Chapter 17

Dividends and Dividend Policy

Learning Objectives

1. Explain what a dividend is and describe the different types of dividends and the dividend payment process.

2. Explain what a stock repurchase is and how companies repurchase their stock.

3. Discuss the benefits and costs associated with dividend payments, and compare the relative advantages and disadvantages of dividends and stock repurchases.

4. Define stock dividends and stock splits, and explain how they differ from other types of dividends and from stock repurchases.

5. Describe factors that managers consider when setting the dividend policies of their firms.

I. Chapter Outline

17.1 Dividends

The term dividend policy is generally used to refer to a firm’s overall policy regarding

distributions of value to stockholders.

A dividend is something of value that is distributed to a firm’s stockholders on a pro-rata

basis—that is, in proportion to the percentage of the firm’s shares that they own.

A dividend can involve the distribution of cash, assets, or something else, such as

discounts on the firm’s products that are available only to stockholders.

When a firm distributes value through a dividend, it reduces the value of the

stockholders’ claims against the firm.

A dividend reduces the stockholders’ investment in a firm by returning

some of that investment to them.

The value that stockholders receive through a dividend was already theirs,

and so a dividend simply takes this value out of the firm and returns it to

stockholders.

A. Types of Dividends

The most common form of dividend is the regular cash dividend, which is a cash

dividend paid on a regular basis.

These dividends are generally paid quarterly and are a common means by

which firms return some of their profits to stockholders.

The size of a firm’s regular cash dividend is typically set at a level that

management expects the company to be able to maintain in the long run, barring

some major change in the fortunes of the company.

Management does not want to have to reduce the dividend.

Management can afford to err on the side of setting the regular cash dividend too

low because it always has the option of paying an extra dividend if earnings are

higher than expected.

Extra dividends are often paid at the same time as regular cash dividends and are

used by some companies to ensure that a minimum portion of earnings is

distributed to stockholders each year.

A special dividend, like an extra dividend, is a one-time payment to stockholders.

Special dividends tend to be considerably larger than extra dividends and

to occur less frequently.

They are used to distribute unusually large amounts of cash.

A liquidating dividend is a dividend that is paid to stockholders when a firm is

liquidated.

Distributions of value to stockholders can also take the form of discounts on the

company’s products, free samples, and the like.

These noncash distributions are not thought of as dividends, in part

because the value received by stockholders is not in the form of cash and

in part because the value received by individual stockholders does not

often reflect their proportional ownership in the firm.

B. The Dividend Payment Process

The Board Vote: The process begins with a vote by a company’s board of

directors to pay a dividend.

As stockholder representatives, the board must approve any distribution of

value to stockholders.

The Public Announcement: The date on which this announcement is made is

known as the declaration date, or announcement date, of the dividend.

The announcement typically includes the amount of value that

stockholders will receive for each share of stock that they own, as well as

the other dates associated with the dividend payment process.

The price of a firm’s stock often changes when a dividend is announced

because the public announcement sends a signal to the market about what

management thinks the future performance of the firm will be.

o If the signal differs from what investors expected, they will

adjust the prices at which they are willing to buy or sell the

company’s stock accordingly.

o This means that a dividend decision sends information to

investors and that information is incorporated into stock prices

at the time of the public announcement.

The Ex-Dividend Date: The ex-dividend date is the first date on which the stock

will trade without rights to the dividend.

An investor who buys shares before the ex-dividend date will receive the

dividend, while an investor who buys the stock on or after the ex-dividend

date will not.

Before the ex-dividend date, a stock is said to be trading cum dividend, or

with dividend.

On or after the ex-dividend date, the stock is said to trade ex dividend.

The price of the firm’s shares changes on the ex-dividend date even if

there is no new information about the firm.

o This drop simply reflects the difference in the value of the cash

flows that the stockholders are entitled to receive before and

after the ex-dividend date.

The Record Date: The record date typically follows the ex-dividend date by two

days.

The record date is the date on which an investor must be a stockholder of

record (that is, officially listed as a stockholder) in order to receive the

dividend.

The ex-dividend day precedes the record date because it takes time to

update the stockholder list when someone purchases shares.

The Payable Date: The final date in the dividend payment process is the

payable date, when the stockholders of record actually receive the dividend.

The divided payment process is not as well defined for private companies

as it is for public companies, because in private companies shares are

bought and sold less frequently, there are fewer stockholders, and no stock

exchange is involved in the dividend payment process.

17.2 Stock Repurchases

With a stock repurchase, a company buys some of its shares from stockholders.

A. How Stock Repurchases Differ from Dividends

Stock repurchases differ from dividends in four ways.

First, they do not represent a pro-rata distribution of value to the

stockholders because not all stockholders participate.

o Individual stockholders decide whether they want to participate in

a share repurchase.

Second, when a company repurchases its own shares, it removes them

from circulation.

o This reduces the number of shares of stock that are held by

investors, thereby removing a large number of shares from

circulation. This can change the ownership of the firm.

Third, stock repurchases are taxed differently than dividends.

o The total value of dividends is normally taxed.

o Conversely, when a stockholder sells shares back to the company,

the stockholder is taxed only on the profit from the sale.

Fourth, the way in which we account for dividends and stock repurchases

on a company’s balance sheet is also different.

o When the company pays a cash dividend, the cash account on the

assets side of the balance sheet and the retained earnings account

on the liabilities and stockholders’ equity side of the balance sheet

are reduced.

o In contrast, when a company uses cash to repurchase stock, the

cash account on the assets side of the balance sheet is reduced,

while the treasury stock account on the liabilities and stockholders’

equity side of the balance sheet is increased.

B. How Stock Is Repurchased

Companies repurchase stock in three general ways.

First, they can simply purchase shares in the market, much as you would.

These kinds of purchases are known as open-market repurchases, which

are a very convenient way of repurchasing shares on an ongoing basis.

o Open-market repurchases can be cumbersome because the

government limits the number of shares that a company can

repurchase on a given day.

These limits, which are intended to restrict the ability of

firms to influence their stock price through trading activity,

mean that it could take months for a company to distribute

a large amount of cash using open-market repurchases.

o When the management of a company wants to distribute a large

amount of cash at one time and does not want to use a special

dividend, it can repurchase shares using a tender offer, which is

an open offer by a company to purchase shares.

There are two types of tender offers: fixed price and Dutch

auction.

With a fixed-price tender offer, management

announces the price that will be paid for the

shares and the maximum number of shares

that will be repurchased.

o Interested stockholders then tender

their shares by letting management

know how many shares they are

willing to sell.

With a Dutch auction tender offer, the firm

announces the number of shares that it

would like to repurchase and asks the

stockholders how many shares they would

sell at a series of prices, ranging from just

above the price at which the shares are

currently trading to some higher number.

o Stockholders then tell the company

how many of their shares they would

sell at the various offered prices.

o The third general way in which shares are repurchased is through

direct negotiation with a specific stockholder, where targeted

stock repurchases are typically used to buy blocks of shares from

large stockholders.

o These repurchases can benefit stockholders because managers may

be able to negotiate a per-share price that is below the current

market price because the stockholder who owns a large block of

shares might have to offer the shares for a below-market price in

order to sell them all in the open market.

17.3 Dividend Policy and Firm Value

Dividend policy can affect the value of a firm.

The general conditions under which capital structure policy does not affect firm value:

1. There are no taxes.

2. There are no information or transaction costs.

3. The real investment policy of the firm is fixed.

Dividend policy does not matter under the above conditions because a stockholder can

“manufacture” any dividends he or she wants at no cost when these conditions hold.

A stockholder could also undo a company’s dividend policy by simply reinvesting the

dividends that the company pays in new shares.

If investors could replicate a company’s dividend policy on their own at no cost, they

would not care whether or not the company paid a dividend.

A. Benefits and Costs of Dividends

One benefit of paying dividends is that it attracts investors who prefer to invest in

stocks that pay dividend yields.

Although it is true that the investor could simply sell some stock each month to

cover expenses, in the real world it may be less costly—and it is certainly less

trouble—to simply receive regular cash dividend payments instead.

Recall that under the M&M conditions, there are no transaction costs.

In the real world, however, the retiree or institutional investor will have to

pay brokerage commissions each time he or she sells stock.

The dividend check, in contrast, simply arrives each quarter.

o Of course, the retiree will have to consider the impact of taxes on

the value of dividends versus the value of proceeds from the sale of

stock; but it is quite possible that receiving dividends might, on

balance, be more appealing.

Other investors have no current need for income from their investment

portfolios and prefer not to receive dividends.

Some argue that a large regular dividend indicates that a company is

financially strong because the “signal” of strength can result in a higher

stock price.

o This argument is based on the assumption that a company that is

able to pay a large dividend, rather than holding on to cash for

future investments, is a company that is doing so well that it has

more money than it needs to fund its available investments.

o The problem with this line of reasoning is that it ignores the

possibility that a company might have more than enough money

for all its future investment opportunities because it does not have

many future investment opportunities.

If the board of directors of a company votes to pay the stockholders

dividends that amount to more than the excess cash that the company is

producing from its operations, then the money to pay the dividends will

have to come from selling equity periodically in the public markets.

o The need to raise equity in the capital markets will help align the

incentives of managers with those of stockholders because it

increases the cost to mangers of operating the business

inefficiently.

There are costs to the firm associated with dividends.

Taxes are among the most important costs.

Owners of stocks that pay dividends often have to pay brokerage fees if

they want to reinvest the proceeds.

o To eliminate this cost, some companies offer dividend

reinvestment programs (DRIPs). Through a DRIP, a company

sells new shares, commission free, to dividend recipients who elect

to automatically reinvest their dividends in the company’s stock.

To the extent that a company uses a lot of debt financing, paying

dividends can increase the cost of debt.

Using the cash flow identity of sources and uses of cash, we can see that an

expected increase in the cash flow from operations is a good signal, and investors

will interpret it as suggesting that cash flows to stockholders will increase in the

future.

The cash flow identity suggests that managers change dividend polices when

something fundamental has changed in the business; it is this fundamental change

that causes the stock price to change.

The dividend announcement is really just the means by which investors

find out about the fundamental change.

Stock repurchases are an alternative to dividends as a way of distributing, and

they have some distinct advantages over dividends.

They give stockholders the ability to choose when they receive the

distribution, which affects the timing of the taxes they must pay as well as

the cost of reinvesting funds that are not immediately needed.

Stockholders who sell shares back to a company pay taxes only on the

gains they realize. Historically, these capital gains have been taxed at a

lower rate than dividends.

From management’s perspective, stock repurchases provide greater

flexibility in distributing value.

o Even when a company publicly announces an ongoing open-

market stock repurchase program, as opposed to a regular cash

dividend, investors know that management can always quietly cut

back or end the repurchases at any time.

o This means that if future cash flows are not certain, managers are

likely to prefer to distribute extra cash today by repurchasing

shares through open-market purchases because this enables them to

preserve some flexibility.

o Since most ongoing stock repurchase programs are not as visible as

dividend programs, they cannot be used as effectively to send a

positive signal about the company’s prospects to investors.

o A more subtle issue concerns the fact that managers can choose

when to repurchase shares in a stock repurchase program.

Just like other investors, managers prefer purchasing shares

when they believe that the shares are undervalued in the

market.

The problem is that since managers have better information

about the prospects of the company than do other investors,

they can take advantage of this information to the detriment

of other investors.

o Management is supposed to act in the best interest

of all its stockholders.

17.4 Stock Dividends and Stock Splits

A. Stock Dividends

One type of “dividend” that does not involve the distribution of value is known as

a stock dividend.

When a company pays a stock dividend, it distributes new shares of stock

on a pro-rata basis to existing stockholders.

The only thing that happens when the stock dividend is paid is that the

number of shares each stockholder owns increases and their value goes

down proportionately.

o The stockholder is left with exactly the same value as before.

B. Stock Splits

A stock split is quite similar to a stock dividend, but it involves the distribution of

a larger multiple of the outstanding shares.

We can often think of a stock split as an actual division of each share into

more than one share.

Besides their size, a key distinction between stock dividends and stock splits is

that typically stock dividends are regularly scheduled events, like regular cash

dividends, while stock splits tend to occur infrequently during the life of a

company.

C. Reasons for Stock Dividends and Splits

The most often cited reason for stock dividends or splits is known as the trading

range argument, which proposes that successful companies use stock dividends or

stock splits to make their shares more attractive to investors.

It has historically been more expensive for investors to purchase odd lots

of less than 100 shares than round lots of 100 shares.

Odd lots are less liquid than round lots because more investors want to

buy round and it is relatively expensive for companies to service odd-lot

owners.

Researchers have found little support for this explanation.

The transaction costs argument no longer carries much weight, as there is

now little difference in the costs of purchasing round lots and odd lots.

One real benefit of stock splits is that they can send a positive signal to investors

about management’s outlook for the future, and this, in turn, can lead to a higher

stock price.

Management is unlikely to want to split the stock of a company 2-for-1 or

3-for-1 if it expects the stock price to decline. It is likely to split the stock

only when it is confident that the stock’s current market price is not too

high.

Reverse stock splits may be undertaken to satisfy exchange requirements.

The New York Stock Exchange generally requires listed shares to trade

for more than $5, and the NASDAQ requires shares to trade for at least $1.

17.5 Setting a Dividend Policy

The best-known survey of dividend policy was published in 1956, more than 50 years

ago, by John Lintner. The survey asked managers at 28 industrial firms how they set their

firms’ dividend policies.

The key conclusions from the Lintner study are as follows:

1. Firms tend to have long-term target payout ratios.

2. Dividend changes follow shifts in long-term sustainable earnings.

3. Managers focus more on dividend changes than on the absolute level

(dollar amount) of the dividend.

4. Managers are reluctant to make dividend changes that might have to be

reversed.

A more recent study, by Brav, Graham, Harvey, and Michaely published in 2005, updates

Lintner’s findings.

The link between earnings and dividends is weaker today than when Lintner

conducted his survey.

They found that rather than setting a target level for repurchases, managers tend to

repurchase shares using cash that is left over after investment spending.

In addition, many managers prefer repurchases because repurchase programs are

more flexible than dividend programs and because they can be used to time the

market by repurchasing shares when management considers a company’s stock

price too low.

Finally, the managers who were interviewed appeared to believe that institutional

investors do not prefer dividends to repurchases or vice versa.

o In other words, the choice between these two methods of distributing

value does not have much of an effect on who owns the company’s stock.

A. Practical Considerations in Setting a Dividend Policy

A company’s dividend policy is largely a policy about how the excess value in a

company is distributed to its stockholders.

It is extremely important that managers choose their firms’ dividend polices in a

way that enables them to continue to make the investments necessary for the firm

to compete in its product markets.

Managers should consider several practical questions when selecting a dividend

policy:

1. Over the long term, how much does the company’s level of earnings (cash

flows from operations) exceed its investment requirements? How certain

is this level?

2. Does the firm have enough financial reserves to maintain the dividend

payout in periods when earnings are down or investment requirements are

up?

3. Does the firm have sufficient financial flexibility to maintain dividends if

unforeseen circumstances wipe out its financial reserves when earnings

are down?

4. Can the firm raise equity capital quickly if necessary?

5. If the company chooses to finance dividends by selling equity, will the

increased number of stockholders have implications for control of the

company?

II. Suggested and Alternative Approaches to the Material

Chapter 17 discusses dividends and other methods of distributing value to stockholders. The

discussion begins with a definition of a dividend as well as some practical details that are needed

to study the topic. The chapter then turns to stock repurchases as an alternative to delivering

value to stockholders. The chapter next discusses how a firm’s dividend policy might affect firm

value. A brief discussion of dividend splits and stock dividends is then discussed, and finally the

chapter ends by discussing the practical matters associated with setting a dividend policy.

Although the material in the chapter is introduced formally, for the first time, the

discussion of whether dividend policy matters will look familiar to the student due to the

irrelevance arguments used by the Modigliani and Miller discussion just as with the capital

structure chapter. As such, the student should understand the line of reasoning needed to

comprehend the material. It may be tempting to leave the practical discussion of dividends for

students to pick up from the text, but they need that material to reconcile how dividends actually

affect firm value, versus the theoretical discussion.

This material is generally considered advanced, but the chapter is highly recommended to

anyone who has the time to cover the material during a quarter or semester. Many students will

not be exposed to this topic again, and others will find this discussion useful for their later work

in this area.

III. Summary of Learning Objectives

1. Explain what a dividend is, and describe the different types of dividends and the

dividend payment process.

A dividend is something of value that is distributed to a firm’s stockholders on a pro-rata

basis—that is, in proportion to the percentage of the firm’s shares that they own. There

are four types of dividends: (1) regular cash dividends, (2) extra dividends, (3) special

dividends, and (4) liquidating dividends. Regular cash dividends are the cash dividends

that firms pay on a regular basis (typically quarterly). Extra dividends are paid, often at

the same time as a regular cash dividend, when a firm wants to distribute additional cash

to its stockholders. Special dividends are one-time payments that are used to distribute a

large amount of cash. A liquidating dividend is the dividend that is paid when a company

goes out of business and is liquidated.

The dividend payment process begins with a vote by the board of directors to pay

a dividend. This is followed by the public announcement of the dividend on the

declaration date. On the ex-dividend date, the shares begin trading without the right to

receive the dividend. The record date, which follows the ex-dividend date by two days, is

the date on which an investor must be a stockholder of record in order to receive the

dividend. Finally, the payable date is the date on which the dividend is paid.

2. Explain what a stock repurchase is and how companies repurchase their stock.

A stock repurchase is a transaction in which a company purchases some of its own shares

from stockholders. Like dividends, stock repurchases are used to distribute value to

stockholders. Stock is repurchased in three ways: (1) open-market repurchases, (2) tender

offers, and (3) targeted stock repurchases. With open-market repurchases, the company

purchases stock on the open market, just as any investor does. A tender offer is an open

offer by a company to purchase shares. Finally, targeted stock repurchases are used to

repurchase shares from specific stockholders.

3. Discuss the benefits and costs associated with dividend payments, and compare the

relative advantages and disadvantages of dividends and stock repurchases.

The potential benefits from paying dividends include (1) attracting certain investors who

prefer dividends, (2) sending a positive signal to the market concerning the company’s

prospects, (3) helping to provide managers with incentives to manage the company more

efficiently, and (4) helping to manage the company’s capital structure. One cost of

dividends results when a stockholder must take a dividend and pay taxes on the dividend,

whether or not he or she wants the dividend. Stockholders who want to reinvest the

dividend in the company must, unless there is a dividend reinvestment program (DRIP),

pay brokerage fees to reinvest the money. Finally, paying a dividend can increase a

company’s leverage and thereby increase its cost of debt.

With a stock repurchase program, investors can choose whether they want to sell

their shares back to the company. Stock repurchases also receive more favorable tax

treatment. From management’s point of view, stock repurchase programs offer more

flexibility than dividends and can have less of an effect on the company’s stock price.

One disadvantage of stock repurchases involves an ethical issue: Managers have better

information than others about the prospects of their companies, and a stock repurchase

can enable them to take advantage of this information in a way that benefits the

remaining stockholders at the expense of the selling stockholders.

4. Define stock dividends and stock splits, and explain how they differ from other types

of dividends and from stock repurchases.

Stock dividends involve the pro-rata distribution of additional shares in a company to its

stockholders. Stock splits are much like stock dividends but involve larger distributions

of shares than stock dividends. Stock dividends and stock splits differ from other types of

dividends because they do not involve the distribution of value to stockholders. After a

stock dividend or stock split, each shareholder has the same amount of value as before. In

fact, since they do not involve the distribution of value, stock dividends are not really

dividends at all.

5.Describe factors that managers consider when setting the dividend policies for their

firms.

A company’s dividend policy is largely a policy about how excess value in the company

is distributed to its stockholders. Setting the policy depends on several factors: the

expected level and certainty of the firm’s future profitability, the firm’s future investment

requirements, the firm’s financial reserves and financial flexibility, the firm’s ability to

raise capital quickly if necessary, and the control implications of financing dividends by

selling equity.

IV. Summary of Key Equations

The chapter is primarily a qualitative chapter and does not have a relevant summary of key

equations.

IV. Before You Go On Questions and Answers

Section 17.1

1. How does a dividend affect the size of a stockholder’s investment in a firm?

A dividend reduces the size of the stockholder’s investment in a firm. After a dividend is

issued, the shareholder owns the same percentage of the company, which is worth less

than it did before the dividend. The shareholder can use the dividend as he or she sees fit

(after paying taxes).

2. List and define four types of dividends.

1. Regular Cash Dividend—Paid out regularly, usually quarterly. This dividend is

usually set at a level that the board expects to be sustainable in the long run.

2. Extra Dividend—U sually paid at the same time as a regular dividend. Often used to

pay out extra earnings that will not be maintainable over the long run and/or to ensure

that a certain percentage of earnings are returned to shareholders as dividends.

3. Special Dividend—One- time dividend usually resulting from a special event such as

the sale of an asset or a large cash balance. For example, Microsoft’s special dividend

of $3 per share at the beginning of the chapter.

4. Liquidating Dividend—D ividend resulting from the sale of assets of a company

being liquidated (dissolved). This is the value left over for shareholders after the

claims of other investors, such as bondholders, have been paid.

3. What are the key events and dates on the dividend payment process?

Board Vote—T he firm’s board votes to issue a dividend, specifying the amount and

key dates of the issue.

Public Announcement Date—The firm releases the information regarding the

dividend payment. Often the stock price will move on the dividend announcement

date because investors use this dividend information as a signal regarding the future

prospects of the firm.

Ex-Dividend Date—T his is the first date on which purchasing the stock will not

result in receiving a dividend.

Record Date—T his is the date on which one must be a stockholder of record to

receive a dividend. This date is set by the board and is used by the exchange to set the

ex-dividend day. The difference between the ex-dividend date and the record date

reflects the time needed to compile and update the records of stock ownership.

Payable Date—T his is the date the dividend will actually be paid.

Section 17.2

1. What is a stock repurchase?

A stock repurchase takes place when a company purchases some of its own stock from

shareholders. Shareholders who choose to participate receive payment in exchange for

their shares.

2. How do stock repurchases differ from dividends?

There are four major ways in which stock repurchases differ from dividends. First, the

payments are not made on a pro-rata basis. Some stockholders choose to take the

repurchase offer, whereas others choose to hold on to their shares. Second, stock

repurchases reduce the number of outstanding shares. This can change the liquidity of the

shares and ownership control of the firm. Third, stock repurchases are taxed differently,

often resulting in a smaller tax burden for investors. Finally, accounting for stock

repurchases and dividends is different. When a dividend is issued, the retained earnings

account decreases on the liability and stockholder’s equity side of the balance sheet. For a

stock repurchase, the treasury stock account on the right side of the balance sheet

becomes more negative. Both stock repurchases and dividends reduce the cash account on

the asset side of the balance sheet.

3. In what ways can a company repurchase its stock?

Open-Market Repurchase—The company purchases shares at the exchange in the same

manner as normal trades. This is convenient for small ongoing repurchases. Regulations

meant to prevent price manipulation limit the amount that a company can purchase at the

exchange in a day. These regulations make an open-market repurchase cumbersome for

large share repurchases.

Tender Offer Repurchases—The company makes an open offer to buy shares. There are

two types of tender offers. In a fixed-price offer, the company offers a fixed price to

investors who agree to sell their shares. In a Dutch auction offer, the company seeks bids

for the number of shares investors would sell at a series of prices. The company may then

choose the price in the series that will result in the desired number of shares being

repurchased.

Targeted Stock Repurchase—A company repurchases shares directly from one or more

large stockholders. This is sometimes used to negotiate with a large stockholder who is

attempting to gain control of the company.

Section 17.3

1. What are the benefits and costs associated with dividends?

The benefits associated with dividends are as follows:

a. Dividends may attract investors who prefer to receive income directly from their

investments. However, the tax costs of dividends may drive away other investors.

b. Dividends can function as a signal to investors that the company is performing

well and has higher then expected cash flows.

c. Dividends can help align manager and stockholder incentives. By issuing

dividends and raising capital through equity issues (rather than internal funds),

managers are subject to more scrutiny. This increases the incentives for managers

to perform well.

d. Dividends reduce equity claims on the company; this can help managers achieve the

target capital structure suggested by the trade-off theory.

Some costs associated with dividends include:

a. Taxes. Dividends have historically taxed at a higher rate than other forms of income.

b. Reinvestment costs. Investors who don’t intend to spend the cash must pay the

transactions costs associated with reinvesting (brokerage fees, etc.).

c. Increased cost of debt. By reducing the amount of equity through a dividend issue, the

firm becomes more leveraged. If the increase is significant, this could increase the

risk associated with the company and increase the cost of debt should the

company desire to borrow.

2. How do stock prices react to dividend announcements?

Stock prices generally react favorably to announcements of higher than expected

dividends and negatively to announcements of lower than expected dividends. This is

consistent with the theory that dividends act as signals that convey to investors positive or

negative changes to the firm’s fundamentals.

3. Why might stock repurchases be preferred to dividends?

Stock repurchases might be preferred to dividends because they result in lower taxes for

investors and allow management more flexibility in distributing value. If the company has

excess cash flow that is uncertain to continue in the future, it may be beneficial for

management to initiate a stock repurchase, which can be quietly halted without sending a

negative signal to investors.

Section 17.4

1. What is a stock dividend?

A stock dividend is a distribution of shares of stock to existing stockholders in proportion

to the fraction of shares they own.

2. How does a stock dividend differ from a stock split?

A stock dividend usually occurs on a regular basis, and the number of new shares is

usually small compared to the number of existing shares. Stock splits are infrequent and

involve a large number of new shares. For example, in a 2-for-1 split the number of

newly created shares is equal to the number of existing shares, and the total number of

shares is doubled.

3. How does a stock dividend differ from other types of dividends?

Unlike other dividends, a stock dividend does not distribute anything of value, as the

stockholders’ claim on the assets of the firm is unchanged. A stockholder may own more

shares, but each share is worth less. The effects must exactly offset each other.

Section 17.5

1. How are dividend policies affected by expected earnings?

Managers tend to set dividend policies that are achievable with expected long-run

sustainable earnings. Because of the negative effect of a dividend reduction, managers are

hesitant to increase dividends if they are concerned that the increase may have to be

undone in the future.

2. What did the 2005 study conclude about how managers view stock repurchases?

The study concluded that managers tend to view repurchases as the preferred option for

returning extra cash left over after investment spending. The study also found that

managers prefer the flexibility of share repurchase plans, repurchasing shares when they

believe the companies’ stock is undervalued. Finally, managers believe that the decision

between share repurchases and dividend payments has little effect on what type of

investor is likely to own the company’s stock.

3. List three practical considerations that managers should take into account when setting a

dividend policy?

The level of earnings (cash flows from operations) in excess of a company’s

investment requirements over the long run and how certain this level is.

Whether the firm has sufficient financial reserves to maintain the dividend payout

during periods when earnings are down or investment opportunities are up.

Whether the firm has sufficient financial flexibility to maintain dividends if

unforeseen circumstances wipe out its financial reserves when earnings are down.

Whether the firm is able to quickly raise enough capital if necessary.

The control (voting) implications if a firm chooses to finance dividends by selling

equity.

VI. Self-Study Problems

17.1 You would like to own a common stock that has a record date of March 20, 2009

(Friday). What is the last date that you can purchase the stock and still receive the

dividend?

Solution:

The ex-dividend date is the first day that the stock will be trading without the rights to the

dividend, and that occurs two days before the record date, or on March 18, 2009.

Therefore, the last day that you can purchase the stock and still receive the dividend will

be the day before the ex-dividend date, or Tuesday, March 17, 2009.

17.2 You believe that the average investor is subject to a 10 percent tax rate on dividend

payments. If a firm is going to pay a $0.30 dividend, by what amount would you expect

the stock price to drop on the ex-dividend date?

Solution:

If the tax rate of the average investor is reflected in the stock price change, we would

expect investors to receive 90 percent (1.0 − 0.1) of the dividend after paying taxes. This

would necessitate a $0.27 (0.9 × $0.30) drop in the stock price of the firm on the ex-

dividend date.

17.3 The Veil Acts Company just announced that instead of a regular dividend this quarter, it

will be repurchasing shares using the same amount of cash that would have been paid in

the suspended dividend. Should this be a good or bad signal from the firm?

Solution:

Veiled Acts has replaced a committed cash flow with one that is stated but does not have

to be acted on. Therefore, the firm’s actions should be greeted with suspicion, and the

signal is not a good one.

17.4 The Bernie Rubbel Company has just declared a 3-for-1 stock split. If you own 12,000

shares before the split, how many shares do you own after the split? What if it were a 1-

for-3 reverse stock split?

Solution:

You will own three shares of Bernie Rubbel for every one share that you currently own.

Therefore, you will own 3 × 12,000 = 36,000 shares of the company. In the case of the

reverse split, you will own 1/3 × 12,000 = 4,000 shares of the company.

17.5 Two publicly traded companies in the same industry are similar in all respects except

one. Where Publicks has issued debt in the public markets (bonds), Privicks has never

borrowed from any public source. In fact, it always uses private bank debt for its

borrowing. Which firm might be marginally more inclined to have a more aggressive

regular dividend payout than the other? Explain.

Solution:

If all other things are the same about the two companies, then Publicks could be expected

to have a more aggressive dividend payout policy. Since Publicks has issued debt in the

past, while Privicks has not, we could expect Publicks to have greater access to the capital

markets than Privicks. Firms with greater access to capital markets can be more

aggressive in their dividend payouts to the extent that they can raise capital more easily

(cheaply).

VII. Critical Thinking Questions

17.1 Suppose that you live in a country where it takes ten days to settle a stock purchase. How

many days before the record date will be the ex-dividend date?

The ex-dividend date is the first day that a stock will trade without the right to a dividend.

In the United States, where it takes three days for a stock purchase to settle, the ex-

dividend date is two days before the record date. Therefore, if it takes ten days for a stock

purchase to settle, then the ex-dividend date will be nine days before the record date.

17.2 The price of a share of stock is $15.00 on February 14, 2009. The record date for a $0.50

dividend is Friday, February 17, 2009. If there are no taxes on dividends, what would you

expect the price of a share to be on February 13 through 17? Assume that no other

information occurs and that could change the price of a share.

Since we are excluding all nondividend-related information, the price of the shares will

remain constant until the ex-dividend date, when the price will drop by $0.50 per share.

February 13—$15.00

February 14—$15.00

February 15—$14.50

February 16—$14.50

February 17—$14.50

17.3 You find that you are the only investor who owns a particular stock who is subject to a 15

percent tax rate on dividends (all other investors are subject to a 5 percent tax rate on

dividends). Is there greater value to you to hold on to the stock beyond the ex-dividend

date or to sell the stock and repurchase the stock on or after the ex-dividend date?

Assume that the stock is currently selling for $10.00 per share and the dividend will be

$0.25 per share.

All of the other investors (who we can assume will be dictating the market equilibrium

price) expect to pay 5 percent of their dividend receipt in taxes. Therefore, they expect to

keep $0.25 × (1 – 0.05) = $0.2375 of the dividend after taxes are paid. Then, you would

expect the price of the shares to be $9.7625 ($10.00 – $0.2375) on the ex-dividend date.

However, you believe the correct price (based on your tax situation) to be $10.00 – (0.25

x (1 – 0.15)) = $9.7875. Therefore, by holding on to the stock, you would find that the

share price dropped by $0.025 more than what you expected. Therefore, if we ignore

transactions costs, it would be beneficial for you to sell your shares before the ex-

dividend date and then repurchase them on the ex-dividend date. This argument, of

course, ignores any taxes that might have to be paid by selling the shares at $10.00.

17.4 Discuss why the dividend payment process for private companies is so much simpler than

that for public companies.

Since private companies have greater access to their shareholders than their public

counterparts, the process of paying a dividend is not complicated by having to constantly

monitor who owns the companies’ shares at any given time. In fact, the shares change

hands very infrequently. This makes the dividend process much easier for private

companies than for the public ones.

17.5 You are the CEO of a firm that has been the subject of a hostile takeover. Thibeaux

Piques has been accumulating the shares of your stock to a material percentage. You

would like to purchase the shares that he owns. What method of stock repurchase will

you choose?

Since Mr. Piques is hostile to your firm, it will probably not help you to use an open-

market purchase. You could announce a tender offer, but unless he is willing to sell his

shares for purely economic gain (and ignore the benefits of control of your firm), then a

tender offer would probably not work very well either. You could negotiate directly with

Mr. Piques for his shares and therefore isolate the shares that you need to purchase using

a targeted share repurchase. However, this direct negotiation might not be advantageous

to your remaining shareholders, and it may require a premium price to convince Mr.

Piques to sell his shares.

17.6 You have accumulated a 20 percent interest in a firm that does not pay cash dividends. As

the largest shareholder, your 20 percent interest allows you to exert a significant amount

of control over the firm. You have read that Modigliani and Miller proposed that you

could create a homemade dividend should you require cash. Discuss why this choice may

not be very good for your position.

You could sell a portion of your shares to generate a cash dividend for yourself. However,

if no other investors take that course of action, then you would be the only investor

liquidating a portion of your holdings. If 20 percent of the voting interest in this firm

helps you maintain a certain level of control of the firm, then dropping below that

threshold might be enough for your diluted voting interest to lose whatever control of the

firm you had maintained.

17.7 You have just read the press release of a firm that claims to have reached a point where it

will be able to generate a higher level of cash flow for its investors going forward.

Explain the choice of dividends that could credibly convey that information to the market.

Either an extra or a special dividend is signaling a higher level of cash flow but without

sustainability. The best way to convey to the market that this new level of cash flow is

permanent is to increase (or commence) a regular cash dividend since a regular dividend

comes with the expectation that it will not be reduced without unforeseen events

occurring in the future.

17.8 Some may argue that a high tax rate on dividends creates incentives for managers to

continue about their business without credibly convincing investors that the firm is doing

well. Discuss how this may be true.

A credible signal is usually interpreted as a signal that is costly. Paying a regular dividend

is costly, and we know that it credibly signals that the firm expects to maintain the current

level of cash flow. If dividends are taxed at a rate high enough to discourage firms from

paying them (discouraged because a very small portion of the cash sent to investors

reaches them after the effects of taxes), the government is discouraging a credible signal

that the firm’s prospects are still good. Without that costly signal, managers may continue

about their normal routine without finding other ways to convey a firm’s prospects to

investors.

17.9 Fled Flightstone Mining does not like to pay cash dividends due to the volatility of its

cash flow. Fled has found that without paying dividends, its stock price becomes too

expensive for individual investors to be able to afford 100 shares. What course of action

should Fled take to get its stock price down without dissipating value for stockholders?

Fled Flightstone Mining can double, triple, quadruple, etc., the number of shares

outstanding without taking any meaningful economic steps. That is, it can take a 2-for-1,

3-for-1, or 4-for-1 stock split. This would increase the number of shares outstanding and

decrease the value of each share outstanding. Since each shareholder would continue

owning his or her prior pro-rata share of the firm, shareholders would not see any of their

value dissipated by the firm’s actions.

17.10 Lintner found that firms are reluctant to make dividend changes that might have to be

reversed. Discuss the rationale for that behavior.

The simplest reason is that the markets look to dividends for the information that the

dividends convey as well as for their economic benefit. That is, an increase in the

dividend rate tells the market that the cash flow that the firm produces, above and beyond

that needed for projects, is anticipated to remain high. If the firm were to quickly reverse

the increased dividend rate, then that might convey to the firm that the firm’s fortunes

either were not that good to begin with or have changed drastically. Such a reversal could

convey that the firm is riskier than what investors anticipated before the series of events

described above. Therefore, firm management would naturally want to keep from having

to quickly reverse its dividend decisions.

VIII. Questions and Problems

BASIC

17.1 Dividends: The Poseidon Shipping Company has paid a $0.25 dividend per quarter for

the past three years. Poseidon just lowered its declared dividend to $0.20 for the next

dividend payment. Discuss what this new information might convey concerning

Poseidon’s management’s belief concerning the future of the company.

Solution:

Since dividends convey information concerning the future prospects of the firm, any

change in dividend levels is also believed to convey a change in management’s forecast

of the firm’s prospects. That is, lowering the dividend from $0.25 to $0.20 suggests that

the firm’s future cash flow may be reduced. This reduction could be because of a general

reduced level of profitability, because the firm’s projects are winding down, or even

because of an increased need to invest in new positive NPV projects for the future.

17.2 Dividends: Marx Political Consultants has decided to discontinue all of its business

operations. The firm has total debts of $7 million, and the liquidation value of its assets is

$10 million. If the book value of the firm’s equity is $5 million, then what will be the

amount of the liquidating dividend when the firm liquidates all of its assets?

Solution:

The liquidating value of the firm’s assets is $10 million while the firm owes $7 million.

Therefore, $3 million will remain after complete liquidation for the shareholders. The

firm will be able to pay a $3 million dividend to its shareholders.

17.3 Dividends: Place the following in the proper chronological order, and describe the

purpose of each: ex-dividend date, record date, payment date, and declaration date.

Solution:

1. Declaration date: the day the dividend payment was announced.

2. Ex-dividend date: the first day you can buy shares and not receive the dividend.

3. Record date: the day shareholders of record receive the dividend when it is paid.

4. Payment date: the date when the dividend is actually paid.

17.4 Dividend policy and firm value: Explain how the issuance of new securities by a firm

can produce useful information about the issuing firm. Why does the revelation of this

information make the shares of the firm more valuable, even if this information is merely

confirmation of existing information about the firm?

Solution:

When issuing new securities, the issuing firm must submit to a process that amounts to a

special audit by outsiders such as investment bankers and other experts. This additional

production of information increases the level of monitoring concerning the firm’s actual

financial status. In a sense, it reduces the variability in the information that the firm may

already have released. If the production of this information reduces the level of risk borne

by investors, then the issue of new securities could actually increase the value of the

securities issued by the firm and, in turn, the total value of the firm.

17.5 Dividends: Explain why holders of a firm’s debt should insist on a covenant that restricts

the amount of cash dividends.

Solution:

We have to remember that any cash paid to shareholders reduces the amount that is

available to bondholders in the event of bankruptcy. Because bondholders are aware of

this potential problem, they should then restrict the amount of cash that can be paid to

shareholders to at least a level where bondholders will still be able to generate their

expected rate of return.

17.6 Stock splits and stock dividends: Explain why firms prefer that their shares trade in a

reasonably priced range instead of an expensive dollar-per-share cost. How do firms keep

the stock trading in a moderate price range?

Solution:

Historically, the transactions and liquidity costs to trade 100 shares were lower than the

cost to trade a smaller number of shares. Therefore, if small investors could not afford to

trade 100 shares, then they might refrain from purchasing the shares. In that event, the

high per-share price of the shares might eliminate potential investors for those shares.

Consequently, firms preferred that their shares trade in an affordable range rather than at

an expensive price per share. Note that no conclusive empirical evidence supports that

notion.

17.7 Dividends: Scintilla, Inc., is trading for $10.00 per share on the day before the ex-

dividend date. If the amount of the dividend is $0.25 and there are no taxes, what should

the price of the shares be trading for on the ex-dividend date?

Solution:

Since there are no taxes, the value of the shares should drop by the amount of the

dividend. Therefore, the shares should trade for $9.75 on the ex-dividend date.

17.8 Dividends: A company announces that it will make a $1.00 dividend payment. Assuming

all investors are subject to a 15 percent tax rate on dividends, how much should the

company’s share price drop on the ex-dividend date?

Solution:

Investors will be able to capture 85 percent of the amount of any dividend paid.

Therefore, the price on the ex-dividend date should go down by $0.85 per share.

INTERMEDIATE

17.9 Dividend policy and firm value: Explain how a stock repurchase, although it places

cash in the hands of its stockholders, is different from a dividend payment.

Solution:

A share repurchase, if followed through by management, will place the same amount of

cash in the hands of its shareholders. However, since shareholders have the option of

selling their shares or holding on to their shares, the repurchase leaves it up to the

individual shareholders whether or not they would like to receive the cash. The dividend

payment method will effectively force the shareholders to receive the cash.

17.10 Dividend policy and firm value: You have just encountered two identical firms with

identical investment opportunities, as well as the ability to fund these opportunities. You

have found that one of the firms has just announced an introductory dividend policy,

whereas the other has continued with a no-dividend policy. Taking into account the

assumptions proposed by Modigliani and Miller, which of the two firms is worth more?

Explain.

Solution:

If we begin with a world described by the Modigliani and Miller paper in 1961, which

assumes that (1) investors incur no taxes, (2) there are no information or transactions

costs, and (3) the dividend payout rates have no effect on the firm’s real investment

policy, then both firms will be worth exactly the same. That is because investors who

want dividends but own a no-dividend stock can liquidate their appreciated value shares

to create a homemade dividend, and shareholders who do not want dividends but own a

dividend-paying stock can use their “unwanted” dividends to purchase additional shares

of that stock.

17.11 Dividend policy and firm value: Explain what the introduction of transaction costs will

do to the Modigliani and Miller assumption that dividends are irrelevant. Start with a firm

that pays dividends to a group of its investors that do not want to receive dividend

payments. Do not consider taxes.

Solution:

The no-transaction costs assumption is required for investors to create their own

homemade dividends or for investors to “undo” their unwanted dividend payments by

purchasing additional shares of the company stock. Therefore, by relaxing the no

transaction cost assumption, we would increase the cost of producing the homemade

dividend or the cost of undoing the unwanted dividends, which would then make

dividend policy a relevant factor when valuing shares. For instance, receiving an

unwanted dividend would now make it more costly to convert that dividend into new

shares, inasmuch as part of that dividend would be dissipated to transaction costs. In that

situation, the investor would value a nondividend-paying share at a higher value than a

dividend-paying share.

17.12 Dividend policy and firm value: CashCo. has been increasing its cash dividends each

quarter for the past eight quarters. Although this may signal that the firm is financially

very healthy, what else could we conclude from these actions?

Solution:

If we rule out the possibility that the firm is just producing a high level of cash, then we

must conclude that the firm has more cash than it has investment opportunities to utilize

that cash. In short, we might conclude that the firm’s growth rate will be slowing down in

the future.

17.13 Dividend policy and firm value: Currently, dividends are taxed to a maximum of 15

percent. Unless Congress acts by 2008, this favorable tax treatment will lapse. What do

you expect to happen to the stock prices of dividend-paying stock versus that of

nondividend-paying stocks if Congress does not act?

Solution:

If Congress does not act, then taxes on dividends will increase relative to those currently

being paid. Therefore, the value of a dividend received, after taxes are included, will be

less than before. Therefore, we would expect the value of dividend-paying stocks to

decrease relative to nondividend-paying stocks.

17.14 Dividends: Undecided Corp. has additional cash on hand right now, although it isn’t sure

about the level of cash flow going forward. If the firm would like to put cash in its

stockholders’ hands, what kind of dividend should it pay, and why?

Solution:

Since this is a one-time increase in cash flow, the firm would not want to commit to an

ongoing higher dividend rate. If the firm went that route but then later had to reduce the

dividend back to current dividend levels, then the market could interpret that action as

indecision on the part of management, or worse. Therefore, an increase in the regular

dividend would not be appropriate. A more appropriate choice would be to declare an

extra dividend. Note that it would be called a special dividend if the extra cash flow came

from something other than the firm’s regular operations or if the cash were an unusually

large amount.

17.15 Dividend policy and firm value: A firm can deliver a negative signal to stockholders by

increasing the level of dividends or by reducing the level of dividends. Explain.

Solution:

When a firm reduces its dividend, the firm is telling the market that it does not have

sufficient cash, which is of course a bad or negative signal. However, by increasing the

dividend, the firm is telling its investors that it has greater cash than it has investment

uses for that cash. If the firm is currently viewed as a growth firm, then the market could

interpret an increase in the dividend as a slowdown in the growth rate of the firm

precipitated by the firm’s lower investment rate.

17.16 Stock splits and stock dividends: You are a stockholder of a firm that has enough cash

on hand to distribute to stockholders. You do not want the cash. What course of action

would you prefer the firm take?

Solution:

You would prefer that the firm initiate a share repurchase. You can opt not so sell your

shares to the firm but still participate in the increased value of the firm’s shares since your

pro-rata share of the expected future cash flows generated by the firm will increase. You

would not like a dividend payment since you would then be required to receive the cash if

you owned the shares at the time of the record date.

17.17 Stock splits and stock dividends: Stock repurchases, once announced, do not have to

actually occur in total or in part. From a signaling perspective, why would a special

dividend be better than a stock repurchase?

Solution:

If we ignore the preferences of individual shareholders, then a special dividend is

preferred to a share repurchase. Although dividends are binding, once declared by the

firm’s board of directors, a share repurchase is not binding. Therefore, a special dividend

is considered a stronger signal than a share repurchase.

17.18 Stock splits and stock dividends: Consider a firm that repurchases shares from its

stockholders in the open market, and explain why this action might be detrimental to the

stockholders to whom the firm is attempting to deliver value through its action.

Solution:

To understand this argument, we have to consider two points. First, the firm should be

managed for the benefit of its shareholders. Second, the firm is the ultimate insider

concerning the value of its shares.

Given the above points, we must realize that any time the firm is purchasing its

shares, it must be doing so because the firm’s management believes that the firm’s shares

are undervalued. Therefore, by purchasing its shares, the firm is utilizing its inside

information to purchase shares and ultimately to take advantage of the current owner of

those shares in order to benefit the remaining shareholders of the firm. It is then not doing

something in the interest of all of its shareholders since those who sell will be selling at a

price lower than what they could have realized had they held their shares until the

repurchase was complete.

17.19 Dividend policy and firm value: Explain why a firm might raise money to pay a cash

dividend by selling equity to new stockholders.

Solution:

While this process may seem circular at best, it does have the advantage of producing

information concerning the firm for investors. That is, the underwriting process helps

additional information on the firm to become public. This information production may be

a credible way for the firm to let the market know about its operations. So although the

cash flow circularity does exist, the process is good for the investing public in that

information is learned about the firm.

17.20 Stock splits and stock dividends: Briefly discuss the methods available for a firm to

repurchase its shares and explain why you might expect the stock price reactions to the

announcement of each of these methods to differ.

Solution:

1. Open-market purchase—the firm simply purchases the shares in the market.

2. Tender offer—the firm makes an offer through a general announcement, offering to

buy up to a certain number of shares from anyone who wishes to sell. Note that either the

fixed-price or Dutch auction method can be used for a tender offer.

3. Targeted share repurchases—the firm directly negotiates with an individual

shareholder to buy shares from that individual.

17.21 Stock repurchases: What is the advantage of a Dutch auction offer over a fixed-price

tender offer?

Solution:

If the firm that is trying to purchase its own shares believes that there may be some

variability in the supply curve for those shares, then a Dutch auction would essentially

provide the firm with the necessary information to make the tender offer successful. In

those same circumstances, a fixed-price tender offer might leave the firm paying too

much for the shares or unable to purchase the desired number of shares given the fixed-

price offer.

ADVANCED

17.22 In the early 1990s, the amount of time between purchasing a stock and actually obtaining

that stock was five business days. This period of time was known as the settlement

period. The settlement period for stock purchases is now three business days. Describe

what should have happened to the number of days between the ex-dividend date and the

record date at the time of this change.

Solution:

The purpose of setting the number of days between the ex-dividend date and the record

date is to allow for a sale of securities to clear in order to determine which “owner” is

entitled to the dividend. Since the settlement period was reduced from five days to three

days, we should have seen the number of days between the ex-dividend date and the

record date to be reduced from four days to two.

17.23 WeAreProfits, Inc., has not issued any new debt securities in 10 years. It will begin

paying cash dividends to its stockholders for the first time next year. Explain how a

dividend might help the firm get closer to its optimal capital structure of 50 percent debt

and 50 percent equity.

Solution:

If the firm has been successful over the last 10 years, then the value of its equity has

increased but the total value of its debt has not increased accordingly. Therefore, the debt-

to-equity ratio of the firm has been dropping. By paying a dividend, the value of the

equity, after the dividend is paid, will drop relative to that of the debt. This will help the

firm to balance out its debt-equity ratio and get closer to a 50 percent-50 percent mix

(assume that thedebt was below the 50 percent level to begin with).

17.24 The Shadows, Inc., had shares outstanding that were valued at $120 per share before a 2-

for-1 stock split. After the stock split, the shares were valued at $62 per share. If we

accept that the firm’s financial maneuver did not create any new value, then why might

the market be increasing the total value of the firm’s equity?

Solution:

We know that the stock split did not create value for investors by itself. Therefore, there

must be information in the split that accounts for the $4 increase in value to shareholders.

Generally speaking, firms have a tendency to increase their dividend rate after a stock

split. Therefore, since a stock split is generally followed by dividend rate increases, the

increase tends to generate information for investors that there is a potential increase in

cash flow to investors of the firm’s equity.

17.25 The Saguaro Company currently has 30,000 shares outstanding. Each share has a market

value of $20. If the firm pays $5 per share in dividends, what will the value of each share

be worth after the dividend payment? Ignore taxes.

Solution:

The current value of all of the shares is 30,000 x $20 = $600,000. If the firm pays $5 per

share, then the total cash paid out will be 30,000 x $5 = $150,000. Therefore, the value of

all of the shares will be worth $150,000 less or $450,000, and the price of each share will

be $450,000 / 30,000 = $15 per share.

However, it seems logical that if shares were worth $20 before the dividend

payout, then they should be worth $5 less after the dividend payout, or $15 just as we

have calculated.

17.26 The Cholla Company currently has 30,000 shares outstanding. Each share has a market

value of $20. If the firm repurchases $150,000 worth of shares, what will the value of

each share be after the repurchase? Ignore taxes.

Solution:

The current value of all of the shares is 30,000 × $20 = $600,000. If the firm repurchases

$150,000 worth of shares, then it will repurchase $150,000 / $20 = 7,500 shares.

Therefore, the value of all of the shares not purchased will be worth $150,000 less, or

$450,000, and the price of each share will be $450,000 / (30,000 – 7,500) = $20 per share.

It seems logical, however, that if shares were worth $20 before the repurchase,

then they should be worth $20 after the repurchase since investors should be indifferent

between selling their shares to the firm and retaining shares.

17.27 You purchased 1,000 shares of Koogal five years ago at a price of $30 per share. Today

Koogal is repurchasing its shares through a fixed-price tender offer price of $80 per

share. What is the amount of after-tax proceeds that you will get to keep if only the

capital gain is taxed at a 15 percent rate?

Solution:

The tax on the stock would be 1,000 × ($80 – $30) × 0.15 = $7,500. Therefore, the after-

tax proceeds would equal (1,000 × $80) – $7,500 = $72,500.

17.28 You purchased 1,000 shares of Zebulon Copper Co. five years ago at a price of $50 per

share. Today Zebulon is considering repurchasing its shares through a fixed-price tender

offer price of $70 per share. Zebulon is also considering paying a $70 cash dividend per

share. If capital gains are taxed at a 15 percent rate, then at what rate must dividends be

taxed for you to be indifferent between the dividend and selling your shares back to

Zebulon?

Solution:

The tax on the stock would be 1,000 × ($70 – $50) × 0.15 = $3,000. Therefore, the tax on

the dividend must be equal to $3,000 for you to be indifferent between the two choices.

Therefore,

$3,000 = 1,000 × $70 × Div Tax rate ==> Div Tax rate = 4.29%

If dividends are taxed at any rate higher than 4.29 percent, then you would prefer the

share repurchase. Note that the point of indifference is partially a function of the ratio of

capital gains to the cash dividend.

17.29 The Llama Substitute Wool Company is trying to do some financial planning for the

coming year. Llama plans to raise $10,000 in new equity this year and wants to pay a

dividend to stockholders of $30,000 in total. The firm must pay $20,000 interest during

the year and will also pay down principal on its debt obligations by $10,000. If the firm

continues with its capital budgeting plan, it will require $100,000 for capital expenditures

during the year. Given the above information, how much cash must be provided from

operations for the firm to meet its plan?

Solution:

Using the equation given in the text:

CF Opnst + Equityt + Debtt = Divt + Interestt + Principalt + Cap Expt ==>

CF Opnst + $10,000 = $30,000 + $20,000 + $10,000 + $100,000 ==>

CF Opnst = $150,000

17.30 You are the CFO of a large publicly traded company. You would like to convey positive

information about the firm to the market. If you intuitively understand (and agree with)

the results from the Lintner study, then will you keep paying your currently high dividend

or will you raise that dividend by a small amount?

Solution:

Although the current high level of dividends certainly suggests that the firm has the

ability to sustain a high payout to investors, that high payout does not convey any new,

positive information to the market. However, by increasing the dividend, the CFO would

be telling the market that the firm will be able to support an even higher level of cash

payout in the future. Therefore, you think it would be better to increase the dividend.

CFA Problems

17.31. Assume that a company is based in a country that has no taxes on dividends and capital gains. The company is considering either paying a special dividend or repurchasing its own shares. Shareholders of the company would have

A. greater wealth if the company paid a special cash dividend.B. greater wealth if the company repurchased its shares.C. the same wealth under either a cash dividend or share repurchase program.D. less wealth under either a cash dividend or share repurchase program.

Solution:

C is correct.

17.32. Aiken Instruments (AIK) has recently declared a regular quarterly dividend of $0.50, payable on 12 November, to holders of record on 1 November. 28 October is the ex-date. Which date below would be the last day an investor purchasing AIK shares would receive the quarterly dividend?

A. 27 OctoberB. 28 OctoberC. 1 NovemberD. 12 November

Solution:

A is correct. To receive the dividend, one must purchase before the ex-date.

17.33. Which of the following is most likely to signal negative information concerning a firm?A. Share repurchase.B. Increase in the payout ratioC. Decrease in the quarterly dividend rate.D. A two-for-one stock split.

Solution:

C is correct. Decreases send negative signals regarding future prospects.

17.34. Investors may prefer companies which repurchase their shares instead of paying a cash dividend when

A. capital gains are taxed at higher rates than dividends.B. capital gains are taxed at lower rates than dividends.C. capital gains are taxed at the same rate as dividends.D. the company needs more equity to finance capital expenditures.

Solution:

B is correct.

Sample Test Problems

17.1 Is it possible to own a stock for a single day and receive the cash dividend paid on the

stock, although you do not own the stock at the time of payment?

Solution:

Yes. In order to receive the dividend, you must own the share on the day before the ex-

dividend date. You could then sell the stock on the ex-dividend date and receive the

dividend a couple of weeks later without even owning the share at the time the dividend

check or electronic transfer is sent to you.

17.2 Is it possible for your voting interest in a firm to increase without your having to purchase

additional shares in that firm?

Solution:

Yes, if the firm commences a stock repurchase plan and repurchases shares without you

selling your shares to the firm. Then you will find that your voting interest in the firm

increases.

17.3 Since dividends that are not yet declared by the firm are not legal obligations of the firm,

does that mean that the firm can alter its dividend payouts without cost?

Solution:

No. Since dividends are a costly signal sent by management concerning the future

prospects of the firm, then lowering a dividend once the market has formed an

expectation about the dividend can tell the market (even inadvertently) that the firm is not

doing as well as expected. The cost of lowering a dividend will create a cost borne by

shareholders.

17.4 Evaluate the statement that the government does not have an impact on the valuation of

stocks.

Solution:

The statement is false. Government can affect the valuation of securities by the tax

treatment of cash flows and gains and losses. For instance, by lowering the tax rate on

dividends, the government can positively impact the price of dividend-paying stocks,

relative to nondividend-paying stocks.

17.5 A recent survey of financial executives found that they favor stock repurchases over

dividends. How does that finding seem to contradict the idea that firms use distribution

decisions to signal future firm prospects to the market?

Solution:

Although repurchases provide the firm with greater flexibility to sustain cash distributions

to shareholders, this increased flexibility for the firm could be perceived as a lack of

commitment to a large future cash payout, if signaling theory is correct. Thus, although

the finding does not prove signaling theory wrong, it does bring into question the level of

importance that financial managers put in signaling.