In Spite Of The Theoretical Argument That Dividend Policy Should Be Irrelevant The Fact Remains That Many Investors Like High Dividends. If Preference Exists A Firm Can Boost Its Share Price By Increasing Its Dividend Payout Ratio. Explain The Fallacy In

Clienteles 515 Date of payment 497 Date of record 496 Declaration date 496 Ex-dividend date 496

Homemade dividends 501 Information-content effect 514 Regular cash dividends 495 Stock dividend 496 Stock split 496

Ross-Westerfield-Jaffe: IV. Capital Structure and Corporate Finance, Sixth Dividend Policy Edition

1S. Dividend Policy: Why Does It Matter?

© The McGraw-Hill Companies, 2002

Chapter 18 Dividend Policy: Why Does It Matter?

Suggested Readings

The breakthrough in the theory of dividend policy is contained in

Miller, M., and F. Modigliani. "Dividend Policy, Growth and the Valuation of Shares." Journal of Business (October 1961).

A survey of dividend policy can be found in

Allen, Franklin, and Roni Michaely. "Dividend Policy." In R. A. Jarrow, V. Maksimovic, and W. T. Ziemba (eds.). Handbooks in Operations Research and Management Science: Finance. Amsterdam: Elsevier Science (1995), 793-838.

Current trends in dividend policy are examined in

Fama, Eugene F., and Kenneth R. French. "Disappearing Dividends: Changing Firm

Characteristics or Lower Propensity to Pay?" (March 1999). Graduate School of Business, University of Chicago, Unpublished paper.

The Mechanics of Dividend Payouts

18.1 Identify and describe each of the following dates that are associated with a dividend payment on common stock:

February 16 February 24 February 26 March 14

18.2 On April 5, the board of directors of Capital City Golf Club declared a dividend of $.75 per share payable on Tuesday, May 4, to shareholders of record as of Tuesday, April 20. Suppose you bought 350 shares of Capital City stock on April 6 for $8.75 a share. Assume there are no taxes, no transaction costs, and no news between your purchase and sale of the stock. If you were to sell your stocks on April 16, how much would you be able to sell your stock for?

18.3 The Mann Company belongs to a risk class for which the appropriate discount rate is 10 percent. Mann currently has 100,000 outstanding shares selling at $100 each. The firm is contemplating the declaration of a $5 dividend at the end of the fiscal year that just began. Answer the following questions based on the Miller and Modigliani model, which is discussed in the text.

a. What will be the price of the stock on the ex-dividend date if the dividend is declared?

b. What will be the price of the stock at the end of the year if the dividend is not declared?

c. If Mann makes $2 million of new investments at the beginning of the period, earns net income of $1 million, and pays the dividend at the end of the year, how many shares of new stock must the firm issue to meet its funding needs?

d. Is it realistic to use the MM model in the real world to value stock? Why or why not?

18.4 On February 17, the board of directors of Exertainment Corp. declared a dividend of $1.25 per share payable on March 18 to all holders of record on March 1. All investors are in the 31-percent tax bracket.

a. What is the ex-dividend date?

b. Ignoring personal taxes, how much should the stock price drop on the ex-dividend date?

The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy

18.5 The growing-perpetuity model expresses the value of a share of stock as the present value of the expected dividends from that stock. How can you conclude that dividend policy is irrelevant when this model is valid?

Questions and Problems

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Does It Matter? Companies, 2002


526 Part IV Capital Structure and Dividend Policy

18.6 Andahl Corporation stock, of which you own 500 shares, will pay a $2-per-share dividend one year from today. Two years from now Andahl will close its doors; stockholders will receive liquidating dividends of $17.5375 per share. The required rate of return on Andahl stock is 15 percent.

a. What is the current price of Andahl stock?

b. You prefer to receive equal amounts of money in each of the next two years. How will you accomplish this?

18.7 The net income of Novis Corporation, which has 10,000 outstanding shares and a 100-percent payout policy, is $32,000. The expected value of the firm one year hence is $1,545,600. The appropriate discount rate for Novis is 12 percent.

a. What is the current value of the firm?

b. What is the ex-dividend price of Novis's stock if the board follows its current policy?

c. At the dividend declaration meeting, several board members claimed that the dividend is too meager and is probably depressing Novis's price. They proposed that Novis sell enough new shares to finance a $4.25 dividend.

i. Comment on the claim that the low dividend is depressing the stock price. Support your argument with calculations.

ii. If the proposal is adopted, at what price will the new shares sell and how many will be sold?

18.8 Gibson Co. has a current period cash flow of $1.2 million and pays no dividends, and the present value of forecasted future cash flows is $15 million. It is an all-equity-financed company with 1 million shares outstanding. Assume the effective personal tax rate is zero.

a. What is the share price of the Gibson stock?

b. Suppose the board of directors of Gibson Co. announces its plan to pay out 50 percent of its current cash flow as cash dividends to its shareholders. How can Jeff Miller, who owns 1,000 shares of Gibson stock, achieve a zero payout policy on his own?

Taxes, Issuances Costs, and Dividends

18.9 National Business Machine Co. (NBM) has $2 million of extra cash. NBM has two choices to make use of this cash. One alternative is to invest the cash in financial assets. The resulted investment income will be paid out as a special dividend at the end of three years. In this case, the firm can invest in Treasury bills yielding 7 percent, or an 11 percent preferred stock. Only 30 percent of the dividends from investing in preferred stock would be subject to corporate taxes. Another alternative is to pay out the cash as dividends and let the shareholders invest on their own in Treasury bills with the same yield. The corporate tax rate is 35 percent, and the individual tax rate is 31 percent. Should the cash be paid today or in three years? Which of the two options generates the highest after-tax income for the shareholders?

18.10 The University of Pennsylvania pays no taxes on capital gains, dividend income, or interest payments. Would you expect to find low-dividend, high-growth stock in the university's portfolio? Would you expect to find tax-free municipal bonds in the portfolio?

18.11 In their 1970 paper on dividends and taxes, Elton and Gruber reported that the ex-dividend-date drop in a stock's price as a percentage of the dividend should equal the ratio of 1 minus the ordinary income tax rate to 1 minus the capital gains rate; that is,


Pe = The ex-dividend stock price Pb = The stock price before it trades ex-dividend D = The amount of the dividend To = The tax rate on ordinary income

Tc = ihe effective tax rate on capital gains

Ross-Westerfield-Jaffe: IV. Capital Structure and Corporate Finance, Sixth Dividend Policy Edition

18. Dividend Policy: Why Does It Matter?

© The McGraw-Hill Companies, 2002

Chapter 18 Dividend Policy: Why Does It Matter?

Note: As we pointed out in the text, effective tax rate of capital gains is less than the actual tax rate, because their realization may be postponed. Indeed, because investors could postpone their realizations indefinitely, the effective rate could be zero.

a. If To = Tc = 0, how much will the stock's price fall?

d. Do the results of Elton and Gruber's study imply that firms will maximize shareholder wealth by not paying dividends?

18.12 After completing its capital spending for the year, Carlson Manufacturing has $1,000 extra cash. Carlson's managers must choose between investing the cash in Treasury bonds that yield 8 percent or paying the cash out to investors who would invest in the bonds themselves.

a. If the corporate tax rate is 35 percent, what tax rate on ordinary income would make the investors equally willing to receive the dividend and to let Carlson invest the money?

b. Is the answer to part (a) reasonable? Why or why not?

c. Suppose the only investment choice is stock that yields 12 percent. What personal tax rate will make the stockholders indifferent to the outcome of Carlson's dividend decision?

d. Is this a compelling argument for a low dividend payout ratio? Why or why not? Expected Return, Dividends, and Personal Taxes

18.13 A political advisory committee recently recommended wage and price controls to prevent the spiraling inflation that was experienced in the 1970s. Members of the investment community and several labor unions have sent the committee reports that discuss whether or not dividends should be under the controls.

The reports from the investment community demonstrated that the value of a share of stock is equal to the discounted value of its expected dividend stream. Thus, they argued that any legislation that caps dividends will also hold down share prices, thereby increasing companies' costs of capital.

The union reports conceded that dividend policy is important to firms that are trying to control costs. They also felt that dividends are important to stockholders, but only because the dividend is the shareholder's wage. In order to be fair, the unions argued, if the government controls labor's wage, it should also control dividends. Discuss these arguments and explain the fallacy in them.

18.14 Deaton Co. and Grebe, Inc., are in the same risk class. Shareholders expect Deaton to pay a $4 dividend next year when the stock will sell for $20. Grebe has a no-dividend policy. Currently, Grebe stock is selling for $20 per share. Grebe shareholders expect a $4 capital gain over the next year. Capital gains are not taxed, but dividends are taxed at 25 percent.

a. What is the current price of Deaton Co. stock?

b. If capital gains are also taxed at 25 percent, what is the price of Deaton Co. stock?

c. Explain the result you found in part (b).

18.15 Payall Inc., Payless Inc., and Paynone Inc. are equally risky. They follow a 100-percent, 50-percent, and zero payout policy, respectively. The expected share prices at dates 0 and 1 for Paynone Inc. are $100 and $125. The market prices are set so that their after-tax expected returns are equal. What should the current share prices of Payless Inc. and Payall Inc. be? Assume the marginal personal tax rate on dividends is 25 percent, and the effective tax rate on capital gain is zero.

18.16 Suppose the Du Pont Company currently has outstanding series 4.50, nonconvertible preferred stock that pays an annual dividend of $4.50. Du Pont has also issued 11-percent bonds that will mature in 10 years. The stock and bonds have about the same risk.

a. The current price of the 4.50 preferred stock is 50/2. What is its dividend yield?

b. The bonds were sold at par. What is their yield to maturity?

Ross-Westerfield-Jaffe: I IV. Capital Structure and I 18. Dividend Policy: Why I I © The McGraw-Hill

Corporate Finance, Sixth Dividend Policy Does It Matter? Companies, 2002


528 Part IV Capital Structure and Dividend Policy c. As a financial consultant, you want to know the after-tax yields for each of these investments. The corporate tax rate is 34 percent and the personal tax rate is 28 percent. Compute the after-tax yields on Du Pont's preferred stock and its bonds for each of the following groups:

i. General Motors's tax-exempt pension.

ii. General Motors Corporation.

d. Which group do you believe owns the most Du Pont stock?

Real-World Factors Favoring a High-Dividend Policy

18.17 The bird-in-the-hand argument, which states that a dividend today is safer than the uncertain prospect of a capital gain tomorrow, is often used to justify high dividend-payout ratios. Explain the fallacy behind the argument.

18.18 The desire for current income is not a valid explanation for preference for high-current-dividend policy, as investors can always create homemade dividends by selling a portion of their stocks. Comment.

18.19 Your aunt is in a high tax bracket and would like to minimize the tax burden of her investment portfolio. She is willing to buy and sell in order to maximize her after-tax returns and she has asked for your advice. What would you suggest she do?

A Resolution of Real-World Factors?

18.20 In the May 4, 1981, issue of Fortune, an article entitled "Fresh Evidence That Dividends Don't Matter" stated, "All told, 115 companies of the 500 [largest industrial corporations] raised their payout every year during the period [1970-1989]. Investors in this ... group would have fared somewhat better than investors in the 500 as a whole: the median total [annual compound] return of the 115 was 10.7% during the decade versus 9.4% for the 500."

Is this evidence that investors prefer dividends to capital gains? Why or why not?

18.21 Last month Central Virginia Power Company, which had been having trouble with cost overruns on a nuclear plant that it had been building, announced that it was "temporarily suspending dividend payments due to the cash flow crunch associated with its investment program." When the announcement was made, the company's stock price dropped from 28 % to 25. What do you suspect caused the change in the stock price?

18.22 Southern Established Inc. has been paying out regular quarterly dividends ever since 1983. It just slashed the dividend by half in the current fiscal quarter and a more severe cut is to be underway. Southern's stock price dropped from $35.25 to $31.75 when the dividend cut was announced. Explain the possible reasons for this price drop.

18.23 Cap Henderson owns Neotech stock because its price has been steadily rising over the past few years and he expects its performance to continue. Cap is trying to convince Widow Jones to purchase some Neotech stock, but she is reluctant because Neotech has never paid a dividend. She depends on steady dividends to provide her with income.

a. What preferences are these two investors demonstrating?

b. What argument should Cap use to convince Widow Jones that Neotech stock is the stock for her?

c. Why might Cap's argument not convince Widow Jones?

18.24 If the market places the same value on $1 of dividends as on $1 of capital gains, then firms with different payout ratios will appeal to different clienteles of investors. One clientele is as good as another; therefore, a firm cannot increase its value by changing its dividend policy. Yet empirical investigations reveal a strong correlation between dividend payout ratios and other firm characteristics. For example, small, rapidly growing firms that have recently gone public almost always have payout ratios that are zero; all earnings are reinvested in the business. Explain this phenomenon if dividend policy is irrelevant.

18.25 In spite of the theoretical argument that dividend policy should be irrelevant, the fact remains that many investors like high dividends. If this preference exists, a firm can boost its share price by increasing its dividend-payout ratio. Explain the fallacy in this argument.

Ross-Westerfield-Jaffe: IV. Capital Structure and Corporate Finance, Sixth Dividend Policy Edition

18. Dividend Policy: Why Does It Matter?

© The McGraw-Hill Companies, 2002

Chapter 18 Dividend Policy: Why Does It Matter?

What We Know and Do Not Know about Dividend Policy

18.26 The Sharpe Co. has a period 0 dividend of $1.25. Its target payout ratio is 40 percent. The period 1 EPS is expected to be $4.5.

a. If the adjustment rate is 0.3 as defined in the Lintner Model, what will be the Sharpe Co. dividend in period 1?

b. If the adjustment rate is 0.6 instead, what is the dividend in period 1?

18.27 Empirical research found that there have been significant increases in stock price on the day an initial dividend (i.e., the first time a firm pays a cash dividend) is announced. What does this finding imply about the information content of initial dividends?

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