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CHAPTER 26
I. Questions
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
6. A corporation can make a rational case for purchasing its own equity
share as an alternate to a cash dividend policy. Earnings per share will go
up and if the P/E ratio remains the same, the shareholder will receive the
same peso benefit as through a cash dividend. Because the benefits are in
the format of capital gains, the tax rate will be lower and the tax may be
deferred until the equity share is sold.
A corporation also may justify the repurchase of its own equity share
because it is at a very low price, or to maintain constant demand for the
shares. Reacquired shares may be used for employee options or as a part
of a tender offer in a merger or acquisition. Firms may also reacquire part
of their equity share as protection against a hostile takeover.
7. Dividend reinvestment plans allow corporations to raise funds
continually from present shareholders. This reduces the need for some
external funds. These plans allow shareholders to reinvest dividends at
low costs and to buy fractional shares, neither of which can be easily
accomplished in the market by an individual. The strategy of dividend
reinvestment plans allows for the compounding of dividends and the
accumulation of ordinary equity share over time.
8. Dividend policy determines the distribution of a firms earnings between
retention and dividend payments to shareholders.
9. The three major arguments favoring the relevance of dividends are: (1)
the bird-in-the-hand theory, (2) the informational content effect, and
(3) the clientele effect.
10. The residual theory of dividends states that a firm will pay dividends
only if acceptable investment opportunities for these funds are currently
unavailable.
11. Numerous factors influence a firms choice of dividend policy, including
legal, contractual, and internal constraints; investment opportunities and
growth prospects; alternative sources of capital; owner considerations,
including their preferences and desire for control; the cost of selling
equity share; the earnings record; and legal listing.
12. Managers generally prefer a stable peso amount of dividends because
they believe that this policy leads to higher equity share prices and
avoids erroneous informational content.
13. Both a stock dividend and a stock split are ways of distributing shares to
ordinary equity shareholders. In theory, they do not increase shareholder
wealth. However, they can convey information to investors. The only
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
1. A 4. B 7. C
2. D 5. D 8. D
3. D 6. A 9. D
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
III. Problems
Problem 1
The after-tax dividend is the pretax dividend times one minus the tax rate, so:
The equity share price should drop by the after-tax dividend amount, or:
Problem 2
Since the par value of the new shares is P1, the capital surplus per share is
P29. The total capital surplus is therefore:
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
Since the par value of the new shares is P1, the capital surplus per share is
P29. The total capital surplus is therefore:
Problem 3
(a) To find the new shares outstanding, we multiply the current shares
outstanding times the ratio of new shares to old shares, so:
The equity accounts are unchanged except the par value of the equity share is
changed by the ratio of new shares to old shares, so the new par value is:
(b) To find the new shares outstanding, we multiply the current shares
outstanding times the ratio of new shares to old shares, so:
The equity accounts are unchanged except the par value of the equity share is
changed by the ratio of new shares to old shares, so the new par value is:
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Problem 4
To find the new equity share price, we multiply the current equity share price by
the ratio of old shares to new shares, so:
(e) To find the new shares outstanding, we multiply the current shares
outstanding times the ratio of new shares to old shares, so:
Problem 5
(a) Let x be the ordinary income tax rate. The individual receives an after-tax
dividend of:
which she invests in Treasury bonds. The Treasury bond will generate after-
tax cash flows to the investor of:
And the proceeds to the investor when the firm pays a dividend will be:
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
Note that this argument does not depend upon the length of time the
investment is held.
(b) Yes, this is a reasonable answer. She is only indifferent if the after-tax
proceeds from the P1,000 investment in identical securities are identical.
That occurs only when the tax rates are identical.
(c) Since both investors will receive the same pre-tax return, you would expect
the same answer as in part (a). Yet, because Woodrose enjoys a tax benefit
from investing in equity share (70 percent of income from equity share is
exempt from corporate taxes), the tax rate on ordinary income which induces
indifference, is much lower. Again, set the two equations equal and solve for
x:
(d) It is a compelling argument, but there are legal constraints, which deter firms
from investing large sums in equity share of other companies.
Problem 6
Assuming no capital gains tax, the after-tax return for the FYI Company is the
capital gains growth rate, plus the dividend yield times one minus the tax rate.
Using the constant growth dividend model, we get:
After-tax return = g + D (1 t)
= .15
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
The equivalent pretax return for FYI Company, which pays no dividend, is:
Pretax return = g + D
= .1175 + .05
= .1675 or 16.75%
Problem 7
(a) If the company makes a dividend payment, we can calculate the wealth of a
shareholder as:
The equity share price after the dividend payment will be:
PX = P64 9
= P55 per share
The shareholder will have an equity shares worth P55 and a P9 dividend for a
total wealth of P64. If the company makes a repurchase, the company will
repurchase:
If the shareholder lets their shares be repurchased, they will have P64 in cash.
If the shareholder keeps their shares, they are still worth P64.
(b) If the company pays dividends, the current EPS is P1.30, and the P/E ratio is:
P/E = P55/P1.30
= 42.31
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
If the company repurchases equity share, the number of shares will decrease.
The total net income is the EPS times the current number of shares
outstanding. Dividing net income by the new number of shares outstanding,
we find the EPS under the repurchase is:
The equity share price will remain at P64 per share, so the P/E ratio is:
P/E = P64/P1.51
= 42.31
Problem 8
Since the P2,000,000 cash is after corporate tax, the full amount will be invested.
So, the value of each alternative is:
Alternative 1:
The firm invests in T-bills or in preferred share, and then pays out as
special dividend in 3 years.
If the firm invests in T-bills, the after-tax yield of the T-bills will be:
So, the future value of the corporate investment in T-bills will be:
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Since the future value will be paid to shareholders as a dividend, the after-
tax cash flow will be:
If the firm invests in preferred share, the assumption would be that the
dividends received will be reinvested in the same preferred share. The
preferred share will pay a dividend of:
And the taxes the company must pay on the preferred dividends will be:
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
The future value of the companys investment in preferred share will be:
FV of investment in preferred share = P2,000,000 (1 + .0716) 3
= P2,461,093.48
Since the future value will be paid to shareholders as a dividend, the after-
tax cash flow will be:
Alternative 2:
The firm pays out dividend now, and individuals invest on their own. The
after-tax cash received by shareholders now will be:
So, the future value of the individual investment in Treasury bills will be:
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
= P136,000
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
The future value of the individual investment in preferred share will be:
The after-tax cash flow for the shareholders is maximized when the firm
invests the cash in the preferred shares and pays a special dividend later.
Problem 9
= P2.00
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Problem 10
The dividend payout is computed by dividing the yearly dividends per share by
the earnings per share.
Dividend (4) (P0.25)
payout ratio = P2.50
= 0.40 or 40%
Problem 11
To provide the P4,900,000 in required equity, Glee Mining Company must retain
the entire P4,000,000 in earnings and issue new equity share for the remaining
P900,000. By following the current dividend policy, the company will pay no
cash dividends.
Problem 12
(a) The legal limit depends on the law. If the capital impairment provisions of
law are limited to the par value of ordinary equity share, the maximum
amount of dividends is P2,500,000, which is the amount of retained earnings
(P500,000) plus capital in excess of par (P2,000,000). Otherwise, the
maximum amount of dividends is the retained earnings of P500,000. Neither
amount is realistic because the company would not have the cash available to
pay.
(b) In practice, the companys dividends could not exceed the balance of the
retained earnings.
Problem 13
(a) With a stable dividend policy, Elena Company will maintain its current P1.50
cash dividend per share.
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
(b) With constant dividend payout ratio policy, dividends per share will be
P1.75.
Dividends last year = (P1.50) (800,000)
= P1,200,000
P1,200,000
Dividend payout ratio = P3,000,000
= 0.40 or 40%
= P1.75
Problem 14
(b) A total of 40,000 shares (0.20 x 200,000) is added to the ordinary equity
share account.
(c) Of the P1,200,000 transferred from retained earnings, P120,000 (P3 par x
40,000) is added to the ordinary equity share account, and P1,080,000
(P1,200,000 P120,000) is added to the capital in excess of par account. The
shareholders equity accounts are as follows:
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Problem 15
With a 3-for-1 stock split, the par value declines from P3 to P1, and the number
of outstanding shares triples to 600,000 shares.
Problem 16
Dividends = Earnings Retained funds
= P160 million P100 million
= P60 million
Dividends
Payout ratio = Earnings
P60 million
= P160 million
= 0.375 or 37.5%
Problem 17
Addition to retained
earnings = Earnings Dividends
= P800 million P280 million
= P520 million
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
Problem 18
Grape Co. is not growing very fast so it does not need cash for growth unless it
desires to change its policies. Assuming it does not, Grape Co. should have a
high payout ratio.
Cherry Corp. is growing very fast and needs its cash for reinvestment in assets.
For this reason, Cherry should have a low dividend payout.
Problem 19
(b) Plan A
Dividend Per Share X PVIF (10%) PV
1 P1.50 .909 P1.36
2 1.50 .826 1.24
3 1.50 .751 1.13
4 1.60 .683 1.09
5 1.60 .621 .99
Present Value of Future Dividends P5.81
Plan B
Dividend Per Share X PVIF (12%) PV
1 P .50 .893 P .45
2 2.00 .797 1.59
3 .20 .712 .14
4 4.00 .636 2.54
5 1.70 .567 .96
Present Value of Future Dividends P5.68
Problem 20
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Problem 21
Retain
Incremental earnings = (15%) (P400,000)
= P60,000
P750,000 + P60,000
Earnings per share = 300,000
P810,000
= 300,000
= P2.70
Payout
P750,000
Earnings per share = 300,000
= P2.50
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
Problem 22
(a) Eight (8) million shares would be outstanding at a par value of P5 per share.
Everything else will be the same.
(b) Twelve (12) million shares would be outstanding at a par value of P3.33 per
share. Everything else will be the same.
(c) P14,000,000
EPS Before = 4,000,000
= P3.50 EPS
P14,000,000
EPS After 2-1 Split = 8,000,000
= P1.75 EPS
P14,000,000
EPS After 3-1 Split = 12,000,000
= P1.17 EPS
(e) Probably not. A stock split should not change the price-earnings ratio unless
it is combined with a change in dividends to the shareholders. Generally
speaking, nothing of real value has taken place. Only to the limited extent
that new information content from this split increased investors expectations
would the stock split possibly have an impact on the P/E ratio.
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Chapter 26 Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts
Problem 23
= P5
P4,000,000
Dividends per share = 1,000,000
(b)
= P4
P4,000,000
(c) Shares reacquired = P54
= 74,074
P5,000,000
EPS = 925,926
= P5.40
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Sharing Firm Wealth: Dividends, Share Repurchases and Other Payouts Chapter 26
(h) The corporation may think its shares are underpriced in the market. The
purchase may stave off further decline and perhaps even trigger a rally.
Reacquired shares may also be used for employee equity share options or as
part of a tender offer in a merger or an acquisition. Firms may also reacquire
part of their shares as a protective device against being taken over as a
merger candidate.
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