Chapter 16 Dividend Policy 16-1. Given a firms earnings per share, #shares ( ) t NI E t , and its payout ratio, ( ) t t D E , we can find the dividend per share, D t , by simply multiplying the two together: D t = E t , t t D E
(where the t subscript refers to time t: The payout ratio is the dividend paid at time t from earnings per share at time t). Thus, for our three companies, we have: A B C = A*B payout earnings dividend company ratio per share per share Emerson Electric Co. 52% $2.49 $1.29 Intel Corporation 127% $0.438 $0.56 Wal-Mart Stores 30% $3.41 $1.02
So, for example, Wal-Mart chose to pay out 30% of its earnings as dividends (reinvesting the other 70%), so it paid out $1.02 from of EPS of $3.41 ([$1.02/$3.41] = 0.30). Intel actually paid out more than it made! It must therefore have raised cash another way (e.g., loans, stock sales, asset sales) in order to increase its dividend above its earnings. 16-2. Costco paid total dividends in 2008 of $265,029,000, from its net income of $1,282,725,000. A. We can therefore simply find its payout ratio by dividing its total dividends by its net income:
dividend per share payout ratio earnings per share total dividends /(#of shares) net income /(#of shares) total dividends . net income t t t t t t t
=
=
=
Thus, for 2008, we find a payout ratio of 20.66%, or $265,029,000 $1,282,725,000 ( ). 416 Titman/Keown/Martin Financial Management, Eleventh Edition 2011 Pearson Education, Inc. Publishing as Prentice Hall B. We can then find 2009s total dividends by multiplying this payout ratio by 2009s net income, as shown below: 2008 notes total cash dividends = $265,029,000 A net income = $1,282,725,000 B payout ratio = 20.66% C = A/B 2009 net income = $1,500,000,000 D (given) payout ratio = 20.66% C (as before) total cash dividends = $309,921,066 E = D*C % change in net income = 16.94% F = (D - B)/B % change in dividends = 16.94% G = (E - A)/A
Since Costcos net income rises, but its payout ratio remains the same, the firm is paying out the same proportion of a larger whole. The firms total dividend payment therefore rises, and by the same percentage as its net income. (We can verify this statement about percentage changes by noting that : %divs = [(divs 2009 divs 2008 )/divs 2008 ] = [(NI 2009 payout 2009 NI 2008 payout 2008 )/NI 2008 payout 2008 ] = [(NI 2009 NI 2008 )/NI 2008 ], as long as payout 2009 = payout 2008 .) 16-3. If Paylins stock is selling for $28 one day before the ex-date (so that investors who buy the stock then will receive the $3 dividend), it should sell for ($28 $3) after the ex-date (when investors then buying will not receive the dividend). Investors who wont receive a $3 dividend will not pay as much for Paylins shares as will investors who will receive the dividend; therefore, the stock price will fall on the ex-day. Remembering the dividend discount model for stock pricing, we see: stock price just before ex-day = PV(all dividends to be paid from now to infinity) $28 = PV(next dividend of $3 + all other future dividends) $28 = PV(next dividend of $3) + PV(all other future dividends), whereas: stock price just after ex-day = $0 + PV(all other future dividends). (See equation 16-1 in Checkpoint 16.1.) The difference in the prices before and after the ex-day is therefore the PV of the $3 dividend. The present value of that dividend is very nearly $3, since its so close to being paid, so the difference between the stock prices will be very close to $3. Thus we expect the stocks price to fall by approximately $3 on the ex-day. Solutions to End of Chapter ProblemsChapter 16 417 2011 Pearson Education, Inc. Publishing as Prentice Hall 16-4. Elco Electrics management is considering paying a one-time $40 special dividend. Its current share price is $150. Using the same logic as in Problem 16-3, and again appealing to equation 16-1, we would expect, all else equal, for the firms stock price to fall by $40 to $110 once the dividends ex-date passes. Management asserts that its reason for the special dividend is that the firm has more cash than it can profitably invest, and that the large cash balance would adversely affect the incentives of the workforce to strive to create shareholder value. Given these incentives, is it possible that the stock price would not fall by $40, as expected? Do these incentives undermine our all else equal assumption? The answer depends upon the message that investors draw from the special dividend. This could go either way: Investors view the dividend as good news, and stock price falls by less than $40. Possible explanations for this outcome include: Investors see that managers want to maximize shareholder value, and that managers are willing to voluntarily divest themselves of free cash flow, as finance theory says they should, so that investors can more profitably invest that cash elsewhere. This improves investors view of management and their expectations about future good decisions by management. Investors note that by releasing the free cash flow, managers remove their incentives to invest the cash for perquisites or other negative net present value projects. Firm value rises as the expected probability of future negative NPV investments falls. By eliminating the excess cash, managers eliminate a prime motivation for a takeover, saving investors from a potentially expensive takeover battle (and preserving good current management). As posited by management, employees are now more motivated to work, enhancing shareholder value. The huge dividend returns the stock to its preferred trading range, as discussed in section 16.2 of the text. (However, this is not a likely interpretation here, given managements story about the dividend.) The dividend attracts attention, so it cant be bad. (Again, this is a rationale discussed in section 16.2.) Investors view the dividend as bad news, and stock price falls by more than $40. Possible explanations for this outcome include: Investors focus on the big picture here, which is that the firm can no longer find enough positive net present value projects. The firm has left its growth phase and entered maturity. Future growth will be lower; as the lower growth rate is impounded in price, price falls. Growth investors will need to leave the firm to find growth firms, incurring transactions costs from selling their shares. Those who stay can count on higher (taxed!) dividends in the future, as the mature firmnow a cash cowcontinues to disgorge cash. There is no compensating increase in employee motivation, since lower-level employees are primarily motivated by their paychecks. Its management whose hands are tied by the lack of free cash flow, not employees. There is now a lower probability of a value-enhancing takeover, given that one attraction for acquirers is large amounts of free cash flow. The extent to which a poor current management is entrenched has increased. (However, the decision to disgorge the cash in the first place suggests that this negative assessment of management does not apply in Elcos case.) 418 Titman/Keown/Martin Financial Management, Eleventh Edition 2011 Pearson Education, Inc. Publishing as Prentice Hall If (currently unforeseen) positive NPV projects arise, Elco may now have to resort to (more expensive) outside financing to finance them, reducing their value. Elco has reduced its financial slack. To the extent that such slack is valuable, Elco has lost value. Given all these possible interpretations, I think price will fall by more than $40. This firm has just admitted that its growth days are over. Its expected future earnings, and its P/E ratio, will fall as a result. 16-5. Stock dividends do not change firm value; they only change the number of shares outstanding. If the number of shares increases but aggregate value does not, it must be that stock dividends cause stock price to fall. We can see this as follows. First, note that: current stock price = firm value . #of shares
Now, if: initial stock price = firm value old # of shares
= $30, then: firm value = $30 (old # of shares). Now assume that the firm pays a 10% stock dividend, so that there will be 10% more shares outstanding. This gives us the following: new firm value = old firm value (new price) (new # of shares) = ($30) (old # of shares) (new price) [(1.10) (old # of shares)] = ($30) (old # of shares), so that: new price = ($30)/(1.10) = $27.27. If the stock dividend were larger, the dilution would be even greater. For a 20% dividend, the new price is ($30)/(1.20) = $25.00. notes current stock price = $30.00 A stock dividend % = 10% B stock price after stock dividend = $27.27 C = A/(1+B) current stock price = $30.00 D stock dividend % = 20% E stock price after stock dividend = $25.00 F = D/(1+E)
Solutions to End of Chapter ProblemsChapter 16 419 2011 Pearson Education, Inc. Publishing as Prentice Hall 16-6. As we saw in Problem 16-5, if a firm wants its stock price to fall, it can issue a stock dividend, which will dilute price. If Templeton Care Facilities wants its stock price to fall from $150 to $50, it would need to cut the price to 1/3 its current value. Since this wont affect firm value, we can solve for the necessary stock dividend percentage as follows: new firm value = old firm value (new price) (new # of shares) = (old price) (old # of shares) ($50) [(1 + x) (old # of shares)] = ($150) (old # of shares) (1 + x) = ($150)/($50) = 3 x = 2 = 200%. Templeton would therefore have to issue a 200% stock dividenda proportion so large that its really not a stock dividend but a stock split. (As described in the texts footnote 3, the accounting response would be affected by the name Templeton gives to this transaction. However, the economic impact is the same either way.) 16-7. Since Templeton Care Facilities needs to have three times as many shares outstanding after than event (so that price will fall to 1/3 of its current value), the firm would need a 3-for-1 split. We can see this as: new firm value = old firm value (new price) (new # of shares) = (old price) (old # of shares)
old price 3
[(old # of shares) 3] = (old price) (old # of shares). Thus, the new number of shares must be three times as large as the old number of shares: Each old share must be exchanged for three new ones. 16-8. The important thing to remember for this problem is that stock splits and stock dividends do not change firm value. Once we know that, the problem simply boils down to determining how many new shares the firm will issue. A. For stock dividends, the new number of shares is simply (# of old shares) (1 + stock dividend percentage). Thus a 20% dividend means that the number of shares rises by 20%, so that the new number of shares equals (# of old shares) (1.20). For an x-for-1 stock split, we simply multiply the old number of shares by x. For example, a 2- for-1 split doubles the number of shares; a 4-for-1 multiplies it by 4. Given that the firm value will not change, and that the number of shares outstanding will be increased, it must be true that stock price will fall. For the three changes we were given for B/D. Chaneys Fat burner Gyms, we therefore have the following: 420 Titman/Keown/Martin Financial Management, Eleventh Edition 2011 Pearson Education, Inc. Publishing as Prentice Hall A B C = 8,000,000*(1+B) D = A/C % change in event firm value # of shares # shares price initial situation $96,000,000 8,000,000 $12.00 20% stock dividend $96,000,000 20% 9,600,000 $10.00 4-for-1 split $96,000,000 300% 32,000,000 $3.00 32.5% stock dividend $96,000,000 32.5% 10,600,000 $9.06
(Note that for the 4-for-1 split, we have quadrupled the number of shares outstanding. Thus, column B, which shows the percentage change in shares outstanding, shows [32M 8M]/8M = 24M/8M = 3, or 300%.) The chart below shows the relationships between the split/dividend percentage, the resulting stock price, and the new number of shares outstanding. 8,000,000 13,000,000 18,000,000 23,000,000 28,000,000 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00 $9.00 $10.00 $11.00 $12.00 0% 50% 100% 150% 200% 250% 300% percentage change in number of shares price per share #of shares
16-9. Here is the initial balance sheet for Marshall Pottery Barn: initial situation Cash $18,000 Accounts Payable $22,000 Accounts Receivable $22,000 Notes Payable $5,000 Inventories $30,000 Current Liabilities $27,000 Current Assets $70,000 Long-term Debt $33,000 Fixed Assets $130,000 Equity $140,000 Total Assets $200,000 Total D&E $200,000 MARSHALL POTTERY BARN BALANCE SHEET (as of mm/dd/yy)
Solutions to End of Chapter ProblemsChapter 16 421 2011 Pearson Education, Inc. Publishing as Prentice Hall The total dividend that Marshall is considering is ($1.50/share)*(5,000 shares) = $7,500: notes #of shares = 5,000 A dividend per share = $1.50 B total dividends paid = $7,500 C = A*B
A. When the firm pays its cash dividend, it obviously will lower cash. It will also lower equity: Dividends paid come out of the equity stake of the company. Investors are essentially cashing out some of their equity. The accounting entry would be to debit equity and credit cash: equity $7,500 cash $7,500 (payment of cash dividend)
Thus Marshalls balance sheet will look like this after the dividend payment: after dividend Cash $10,500 Accounts Payable $22,000 Accounts Receivable $22,000 Notes Payable $5,000 Inventories $30,000 Current Liabilities $27,000 Current Assets $62,500 Long-term Debt $33,000 Fixed Assets $130,000 Equity $132,500 Total Assets $192,500 Total D&E $192,500 MARSHALL POTTERY BARN BALANCE SHEET (as of mm/dd/yy)
Note that total firm value has fallen by the amount of the dividend. B. If this were interpreted as a market-value balance sheet, there would be no difference. The firm would still have $7500 less in cash. Since the value of each share of stock would have fallen by $1.50 after the dividend payment, the total market value of stock held by all investors would still fall by $7500. Thus, there would be no difference in our post-dividend balance sheet. (Of course, equityholders are not worse off, ignoring taxes. Their holding of the firm used to be worth $140,000; now its worth only $132,500, but they also have $7500 in cash. Either way, they have $140,000 worth of financial assets.) 16-10. In Section 16.2 of the text, we learn about Individual Wealth EffectsPersonal Taxes. Fact #2 in that subsection tells us that a stock seller only pays capital gains taxes on the difference between his selling price and his buying price (i.e., the capital gain). Since Stan bought his shares for $8 and will sell them for $10, he will only need to pay tax on his ($10 $8) = $2/share capital gain. Thus: 422 Titman/Keown/Martin Financial Management, Eleventh Edition 2011 Pearson Education, Inc. Publishing as Prentice Hall notes current stock price = $10 A (given) Stan's initial price = $8 B (given) Stan's capital gain per share = $2 C = A - B #of shares that Stan will sell = 2,000 D (given) Stan's total proceeds = $20,000 E = A*D Stan's total capital gain = $4,000 F = C*D capital gains rate = 15% G (given) Stan's tax bill = $600 H = F*G Stan's after-tax proceeds = $19,400 I = E - H
Stan sells 2000 shares at $10/share, for a total of $20,000. However, he doesnt pay tax on this full amount; instead, he pays tax on only his $2/share capital gain, or ($2/share) (2000 shares) = $4000. Tax on $4000 at 15% is (15%) ($4000) = $600, so Stan ends up with ($20,000 total proceeds $600 tax) = $19,400. An important point here is that a capital gain is not a cash flow. Instead, a capital gain is an accounting value that determines a tax bill (the tax bill, of course, is a cash flow). We never receive checks for capital gains; we only receive checks for total proceeds (and then write checks for taxes). Thus, when were finding a cash flow, like after-tax proceeds, we combine only other cash flows: total proceeds and taxes. 16-11. In Section 16.2 of the text, we learn about Individual Wealth EffectsPersonal Taxes. Fact #1 tells us that 100% of cash dividends are taxable in the year they are received. Thus, if Stan owns 10,000 shares, and the firm pays a dividend of $2/share, Stan will receive (10,000 shares) ($2/share) = $20,000. This full amount is taxed at 15%, so Stans tax bill will be ($20,000) (15%) = $3000a much more severe tax hit than Stan faced in Problem 16-10. When Stan received the $20,000 from share sales, he was taxed only on the $2/share capital gain on the 2000 shares he sold. Even then he had a choice: He did not have to sell. In this case, however, the dividend is paid on all 10,000 shares, the full amount received is taxable, and Stan has no choice about receiving the cash flow (unless he sells the shares in the market at $10 before they go ex-dividend). notes #of shares owned by Stan = 10,000 A (given) dividend per share = $2 B (given) total dividends received by Stan = $20,000 C = A*B dividend tax rate = 15% D (given) Stan's tax bill = $3,000 E = C*D Stan's after-tax proceeds = $17,000 F = C - E
Of course, Stans tax situation would have been even worse if dividends were still taxed as ordinary incomeat rates up to 35%. Solutions to End of Chapter ProblemsChapter 16 423 2011 Pearson Education, Inc. Publishing as Prentice Hall 16-12. A. If Caraway Seeds pays $200,000 today and $1.2M in one year to its equityholders, and if those equityholders require a 10% return, then the value of the equity must be the present value of those two payments. (The value of stockholders equity is the PV of all future dividends, and, for Caraways equityholders, these are the only two dividends they will receive. After the t = 1 dividend, the firm shuts down.) Thus, we have: value of Caraways equity = PV(all future dividends) [PV of t = 0 dividend] + [PV of t = 1 dividend] = $200,000 + 1 $1, 200, 000 (1.10)
= $200,000 + $1,090,909 = $1,290,909. (Compare our work to equation 16-1, and the related calculations for Clinton Enterprises from the text, as well as Northwest Wire and Cable from Checkpoint 16.1.) Now if Caraway decided to pay $600,000 in t = 0 dividends ($400,000 more than it has available), it will raise $400,000 in new stock. The holders of this new stock also require a 10% return, so they will demand $400,000 (1.10) = $440,000. Paying $440,000 at t = 1 leaves only ($1,200,000 $440,000) = $760,000 for the old shareholders. Thus, the value of the old shareholders equity is now: value of old equity = PV(all future dividends to original shareholders) [PV of t = 0 dividend] + [PV of t = 1 dividend] = $600,000 + 1 $760, 000 (1.10)
= $600,000 + $690,909 = $1,290,909. Its the same either way! The old shareholders either get more money now or more money later, but the PRESENT VALUE of these payments is unchanged. How could it be otherwise? The PV is simply the value of the firm, which is not affected by these alternatives. The situation of Caraways old shareholders is pictured below. Under either alternative #1 (payment today of $200,000; payment in 1 year of $1.2M) or alternative #2 (payment today of $600,000; payment in 1 year of $760,000), these shareholders receive payments whose PRESENT VALUES (which are what is pictured below) are worth $1,290,909. The packaging doesnt matter; the value is the same. 424 Titman/Keown/Martin Financial Management, Eleventh Edition 2011 Pearson Education, Inc. Publishing as Prentice Hall $200,000 $600,000 $1,090,909 $690,909 $0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 alternative #1 alternative #2 t=1 payment t=0 payment $1,290,909
This result depends upon the new shareholders getting what they paid for, and on their having the same 10% required return as our current shareholders. That is, when they give us $400,000 today, they are getting shares worth $400,000. The new shares owners receive $440,000 in one year; this payment is worth $440,000/(1.10) 1 = $400,000. When the old shareholders choose this alternative, they receive something today worth $400,000, in return for something in one year that is also currently worth $400,000. Thus, there is no effect on current shareholders. We can also think of this as follows. Under alternative #1, just after the t = 0 dividend is paid, we have: firm value = value of old shareholders shares = $1,090,909. The old shareholders also have $200,000 in cash, so their total worth is $1,290,909. Under alternative #2, it looks like this: firm value = value of old shareholders shares + value of new shareholders shares = $690,909 + $400,000 = $1,090,909. The old shareholders also have $600,000 in cash, so their total worth is $1,290,909, just as it is under alternative #1. 16-13. A. If the Tyler Brick Manufacturing Company pays its shareholders $125,000 today and $14M in one year, then the all-equity firms value (given a required return to equity of 15%) is found as follows: value of Tylers equity = PV(all future dividends) = [PV of t = 0 dividend] + [PV of t = 1 dividend] = $125,000 + 1 $14, 000, 000 (1.15)
= $125,000 + $12,173,913 = $12,298,913. Solutions to End of Chapter ProblemsChapter 16 425 2011 Pearson Education, Inc. Publishing as Prentice Hall B. If, however, the firm raises new equity at 15% in order to increase todays dividend to $1,000,000, we have: value of old equity = PV(all future dividends to original shareholders) = [PV of t = 0 dividend] + [PV of t = 1 dividend] = $1,000,000 + 1 $12, 993, 750 (1.15)
= $1,000,000 + $11,298,913 = $12,298,913, the same as with alternative #1. The payment to old shareholders under the second alternative equals the $14M available, less the payment required by the new shareholders. Since the new shareholders provided $875,000 at t = 0 (the $1M dividend $125,000 available), they will require ($875,000) (1.15) = $1,006,250 at t = 1. This leaves ($14M $1,006,250) = $12,993,750 for the old shareholders. Thus, under either alternative, the old shares are worth $12,298,913 at t = 0 (including the t = 0 dividend). The new shares under alternative #2 are worth what they cost, $875,000. We can see this, as shown below: $125,000 $1,000,000 $12,173,913 $11,298,913 $0 $2,000,000 $4,000,000 $6,000,000 $8,000,000 $10,000,000 $12,000,000 alternative #1 alternative #2 t=1 payment t=0 payment $12,298,913
Under either alternative, the old shares are worth $12,298,913: the old shareholders either get more money at t = 0 (alternative #2) or more money at t = 1 (alternative #1); either way, the PRESENT VALUE of both of their payments is $12,298,913.