer economies of scale and hence, lower ransacions coss in generaing homemade dividends. Third, if hey hold significan fracions of he firm s sock, hey migh be more acivis and monior managers o a greaer exen. 5. This is no always rue. If ax raes are very low, or if he ax raes are equal for capial gains and dividend income, here will be very lile ax disadvanage o dividends. This is of course, always rue for invesors who are hemselves ax-exemp. However, here is always a ax-iming opion for capial gains, in ha capial gains are axable only when realized, and he invesor can choose o realize hem a imes when his/her marginal ax rae is low.
6. The firm migh aemp o lower dividends in order o use he funds for capial expendiures. Shareholders, migh however, be unhappy wih his. Markes migh also misinerpre his. However, if he firm announces he new siuaion ahead of ime, i may be possible for he firm o acquire a new clienele ha is happier wih he lower dividend yield. 7. Since dividends are generally sicky, firms increase dividends only when hey believe hey can mainain he new level of dividends. Consequenly, an announcemen of higher dividends is ofen inerpreed as an indicaion ha he firm has informaion unavailable o he marke ha is earnings are going o increase o a permanenly higher level. There is a fair number of sudies ha show ha he cumulaive abnormal reurns o a dividend increase announcemen are posiive. 7. Yes. If he reason for he dividend increase is an acknowledgemen ha i canno coninue o make invesmens a accepable raes of reurn, his would be a negaive signal. However, here is no much empirical evidence of his. 8. PA D 41.67% = o. Subsiuing, we find (50-46.5)/5 = (1- o )/(1-.4 o ). Solving, we ge o = 10. The ex-dividend day equaliy is PA D = o. For shareholders who are companies, he effecive ax rae on dividends is 15% of he ordinary corporae ax rae on ordinary income, because 85% of hese dividends are exemp from axes. Hence he PA 0.15o equaliy becomes =. D 11. By buying he socks before he paymen of dividends, receiving he dividend and selling hem aferwards, he ax exemp invesor realizes (48-50) + 4 = $2, (67-70) + 4 = $1, and (95-100) + 5 = $0 respecively from he hree socks. However, here is he risk, ha prices migh move even more unfavorably beween he purchase and resale. This risk can be reduced by aemping dividend arbirage on a large number of socks across a large number of ex-dividend days. 10 9.2 0.5 12. We solve he equaion = n 1 0.5 /(1.1) approximaely.. Solving, we find n = 3.02 or 3 years, 13. P D A 0.15 = o. Subsiuing, 10 P A 0.5 = 1 0.15(0.4). Solving, P A = $9.35. 0.28
14. Since he announced dividend increase is only 2%, i.e. less han he expeced increase, here migh be a price drop following he announcemen. 15. Under he hypohesis ha his indicaes lower growh, one migh expec a lower price. However, here may be oher reasons for his as well. For example, he firm migh now find i cheaper o use more deb financing hus freeing up some of he free cash flow for dividend paymens. 16. In his case, here is less reason o expec ha he increase in dividends is a negaive signal, since he firm was already paying dividends; mos high-growh firms pay no dividends a all. Hence here will probably be a price increase. 17. If he firm were followed by a lo of analyss, here migh be less of a surprise for he marke when i ges he dividend increase announcemen. Consequenly, we d expec less of a price change. 18. In his case, he dividend confirms he bad news, and here migh be some price drop because of a corroboraion effec. 19. I seems ha shareholders were worried abou managers misusing free cash flow. Hence he paymen of increased dividends would be an indicaion of poenially beer managemen of he firm s resources. The marke migh reward his wih a price increase. 20. Nabisco s bonds would probably drop in value because of he reduced asse base available for saisfacion of promised paymens o bondholders. 21. If here are oher ways o disciple managers, hen increased dividends would be less necessary, since free cash flow is less of a problem. The firm migh hen reduce dividends so as o have funds available for emergencies. 22. Dividend payou raios migh rise, since he dividend ax penaly is reduced. 23. Lower dividends imply increased funds wih firms for reinvesmen. If he governmen wans o provide incenives for invesmen, his migh be one mehod (alhough no necessarily an opimal sraegy). 24. If he excess cash is a one-ime phenomenon, hen a special dividend or an equiy buyback migh be appropriae, so ha invesors do no misinerpre he dividend payou. Which of hese wo mehods is chosen migh depend on wheher managemen feels ha he sock is currenly undervalued and on wheher is shareholders have ax preferences for capial gains or have heerogeneous ax siuaions. In all hese cases, a sock buyback would be indicaed.
25. Signaling benefis are posiively relaed o firm commimen o coninue he acion. A special dividend clearly indicaes no such commimen a all, whereas an equiy buyback migh indicae some commimen. On he oher hand, a regular dividend carries he definie implicaion ha he firm will ry o mainain he new dividend level. 26. I could. However, i would be much more efficien o use he windfall o make up he projeced dividend decrease. However, if he dividend decrease is due o srucural reasons ha canno be avoided, he firm migh also make a simulaneous announcemen o allow shareholders o make alernae arrangemens and hence smoohly change is shareholder clienele. 27. Any ime ha shareholders have heir opions curailed, hey are generally hur. In his case, presumably he price paid o he argeed shareholder is higher han he marke price. This would dilue he value of he remaining shares, and migh even help shield managerial inefficiency. 28a. If he ineres rae is lower han he reurn on asses, he EPS will rise. b. However, his is no necessarily opimal. If he ax and managerial discipline advanages o he increased leverage are ouweighed by he agency and bankrupcy coss, he sock price will probably drop. c. If higher leverage is indicaed, he price will go up. 29 a. Curren marke value of deb = curren marke value of sock = $42 * 1 million = $42 million Afer $5 million of deb is reired, oal deb becomes $37 million EPS = (15,000,000-37,000,000*10%) (1-40%) / (1,000,000-100,000) = $7.53 b. Curren EPS = (15,000,000-42,000,000 *10%) (1-40%) / 1,000,000 = $6.48 Curren P/E raio = $42 / $6.48 = 6.48 The new price would be $7.53*6.48 or $48.79 per share. I is lower han he endering price of $50. The managemen would probably argue ha he P/E raio would be higher, leading o a higher price. c. I he socks are bough back a he ongoing marke price, i is less likely ha he marke would believe he argumen made by he managemen ha he sock is underpriced. d. The answer o (b) and (c) may differ if he managemen is allowed o ender shares. The prices would go down because he marke may conclude ha he managemen is rying o unload is shares. 30. a. The repurchase opion gives (1-0.28)(30-27) = $2.16 per share, afer ax, assuming ha he pos-dividend price is he ax basis for shareholders. The dividend opion gives shareholders an afer-ax payou of $3(1-0.6) = $1.20 per share. Hence he buyback opion is preferable. b. If he firm s shareholders are mainly oher corporaions, he relaive preference of shareholders would be for dividends (since 85% of dividends are ax-exemp), and we would recommend he dividend roue.
31 a. Wihou Wih Borrowing Borrowing EBIT 20 20 Ineres Exp. 0 4.8 EBT 20 15.2 Taxes 10 7.6 Ne Income 10 7.6 No. of Shares 100,000 60,000 EPS 100 126.67 b. The ineres rae on deb would have o be 12.5% for he EPS effec o disappear. 32. The firm migh wan o dives he obacco division in order o insulae he res of he firm from he expeced liabiliy. There may, however, be covenans on he deb resricing he abiliy of he firm o underake such an acion. 33. If he price drop is due o he marke s percepion ha managemen is no efficien, he spli off will no help as long as he managemen of he divisions does no change. The firm should look o changing he managemen of a leas one of he divisions. This can help if he marke hinks ha he curren managemen has moved ou of is core compeency, or ha i is sreched oo hin.
34. The price increase could be due o several reasons. If he marke feels ha associaion of a given division of he firm wih a second division is disadvanageous because of he burden of poenial liabiliies from he second division or if he firs division is unable o raise funds a advanageous raes because of he associaion wih he second division, a spinoff can raise value. A spinoff can also ransfer wealh from bondholders because bondholders lose he diversificaion effec of he firm having several businesses. 35. The marke will see hrough his maneuver. There migh even be a negaive effec, since he acion indicaes managemen s desperaion. 36. The marke migh have fel ha here was some unwarraned cross-subsidizaion of he Limied by he oher divisions. This would explain a posiive price response. 37. The resricions on financing policy for he regulaed componen migh make i difficul for he firm o raise funds for he non-regulaed divisions on he bes erms. This is because some of he resricions migh apply o he firm as a whole. 38. A spinoff or splioff migh make i easier for analyss o value a firm since he new firms now provide more deailed informaion by division. There are oher reasons for spinoffs and splioffs, such as disencumbering one division of resricions on or more of he oher divisions. Firms where such a siuaion exiss would be more likely o underake a spinoff or a splioff. 39. The allocaion of hese coss is an accouning ac. Divesiure will no reduce he amoun of hese coss. Alhough i is rue ha he buyer of he divesed business will no have o pay hese coss, he exisiing firm will. In he case of JC Conglo, which is a conglomerae, i is possible ha he organizaional srucure is no sufficienly shallow. This migh preven efficien managemen of he firm. There may be some posiive effecs of keeping he firm as is: for example, reained earnings from one division could be used for capial expendiures in he oher divisions. Oher examples of greaer flexibiliy could be poined ou. 40. The sockholders presenly wan o reduce free cash flow under he conrol of managers. The suggesed acion would no achieve his, and sockholders would no be saisfied.