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CHAPTER 15

DIVIDENDS
FOCUS Dividends are central to valuation, yet their effect on stock price is uncertain. Our focus is on understanding that issue, as well as investors' attitudes about dividends. Practical matters including the mechanics of cash dividends, stock dividends and splits, and repurchases are also discussed. PEDAGOGY Dividend issues are straightforward and relatively easy to understand. The subject is effectively covered with plainly written prose. TEACHING OBJECTIVES Students should complete this chapter with an understanding of the role of dividends in financial management. They should particularly appreciate the uncertainty involved in the trade-off between paying dividends and using the cash to enhance a firm's prospects for growth. In addition they should gain a thorough grounding in the following procedural issues: Cash dividend payments Payment Restrictions Dividend policies Stock repurchases Stock splits and dividends Signaling OUTLINE I. BACKGROUND A. Dividends as a Basis for Value The value of stock is based on cash flows which come from dividends. B. Understanding the Dividend Decision How much to pay. Stockholders receive either current cash or potential growth through reinvested earnings.

II. THE DIVIDEND CONTROVERSY Does paying dividends or paying larger dividends affect stock price? Three theories: A. Dividend Irrelevance Dividends viewed as a trade-off between future and present benefits for a wash in present value. Tailoring a cash flow stream to meet current income needs. Practical problems with the concept. B. Dividend Preference A bird in the hand, stockholders know they've got a current dividend, value appreciation is uncertain. C. Dividend Aversion Ordinary income versus capital gains. D. Other Theories and Ideas The clientele effect, dividends as a residual, the signaling effect. E. Conclusion There's no general rule. All the ideas have some validity. III. PRACTICAL CONSIDERATIONS A. Legal and Contractual Restrictions Capital impairment and solvency rules. Restrictive covenants, cumulative preferred stock.

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B. Dividend Policy Payout ratio and dividend stability. Typical policies: target payout ratio, stable dividend per share, small dividend with extras. C. The Mechanics of Dividend Payments Four key dates: declaration, record, payment, and ex-dividend. Reinvestment plans. D. Stock Splits and Dividends Definitions, effects, rationale, accounting. IV. STOCK REPURCHASES A. Repurchase as an Alternative to a Dividend The mechanics and effects of repurchasing shares to accomplish a distribution to stockholders B. Other Repurchase Issues Other reasons to repurchase shares. QUESTIONS 1. Dividends are said to be the basis for the value of stocks. If that's true, how do we explain the fact that companies that pay no dividends often have substantial market value? (Such companies are usually relatively young and in high growth fields.) First explain the phenomenon in terms of the individual valuation model (a stream of dividends followed by a selling price, equation (15-1)). Then reconcile the idea with the whole market model (an infinite stream of dividends). Can you explain cases in which managements claim their companies will never pay dividends? (Hint: Does such a claim make sense?) ANSWER: When a company with positive earnings doesn't pay dividends, the income is reinvested enabling the firm to grow faster in the future. Faster growth implies market price and later dividends may be larger than they would have been had the earnings not been retained. In the context of the individual valuation model, the no-dividend choice implies a trade-off between current dividends and a combination of larger future dividends and stock price appreciation. In the whole market model, the trade-off is between current and future dividends only. Many investors are happy with the prospect of future income substituted for current income and therefore value stocks that don't pay dividends. This is especially true when firms have promising growth opportunities. In such cases, investors expect their future incomes to be much larger that what the firm could pay out currently. Taken as a whole, the investment community simply doesn't believe statements that firms will never pay dividends. If such statements were true, it would be irrational to put any value on the stocks involved, since dividends are the only way firms can pass value back to investors. 2. Given the importance of dividends to the well-being of equity investors, why do they put up with the fact that dividends are discretionary? ANSWER: The discretionary nature of dividends is part of the risk that comes along with the expectation of higher returns. A discretionary dividend may be lowered or held constant, but also may be raised, and that's what appeals to investors. 3. Fully explain the choices implied by the dividend decision. Are the results of the choices known or uncertain? ANSWER: The dividend decision involves the choice between paying earnings out as dividends or retaining them for reinvestment. To the extent earnings are reinvested, the firm is expected to grow

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faster making its stock more valuable. Hence, the dividend decision involves management's choice about what to do with the stockholders' income. It can be paid out currently as an immediate benefit, or retained to provide a deferred benefit. There is uncertainty in the decision because the future benefit of increased value can never be guaranteed. 4. There is said to be a controversy over dividends. What is it and why is it important?

ANSWER: The dividend controversy is over whether or not paying dividends out of positive earnings makes a difference in stock price. That is, whether investors are sensitive to the difference between current income received from dividends and the deferred income implied by the price appreciation associated with retaining earnings. The issue is important because it bears on management's most important goal of maximizing shareholder wealth through stock price. 5. You're an investment advisor, and have several well-off older people among your clients. One of these individuals, Charlie Haverty, steadfastly refuses to invest in companies that pay significant dividends. A successful investment counselor advised him to avoid such stocks in 1965, and he's stuck to that view ever since. However, he never really did understand the reasoning behind the advice. How would you advise Charlie today? Include an explanation of why the advisor said what he did in 1965, and whether it was better advice then than it is now. ANSWER: There are two possible reasons for the 1965 advice. The first has to do with taxes. At that time marginal tax rates for the wealthy were much higher than they are today, and capital gains received very favorable tax treatment (rates as much as 60% below ordinary rates). Therefore, it made sense for wealthy people to seek investments in which the returns came from price appreciation (taxed as capital gains) rather than dividends (taxed as ordinary income). Today that incentive isn't nearly as strong, because top rates are lower and the preferential treatment of capital gains is much less significant. The second reason for the 1960's advice has to do with age-related investment strategies. No (or low) dividend stocks are often high risk-high reward issues. Investment advisors frequently put younger clients into such stocks, because they have a lifetime to recover from losses. Older clients tend to be put into stable, conservative issues that usually pay at least half of their earnings in dividends. The 1965 advisor may have been basing his recommendation on the tax issue or the fact that Charlie was relatively young then. The tax code has changed and Charlie is no longer young. Hence he should be advised to abandon the strategy of avoiding dividends. 6. You're a financial analyst for a large mutual fund. You're doing an analysis of the Truebright Apparel Company, which makes stylish cotton clothes for teenagers. The company has recently been under attack by foreign competition, and seems to have lost its edge in the fashion market. EPS fell from $2.00 to $1.80 and then down to $1.20 over the past three years. However, dividends were steady at $1.00 per share in spite of the declining earnings, and last year the dividend was raised to $1.50. Why do you think the dividend was maintained and then raised? How would this affect your recommendation? ANSWER: Maintaining the dividend in the face of declining earnings was probably an attempt by management to signal to investors that the firm's problems were temporary, and that a recovery was expected. Raising the dividend in the face of a continuing decline seems to be an attempt to send a stronger message to the same effect. In this case the last signal appears to contain an element of desperation and might therefore affect an analyst's opinion negatively.

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BUSINESS ANALYSIS 1. You're the treasurer of SuperTech Inc., a high technology firm in the fast growing computer business. The management team has recently been trying to decide on a long-term dividend policy. Earnings are good, but the firm has far more investment opportunities than income. There's no doubt that the company will need to sell more equity in the near future to fund its growth. Therefore management wants to do everything possible to maximize stock price including making the right dividend decision. This morning the chief engineer, Susan Mathematica, came into the meeting and professed to have the answer to the firm's problems. She said she's been taking a high-powered finance course at night, and that her instructor assured her that dividends don't matter to stock price. According to Susan, that's because investors are perfectly capable of tailoring their own income stream from any investment. Therefore, she suggests not paying any dividends and using the money for projects. How would you respond to Susan's suggestion? Do you think she's missed part of her instructor's message? Is it possible that her suggestion is right, but for the wrong reason? What would you recommend that SuperTech do? ANSWER: Susan has taken some theory out of context. Theoretically investors can tailor an income stream by selling off shares of stock to make up for the current income lost if dividends aren't paid. In practice, however, transactions costs, especially brokerage commissions, limit this ability. Further, real investor's don't like going to the trouble of selling off shares little by little. The instructor will probably get to these points in the next lecture. However, Susan's suggestion is likely to be right for a different reason. In high growth situations many firms don't pay dividends, because the money can be used to fund high return projects. Stockholders don't mind because they get a big growth in stock price in return for foregoing dividends. In fact, high risk - high return companies like SuperTech generally attract the kind of investor that doesn't require dividends but is more interested in price appreciation. An appropriate policy for SuperTech would probably be to pay no dividends or very small ones while high growth opportunities exist reviewing the situation periodically. 2. The Tanglefern Corporation has traditionally paid out 60% of its earnings in dividends. Recently some marvelous growth opportunities have arisen that involve only a little risk but require a lot of cash. Most of the executive team thinks the firm should do two things to raise the cash needed to take advantage of the opportunities. They want to (1) sell more stock and (2) suspend dividend payments for two to three years. The dividend suspension would be accompanied by an explanation to stockholders of what was going on. You're the company's CFO. Prepare a response to the others' suggestion. Do the two proposed actions taken together create a particular problem? ANSWER: Executive Staff: The two-part proposal to sell stock and suspend dividends creates a financial problem. Since we've been paying a substantial dividend for a long time, we've attracted a stockholder group that likes the current income derived from the payments. Indeed, many probably need their quarterly Tanglefern dividend to live comfortably. The fact that companies attract investors who like their particular dividend paying policies is well known and is called the "clientele effect." The result of the clientele effect is that if a firm like Tanglefern suspends dividends, it upsets most of its stockholders who are then likely to dump their stock. That depresses its market price. This means if we try to sell new shares at the same time we suspend dividends, we're likely to get a lot less for them than we would if we didn't suspend dividends at the same time. Hence I recommend that we either sell new stock or suspend dividends, but not do both at the same time.

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3. You're a bank officer considering making a loan to small family-owned company. The firm's principal owner is a hard-working, conservative woman who has built up the company over a number of years. However, two of her grown children are now active in the company's management. They're both bright and hard-working, but have a reputation for taking business risks as well as for extravagant living. You'd like to make the loan, but are concerned about a potential change in the character of the company. How might you make the loan and still protect your bank's investment? ANSWER: Include restrictive covenants in the loan agreement that limit payments of any kind (mainly salary or dividends) to the principal owners while the loan remains outstanding. Also include limits on the risks the firm can undertake by requiring bank approval of substantial new projects. Require minimum levels of performance on key ratios and measures. Secure the loan with marketable assets and stipulate the conditions constituting default carefully. Stipulate that if default occurs, the bank takes control of the company until the loan is satisfied. If default occurs, act promptly to take control. 4. Your pal, Fred Flinderbinder, came into class this morning grinning from ear to ear. It seems a stock in which he advised his parents to invest is doing fabulously well. Fred said the firm usually pays a dividend of $2.00 a share, which is about 4% of its recent $50 market price. Yesterday, however, his folks got a letter that said the cash dividend was being passed, but instead the firm was issuing a stock dividend of one share for every 10 owned. Fred calculates that's worth the equivalent of $5 a share, two and a half times the normal cash dividend! Fred has told you all this knowing you're taking finance. He's asked you what you think obviously expecting praise and approval. What would you say to Fred? ANSWER: Fred, old buddy, you've got the wrong idea. A stock dividend gives extra shares to existing shareholders but increases the overall number of shares outstanding by the same proportion. Since the company isn't worth any more by virtue of the dividend, nobody has actually gotten anything. In other words, the value of the existing shares decreases by an amount exactly equal to the value of the new shares issued. The bad news is that if the stock dividend accompanied a passing of a cash dividend, it could be an attempt to disguise the fact that the company is in trouble. The firm may not have the cash to make the regular dividend payment, but wants to give a prosperous impression, so it gives something that doesn't cost anything. 5. Blazingame Mill Works recently sold a tract of land it owned for 30 years. All expenses and taxes have been paid, and the company has $10 million sitting in the bank as a result of the sale. As there aren't any pressing investment opportunities available, and the board would like to distribute the money to shareholders. Most of the board members are high-income individuals and major stockholders themselves. Discuss the company's options for disposing of the money. ANSWER: Blazingame can pay the money to its shareholders as a special, one-time dividend. That, however, would create a current tax liability for each stockholder based on ordinary income tax rates. Alternatively the firm could repurchase and retire some of its own stock. Stockholders who sell would be subject to a capital gains tax on any appreciation of their shares since the time they were purchased. After the repurchase, remaining shares would represent proportionately more of the company, and can be expected to rise in value. There would be no tax on this increase in value until those shares are sold. Then the tax would be at capital gains rates (unless the repurchase is challenged by the IRS as a dividend in disguise, which is unlikely if it's only done once).

PROBLEMS
Dividends and Ratios: Example 15-1 (page 651)

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1. The Argo Pamphlet Companys dividend payout ratio is 35%. It is currently paying an annual dividend of $1.30. a. What is Argos EPS? b. What is the market price of Argos stock if its P/E ratio is 14? c. How much current income per share will stockholders lose if Argo cuts its payout ratio to 20% and nothing else changes? d. If the change in payout ratio does not affect the stocks price, approximately how many shares would a stockholder who owns 1,000 shares have to sell to make up her loss in current income? Ignore tax effects and transaction costs. SOLUTION: a. Payout ratio = Total Dividends / Earnings or on a per share basis Payout ratio = Dividends per Share / EPS .35 = $1.30 / EPS EPS = $1.30 / .35 = $3.71 b. P/E = P0 / EPS 14 = P0 / $3.71 P0 = $51.94

c. The new dividend will be Dividends per Share = EPS Payout ratio = $3.71 .20 = $.74 The loss in current dividend income per share is then $1.30 $.74 = $.56 d. The stockholders dividend income loss would be $.56 1,000 = $560.00 $560.00 / $51.94 = 10.78 Hence the stockholder would have to sell about 11 shares.

Dividend Irrelevance and Taxes: Example 15-2 (page 653)


2. Richard Ingram just bought 1,000 shares of Sisson Electronics at $40 per share. He plans to hold the stock for one year before selling. Sisson is in the process of selecting a new dividend policy. The firm will either pay out all of its earnings in dividends or retain and reinvest them all. Analysts expect the stock to be worth $45 in one years time if no dividends are paid and $40 if dividends of $5 per share are distributed. Assume Richards marginal tax rate on ordinary income including dividends is 33%, and the capital gains rate is capped at 20%. a. How much difference will Sessions decision make in Richards after-tax income? b. Compare the results of part a. with the results under the tax code in effect in mid 2009 as described on page 48. c. Calculate Richards pre-tax and after tax returns under both of Sissons possible policies. (Assume the hypothetical tax rates in the problem.) d. What after tax rate of return would make Richard indifferent between the two policies? SOLUTION: a. Richard will either have a (1,000 x $5=) $5,000 capital gain or dividend income of the same amount. If Session pays a dividend and its taxed as ordinary income hell pay tax of

Dividends .33 x $5,000 = $1,650. If no dividend is paid hell pay capital gains tax of .20 x $5,000 = $1,000 Difference $ 650 b. Under the code provision still in place in 2009, the rates on capital gains and dividend income are both capped at 15%, so in either case he would pay .15 x $5,000 = $ 750 c. Pre Tax Richard receives income of $5 under both policies so his return is $5 / $40 = .125 = 12.5% After Tax Dividend only policy Dividend $5(1 - .33) = $5 (.67) = $3.35 After tax return on dividend $3.35 / $40 = .08375 = 8.375% Growth only policy Capital gain $5 (1 - .2)= $5 (.8) = $4 After tax return on capital gain $4 / $40 = .10 = 10%

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d. The capital gain required to yield an after tax profit of $3.35 under the growth-only policy with a tax rate (T) of 20% is $3.35 / (1-T) = $3.35 / .8 = $4.19 To achieve that pre tax capital gain the stock would only have to increase in value from $40 to $44.19 in one year. Hence $40 (1+g) = $44.19 Solving for g (1+g) = $44.19 / $40 = 1.10475 g = 1.10475 - 1 = .10475 = 10.0475%

Tailoring the Income Stream: Example 15-3 (page 655)


3. Randal Flapjack is a retired short-order cook living on a fixed income in the state of Utopia where all financial markets are perfectly efficient. Randal has 20,000 shares of the Sugarcooky Corp., which pays an annualized dividend of $1.00 per share. Sugarcooky sells at a P/E of 10, has maintained a payout ratio of 50% for many years, and has not grown in some time. Management has recently announced that it will reduce Sugarcooky's payout ratio to 25% but expects earnings to grow at 5% from now on. a. What is Sugarcooky's current price? b. How much current income is Randal losing as a result of management's action? c. If Randal keeps his money in Sugarcooky but needs to maintain his current income, how many shares will he have to sell in the first year? d. What will be the value of his remaining shares at the end of a year if the P/E remains the same? Is his investment growing? Why? SOLUTION: a. Payout ratio EPS P = 50%, Dividend = $1.00 = $1/.50 = $2 = EPS P/E = $20

107 b. c. d.

Chapter 15 D = $2.00 .25 = $0.50, a reduction of $0.50 per share. $.50 20,000 = $10,000 $10,000 / $20 = 500 shares New EPS = $2 1.05 = $2.10 P = EPS P/E = $2.10 10 = $21 New value = 19,500 $21 = $409,500 Old value = 20,000 $20 = $400,000 Growth in investment =$ 9,500

The stock's value is increasing at 5%, but Randal sold off only 2.5% of his shares, his net investment is therefore growing. 4. Biltmore Industries has grown at an average of 6% per year over its long history. Its stock price is currently $40 and its most recent dividend was $2.50. Biltmore just announced that it plans to discontinue dividends for several years to take advantage of some growth opportunities. Analysts expect the stock price to increase by 10% per year for at least the next two years because of this growth. Elmer Bartlett owns 4,000 shares of Biltmore and has counted on their dividend payments to supplement his retirement income. Now it appears that he will have to start selling off his Biltmore stock to replace this lost income. How many shares of stock will Elmer have to sell in each of the next two years to replace his lost dividend income? Ignore taxes and transaction costs. SOLUTION: Year 1 Dividend Year 2 Dividend Year 1 Stock Price Year 2 Stock Price Year 1 Sale Year 2 Sale 4,000 x $2.50 x 1.06 = $10,600 4,000 x $2.50 x (1.06)2 = $11,236 $40 x 1.1 $40 x (1.1)2 $10,600/$44 $11,236/$48.40 = $44.00 = $48.40 = 241 shares = 233 shares

The Residual Dividend Theory: Example 15.4 (page 658)


5. The Holderall Rope and Yarn Co. has 2 million common shares outstanding. Its capital structure is two-thirds equity. The firm expects earnings of $10 million next year, and anticipates capital spending of $12 million on projects. How much will the per-share dividend be next year if the firm adheres to a residual dividend policy? SOLUTION: Capital spending is $12M, two-thirds of which will be equity financed, hence $8M of the earnings will be spent on the capital program. The remaining ($10M $8M=) $2M is the residual available for dividends. The per share dividend is then D = $2M/2M shrs = $1.00 per share.

Dividend Reinvestment Plans: Example 15-5 (page 664)


6. The Montauk Company has a dividend reinvestment plan in which shareholders owning 25% of its common stock participate. Last year the firms EPS was $4.20 and its payout ratio was 50%. There are 2 million shares of common stock outstanding. How much new capital did Montauk raise through the reinvestment program?

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SOLUTION: Earnings = EPS x number of shares = $4.20 2M = $8.4M Dividends = earnings x payout ratio = $8.4M .50 = $4.2M Reinvested = dividends x participation = $4.2 .25 = $1.05M 7. Segwick Petroleum Ltd. has a dividend reinvestment plan in which new stock is issued to participating investors. Segwick's payout ratio is 40%, and 30% of stockholders participate in the plan. The firm's ROE is 10%. What percentage increase in flotation-cost-free equity capital does the plan provide? SOLUTION: Earnings are 10% of equity 40% of 10% = 4% is paid out 30% of 4% = 1.2% is reinvested 8. Harrison Hardware anticipates $2 million in net income next year and a 20% participation in the firms dividend reinvestment plan. Management expects to spend $2.375 million on new capital projects, and maintain the current capital structure which is 64% equity without issuing new stock. What dividend payout ratio has Harrison included in its plan for next year?

SOLUTION: Of the $2.375 million capital program for next year, $2.375 x .64 or $1.52 million will have to come from equity, which will be sourced from retained earnings and dividend reinvestment. d = Dividend Payout Ratio [$2.0 million x (1 d)] + [20% x $2.0 million x d] = $1.52 million 2 2d + .4d = 1.52 1.6d = .48 d = .3 = 30% Dividend Payout Ratio

Stock Splits: Basics (page 665)


9. You own 1,000 shares of Jennings Corp. stock, which is currently selling for $88.00. Calculate the number of shares you would own and the stocks market price after each of the following stock splits. A two-for-one stock split A three-for-one stock split A three-for-two stock split A three-for-four reverse stock split A five-for-three stock split

a. b. c. d. e.

SOLUTION: a. b. 1,000 x 2 = 2,000 shares $88/2 = $44 1,000 x 3 = 3,000 shares

109 $88/3 = $29.33 c. d. e. (3/2) x 1,000 = 1,500 shares (2/3) x = $58.67 (3/4) x 1,000 = 750 shares (4/3) x $88 = $117.33 (5/3) x 1,000 = 1,666 shares (3/5) x $88 = $52.80

Chapter 15

Accounting for Stock Splits and Dividends: Tables 15-1 15-3, (pages 666-667)
10. The Addington Book Company has the following equity position. The stock is currently selling for $3 per share. Common Stock (8 million shares outstanding, $2 par) .$16,000,000 Paid in Excess................................ 4,000,000 Retained Earnings.............................12,000,000 Total Common Equity............................$32,000,000 Book Value per share............................$4.00 a. What was the average price at which the company originally sold its stock? b. Reconstruct the equity statement above to reflect a four-for-one stock split. c. Reconstruct the statement to reflect a 12.5% stock dividend. SOLUTION: a. Amount paid for 8M shares: Par $16M Excess 4M $20M Original price = $20M/8M shares = $2.50 per share. b. Common Stock (32 million shares outstanding, $.50 par)...$16,000,000 Paid in Excess.................................. 4,000,000 Retained Earnings...........................12,000,000 Total Common Equity..............................$32,000,000 Book Value per share..................................$1.00 Additional shares = 8M 12.5% = 1M Added par value = $2.00 1M = $2.0M Added paid in Excess = $1.00 1M = $1.0M Retained Earnings reduced by $3.0M Common Stock (9 million shares outstanding, $2 par)...$18,000,000 Paid in Excess................................ 5,000,000 Retained Earnings.............................. 9,000,000 Total Common Equity............................$32,000,000 Book Value per share............................$3.56

c.

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11. Seinway Corp. just declared a 10% stock dividend. Before the dividend the stock sold for $34 per share and the equity section of the firms balance sheet was as follows: Common stock (10,000,000 shares, $.50 par) $ 5,000,000 Paid in excess 56,000,000 Retained earnings 87,500,000 Total $148,500,000 Restate the equity accounts and estimate the stocks price after the dividend. SOLUTION: A 10% stock dividend requires issuing 1,000,000 new shares at a par value of $.50. The common stock account will increase by the par value of the new shares or $500,000 to $5,500,000. The paid in excess account will increase by the remainder of the market value of the new shares as if they were sold. Thats $33.50 per share or ($33.50 x 1,000,000 =) $33,500,000 raising the paid in account to ($56,000,000+$33,500,000=) $89,500,000. Both of these increases come out of the retained earnings account which becomes ($87,500,000 $34,000,000 =) $53,500,000. Hence the new equity section will be: Common stock (11,000,000 shares, $.50 par) Paid in excess Retained earnings Total 5,500,000 89,500,000 53,500,000 $148,500,000 $

If the firms market value remains unchanged through the stock dividend at ($34 x 10,000,000 =) $340,000,000, the new price will be $340,000,000 / 11,000,000 shares = $30.91. As a practical matter, many would simply say that the stocks price should decrease by approximately 10% to (.9x$34=) $30.60. 12. a. b. c. Wysoski Enterprises is considering a stock dividend. The firms capital includes 3 million shares of $1 par value stock issued at an average price of $8. Retained earnings total $20 million. State the equity accounts now and after each of the following possible stock dividends. Wysoski declared a 5% stock dividend and the current price of the stock is $15 Wysoski declared a 10% stock dividend and the current price of the stock is $20 Wysoski declared a 15% stock dividend and the current price of the stock is $23

SOLUTION: Equity Accounts Now Common Stock (3,000,000 shares @ $1 par) Excess (3,000,000 x $7) RE a. new shares = 3,000,000 x .05 = 150,000 Common Stock (3,150,000 shares @ $1 par) Excess ($21M + 150,000 x $14 = $21M + $2.1M =) RE ($20M - $150,000 2.1M =) new shares = 3,000,000 x .10 = 300,000 Common Stock (3,300,000 shares @ $1 par) Excess ($21M + 300,000 x $19 = $21M + $5.7M =) RE ($20M - $300,000 5.7M =)

$ 3,000,000 21,000,000 20,000,000 $44,000,000 $ 3,150,000 23,100.000 17.750,000 $44,000,000 $ 3,300,000 26,700.000 14.000,000

b.

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c.

new shares = 3,000,000 x .15 = 450,000 Common Stock (3,450,000 shares @ $1 par) Excess ($21M + 450,000 x $22 = $21M + $9.9M =) RE ($20M - $450,000 9.9M =)

$ 3,450,000 30,900.000 9,650,000 $44,000,000

13. The Alligator Lock Company is planning a two-for-one stock split. You own 5,000 shares of Alligator's common stock that is currently selling for $120 a share. a. What is the value of your Alligator stock now, and what will it be after the split? b. Alligator's CFO says that the value of the shares will decline less than proportionately with the split because the stock is now out of its trading range. If the decline is 45% how much will the split make you? SOLUTION: a. Now 5,000 $120 = $600,000 After 10,000 $ 60 = $600,000 b. 45% decline implies new P = $120(1 .45) = $66 Value = 10,000 $66 = $660,000 gain = $60,000

Stock Repurchases: Example 15-6 (page 668)


14. The Featherstone Corp. has $8M in cash for its next dividend but is considering a repurchase instead. Featherstone has 10M shares outstanding, currently selling at $40 per share. The P/E is 20 on EPS of $2. a. If the dividend is paid how large will it be per share? b. If stock is repurchased how many shares will remain outstanding and what will the new EPS be? c. If the P/E holds at 20, what will be the new stock price and how much per share will continuing stockholders have gained? How does that compare with the dividend that could have been paid? d. Are there other considerations (words only)?

SOLUTION:
a. b. Dividend = $8M / 10M shares = $.80 per share Shares purchased = $8M / $40 = .2M Remaining shares 10M .2M = 9.8M Earnings = Current EPS Shares = $2 10M = $20M New EPS = $20M / 9.8M = $2.04 New Price = New EPS P/E = $2.04 20 = $40.80 Gain = $40.80 $40.00 = $.80

c.

d. Yes. The gain is in share price rather than cash, so it isnt available as current income to stockholders without selling some shares. If thats done the gain will probably be taxed as a capital gain rather than as ordinary income. This is a favorable result as long as Featherstone hasnt done repurchased stock often. Finally there is some risk that the P/E wont remain constant through the repurchase.

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15. Parnell Bolts Inc. has 20 million common shares outstanding and net income of $30 million. The stock sells at a P/E of 15. The company has $5 million available to pay the next quarterly dividend, but is considering a repurchase instead. a. If Parnell pays the cash dividend, what will be its dividend yield on an annualized basis? b. How many shares will be redeemed if the repurchase option is chosen and the stock is acquired at market value? c. What will be the EPS after the repurchase if earnings remain unchanged? d. What will be the new stock price if the P/E remains unchanged? SOLUTION: a. EPS = $30M/20M shares = $1.50 P = EPS P/E = $1.5 15 = $22.50 Dividend per share = $5M/20M shares = $.25 Dividend yield = $.25/$22.5 = 1.11% per quarter 4 = 4.44% annualized b. c. d. $5M/$22.50 = 222,222 shares New # shares = 20,000,000 222,222 = 19,777,778 EPS = $30M/19,777,778 = $1.5169 P = EPS P/E = $1.5169 15 = $22.75

The Opportunistic Repurchase: Example 15-7 (page 670)


16. Tydek Inc. just lost a major lawsuit and its stock price dropped by 40% to $6. There are 3.5 million shares outstanding with a book value per share of $10. The company has $5 million in cash readily available. The CFO feels the decline in price is temporary and the firm's stock is an excellent investment at this time. If Tydek spends the entire $5 million on its own stock, and the market to book value ratio returns to its former level, how much more will each remaining share be worth than it was before the temporary price decline? SOLUTION: Previous price = $6/.6 = $10 = Book value, so book to market value ratio is 1.0, and total Book Value = $10 3.5M shares = $35M. Shares purchased = $5M/$6 = 833,333 Remaining shares = 3,500,000 833,333 = 2,666,667 New book value = $35M $5M = $30M New book value per share = $30M/2,666,667 = $11.25 If the book to market value ratio returns to 1.0, new P = $11.25 and per share price increase is $1.25. 17. The stock market is generally depressed, and the price of Westin Metals Inc.s common shares has been below its historic average value for some time. The shares are trading at $35 which represents a P/E of 19 on earnings of $7,000,000. Before the current slump, Westin generally maintained a P/E of at least 24. Despite the general downturn, the firm is doing well, and the CFO is considering an equity repurchase to enhance the position of stockholders who retain their shares when the market recovers. She has identified a piece of real estate the company owns but isnt using, which was purchased 20 years ago for $2,000,000 and can be sold for $9,000,000 today. Using the proceeds of such a sale would

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make it possible to do the repurchase without impacting dividends or the capital budget. The CFO has asked you to quantify the effect of her plan on stock price, and make a recommendation as to whether she should present it to the Board of Directors. Assume it takes two years for the market to recover and that Westins P/E returns to 24 at that time. Also assume earnings grow at 5% per year until then and the companys marginal tax rate is 37%. (Round any number of shares calculations to the nearest 1,000 shares.) SOLUTION: First calculate the number of shares outstanding (# Shrs): P/E = P / EPS EPS = $35 / 19 = 1.8421 EPS = EAT / # Shrs # Shrs = $7,000,000 / 1,8421 = 3,800,011 use 3,800,000 Next calculate cash available from land sale Sale proceeds Basis Accounting profit Tax @ 37% Cash available $9,000,000 2,000,000 7,000,000 2,590,000 $4,410,000

Number of shares repurchased = $4,410,000 / $35 = 126,000 shares Number of shares remaining = 3,800,000 126,000 = 3,674,000 Earnings after two years = $7,000,000 (1.05)2 = $7,717,500 EPS with repurchase = $7,717,500 / 3,674,000 = $2.1006 Stock price with repurchase = $2.1006 x 24 = $50.41 EPS without repurchase = $7,717,500 / 3,800,000 = $2.0309 Stock price without repurchase = $2.0309 x 24 = $48.74 Increase in stock price from repurchase = $50.41 - $48.74 = $1.67 % increase $1.67 / $48.74 = 3.4% The impact on stock price is relatively small. It is within the short term variation seen in most stocks on a monthly basis. Therefore the CFO should be cautious about making her proposal to the Board as it may generate expectations that wont be met. It might be especially ill advised if selling the land is difficult or if there is a potential use for it in the future.