CHAPTER: 14

DIVIDEND/PAYOUT POLICY
Payout policy: The term payout policyrefers to the decisions that firms make about whether to distribute
cash to shareholders, how much cash to distribute, and by what means the cash should be distributed.
Payout policy refers to the cash flows that a firm distributes to its common stockholders. A share of
common stock gives its owner the right to receive all future dividends. The present value of all those future
dividends expected over a firm’s assumed infinite life determines the firm’s stock value. Corporate payouts
not only represent cash flows to shareholders but also contain useful information about the firm’s current
and future performance. Such information affects the shareholders’ perception of the firm’s risk. A firm can
also pay stock dividends, initiate stock splits, or repurchase stock. All of these dividend-related actions can
affect the firm’s risk, return, and value as a result of their cash flows and informational content. Although
the theory of relevance of dividends is still evolving, the behavior of most firms and stockholders suggests
that dividend policy affects share prices. Therefore, financial managers try to develop and implement
dividend policy that is consistent with the firm’s goal of maximizing stock price.

Dividend theory:
Modigilani and Miller (MM) theory

According to the MM approach, the dividend policy of a firm has no effect on the value of the firm.
Modigilani and millers proof in support of their argument in summarized in Exhibit 12.1

Step 1. The market price of a share at the beginning of the period is equal to the present value (PV) of
dividend paid at the end of the period, plus the market price of the share at the end of the period.
Symbolically
1
P0 = (1+𝑘𝑒) (𝐷1 + 𝑃1) ……………………….. 12.1

Where, P0 = prevailing market price of share (MPS)

Ke = cost of equity capital
D1 = Dividend to be received at the end of period, 1
P1 = MPS at the end of period, 1

Step 2:
Assuming no external financing, total capitalized value of the firm would simply be the number of share (n)
times the price of each share (P0) thus,
1
nP0= (1+𝑘𝑒) (𝑛𝐷1 + 𝑛𝑃1) ……………………………..12.2

step 3.
If the firm’s sources of financing its investment opportunities fall short of the funds required, and n is the
number of new shares issued at the end of year 1, at P1
1
nP0 = (1+𝑘𝑒) [𝑛𝐷1 + (𝑛 + ∆𝑛)𝑃1 − ∆𝑛𝑃1)] ….......................12.3
Where, n = Number of shares outstanding at the beginning of the period
∆𝑛 = Change in number of shares outstanding during the period
It implies that the total value of the firm is the capitalized value of the dividends to be received during the
period, plus the value of the number of shares outstanding at the end of the period, including new shares
issued less the value of the new share issued. Thus in effect eq. 12.3 is equivalent to 12.2

Step 4.
If the firm were to finance all investment proposals, the total amount of new shares issued would be given
by eq. 12.4 as under:
∆𝑛𝑃1 = 𝐼 − (𝐸 − 𝑛𝐷1)
Or, ∆𝑛𝑃1 = 𝐼 − 𝐸 + 𝑛𝐷1 … … … … … … … … … … … … 12.4

Where, ∆𝑛𝑃1 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑 𝑓𝑟𝑜𝑚 𝑠𝑎𝑙𝑒 𝑜𝑓 𝑛𝑒𝑤 𝑠ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡
𝐼 = 𝑇𝑜𝑡𝑎𝑙 𝑓𝑢𝑛𝑑𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑏𝑢𝑑𝑔𝑒𝑡
E = Earnings of the firm during the period
Nd1 = Total dividends paid
E-Nd1 = Retained earnings
Equation 12.4 simply states that whatever investment needs (I) are not financed by retained earnings, must
be financed through the sale of additional equity shares.

Step 5.
If we substitute eq. 12.4 in eq. 12.3, we derive eq. 12.5 as under
1
nP0 = [𝑛𝐷1 + (𝑛 + ∆𝑛)𝑃1 − (𝐼 − 𝐸 + 𝑛𝐷1] ………………………….12.5
(1+𝑘𝑒)

solving equation 12.5 we have,

𝑛𝐷1 + (𝑛 + ∆𝑛)𝑃1 − 𝐼 + 𝐸 − 𝑛𝐷1

𝑛𝑃0 =
(1 + 𝑘𝑒

Thus,
(𝑛+∆𝑛)𝑃1−𝐼+𝐸
nP0= (1+𝑘𝑒)
…………………………………………12.6

Step 6.
Conclusion: since dividends (D) are not found in equation 12.6 MM concludes that dividends to not count.
And the dividend policy has no effect on the share price.

Walter’s Model
According to Walter, the dividend policy of a firm is relevant to its value. The value of the firm, as
measured by the market price per share (MPS), is given by equation 12.7
𝑟
𝐷+( )(𝐸−𝐷)
P= 𝑘𝑒
𝑘𝑒
……………………………………………….12.7
Where,
P = Prevailing MPS
D = Dividend per share
E = Earnings per share
Ke = Equity capitalization rate
r = Rate of return on firm’s investment
Gordon’s Model
According to Gordon’s Model, the value of the share is given by equation 12.8
𝐸(1−𝑏)
P= ………………………………………12.8
𝑘𝑒−𝑏𝑟

Where,
b = Retention ratio
(1-b) = Dividend pay-out ratio
br = g = Growth rate in r, or rate of return on investment of an all-equity firm
This approach also supports the view that the dividend policy of affirm is relevant to its valuation.

The mechanics of payout Policy

[Link] DIVIDEND PAYMENT PROCEDURE:
When a firm’s directors declare a dividend, they issue a statement indicating the dividend amount and
setting three important dates—the date of record, the ex-dividend date, and the payment date. All persons
whose names are recorded as stockholders on the date of record receive the dividend. These stockholders
are often referred to as holders of record. Because of the time needed to make bookkeeping entries when a
stock is traded, the stock begins selling ex dividend 2 business days prior to the date of record. Purchasers
of a stock selling ex dividend do not receive the current dividend. A simple way to determine the first day
on which the stock sells ex dividend is to subtract 2 business days from the date of record.
The payment date is the actual date on which the firm mails the dividend payment to the holders of record.
It is generally a few weeks after the record date. An example will clarify the various dates and the
accounting effects.

[Link] REPURCHASE PROCEDURES:

The mechanics of cash dividend payments are virtually the same for every dividend paid by every public
company. With share repurchases, firms can use at least two different methods to get cash into the hands of
shareholders. The most common method of executing a share repurchase program is called an openmarket
share repurchase. In an open-market share repurchase, as the name suggests, firms simply buy back some
of their outstanding shares on the open market.
In contrast, firms sometimes repurchase shares through a self-tender offer or simply a tender offer. In a
tender offer, a firm announces the price it is willing to pay to buy back shares and the quantity of shares it
wishes to repurchase. The tender offer price is usually set at a significant premium above the current market
price. Shareholders who want to participate let the firm know how many shares they would like to sell back
to the firm at the stated price.
A third method of buying back shares is called Dutch auction. Dutch auction repurchase A repurchase
method in whichthe firm specifies how manyshares it wants to buy backand a range of prices at whichit is
willing to repurchaseshares. Investors specify howmany shares they will sell ateach price in the range,
andthe firm determines theminimum price required to
repurchase its target number of shares. All investors who tender receive the same price.

DIVIDEND REINVESTMENT PLANS

Today many firms offer dividend reinvestment plans (DRIPs), which enable stockholders to use
dividends received on the firm’s stock to acquire additional shares—even fractional shares—at little or no
transaction cost. Some companies even allow investors to make their initial purchases of the firm’s stock
directly from the company without going through a broker. With DRIPs, plan participants typically can
acquire shares at about 5 percent below the prevailing market price. From its point of view, the firm can
issue new shares to participants more economically, avoiding the underpricing and flotation costs that
would accompany the public sale of new shares. Clearly, the existence of a DRIP may enhance the market
appeal of a firm’s shares.

Relevance of Payout Policy

The financial literature has reported numerous theories and empirical findings concerning payout policy.
Although this research provides some interesting insights about payout policy, capital budgeting and capital
structure decisions are generally considered far more important than payout decisions.

residual theory of dividends: A school of thought thatsuggests that the dividend paidby a firm should be
viewed asa residual—the amount leftover after all acceptableinvestment opportunities havebeen
[Link] this approach,
the firm would treat the dividend decision in three steps, as follows:
Step 1 Determine its optimal level of capital expenditures, which would be the level that exploits all of a
firm’s positive NPV projects.
Step 2 Using the optimal capital structure proportions (see Chapter 13), estimate the total amount of equity
financing needed to support the expenditures generated in Step 1.
Step 3 Because the cost of retained earnings, re, is less than the cost of new common stock, rn, use retained
earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet
this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the
surplus amount—the residual—as dividends.

THE DIVIDEND IRRELEVANCE THEORY

dividend irrelevance theory Miller and Modigliani’s theorythat in a perfect world, thefirm’s value is
determinedsolely by the earning powerand risk of its assets(investments) and that themanner in which it
splits itsearnings stream betweendividends and internallyretained (and reinvested) funds
does not affect this [Link] can be a clientele effect. clientele effectThe argument that different
payout policies attract different types of investors but still do not change the value of the firm.
In summary, M and M and other proponents of dividend irrelevance argue that, all else being equal, an
investor’s required return—and therefore the value of the firm—is unaffected by dividend policy. In other
words, there is no “optimal”dividend policy for a particular firm.

ARGUMENTS FOR DIVIDEND RELEVANCE

dividend relevance theory The theory, advanced byGordon and Lintner, that thereis a direct relationship
betweena firm’s dividend policy and itsmarket value. Fundamental to this proposition is their Bird in the
hand argument. bird-in-the-hand argument The belief, in support ofdividend relevance theory, that
investors see current dividendsas less risky than futuredividends or capital [Link] have shown that
large changes in dividends do affect share [Link] in dividends result in increased share price, and
decreases in dividendsresult in decreased share price. One interpretation of this evidence is that it is notthe
dividends per se that matter but rather the informational content of dividendswith respect to future
earnings. In other words, investors view a change in dividends,up or down, as a signal that management
expects future earnings tochange in the same direction. Investors view an increase in dividends as a positive
signal, and they bid up the share price. They view a decrease in dividends as anegative signal that causes
investors to sell their shares, resulting in the shareprice decreasing.
Types of Dividend Policies
The firm’s dividend policy must be formulated with two basic objectives in mind: providing for sufficient
financing and maximizing the wealth of the firm’s owners. Three different dividend policies are described
in the following sections. A particular firm’s cash dividend policy may incorporate elements of each.
dividend payout ratioIndicates the percentage ofeach dollar earned that a firmdistributes to the owners in
theform of cash. It is calculated by dividing the firm’s cashdividend per share by itsearnings per share.

[Link]-PAYOUT-RATIO DIVIDEND POLICY

constant-payout-ratio dividend policy A dividend policy based on thepayment of a certainpercentage of
earnings toowners in each dividendperiod

[Link] DIVIDEND POLICY regular dividend policy A dividend policy based on thepayment of a
fixed-dollardividend in each period
target dividend-payout ratio A dividend policy under whichthe firm attempts to pay out acertain
percentage of earningsas a stated dollar dividend andadjusts that dividend toward atarget payout as
provenearnings increases occur

[Link]-REGULAR-AND-EXTRA DIVIDEND POLICY

low-regular-and-extra dividend policy A dividend policy based onpaying a low regular
dividend,supplemented by an additional(“extra”) dividend whenearnings are higher thannormal in a given
period.
extra dividend is anadditional dividendoptionally paid by the firmwhen earnings are higher thannormal in
a given period

Other Forms of Dividends

STOCK DIVIDENDS:
A stock dividend is the payment, to existing owners, of a dividend in the form ofstock. Often firms pay
stock dividends as a replacement for or a supplement tocash dividends. In a stock dividend, investors simply
receive additional shares inproportion to the shares they already own. No cash is distributed, and no
realvalue is transferred from the firm to investors.

STOCK SPLITS:
Although not a type of dividend, stock splits have an effect on a firm’s share price similar to that of stock
dividends. A stock split is a method commonly used to lower the market price of a firm’s stock by
increasing the number of shares belonging to each shareholder Stock can be split in any way desired.
Sometimes a reverse stock split is made: The firm exchanges a certain number of outstanding shares for
one new share. For example, in a 1-for-3 split, one new share is exchanged for three old shares. In a reverse
stock split, the firm’s stock price rises due to the reduction in shares outstanding. Firms may conduct a
reverse split if their stock price is getting so low that the exchange where the stock trades threatens to delist
the stock.
Target payout ratio:The target percentage ofnet income paid out ascash dividends.
𝐷1
P=
𝑟𝑠−𝑔

If the company increases the payout ratio, this will raise D1, which, taken alone, will cause the stock price
to rise. However, if D1 is raised, less money will be available for reinvestment, which will cause the
expected growth rate to decline; and that will tend to lower the stock’s price. Therefore, any change in the
payout policy will have two opposing effects. As a result, the optimal dividend policymust strike the
balance between current dividends and future growth that maximizes the stock price. In the following
sections, we discuss the major theories that have been advanced to explain how investors regard current
dividends versus future growth.

Residual Dividend Model: A model in which the dividend paid is set equal to net income minus the amount
of retained earnings necessary to finance the firm’s optimal capital budget.

Dividends = Net income- Retained earning required to help finance new investments
Dividends = Net income - ⌊(𝑻𝒂𝒓𝒈𝒆𝒕 𝒆𝒒𝒖𝒊𝒕𝒚 𝒓𝒂𝒕𝒊𝒐 )(𝒕𝒐𝒕𝒂𝒍 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒃𝒖𝒅𝒈𝒆𝒕)⌋
Payment Procedures:
Companies normally pay dividends quarterly; and if conditions permit, the dividend
is increased once each year.
The actual payment procedure is as follows:
[Link] Date:
The date on which a firm’s directors issue a statement declaring a dividend.
[Link]-of-Record Date:
If the company lists the stockholder as an owner on this date, then the stockholder receives the dividend.
[Link]-Dividend Date:
The date on which the right to the current dividend no longer accompanies a stock; it is usually 2 business
days prior to the holder-of-record date.
[Link] Date
The date on which a firm actually mails dividend checks.

Stock Dividends:
A dividend paid in the form of additional shares of stock rather than in cash.
Effect on Stock Prices:
If a company splits its stock or declares a stock dividend, will this increase the market value of its stock?
Several empirical studies have addressed this question. Here is a summary of their findings.13
1. On average, the price of a company’s stock rises shortly after it announces a stock split or dividend.
2. One reason that stock splits and stock dividends may lead to higher prices is that investors often take
stock splits/dividends as signals of higher futureearnings. Because only companies whose managements
believe that things look good tend to split their stocks, the announcement of a stock split is taken as a signal
that earnings and cash dividends are likely to rise. Thus, the price increases associated with stock
splits/dividends may be the result of a favorable signal for earnings and dividends.
3. If a company announces a stock split or dividend, its price will tend to rise. However, if during the next
few months it does not announce an increase in earnings and dividends, the stock price generally will drop
back to the earlier level. This supports the signaling effect discussed earlier.
4. By creating more shares and lowering the stock price, stock splits may also increase the stock’s liquidity.
This tends to increase the firm’s value.
5. There also is evidence that stock splits change the mix of shareholders. The proportion of trades made by
individual investors tends to increase after a stock split, whereas the proportion of trades made by
institutional investors tends to fall. We are not sure how this affects the stock’s value.

STOCK REPURCHASES:
A transaction in which a firm buyback shares of its own stock, thereby decreasing shares outstanding,
increasing EPS, and often increasing the stock price.
The Effects of Stock Repurchases:
𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
[Link] EPS =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

2. Expected market price after repurchase = (P/E) (EPS)

Advantages of Repurchases:
The advantages of repurchases are as follows:
1. A repurchase announcement may be viewed as a positive signal by investors because repurchases are
often motivated by managements’ belief that their firms’ shares are undervalued.
2. The stockholders have a choice when the firm distributes cash by repurchasing stock—they can sell or
not sell. With a cash dividend, on the other hand, stockholders must accept a dividend payment and pay the
tax.
3. A repurchase can remove a large block of stock that is “overhanging” the market and keeping the price
per share down.
4. Repurchases can be used to produce large-scale changes in capital structure.

Disadvantages of Repurchases:
Disadvantages of repurchases include the following:
1. Stockholders may not be indifferent between dividends and capital gains, and the price of the stock might
benefit more from cash dividends than from repurchases. Cash dividends are generally dependable, but
repurchases are not.
2. The selling stockholders may not be fully aware of all the implications of a repurchase, or they may not
have all the pertinent information about the corporation’s present and future activities.
3. The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining
stockholders. If its shares are not actively traded and if the firm seeks to acquire a relatively large amount of
its stock, the price may be bid above its intrinsic value and then fall after the firm ceases its repurchase
operations.

Understand cash payout procedures, their tax treatment, and the role of dividend reinvestment plans:
The board of directors makes the cash payout decisionand, for dividends, establishes the record and
payment dates. As a result ofa tax-law change in 2003, most taxpayers pay taxes on corporate dividends at
amaximum rate of 5 percent to 15 percent, depending on the taxpayer’s taxbracket. Some firms offer
dividend reinvestment plans that allow stockholdersto acquire shares in lieu of cash dividends.

Describe the residual theory of dividends and the key arguments with regard to dividend irrelevance
and relevance:
The residual theory suggests that dividendsshould be viewed as the earnings left after all acceptable
investment opportunitieshave been undertaken. Miller and Modigliani argue in favor of dividend
irrelevance,using a perfect world in which market imperfections such as transaction costs andtaxes do not
exist. Gordon and Lintner advance the theory of dividend relevance,basing their argument on the
uncertainty-reducing effect of dividends, supported bytheir bird-in-the-hand argument. Empirical studies
fail to provide clear support ofdividend relevance. Even so, the actions of financial managers and
stockholders tendto support the belief that dividend policy does affect stock value.

Discuss the key factors involved in establishing a dividend policy:

A firm’s dividend policy should provide for sufficient financing and maximize stockholders’ wealth.
Dividend policy is affected by legal and contractual constraints, by growth prospects, and by owner and
market considerations. Legal constraints prohibit corporations from paying out as cash dividends any
portion of the firm’s “legal capital.” Nor can firms with overdue liabilities and legally insolvent or bankrupt
firms pay cash dividends. Contractual constraints result
from restrictive provisions in the firm’s loan agreements. Growth prospects affect the relative importance of
retaining earnings rather than paying them out in dividends. The tax status of owners, the owners’
investment opportunities, and the potential dilution of ownership are important owner considerations.
Finally, market considerations are related to the stockholders’ preference for the continuous payment of
fixed or increasing streams of dividends.

Review and evaluate the three basic types of dividend policies:

With a constant-payout-ratio dividend policy, the firm pays a fixed percentage of earnings to the owners
each period; dividends move up and down with earnings, and no dividend is paid when a loss occurs. Under
a regular dividend policy, the firm pays a fixed-dollar dividend each period; it increases the amount of
dividends only after a proven increase in earnings. The low-regular-and-extra dividend policy is similar to
the regular dividend policy, except that it pays an extra dividend when the firm’s earnings are higher than
normal.

Evaluate stock dividends from accounting, shareholder, and company points of view:
Firms may pay stock dividends as a replacement for or supplementto cash dividends. The payment of stock
dividends involves a shifting of funds between capital accounts rather than an outflow of funds. Stock
dividendsdo not change the market value of stockholders’ holdings, proportion of ownership,or share of
total earnings. Therefore, stock dividends are usually [Link], stock dividends may satisfy
owners and enable the firm topreserve its market value without having to use cash.

Explain stock splits and the firm’s motivation for undertaking them:
Stock splits are used to enhance trading activity of a firm’s shares by lowering orraising their market price.
A stock split merely involves accounting adjustments;it has no effect on the firm’s cash or on its capital
structure and is usually nontaxable.
Firms can repurchase stock in lieu of paying a cash dividend, to retire outstanding shares. Reducing the
number of outstanding shares increases earningsper share and the market price per share. Stock repurchases
also defer the tax payments of stockholders.

E12-B-C15-1:
Discuss the pros and cons of having the directors formally announce what a firm’s dividend
policy will be in the future.

Answer-1
The biggest advantage of having an announced dividend policy is that it would reduce investor uncertainty,
and reductions in uncertainty are generally associated with lower capital costs and higher stock
prices, other things being equal. The disadvantage is that such a policy might decrease corporate
flexibility. However, the announced policy would possibly include elements of flexibility. On
balance, it would appear desirable for directors to announce their policies.

E12-B-C15-2:
The cost of retained earnings is less than the cost of new outside equity [Link], it is totally
irrational for a firm to sell a new issue of stock and to paydividends during the same year. Discuss the
meaning of those statements.

Answer-2

While it is true that the cost of outside equity is higher than that of retained earnings, it is not neces-
sarily irrational for a firm to pay dividends and sell stock in the same year. The reason is that if the
firm has been paying a regular dividend, and then cuts it in order to obtain equity capital from
retained earnings, there might be an unfavorable effect on the firm’s stock price. If investors lived
in the world of certainty and rationality postulated by Miller and Modigliani, then the statement
would be true, but it is not necessarily true in an uncertain world.
E12-B-C15-3:
Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.

Answer-3
Logic suggests that stockholders like stable dividends—many of them depend on dividend income,
and if dividends were cut, this might cause serious hardship. If a firm’s earnings are temporarily
depressed or if it needs a substantial amount of funds for investment, then it might well maintain its
regular dividend using borrowed funds to tide it over until things returned to normal. Of course, this
could not be done on a sustained basis—it would be appropriate only on relatively rare occasions.
E12-B-C15-8:
What is the difference between a stock dividend and a stock split? As a stockholder, would
you prefer to see your company declare a 100% stock dividend or a two-for-one split?
Assume that either action is feasible.

Answer-8
The difference is largely one of accounting. In the case of a split, the firm simply increases the
number of shares and simultaneously reduces the par or stated value per share. In the case of a
stock dividend, there must be a transfer from retained earnings to capital stock. For most firms, a
100% stock dividend and a 2-for-1 stock split accomplish exactly the same thing; hence, investors
may choose either one.
E12-B-C15-P1:
RESIDUAL DIVIDEND MODEL Axel Telecommunications has a target capital structure thatconsists of
70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be
$3,000,000. If Axel reports net income of $2,000,000 and it follows aresidual dividend payout policy, what
will be its dividend payout ratio?

Answer-P1
70% Debt; 30% Equity; Capital budget = $3,000,000; NI = $2,000,000; PO =?

Equity retained = 0.3($3,000,000) = $900,000.

NI $2,000,000
– Additions to RE 900,000
Earnings remaining $1,100,000
$1,100,000
Payout = = 55%.
$2,000,000

E12-B-C15-P2:
STOCK SPLIT Gamma Medical’s stock trades at $90 a share. The company is contemplatinga 3-for-2
stock split. Assuming that the stock split will have no effect on the market valueof its equity, what will be
the company’s stock price following the stock split?

Answer-P2
P0 = $90; Split = 3 for 2; New P0 =?

$90
= $60.
3 /2

E12-B-C15-P3
: STOCK REPURCHASES Beta Industries has net income of $2,000,000, and it has1,000,000 shares of
common stock outstanding. The company’s stock currently trades at$32 a share. Beta is considering a plan
in which it will use available cash to repurchase 20%of its shares in the open market. The repurchase is
expected to have no effect on net incomeor the company’s P/E ratio. What will be Beta’s stock price
following the stock repurchase?

Answer-P3
NI = $2,000,000; Shares = 1,000,000; P0 = $32; Repurchase = 20%; New P0 =?

Repurchase = 0.2  1,000,000 = 200,000 shares.

Repurchase amount = 200,000  $32 = $6,400,000.

 NI $2,000,000
EPSOld = = = $2.00.
Shares 1,000,000

$32
P/E = = 16.
$2

$2,000 ,000 $2,000,000

EPSNew = = = $2.50.
1,000 ,000 − 200 ,000 800,000

PriceNew = EPSNew P/E = $2.50(16) = $40.

E12-B-C15-P4:
STOCK SPLIT After a 5-for-1 stock split, Strasburg Company paid a dividend of$0.75 per new share,
which represents a 9% increase over last year’s pre-split [Link] was last year’s dividend per share?

Answer-P4

DPS after split = $0.75.

Equivalent pre-split dividend = $0.75(5) = $3.75.

New equivalent dividend = Last year’s dividend(1.09)

$3.75 = Last year’s dividend(1.09)
Last year’s dividend = $3.75/1.09 = $3.44.
E12-B-C15-P5:
EXTERNAL EQUITY FINANCING Northern Pacific Heating and Cooling Inc. has a 6-monthbacklog of
orders for its patented solar heating system. To meet this demand, management plans to expand production
capacity by 40% with a $10 million investment in plant andmachinery. The firm wants to maintain a 40%
debt-to-total-assets ratio in its capitalstructure. It also wants to maintain its past dividend policy of
distributing 45% of last year’snet income. In 2008, net income was $5 million. How much external equity
must NorthernPacific seek at the beginning of 2009 to expand capacity as desired? Assume that thefirm
uses only debt and common equity in its capital structure.

Answer-P5
Retained earnings = Net income (1 – Payout ratio)
= $5,000,000(0.55) = $2,750,000.

External equity needed:

 Total equity required = (New investment)(1 – Debt ratio)
= $10,000,000(0.60) = $6,000,000.

New external equity needed = $6,000,000 – $2,750,000 = $3,250,000.

E12-B-C15-P6:
RESIDUAL DIVIDEND MODEL Welch Company is considering three independent projects,each of
which requires a $5 million investment. The estimated internal rate of return(IRR) and cost of capital for
these projects are presented here:
Project H (high risk): Cost of capital ¼ 16% IRR ¼ 20%
Project M (medium risk): Cost of capital ¼ 12% IRR ¼ 10%
Project L (low risk): Cost of capital ¼ 8% IRR ¼ 9%
Note that the projects’ costs of capital vary because the projects have different levels of [Link] company’s
optimal capital structure calls for 50% debt and 50% common equity. Welchexpects to have net income of
$7,287,500. If Welch establishes its dividends from theresidual model, what will be its payout ratio?

Answer-P6
Step 1: Determine the capital budget by selecting those projects whose returns are greater than the
project’s risk-adjusted cost of capital.

Projects H and L should be chosen because IRR > WACC, so the firm’s capital budget =
$10 million.

Step 2: Determine how much of the capital budget will be financed with equity.

Capital Budget  Equity % = Equity required.

$10,000,000  0.5 = $5,000,000.

Step 3: Determine dividends through residual model.

$7,287,500 – $5,000,000 = $2,287,500.

Step 4: Calculate payout ratio.

$2,287,500/$7,287,500 = 0.3139 = 31.39%.

E13-G-C14–E1:
Stephanie’s Cafes, Inc., has declared a dividend of $1.30 per share for shareholdersof record on Tuesday,
May 2. The firm has 200,000 shares outstanding and will paythe dividend on May 24. How much cash will
be needed to pay the dividend? Whenwill the stock begin selling ex dividend?

Answer: The firm will need $260,000 of cash to pay the dividend. Because a weekend intervenes, the stock
will begin selling ex-dividend on Friday, April 28, which is 4 days before the date of record.

E13-G-C14–E2:
Chancellor Industries has retained earnings available of $1.2 million. The firm plansto make two
investments that require financing of $950,000 and $1.75 million,respectively. Chancellor uses a target
capital structure with 60% debt and 40%equity. Apply the residual theory to determine what dividends, if
any, can be paidout, and calculate the resulting dividend payout ratio.

Answer: 1. New investments $2,700,000

2. Retained earnings available 1,200,000
3. Equity needed (40% of 1) 1,080,000
4. Dividends [(2) – (3)] 120,000
5. Dividend payout ratio [(4) (2)] 10%

E13-G-C14–E3:
Ashkenazi Companies has the following stockholders’ equity account:
Common stock (350,000 shares at $3 par) $1,050,000
Paid-in capital in excess of par 2,500,000
Retained earnings
Total stockholders’ equity
Assuming that state laws define legal capital solely as the par value of common
stock, how much of a per-share dividend can Ashkenazi pay? If legal capital weremore broadly defined to
include all paid-in capital, how much of a per-share dividendcould Ashkenazi pay?

Answer: If legal capital is defined solely as the par value of common stock, Ashkenazi will be able to pay
out paid-in capital in excess of par plus all retained earnings.
Paid-in capital in excess of par 2,500,000
Retained earnings 750,000
Total available for dividends $3,250,000
Potential dividend per share (divide total available by 350,000 shares) $9.29
If legal capital is defined as both the par value of common stock and paid-in capital in excess of par,
Ashkenazi will only be able to pay out the retained earnings.
Total available for dividends $750,000
Potential dividend per share (divide total available by 350,000 shares) $2.14

E13-G-C14–E4:
The board of Kopi Industries is considering a new dividend policy that would setdividends at 60% of
earnings. The recent past has witnessed earnings per share(EPS) and dividends paid per share as follows:
 Year EPS Dividend/share
2009 $1.75 $0.95
2010 1.95 1.20
2011 2.05 1.25
2012 2.25 1.30

Based on Kopihistorical dividend payout ratio, discuss whether a constant payoutratio of 60% would benefit
shareholders.

Answer: The first step in

analyzing the Kopi
scenario is to determine
the historical payout ratio.
Year EPS Dividend/Share Dividend Payout Ratio
2009 $1.75 $0.95 54.29%
2010 1.95 1.20 61.54
2011 2.05 1.25 60.98
2012 2.25 1.30 57.78

E12-G-C14–E5:
The current stockholders’ equity account for Hilo Farms is as follows:
Common stock (50,000 shares at $3 par) $150,000
Paid-in capital in excess of par 250,000
Retained earnings 450,000

Total stockholders’ equity 850,000

Hilo has announced plans to issue an additional 5,000 shares of common stock aspart of its stock dividend
plan. The current market price of Hilo’s common stock is$20 per share. Show how the proposed stock
dividend would affect the stockholder’sequity account.

Answer: After the 10% stock dividend, Hilo’s stockholder’s equity account is as follows:
Common stock (55,000 shares at $3 par) $165,000
Paid-in capital in excess of par 335,000
Retained earnings 350,000
Total stockholders’ equity $850,000

E13-G-C14–P2:
Dividend paymentKathy Snow wishes to purchase shares of CountdownComputing, Inc. The company’s
board of directors has declared a cash dividend of$0.80 to be paid to holders of record on Wednesday, May
12.
a. What is the last day that Kathy can purchase the stock (trade date) and stillreceive the dividend?
 b. What day does this stock begin trading ex dividend?
c. What change, if any, would you expect in the price per share when the stockbegins trading on the ex
dividend day?
d. If Kathy held the stock for less than one quarter and then sold it for $39 pershare, would she achieve a
higher investment return by (1) buying the stock priorto the ex dividend date at $35 per share and collecting
the $0.80 dividend, or(2) buying it on the ex dividend date at $34.20 per share but not receiving
thedividend?
Answer:
a. Friday, May 7
b. Monday, May 10
c. The price of the stock should drop by the amount of the dividend ($0.80).
d. She would be better off buying the stock at $35 and taking the dividend. Her $0.80 dividend would be
taxed at the maximum rate of 15% and her $4 short-term capital gain would be taxed at the ordinary
marginal tax rate, which is probably higher than the 15%. If she bought the stock post dividend for $34.20
she would pay her marginal ordinary tax rate on the full $4.80 of short-term capital gains.

E13-G-C14–P3: Residual dividend policy

As president of Young’s of California, a large clothingchain, you have just received a letter from a major
stockholder. The stockholder asksabout the company’s dividend policy. In fact, the stockholder has asked
you to estimatethe amount of the dividend that you are likely to pay next year. You have notyet collected all
the information about the expected dividend payment, but you do know the following page:

(1) The company follows a residual dividend policy.

(2) The total capital budget for next year is likely to be one of three amounts,depending on the results of
capital budgeting studies that are currently underway. The capital expenditure amounts are $2 million, $3
million, and
$4 million.
(3) The forecasted level of potential retained earnings next year is $2 million.
(4) The target or optimal capital structure is a debt ratio of 40%.
You have decided to respond by sending the stockholder the best information availableto you.
a. Describe a residual dividend policy.
b. Compute the amount of the dividend (or the amount of new common stockneeded) and the dividend
payout ratio for each of the three capital expenditureamounts.
c. Compare, contrast, and discuss the amount of dividends (calculated in part b)associated with each of the
three capital expenditure amounts.

Answer:
a. Residual dividend policy means that the firm will consider its investment opportunities first. If after meeting
these requirements there are funds left, the firm will pay the residual out in the form of dividends. Thus, if the
firm has excellent investment opportunities, the dividend will be smaller than if investment opportunities are
limited.
b.
Capital budget $2,000,000 $3,000,000 $4,000,000
Debt portion (40%) 800,000 1,200,000 1,600,000
Equity portion (60%) 1,200,000 1,800,000 2,400,000
Available retained earnings $2,000,000 $2,000,000 $2,000,000
Dividend 800,000 200,000 0
Dividend payout ratio 40% 10% 0%
c. The amount of dividends paid is reduced as capital expenditures increase. Thus, if the firm chooses larger
capital investments, dividend payments will be smaller or nonexistent.

E13-G-C14–P4:
Dividend constraintsThe Howe Company’s stockholders’ equity account follows:
Common stock (400,000 shares at $4 par) $1,600,000
Paid-in capital in excess of par 1,000,000
Retained earnings
Total stockholders’ equity
The earnings available for common stockholders from this period’s operations are$100,000, which have
been included as part of the $1.9 million retained earnings.
a. What is the maximum dividend per share that the firm can pay? (Assume thatlegal capital includes all
paid-in capital.)
b. If the firm has $160,000 in cash, what is the largest per-share dividend it can paywithout borrowing?
c. Indicate the accounts and changes, if any, that will result if the firm pays the dividends
indicated in parts aand b.
d. Indicate the effects of an $80,000 cash dividend on stockholders’ equity.

Answer:
a. Maximum dividend: $1,900,000 $4.75 per share 400,000
b. Largest dividend without borrowing: $160,000 $0.40 per share 400,000
c. In part a, cash and retained earnings each decrease by $1,900,000. In part b, cash and retained earnings
each decrease by $160,000.
d. Retained earnings (and hence stockholders’ equity) decrease by $80,000.

E13-B-C14–P5:
Dividend constraintsA firm has $800,000 in paid-in capital, retained earnings of$40,000 (including the
current year’s earnings), and 25,000 shares of common stock outstanding. In the current year, it has $29,000
of earnings available for thecommon stockholders.
a. What is the most the firm can pay in cash dividends to each common stockholder?
(Assume that legal capital includes all paid-in capital.)
b. What effect would a cash dividend of $0.80 per share have on the firm’s balance
sheet entries?
c. If the firm cannot raise any new funds from external sources, what do you considerthe key constraint with
respect to the magnitude of the firm’s dividend payments?Why?

Answer:
a. Maximum dividend: $40,000 $1.60 per share 25,000
b. A $20,000 decrease in cash and retained earnings is the result of a $0.80 per share dividend.
c. Cash is the key constraint, because a firm cannot pay out more in dividends than it has in cash, unless it
borrows.

E13-G-C14–P6:
Low-regular-and-extra dividend policyBennett Farm Equipment Sales, Inc., is in ahighly cyclic business.
Although the firm has a target payout ratio of 25%, its boardrealizes that strict adherence to that ratio would
 result in a fluctuating dividend andcreate uncertainty for the firm’s stockholders. Therefore, the firm has
declared a regulardividend of $0.50 per share per year with extra cash dividends to be paid when
earnings justify them. Earnings per share for the last several years are as follows:

Year EPS Year EPS

2012 $3.00 2009 $2.80
2011 2.40 2008 2.15
2010 2.20 2007 1.97

a. Calculate the payout ratio for each year on the basis of the regular $0.50 dividendand the cited EPS.
b. Calculate the difference between the regular $0.50 dividend and a 25% payout for each year.
c. Bennett has established a policy of paying an extra dividend of $0.25 only when the difference between
the regular dividend and a 25% payout amounts to $1.00 or more. Show the regular and extra dividends in
thoseyears when an extra dividend would be paid. What would be done with the “extra” earnings that are
notpaid out?
d. The firm expects that future earnings per share will continue to cycle but will remain above $2.20 per
share in most years. What factors should be considered in making a revision to the amount paid as a regular
dividend? If the firm revises the regular dividend, what new amount should it pay?

Answer:
a.
Year Payout % Year Payout %
2007 25.4 2010 22.7
2008 23.3 2011 20.8
2009 17.9 2012 16.7

b. Year 25% Actual $ Diff. Year 25% Actual $ Diff.

Payout Payout Payout Payout
2007 $0.49 0.50 0.01 2010 0.55 0.50 -0.05
2008 0.54 0.50 –0.04 2011 0.60 0.50 -0.10
2009 0.70 0.50 –0.20 2012 0.75 0.50 -0.25

c. In this example the firm would not pay any extra dividend since the actual dividend did not fall below the
25% minimum by $1.00 in any year. When the ―extra‖ dividend is not paid due to the $1.00 minimum, the
extra cash can be used for additional investment by placing the funds in a short-term investment account.
d. If the firm expects the earnings to remain above the earnings per share (EPS) of $2.20 the dividend
should be raised to $0.55 per share. The 55 cents per share will retain the 25% target payout but allow the
firm to pay a higher regular dividend without jeopardizing the cash position of the firm by paying too high
of a regular dividend.

E13-G-C14–P7:
Alternative dividend policies Over the last 10 years, a firm has had the earnings
per share shown in the following table.

Year Earnings per share Year Earnings per share

2012 $4.00 2007 $2.40
2011 3.80 2006 1.20
 2010 3.20 2005 1.80
2009 2.80 2004 - 0.50
2008 3.20 2003 0.25

a. If the firm’s dividend policy were based on a constant payout ratio of 40% for all years with positive
earnings and 0% otherwise, what would be the annual dividend for each year?
b. If the firm had a dividend payout of $1.00 per share, increasing by $0.10 per share whenever the dividend
payout fell below 50% for two consecutive years, what annual dividend would the firm pay each year?
c. If the firm’s policy were to pay $0.50 per share each period except when earningsper share exceed $3.00,
when an extra dividend equal to 80% of earnings beyond $3.00 would be paid, what annual dividend would
the firm pay each year?
d. Discuss the pros and cons of each dividend policy described in parts a through c.

Answer:
a.
Year Dividend Year Dividend

2003 $0.10 2008 $1.28

2004 0.00 2009 1.12
2005 0.72 2010 1.28
2006 0.48 2011 1.52
2007 0.96 2012 1.60
b.
2003 $1.00 2008 $1.10
2004 1.00 2009 1.20
2005 1.00 2010 1.30
2006 1.00 2011 1.40
2007 1.00 2012 1.50

c.
2003 $0.50 2008 $0.66
2004 0.50 2009 0.50
2005 0.50 2010 0.66
2006 0.50 2011 1.14
2007 0.50 2012 1.30
d. With a constant-payout policy, if the firm’s earnings drop or a loss occurs the dividends will be low or
nonexistent. A regular dividend or a low-regular-and-extra dividend policy reduces owner uncertainty by
paying relatively fixed and continuous dividends.

E13-G-C14–P8:
Alternative dividend policiesGiven the earnings per share over the period 2005–2012 shown in the
following table, determine the annual dividend per share under each of the policies set forth in parts a
through d.

Year Earnings per share

2012 $1.40
2011 1.56
2010 1.20
2009 -0.85
2008 1.05
2007 0.60
2006 1.00
2005 0.44

a. Pay out 50% of earnings in all years with positive earnings.

b. Pay $0.50 per share and increase to $0.60 per share whenever earnings per share rise above $0.90 per
share for two consecutive years.
c. Pay $0.50 per share except when earnings exceed $1.00 per share, in which case pay an extra dividend of
60% of earnings above $1.00 per share.
d. Combine the policies described in parts b and c. When the dividend is raised (in part b), raise the excess
dividend base (in part c) from $1.00 to $1.10 per share.
e. Compare and contrast each of the dividend policies described in parts a through d.

Answer:
a.
Challenge Year Dividend Year Dividend
____________________________________________________
2005 $0.22 2009 $0.00
2006 0.50 2010 0.60
2007 0.30 2011 0.78
2008 0.53 2012 0.70
b.
2005 $0.50 2009 $0.50
2006 0.50 2010 0.50
2007 0.50 2011 0.60
2008 0.50 2012 0.60
c.
2005 $0.50 2009 $0.50
2006 0.50 2010 0.50
2007 0.50 2011 0.88
2008 0.50 2012 0.78
d.
2005 $0.50 2009 $0.50
2006 0.50 2010 0.62
2007 0.50 2011 0.88
2008 0.53 2012 0.78

e. Part a uses a constant-payout-ratio dividend policy, which will yield low or no dividends if earnings
decline or a loss occurs. Part b uses a regular dividend policy, which minimizes the owners’ uncertainty of
earnings. Part c uses a low-regular-and-extra dividend policy, giving investors a stable income which is
necessary to build confidence in the firm. Part d still provides the stability of parts b and c and provides an
extra $0.04 per year.
E13-G-C14–P9:
Stock dividend—FirmColumbia Paper has the following stockholders’ equity account. The firm’s common
stock has a current market price of $30 per share.

Preferred stock $100,000

Common stock (10,000 shares at $2 par) 20,000
Paid-in capital in excess of par 280,000
Retained earnings 100,000

Total stockholders’ equity 500,000

a. Show the effects on Columbia of a 5% stock dividend.
b. Show the effects of (1) a 10% and (2) a 20% stock dividend.
c. In light of your answers to parts aand b, discuss the effects of stock dividends on stockholders’ equity.
 Answer:

(a) 5% Stock (b) (1) 10% Stock (b) (2) 20% Stock Dividend
Dividend Dividend

Preferred stock $100,000 $100,000 $100,000

Common stock (xx,xxx 21,0001 22,0002 24,0003
shares @$2.00 par)
Paid-in capital in excess of 294,000 308,000 336,000
par
Retained earnings 85,000 70,000 40,000
Stockholders’ equity $500,000 $500,000 $500,000

E13-G-C14–P10:
Cash versus stock dividend Milwaukee Tool has the following stockholders’ equity
account. The firm’s common stock currently sells for $4 per share.
________________________________________________________________
Preferred stock $ 100,000
Common stock (400,000 shares at $1 par) 400,000
Paid-in capital in excess of par 200,000
Retained earnings 320,000
________________________________________________________________
Total stockholders’ equity 1020,000

a. Show the effects on the firm of a cash dividend of $0.01, $0.05, $0.10, and
$0.20 per share.
b. Show the effects on the firm of a 1%, 5%, 10%, and 20% stock dividend.
c. Compare the effects in parts aand b. What are the significant differences between the two methods of
paying dividends?

a. Cash Dividend

$0.05 $0.10 $0.20

$0.01

Preferred stock $ 100,000 $ 100,000 $100,000 $100,000

Common stock 400,000 400,000 400,000 400,000
(400,000 shares
@$1.00 par)
Paid-in capital in 200,000 200,000 200,000 200,000
excess of par
Retained earnings 316,000 300,000 280,000 240,000
Stockholders’ equity $1,016,000 $1,000,000 $980,000 $940,000
 b. Stock Dividend

1% 5% 10% 20%

Preferred stock $ 100,000 $ 100,000 $ 100,000 $ 100,000

Common stock 404,000 420,000 440,000 480,000
(xxx,xxx shares
@$1.00 par)
Paid-in capital in 212,000 260,000 320,000 440,000
excess of par
Retained earnings 304,000 240,000 160,000 0
Stockholders’ equity $1,020,000 $1,020,000 $1,020,000 $1,020,000

c. Stock dividends do not affect stockholders’ equity; they only redistribute retained earnings into common
stock and additional paid-in capital accounts. Cash dividends cause a decrease in retained earnings, and
hence in overall stockholders’ equity.

E13-G-C14–P11:
Stock dividend—InvestorSarah Warren currently holds 400 shares of NutriFoods. The firm has 40,000
shares outstanding. The firm most recently had earnings available for common stockholders of $80,000, and
its stock has been selling for $22 per share. The firm intends to retain its earnings and pay a 10% stock
dividend.
a. How much does the firm currently earn per share?
b. What proportion of the firm does Warren currently own?
c. What proportion of the firm will Warren own after the stock dividend? Explain your answer.
d. At what market price would you expect the stock to sell after the stock
dividend?
e. Discuss what effect, if any, the payment of stock dividends will have on Warren’s share of the ownership
and earnings of Nutri-Foods.

Answer:
a. EPS= $80,000/40,000 =2.00
b. Percent ownership = 400/40000= 1.00%
c. Percent ownership after stock dividend: 440/44,000 = 1%; stock dividends maintain the same ownership
percentage. They do not have a real value.
d. Market price: $22 / 1.10 = $20 per share
e. Her proportion of ownership in the firm will remain the same, and as long as the firm’s earnings remain
unchanged, so, too, will her total share of earnings.

E13-G-C14–P12:
Stock dividend—InvestorSecurity Data Company has outstanding 50,000 shares of common stock currently
selling at $40 per share. The firm most recently had earnings available for common stockholders of
$120,000, but it has decided to retain these funds and is considering either a 5% or a 10% stock dividend in
lieu
of a cash dividend.
a. Determine the firm’s current earnings per share.
b. If Sam Waller currently owns 500 shares of the firm’s stock, determine his proportion of ownership
currently and under each of the proposed stock dividend plans. Explain your findings.
c. Calculate and explain the market price per share under each of the stock dividend plans.
d. For each of the proposed stock dividends, calculate the earnings per share after payment of the stock
dividend.
e. What is the value of Waller’s holdings under each of the plans? Explain.
f. Should Waller have any preference with respect to the proposed stock dividend? Why or why not?
Answer:
a. EPS=120000/50000=2.40 per share
b. Percent ownership=500/50000 = 1.0%
His proportionate ownership remains the same in each case
c. Market price = 40/1.05 = $38.10
Market price = 40/1.10 = $36.36
The market price of the stock will drop to maintain the same proportion, since more shares are used.
d. EPS = 2.40/1.05 = 2.29 per share
EPS =2.40/1.10 = 2.18 per share
e. Value of holdings: $20,000 under each plan.
As long as the firm’s earnings remain unchanged, his total share of earnings will be the same.
f. The investor should have no preference because the only value is of a psychological nature. After a stock
split or dividend, however, the stock price tends to go up faster than before.

E13-G-C14–P13:
Stock split—FirmGrowth Industries’ current stockholders’ equity account is as
follows:
Preferred stock $ 400,000
Common stock (600,000 shares at $3 par) 1,800,000
Paid-in capital in excess of par 200,000
Retained earnings 800,000

Total stockholders’ equity 3200,000

a. Indicate the change, if any, expected if the firm declares a 2-for-1 stock split.
b. Indicate the change, if any, expected if the firm declares a 1-for-11/2 reversestock split.
c. Indicate the change, if any, expected if the firm declares a 3-for-1 stock split.
d. Indicate the change, if any, expected if the firm declares a 6-for-1 stock split.
e. Indicate the change, if any, expected if the firm declares a 1-for-4 reverse stock split.

Answer:
a. CS $1,800,000 (1,200,000 shares @ $1.50 par)
b. CS $1,800,000 (400,000 shares @ $4.50 par)
c. CS $1,800,000 (1,800,000 shares @ $1.00 par)
d. CS $1,800,000 (3,600,000 shares @ $0.50 par)
e. CS $1,800,000 (150,000 shares @ $12.00 par)
E13-G-C14–P14:
Stock splitsNathan Detroit owns 400 shares of the food company General Mills, Inc., which he purchased
during the recession in January 2009 for $35 per share.
General Mills is regarded as a relatively safe company because it provides a basic product that consumers
need in good and bad economic times. Nathan read in the Wall Street Journal that the company’s board of
directors had voted to split the stock 2-for-1. In June 2010, just before the stock split, General Mills shares
were trading for $75.14. Answer the following questions about the impact of the stock split on his holdings
and taxes. Nathan is in the 28% federal income tax bracket.
a. How many shares of General Mills will Nathan own after the stock split?
b. Immediately after the split, what do you expect the value of General Mills to be?
c. Compare the total value of Nathan’s stock holdings before and after the split, given that the price of
General Mills stock immediately after the split was $37.50. What do you find?
d. Does Nathan experience a gain or loss on the stock as a result of the 4-for-1 split
e. What is Nathan’s tax liability from the event?

Answer:
a. 400 * 2 = 800 shares will be owned by Nathan after the split.
b. $75.14 / 2 = $37.57 per share of General Mills after the 2:1 split.
c. Value of General Mills in Nathan’s portfolio shares owned price per share. 400* $75.14 = $30,056 value
before the split 800 * $37.57 = $30,056 value after the split
d. Nathan does not experience a gain or a loss, and hence his financial conditions does not change. Nathan
still owns the same percentage of all Apple shares.
e. Even if there was a gain or loss attributable to the split, Nathan would not have any tax liability unless he
actually sold the stock and realized that change for tax purposes.

PS 12.1
The shareholder’s funds of XYZ limited for the year ending march 31 are as follows
12% preference share capital Rs1,00,000
Equity share capital (Rs100 each) 4,00,000
Share premium 40,000
Retained earnings 3,00,000
___________
8,40,000
The earnings available for equity shareholders from this periods operations are Rs1,50,000 which have been
included as part of the Rs 3,00,000 retained earnings.
(i) What is the maximum dividend per share (DPS) the firm can pay?
(ii) If the firm has Rs 60,000 in cash what is the largest DPS it can pay without borrowing?
(iii) Indicate what accounts, if any, will be affected if the firm pays the dividends indicated in (ii) above?
Solution:
(i) Maximum DPS = Total distributable/ number of equity shares outstanding =
Rs3,00,000/4,000(Rs4,00,000/100) = Rs75
(ii) Maximum DPS (without borrowing) = cash available/number of equity outstanding = Rs60,000/4,000 =
Rs 15.
(iii)accounts relating to retained earnings and cash will be affected. Retained earnings balanced will
declined by RS 60000, that is the amount of dividend paid. Cash will be reduced to zero.

PS 12.2

Following is the EPS record of AB Ltd over the past 10 year:

Year EPS Year EPS
10 RS 20 5 RS 12
9 19 4 6
8 16 3 9
7 15 2 (2)
6 16 1 1

(i) Determine the annual dividend paid each year in the following cases.
a. If the firm dividend policy is best on the constant dividend payout ratio of 50% for all years.
b. If the firm pays dividend RS 8 per share, and increases it to RS 10 per share when earning exceed RS
14% share for the previous two consecutive years.
c. if the firm pays dividend at RS 7 per share each year except when EPS exceeds RS 14 per share, when an
extra dividend equal to 80% of earning beyond RS 14 will be paid.
(ii) which type of dividend policy will you recommend to the company and why.

SOLUTION:
(i) a: dividend per share DPS paid in years 10-1
Year EPS DPS Year EPS DPS
10 RS 20 RS 10 5 RS 12 RS 6
9 19 9.5 4 6 3
8 16 8 3 9 4.5
7 15 7.5 2 (2) NIL
6 16 8 1 1 0.5

(b) Dividend per share, DPS, YEARS 10-1:

Year EPS DPS Year EPS DPS
10 RS 20 RS 10 5 RS 12 RS 8
9 19 10 4 6 8
8 16 10 3 9 8
7 15 8 2 (2) 8
6 16 8 1 1 8

(C) Dividend per share DPS, YEAR 10-1:

Year EPS DPS Year EPS DPS
10 RS 20 RS 11.5 5 RS 12 RS 7
9 19 11 4 6 7
8 16 8.6 3 9 7
7 15 7.8 2 (2) 7
 6 16 8.6 1 1 7

(ii) What the investor expect is that they should get an assured fixed amount as dividend which should
gradually and consistency increase over the year, that is a stable dividend.

Ps 12.3
Royal industries ltd has for many years enjoyed a moderate but stable growth in sales and earnings. In
recent years, it is facing a stiff competition in its plastic product line and, consequently, it sales have been
declining. Apprehending further decline in its sales, its management is planning to move eventually out of
plastic business together, and develop new diversified product line in growth oriented industries. To
execute the proposed investment plan of this year, a capital outlay of Rs12 lakh is necessary to purchase
new facilities to start manufacturing a new product; the estimated rate of return on fresh investment is 20
per cent.
The company has been paying a divided of Rs1.50 per share on 400000 equity share (Rs10 each)
outstanding.
The company policy has been to maintain a stable rupee dividend, raising it only when it appears that
earnings have reached a new, permanently higher level. The directors may change such a policy if there are
compelling reasons to do [Link] earnings of the current year are Rs1000000. The current market price
market price of the equity share is Rs15 and the firm’s current leverage ratio(debt/assets) is 40 per
[Link] costs of various forms of financing are;
Debentures 0.15
New equity shares sold at Rs15 to yield 14
Required rate of return on equity 0.18
(a) what would be an appropriate dividend policy for royal industries ltd?
(b) what assumptions, if any, do you make an answer about investors preference for dividends versus capital
gain?

Solution
(a) The company’s management should recognize that it will be consistently in need of more finds owing to
it’sintended policy of moving into new diversified product lines in growth oriented [Link] could be
done immediately by reducing the current divided. Or over a period of [Link] maintaining the current
dividends, as earnings [Link] the extent the shareholders have strong expectations about maintenance of the
current dividend,the policy (of maintaining current dividend at Rs1.50 per share) might be appropriate.
The company, through advertisements, should make the investors aware of the firm’s new growth prospects
and the greater investment opportunities [Link] an announcement will help to prevent the share prices
from falling on reduction of dividend amount paid,if the company adopts a policy of immediate dividend
cut.A better policy, perhaps,would be to maintain the current dividend Rs1.50 per share, and not increase it
until earnings are so much higher thatRs1.50 represents a low percentage of earnings and higher dividend
may be feasible in coming years.
(b)As discussed in part (a),it might perhaps be appropriate to reduce the dividend pay-out ratio as the
management moves into new growth [Link] will tend to decrease the dividend yield components of
investors’ required rate of return in relation to the growth [Link] assumes that the firm’s
shareholders are basically indifferent about the returns earned by them,either in the form if dividend income
or capital [Link] the investors are not indifferent about payment of dividends or retentions owing to tax
exemptions on dividends, they have preference for current dividends: equity capitalization rate will go up if
current dividends are reduced.

PS 12.4
X Cement Ltd requires you to advise them with respect to the dividend policy they have to follow for the
current [Link] cement industry has been through a very trying period in the last few years, and the
constraints on operations have been removed in the early part in the year. The company hopes to improve its
position in the years to come, and has plans to put up an additional plant in the neighbourhoodof the present
factory. Increased profits, due to expansion in capacity, are expected to be 25 per cent of the additional
capital investment after meeting interest charges but before depreciation on the additional plant installed.
Shares of the company are widely distributed, and there is a large majority of holdings in the hands of
investors, whose average holdings do not exceed 500 shares. The following data is also made available to
you:

Particular Last 5 years current year

________________________________________________
1 2 3 4 5
Earnings per share(Rs) 6 5 4.5 4.5 4 17.5
Available cash per
share(Rs) 7.5 6 5 4 4 20.5
Dividend/share (Rs) 3 3 3 2 Nill ?
Payout ratio (%) 50 60 67 44 __ ?
Average market price
(face value Rs 100) 80 70 70 70 60 140
P/E 13.33:1 14:1 15.6:1 15.6:1 15:1 8:1
What recommendations would you make? Give reasons for your answer.

Solution:
The company should, and appears to be, following a stable dividend policy, that is, a policy of maintaining
a stable rupee dividend. The dividend is reduced only when it appears that earnings have reached a new
permanently lower level. Although the EPS declined from Rs 6 in year 1 to Rs 4.5 In year 3, no
corresponding decrease occurred in the

PS 12.5
X Ltd and Y Ltd are two first growing companies in the engineering industry. There close competitors, and
there asset composition capital structure, and profit ability records have been very similar for several year.
The primary difference between the companies, from a financial management perspective, is there dividend
policy. The X Ltd tries too maintain a non-decreasing dividend per share, while Y Ltd maintains a constant
dividend payout ratio. There recent EPS, DPS, and share price (p) history are as follows:
X Ltd Y Ltd
_________________________________ __________________________________
Year EPS DPS P(range) EPS DPS P (range)
______________________________________________________________________________________
1 Rs9.3 Rs2 Rs75-90 Rs9.5 Rs1.9 Rs60-80
2 7.4 2 55-80 7 1.4 25-65
3 10.5 2 70-110 10.5 2.1 35-80
4 12.75 2.25 85-135 12.25 2.45 80-120
5 20 2.5 135-200 20.25 4.05 110-
225
6 16 2.5 150-190 17 3.4 140-
180
7 19 2.5 155-210 20 4 130-
190
In all calculations below that require a share price, use the average of the two price given in the share price
range.
(i) Determine the dividend pay-out (D/P), and P/E ratios for both companies for all the years.
(ii) Determine the average D/E for both the companies over the period 1 through 7.
(iii) the management Y Ltd is puzzled as to why their share prices are lower than those of X Ltd, in spite of
the fact that its profitability record is slightly better (particularly of past three year) as a financial consultant,
how would you explain the situation?

Solution:
Value of the firm (V) at varying retention ratio
(a) 100% (b) 10% (c) No retention

0.15 0.15
0.15/0.10 𝑅𝑠 2.5+ 5+
P =0 + (𝑅𝑠 5 − 0) P= 0.10
(𝑅𝑠 5 − 2.5)P = 0.10
(𝑅𝑠 5 − 5)
0.10 0.10 0.10

= Rs7.5/0.10 = Rs7.5 = Rs6.25/0.10 = Rs62.50 = Rs5/0.10 = Rs50

V = Rs75 *10,00,000 V = Rs62.50*10,00,000 V = Rs50*10,00,000
shares
= Rs750 lakh = Rs625 lakh = Rs500 lakh
The value of the firm is maximum when retention ratio is 100 percent, it is consistent with Walter Model.
It’s fundamental premise is that who can earn more. If the firm earns a return higher than shareholders earn.
400 per cent retention is suggested and vice versa

PS12.6

The following information available in respect of the rate of return on investment (r) the equity
capitalization rate (ke) and earnings per share (E) of manufacturing company:

r = (a)0.12 (b) 0.11 (c)0.10

ke= 0.11

E = Rs 20

Determine the value of its shares as per gordons model (under conditions of certainty) in each alternative,
assuming the following:
______________________________________________________________________________________

D/P ratio (1-b) Retention ratio (b)

(a) 10 90
(b) 20 80
(c) 50 50
Solution:
Value of shares, alternative (a) r = 12 percent, >ke
a. D/P ratio 0.10, retention ratio 0.90
Br(g) = 0.9*0.12 = 0.108
P= RS 20(1-0.9)/(0.11-0.108) = RS 2/0.002 RS 1000
b. D/P ratio 0.20, retention ratio 0.80
br = 0.8*0.12 = 0.096
p = Rs.20(1-0.8)/(0.11 = 0.096) = Rs 4/0.014 Rs285.71
c. D/P ratio 0.50, retention ratio 0.50
br = 0.5*0.12 = 0.060
p = Rs.20(1-0.5)/(0.11-0.60) = Rs 10/0.05 Rs 200
Value of shares, alternative (b), when k = r = 11 per cent = ke
(a) D/P ratio 0.10, retention ratio 0.90
br = 0.9*0.11 = 0.099
p = Rs.20(1-0.90)/(0.11-0.099) = Rs 2/0.011 Rs 181.82
(b) D/P ratio 0.20, retention ratio 0.80
br = 0.8*0.11=0.088
p = Rs.20 (1-0.8)/(0.11-0.088) Rs 4/0.022 Rs 181.82
(c) D/P ratio 0.50, retention ratio 0.50
br = 0.5*0.11 = 0.055
p = Rs.20(1-0.5)/(0.11-0.055) = Rs 10/0.055 Rs 181.82
Value of shares, alternative (c) , when r = 10 per cent <ke
(a) D/P ratio 0.10 , retention ratio 0.90
br = 0.9*0.10 = 0.090
p = Rs.20(1-0.9)/(0.11-0.090)Rs 2/0.02 Rs 100
(b) D/P ratio 0.20, retention ratio 0.80
br = 0.8*0.10 = 0.08
p = Rs .20(1-0.8)/(0.11-0.80) = Rs 4/0.03 Rs 133.33
(c) D/P ratio 0.50, retention ratio 0.50
br = 0.5*0.10 = 0.050
p = Rs .20(1-0.50)/(0.11-0.050) = Rs 10/0.06 Rs 166.67
PS 12.7

A closely-held plastic manufacturing company has been following a dividend policy which can maximize
the market value of the firm as per Walter’s model. Accordingly, each year at dividend time, the capital
budget is reviewed in conjunction with the earnings for the period and alternative investment opportunities
for the shareholders. In the current year, the firm reports net earnings of Rs500,000. it is estimated that the
firm can earn Rs100,000 if the amounts are retained the investors have alternative investment opportunities
that will yield them 10 percent. The firm has 50,000 shares outstanding. What should be the D/P ratio of the
company if it wishes to maximize the wealth of the shareholders?

Solution:
D/P ratio of the company should be zero because at this ratio, market price of the share would be the
maximum as shown by the following calculations:

𝑟
[𝐷+( )(𝐸−𝐷)]
P= 𝐾𝑒
= [0+0.20/0.10(Rs10-0)/0.10
𝐾𝑒
= Rs20/0.10 = Rs200
Working notes:
r = (Rs100,000/5,00,000) *100 = 20 per cent
E = Rs500,000/50,000 = Rs10

PS 12.8
The cost of capital and the rate of return on investments of WM Ltd. Is 10 per cent and 15 per cent
respectively. The company has 10 lakh equity shares of Rs10 each outstanding and its earnings per share is
Rs5.
Calculate the value of the firm in the following situations using Walter’s model: (a) 100 per cent retention
(b) 50 per cent retention, and (c) no retention. Comment on your result.

Solution:
Value of the firm (V) at varying retention ratios

(a) 100% (b) 10% (c) No retention

0+0.15/0.10(𝑅𝑠5−0) 𝑅𝑆2.5+0.15/0.10(𝑅𝑠5−2.5) 𝑅𝑠5+0.15/0.10(𝑅𝑠5−𝑅𝑠5)

p= ; p= ; p=
0.10 0.10 0.10

= Rs7.5/0.10 = Rs75 = Rs6.25/0.10 = Rs62.50 = Rs5/0.10 = Rs50

V =Rs75*10,00,000 shares V = Rs62.50*10,00,000 shares V = Rs50*10,00,000 shares
= Rs750 lakh = Rs625 lakh = Rs500 lakh

The value of the firm is maximum when retention ratio is 100 per cent. It is consistent with Walter’s model.
Its fundamental premise is that who can earn more. If the firm earns a return higher than the shareholders
earn, 400 per cent retention is suggested and vice versa.
 PS 12.9
(a) From the following information supply to you, ascertain whether the firm’s D/P ratio is optimal
according to Walter. The firm was started a year ago with an equity capital of Rs 20 lakh

Earnings of the firm Rs 2,00,000

Dividend paid 1,50,000
P/E ratio 12.5

Number of shares outstanding, 20,000 @ Rs 100 each. The firm is expected to maintain its current rate of
earnings one investment.
(b) What should be the P/E ratio at which the dividend payout ratio will have no effect on the value of
share.
(c) Will your decision change if the P/E ratio is 8, instead of 12.5?

Solution:
(a) P = [Rs7.5 + (0.10/0.08) * (Rs10 – Rs7.5)]/0.08 = Rs10.625/0.08 = Rs132.81
The firm’s D/P ratio is not optimal at 75% D/P ratio, the price per share is Rs132.81.
The zero per cent D/P ratio would be optimum, as at this ratio the value the share would be maximum as
shown in the following calculations,
P = [0 + (0.10/0.08)*(Rs10 – 0)]/0.08 = Rs12.50/0.08 = Rs156.25
Working notes:
(a) Keis the reciprocal of P/E ratio = 1/0.125 = 8 per cent
(b) EPS = Rs2,00,000/20,000/Rs10
(c) ROI(r) = (Rs2,00,000/Rs20,00,000)*100 = 10 per cent
(d) P/E ratio of 10 times; D/P ratio would have no effect on the value of the share because at this rate Ke = r
(e) Yes, the decision would change if the P/E ratio is 8. This implies that Ke is 12.5 per cent. Since Ke> r,
the 100 per cent dividend payout ratio would maximize the value of the share. P =[10+(0.10/0.125)*(Rs10 –
Rs10)]/ 0.125 = Rs80. At all other D/P ratios, the value would be lower.

PS 12.10
The EPS of a company is [Link] market capitalization rate applicable to the company is 12.5 percent.
Retained earnings can be employed to yield a return of 10 [Link] company is considering a pay-out of
25 percent,50 percent and 75 percent. Which of these would maximize the wealth of shareholder as per
Walter models.

SOLUTION:

Value of the share (p)different pay-out ratios

(a) 25% (b) 50% (c) 75%
Rs.4+[.10/.125](Rs.16-Rs4) Rs.8+[.10/.125](Rs.16-Rs.8) Rs.12+[.10/.125](Rs.16-Rs.12)
P=--------------------------------- P=---------------------------------- P=------------------------------------
0.125 0.125 0.125
Rs4+.8(Rs12) Rs.8+.8(Rs.8) Rs.12+0.8(Rs.8)
=------------------ =Rs.108.8 =------------------ =Rs.115.2 =-------------------- =Rs.121.6
0.125 0.125 0.125
None of the above D/P ratios would maximize the wealth of shareholders. The wealth of shareholders will be
maximum (Rs128)at D/P ratio of 100 percent as shone bello:
Rs[.10/.125](Rs.16-Rs.16)
=--------------------------------- = Rs.128
0.125

PS 12.11:
A textile company belongs to a risk-class for which the appropriate P/E ratio is 10. It currently has 50000
outstanding shares selling at Rs. 100 each. The firm is contemplating the declaration of Rs. 8 divided at the end
of the current fiscal year which has just stated. Given the assumption of MM answer the following questions.

(a) What will the price of the share be at the end of the year.(i) if divided is not declared, and (ii)if it is declared?

(b)Assuming that the firm pays the dividend, has a net income?(y) of Rs.500000 and makes new investment of
Rs. 1000000 during the period. how many new shares must be issued?

(iii)What will the value of the firm be;(a)if dividend is declared ,and (b)if divided is not declared?

SOLUTION:

(i) (a) price, p1 whendivided is not declared

P0=(D1+P1)/(1+KE) or Rs.100=0+P1/(1+0.10)=Rs.110

(b)when dividend is declared.

PriceP0=(d1+P1)/(1+KE)= Rs100= (Rs.8+P1)/ 0.10 =Rs.102

(ii) (a) Amount required for new financing

=1-(y-Nd1)=Rs.1000000-(Rs500000-Rs.400000)=Rs.900000
(b)New shares to be issued
∆n=Rs. 900000/102
(iii) (a) Value of the firm (v) when divided is declared
V=[Nd1+(n+n) P1-1+Y-Nd1]/(1+K8)
=[(Rs.400000+102*(50000+(Rs.900000/102)]-1000000+500000-400000]/1.10
=Rs.5500000/1.10 =Rs.5000000
(b)Value, when divided is not declared
V=[(n+∆n)P1-1+Y)/(1+ke)
=[50000+(500000/110*Rs110)/(1+Ke)]-Rs1000000+Rs500000]/1.10
=[Rs6000000-Rs1000000+Rs500000]/1.10 =Rs5000000

PS 12.12:
An engineering company has a cost of equity capital of 15 percent. The current market value of the
firm is Rs 3000000@30 per share. Assuming values for 1 (new investment) Rs900000,E(earnings)
Rs500000,and D(total dividends)Rs300000. Shows that under the MM assumptions,the payment of
dividend does not affects the value of the firm.
SOLUTION:
(a)price of the share ,p1 when dividend is declared.
P0=D1+P1/(1+K0),Rs30=(Rs3+P1)/1.15 0r Rs34.50 =Rs3+P1 or Rs31.50=P1
P1 dividend is declared;
Rs30=P1/1.15, Rs34.50=P1

(b)Amount of new financing

(i)When dividend is declared (i) When dividend is not declared
I-E-(Nd1) I–E
=Rs900000-Rs 200000= Rs70000 =Rs900000-Rs 500000= Rs400000
∆n=Rs 700000/31.50 ∆n=Rs 400000/Rs 34.50

V, when dividend is declared V,When dividend is not declared

=[Rs300000+31.50*(100000+700000/31.50)- V=[100000+(400000/34.50)*Rs34.50-Rs
900000+500000-300000]/1.15 900000+Rs500000]/1.15
=[Rs300000+Rs3850000-Rs900000+Rs500000- =Rs3850000-Rs 900000+Rs 500000]/1.15
Rs300000]1.15 =Rs3450000/1.15
=Rs3450000/1.15 = Rs3000000 =Rs300000

Thus under MMassumption, dividend does notaffects the value of the firm.

PS 12.13
Arvind ltd belongs to a risk-class for which the appropriate capitalization rate is 10 percent. It currently
has outstanding 25000 shares selling at Rs100 each the firm is contemplating the declaration of
dividend of Rs5 per share at the end of the current financial year. the company expects to have a net
income of Rs2.5lakh and has a proposal for new investment of Rs5 lakh.
Show that under the MM assumption the payment of dividend does not affects the value of the firm. Is
the MMmodel realistic with respect to valuation? What factors might mar its validity?

SOLUTION:
Dividend are paid Dividends are not paid
(a) price of the share at the end of the year (P1): P0=(P1+D1)/(1+KE)
P0=(P1+D1)/ (1+KE) Rs100=(P1+0)/(1+0.1)
Rs100=(P1+Rs 5)/(1+0.1) P1=Rs110
P1=Rs105
(b)Amount require for financing: Rs5 lakh – 2.5 lakh
Rs5 lakh – (Rs2.5 lakh – Rs1.25) =Rs2.5 lakh
=Rs3.75 lakh
(c) Number of shares to be issued: ∆n= Rs 2.5 lakh / 110
∆n=Rs 375000/105
(d)Valuation of the firm (v)
Rs125000+(25000+Rs 375000/Rs105) Rs105-[ (25000+ Rs250000/ Rs105) Rs110- [ Rs5 lakh =
Rs5 lakh + Rs2.5 lakh – Rs1.25 lakh ] / 1.1 Rs2.5 lakh / 1.1
= Rs25 lakh = Rs25 lakh
Since the value of the firm is Rs25 lakh, in both the situation when dividends are paid and when
dividends are not paid. it can be concluded that the payment of dividend does not affects the value of
the firm.
The major factors affecting the validity of MM” model are: (i) tax effect, (ii) flotation cost, (iii)
transaction and inconvenience costs, (iv)Preference for current dividend by investors by and resolution
of uncertainty.