Copyright © 2009 MeGraw- Solutions for Chapter 16 Payout Policy May 7: Declaration date June 6: Last with-dividend date June 7: Ex-dividend date June 11: Record date July 2: Payment date ‘The stock price will fall on the ex-dividend date, June 7. The price falls on this, day because, as the stock goes ex-dividend, the shareholders are no longer entitled to that dividend. ‘The annual dividend is $.075 x 4 = §.30. The dividend yield is $.30/S27 = OU = 11% “The payout ratio is $.30/S1.90 = 158 = 15.8% ‘A 10 percent stock dividend is equivalent to a 1.10 for 1 stock split. Shares outstanding increase by 10%, while the firm’s assets are unchanged. The stock dividend therefore will reduce the stock price to $27/1.10 = $24.55. True. True. True, The effective rate can be lower than the stated rate because the realization of gains can be deferred, which reduces the present value of the tax obligation. ‘True. Canadian corporations are not taxed on dividends received from other ‘Canadian corporations. ‘The stock price will fall to $40 x 4/5 = $32. ‘The stock price will fall by a factor of 1.25 to $40/1.25 = $32. A share repurchase will have no effect on price per share. 16-1 ll Ryerson Limited4, Your dividend income will increase from $750 to $1000. If you view the dividend as excessive, you can invest the extra $250 in the firm. Use part of the dividend proceeds to buy 5 shares of stock at $50 per share. When the stock goes ex-dividend, the share price will fall by $1.00 instead of $.75, but you will increase the number of shares you hold, and thereby offset the impact of the higher payout policy. 5. ‘The manager cannot be correct. If all shareholders have the right to buy additional shares at the deep discount, then none of them individually can benefit. As the additional shares are sold at below-market prices, the share price will gradually fall, precisely offsetting the value of the discount. This is analogous to the firm issuing tights to existing sharcholders to buy additional shares at a discount. (See Chapter 14.) The value of the right is offset by the fall in the share price. The firm cannot create value by selling discounted shares. One benefit of the program that the manager does not mention is that if the DRIP clicits a significant cash inflow, the firm may not need to issue equity in the future, thereby saving the costs of a future equity issue. 6. The high rate of share repurchase at a time of low dividend payout rates probably ‘was not a coincidence. Instead, it seems likely that firms were using share repurchase as an alternative to increasing dividends. 7. First, this statement violates the notion of efficient markets. One cannot identify “the bottom of the market” until after the fact. In addition, ifthe firm pays a cash dividend, and 1 do not use my proceeds to purchase shares in the firm, then I have in effect reduced my investment in the firm: the value of my shares falls. This is no different from the situation I would face if I had sold enough shares to raise the same amount of cash, 8. a, P-=$1,000,000/20,000= $50 ‘The price tomorrow will be $I per share lower, or $49. 9. a. After the repurchase, the market value of equity falls to $980,000, and the number of shares outstanding falls by $20,000/$50 = 400 shares to 19,600 shares. Price per shate is $980,000/19,600 = $30, unchanged. An investor who starts with 100 shares and sells two shares to the company ends up with $4,900 in stock and $100 in cash, for a total of $5,000. 16-2 Copyright © 2009 McGraw-Hill Ryerson Limited10. Mu. 12, 13, b. If the firm pays a dividend, the investor would have 100 shares worth $49 each and $100 cash, for a total of $5,000. This is identical to the investor's position after the stock repurchase. ‘A.2 percent stock dividend will have no cash implications. The total market value of equity will remain $1,000,000, and shares outstanding will increase to 20,000 x 1.02 = 20,400. Price per share will fall to $1,000,000/20,400 = $49.02. The investor will end up with 102 shares worth 102 x $49.02 = $5,000. The value of the position is the same as under the cash dividend or repurchase, but the allocation between shares and cash differs. Compare a $10 dividend to a share repurchase, After the first $10 cash dividend is paid (at the end of the year), the shareholders can look forward to a perpetuity of farther $10 dividends. The share price in one year (just after the firm goes ex- dividend) will be $100, and the investors will have just received a $10 cash dividend. If instead the firm does a share repurchase in year 1 (just before the stock would have gone ex-dividend), the share price would be $110 (representing the value of @ perpetuity due, with the first payment coming immediately). For $10 million, it could repurchase 90,909 shares. After the repurchase, the total value of outstanding shares will be $100 million, exactly the same as if the firm had paid out the $10 million in a cash dividend. With only 909,091 shares now outstanding, each share will sell for: $100 miflion/909,091 shares = $110. Thus, instead of getting a $10 dividend, shareholders sce the value of each share increase by $10. In the absence of taxes, they are indifferent between the two outcomes. a, The after-tax value of the dividend to sharcholders equals $2 x (1 — .28) = $1.44. This is the amount by which the stock price ought to fall when the stock goes ex- dividend. The only difference in the share price before and after the ex-dividend moment is the claim to the (after-tax) dividend. b. Nothing special should happen when the cheques are sent out, The claim to the dividend is determined by who owns the shares at the ex-dividend ‘moment. By the time of the payment date, stock prices already reflect any impact of the dividend. a. 1000 x 1.25 = 1250 shares Price per share will fall to $50/1.25 Value of equity initially is 1000 x $5 50,000. 163 Copyright © 2009 McGraw-Hill Ryerson Limited14. 15. It remains at 1250 x $40 = $50,000. AS for4 split will have precisely the same effect on price per share, shares held, and the value of your equity position as the stock dividend. In both cases, the number of shares held increases by 25%. After the dividend is paid, total market value of the firm will be $90,000, representing $45 per share. In addition, the investor will receive $5 per share. So the value of the share today is $50. Dividend Income = $5.00 Grossed Up Dividend = 1.25 x $5.00 = $6.25 Gross Federal Tax = 0.26 x $6.25 = $1.625 Less: Federal Dividend Tax Credit = 0.1333 x $6.25 = $0.833 Net Federal Dividend Tax = $0.792 Gross Provincial Tax = 0.1339 x $6.25 = $0.837 Less: Provincial Dividend Tax Credit = 0.051 x $6.25 = $0.319 Net Provincial Dividend Tax = $0.518 ‘Net Tax on Dividend Income = $1.31 After-Tax Dividend Income = $3.69 : $1.31 Dividend Tax Rate = <7 «100 = 26.2% If the dividend is taxed at 26.2 percent, then the investor will receive an after- tax eash flow of $5 (1 - 0.262) = $3.69, so the price today will be only $45 + $3.69 = $48.69. This is less than the price in “a” by the amount of taxes, investors pay on the dividend. ‘The repurchase will have no tax implications. Because the repurchase does not create a tax obligation for the shareholders, the value of the firm today is the value of the firm’s assets, $100,000, divided by 2000 shares, or $50 per share. ‘The firm will repurchase 200 shares for $10,000. After the repurchase, the stock will sell at a price of $90,000/1800 = $50 per share, the same as before the repurchase. An investor who owns 200 shares and sells 20 shares to the firm will receive 20 x $50 = $1000 in cash and be left with 180 shares worth $9000, for a total value of $10,000. In the absence of taxes, this is precisely the cash and share value that would result if the firm paid a $5 per share cash dividend. If the 16-4 Copyright © 2009 McGraw-Hill Ryerson Limited16. 1. firm had paid the dividend, the investor would have received a cash payment of 200 x $5 = $1000, and each of the 200 shares would be worth $45, as we found in Problem 14.a, We compute the value of the shares once the firm announces its intention to pursue a stock repurchase or pay a dividend, and investors can calculate the after-tax value of the shares. Ifthe firm pursues a share repurchase, today’s share price is $50, and the value of the firm is $50 x 2000 = $100,000. If instead the firm pays a dividend, the with-dividend stock price is $48,692 (see Problem 14.c) so the value of the firm is only $97,384. This is $2616 less than the valuc that would result if the firm pursued a share repurchase. The $2616 difference represents the taxes that will be paid on the $10,000 in dividends ($5 per share x 2000 shares). Price = PV(after-tax dividend plus final share price) $2(1 = 28) +820 _ = it6 =$19.49 Dividend + Capital gain _ $2+ ($20- $19.49) _ 19 _ Before tax return = Price $19.49 12.9% : (1 = 28) + Price = PV(after-tax dividend plus final share price) = $30. —28) + $20 $20.15 — Dividend + Capital gain _ $3 + ($20- $20.15) _ 4 _ betwen r= Didnt Calin 52+ (20-82019) 4). 14.1% ‘The before-tax return is higher because the higher dividend creates a greater tax burden. The before-tax return must rise to provide the same after-tax return of 10%. a, You could find relevant information by using Yahoo or Google. For instance, a search on Google in June 2008 lead to information on Le Chateau Inc., a clothing retailer, which recently announced the company's intention to repurchase up to 925,148 Class A subordinate voting shares, representing 5% of the outstanding shares, The primary reason for the share repurchase, given by the company, is the appropriate and desirable use of the company's available funds which would be in the best interest of the company. Reasons for share repurchases tend to differ across ‘companics. In the instance of Le Chateau Inc., the share repurchase program is in 165 Copyright © 2009 McGraw-Hill Ryerson Limited18. addition to a special dividend of $0.25 per share and 20% increase in the companies’ regular dividend program. db ‘As of June 2008, some representative well known companies which offer Dividend Reinvestment Plans (DRPs) include: BCE Inc., CAE Industries, Magna, and Canadian Tire. Those that offer Share Purchase Plans (SPs) include: Enbridge, Suncor, and TransAlta, Some advantages of DRPs and SPPs include: # Savings to investors on brokerage commissions. © Some investors may have an option to purchase additional shares. ‘© Shares bought through these plans are often at a discount. ‘* These plans enable investors to accumulate their holdings in the particular stocks carrying such plans. Disadvantages of DRPs and SPPs may include the following: ‘© dividends reinvested through such plans may typically represent taxable income. «These plans enable purchases at specific intervals (for instance, monthly or quarterly) and may not be suitable to those investors who need the flexibility to be able to be able to buy or sell stocks quickly. © These plans are typically useful as long-term investment vehicles. Let us a take a representative company, say EnCana Corporation and explain its sequence of dates: Declaration date (April 22, 2008) - date on which, the dividend payment is announced. Ex dividend date (June 11) ~ cut off date set by the stock exchange, usually two business days prior to the record date. Record Date (Juine 13) ~ date on which, the firm announce that it will send a dividend cheque to all shareholders recorded on its book ‘Payable Date (Sune 30) ~ date on which, the dividend cheques are mailed to investors. ‘A pension find would not care about the dividend payout policy and therefore ‘would be indifferent between Hi and Lo. Because the pension fund pays no taxes, it will focus only on the total pretax rate of return. With the dividend tax credit, an individual's preference would depend on her or his tax bracket. A low-taxed individual will, likely, have a lower tax rate on dividend income than on capital gains income. This individual will, therefore, prefer a high dividend payout and opt for the Hi shares, On the other hand, an 166 Copyright © 2009 McGraw-Hill Ryerson Limited19. 20. 21 individual in a high-tax bracket should have a preference for a low dividend payout policy and therefore prefer the Lo shares. For this individual, the stated tax rate on capital gains is lower than the rate on dividend income. Moreover, the ability to defer recognition of capital gains confers a further advantage to a Jow payout policy. ‘A corporation prefers a high payout ratio and therefore prefers the Hi shares. “The exclusion of dividend income from taxable income makes dividends more valuable than capital gains on an after-tax basis, ‘The increase in stock prices reflects the positive information contained in the dividend increase. The stock price increase can be interpreted as a reflection of a new assessment of the firm's prospects, not as a reflection of investors’ preferences for high dividend payout ratios. ‘True. False, Firms smooth out dividends and do not maintain a strict proportional relationship between current eamings and dividends. They move dividends only part way toward the dividend target when earnings change, True. False. Firms seem reluctant to reduce dividends and therefore do not increase dividends in response to earnings increases that are not expected to persist, or that are not expected to be representative of long-run eamings prospects, High-risk companies tend to have low dividend payout ratios to reduce the tisk of dividend cuts in the future. They have low P/E ratios because a high risk premium reduces the present value of an expected stream of earnings or dividends, Firms that experience a temporary decline in profits will have high payout ratios because they try to stabilize dividends despite the fact that earnings have fallen. Their P/E ratios will tend to be higher if the earnings decline is expected to be temporary. The stock price will reflect the entire stream of fature earnings, not just the temporarily low level of current earnings. Companies that expect a decline in profits tend to have low payout ratios since the current dividend paid reflects, in part, the lower expected future profits and will soem high relative to current profits. The P/E ratio also will be low because the price will reflect the anticipation of lower future earnings. 16-7 Copyright © 2009 McGraw-Hill Ryerson Limited4. Growth companies usually have low payout ratios because these firms have ample investment opportunities and can reduce the costs involved in issuing new securities by retaining and reinvesting earnings. Their P/E ratio will be high because the stock price reflects the anticipation of future earnings growth, 22. Companies with unpredictable earnings levels are afraid to commit to dividend levels that might be unsustainable if carnings fall in the future. Therefore, they choose lower target payout ratios relative to current earnings. They also respond ‘more cautiously to increases in earnings, waiting to see whether long-run earnings are high enough to justify an increase in the dividend level ea ‘Dividend Yield Div. Payout Ratio Retention Rate Ca %) 2007 | 2006 | 2007 | 2006 | 2007 | 2006 Enbridge Ine | 2.847 | 2.960 | 64.596 | 65.502 | 35.059 | 34.115 BCE 3.435 | 4.503 | 30.948 | 62.164 | 67.560 | 33.739 Ballard Power | 0 0 0 0 too | i00 | Enbridge and BCE are both older relatively mature companies, and as such have dividend policies which seek to set stable dividend yields and target dividend payout ratios. Ballard Power, on the other hand, is a relatively new firm intent on pursuing growth opportunities (notice the 100% retention rate) rather than paying a dividend. 24 a. The pension fund pays no taxes, The individual pays 27.17 percent taxes on. dividends and 20,08 percent taxes on capital gains. Dividend Tax Rate: = [(1.25 x 0.29) ~ (1.25 x 0,1333)] + [(1.25 x 0.1116) ~ (1.25 x 0.051)] =02717 Capital Gains Tax Rate: = 0.5 (0.29) + 0.5 (0.1116) = 0.2008 168 Copyright © 2009 McGraw-Hill Ryerson LimitedThe corporation pays no tax on dividends and capital gains tax of: 0.5 (0.3612) = 0.1806 The after-tex rate of retum for each investor equals: Dividend (1 = Dividend Tax) + Capital Gains (1 — Capital Gains Tax Price ‘We can use this formula to construct the following table of after-tax retums: Tnvestor Stock | Pension Fund Corporation Individual A 10% 8.194% 7.992% LL 10%. 9.097% 1.638% c 10% 10,00% 1.283% For such investors, the dividend tax rate is: = [(1.25 x 0.16) — (1.25 x 0.1333] + [(1.25 x 0.062) — (1.25 x 0.051)} = (0.2 = 0.167) + (0.0775 ~ 0.06375) = 0.033375 + 0,01375 = 0.04713 ‘The capital gains tax rate is: = 0.5 (0.16) + 0.5 (0.062) = 0.08 + 0.031 = 0.111 ‘The after-tax dollar proceeds from the shares equals: = Dividends x (1 - 0.04713) + Capital Gains x (1 — 0.111) If these proceeds are to provide an 8% after-tax return, then: 0.08 x Po = (Dividend x 0.9529) + (Capital Gains x 0.889) or Po = (Dividend x 0.9529) + (Capital Gains x 0.889) 0.08 Using this formula for each stock, we find: 16.9 Copyright © 2009 McGraw-Hill Ryerson Limited25. Stock Price (Wx 0.9529) + 10x 0.889) = $111.13 his 0.08 (x 0.952) 4 (5 x 0.880) = $115.12 B 0.08, TO x 0.9529) + (0 x 0.889) = $119.11 c 0.08 Notice that a larger proportion of before-tax returns paid in the form of dividends results in a lower stock price. Ifthe firm pays a dividend, the stock price will fall to $19 per share. If the firm does a stock repurchase, the market value of equity will fall to $19,000 ‘and the number of shares will fall by $1000/$20 = 50 shares. The stock price will remain at $19,000/950 = $20 per share. Ifthe firm pays a dividend, earnings per share will be EPS = $2000/1000 = $2. If the firm does the repurchase, EPS = $2000/950 = $2.105. If the dividend is paid, the price-camings ratio will be $19/S2 = 9.5. If the stock is repurchased, the price-earnings ratio will be $20/$2.105 = 9.5, the same as if the dividend is paid. We have just shown that dividends per se do not have an effect on the P/E ratio. The stock sells at the same P/E multiple regardless of whether the firm pays a dividend or repurchases shares. “The most likely reason that firms with high dividend payouts have high price- ‘earnings ratios is that both ratios are computed using current earnings rather than trend or long-run earnings. If earnings are temporarily low, the ratio of price to curren earnings will be temporarily high. So will the ratio of dividends to current eamings because firms set dividend levels based on long run earnings prospects, Therefore, we observe a correlation between P/E ratios and payout ratios. “Another reason firms with high dividend payout ratios may sell at higher P/E ‘multiples is that these firms tend to be in more mature industries with lower risk. If investors thus demand a lower risk premium, they will value the stock at a higher multiple of current dividends and eamings. 16-10 Copyright © 2009 McGraw-Hill Ryerson LimitedSolution to Minicase for Chapter 16 ‘You will find an Excel spreadsheet solution for this minicase at the Online Learning Center (www megrawhill.ca/college/brealey). The statement of cash flows indicates that, in spite of substantial capital expenditures in 2005 ($2.063 billion), Penn Schumann’s cash balance increased by $1.510 billion in 2005. This increase in cash led to substantial increases in liquidity ratios and decreases in leverage, as shown in the Excel spreadsheet. Dividend payout fell from 42% of net income in 2004 to 35% in 2005 despite a $328 million increase in dividends. If the entire $1,510 billion increase in cash had been instead paid out as dividends, then liquidity ‘would still have increased and leverage would still have decreased (as shown in the spreadsheet), although the changes would of course have been iess substantial. The dividend payout ratio would have increased to over 66%. Ms. Rodriquez is probably correct when she states: “I don’t think we should commit to paying out high dividends, but perhaps we could use some of our cash to repurchase stock.” A payout ratio of 66.5% is likely too high to be maintained in the future, but a share repurchase might send a positive signal to the markets without creating the expectation of continued high dividend payout. Should other opportunities arise in the future (.c., a drug for treatment of liver diseases or an acquisition in the biotech field), Penn Schumann would have the option to retain a larger portion of income without reducing the payout ratio, In addition, since debt ratios would improve even with a share repurchase (as shown in the spreadsheet), Penn Schumann may also have additional borrowing capacity to finance such ventures. A payout in the form of a share repurchase ‘would also serve to alleviate the impression that “we fritter away cash on easy living,” 16-11 Copyright © 2009 McGraw-Hill Ryerson Limited