Problems and Questions

1. Based upon the empirical evidence that you have been presented with in this chapter, state
whether the following statements are true or false

a. Firms are reluctant to change dividends. TRUE FALSE

b. Stock prices generally go up on the ex-dividend date by less than the amount of the
dividend TRUE FALSE

c. Increasing dividend payments to stockholders generally makes bondholders in the firm

better off. TRUE FALSE

2. Dividend policy is often described as "sticky. What is meant by this description? What might
explain the sticky nature of dividends?

3. Companies are far more reluctant to cut dividends than to increase them. Why might this be
the case? What are the implications for financial markets when firms announce that they will be
cutting dividends?

4. Under what assumptions can the Miller-Modigliani argument that dividends are irrelevant be
made? What types of firms are most likely to fit these assumptions?

5. Dividends create a tax disadvantage for investors. Is this statement true for all investors and all
markets? Under what conditions is it not true?

6. A company that historically has had low capital investments and paid out high dividends is
entering a new industry, in which capital expenditure requirements are much higher. What should
the firm do to its dividends? What practical problems might it run into?

7. "An increase in dividends operates as a positive financial signal. Explain this statement. Is
there empirical evidence to support it?

8. Can a dividend increase ever be a negative financial signal? Explain. Is there any evidence to
support this hypothesis?

9. If Consolidated Power is priced at $50.00 with dividend, and its price falls to $46.50 when a
dividend of $5.00 is paid, what is the implied marginal rate of personal taxes for its
stockholders? Assume that the tax on capital gains is 40% of the personal income tax.

10. You are comparing the dividend policies of three dividend-paying utilities. You have
collected the following information on the ex-dividend behavior of these firms.

NE SE Western
Gas Bell Electric
Price Before 50 70 100
Price After 48 67 95
Dividends/Share 4 4 5

If you were a tax-exempt investor, which company would you use to make "dividend arbitrage
profits? How would you go about doing so?

11. Southern Rail has just declared a dividend of $ 1. The average investor in Southern Rail faces
an ordinary tax rate of 50%. While the capital gains rate is also 50%, it is believed that the
investor gets the advantage of deferring this tax until future years (The effective capital gains rate
will therefore be 50% discounted back to the present). If the price of the stock before the ex-
dividend day is $10 and it drops to $9.20 by the end of the ex-dividend day, how many years is
the average investor deferring capital gains taxes? (Assume that the opportunity cost used by the
investor in evaluating future cashflows is 10%.)

12. LMN Corporation, a real estate corporation, is planning to pay a dividend of $0.50 per share.
Most of the investors in LMN corporation are other corporations, who pay 40% of their ordinary
income and 28% of their capital gains as taxes. However, they are allowed to exempt 85% of the
dividends they receive from taxes. If the shares are selling at $10 per share, how much would
you expect the stock price to drop on the ex-dividend day?

13. UJ Gas is a utility that has followed a policy of increasing dividends every quarter by 5%
over dividends in the prior year. The company announces that it will increase quarterly dividends
from $1.00 to $ 1.02 next quarter. What price reaction would you expect to the announcement?
Why?

14. Microsoft Corporation, which has had a history of high growth and no dividends announces
that it will start paying dividends next quarter. How would you expect its stock price to react to
the announcement? Why?

15. JC Automobiles is a small auto parts manufacturing firm, which has paid $1.00 in annual
dividends each year for the last 5 years. It announces that dividends will increase to $ 1.25 next
year. What would you expect the price reaction to be? Why? If your answer is different from the
prior problem, explain the reasons for the difference.

16. Would your answer be different for the previous problem, if JC Automobiles is a large firm
followed by 35 analysts? Why or why not?

17. WeeMart Corporation, a retailer of children's clothes announces a cut in dividends following
a year in which both revenues and earning dropped significantly. How would you expect its stock
price to react? Explain.

18. RJR Nabisco, in response to stockholder pressure in 1996, announced a significant increase
in dividends paid to stockholders, financed by the sale of some of its assets. What would you
expect the stock price to do? Why?
19. RJR Nabsico also had $ 10 billion in bonds outstanding at the time of the dividend increase.
How would you expect Nabisco's bonds to react to the announcement? Why?

20. A company that has excess cash on hand is trying to decide whether to pay out the cash as a
regular dividend or a special dividend or to repurchase stock with it. What are some of the
considerations that would enter into this decision.

21. An equity repurchase will always provide a lesser signaling benefit than will an equivalent
dollar increase in regular dividends. Explain this statement. Does it hold true if the comparison
is to special dividends?

22. A firm is planning to borrow money to make an equity repurchase to increase its stock price.
It is basing its analysis on the fact that there will be fewer shares outstanding after the
repurchases, and higher earnings per share.

a. Will earnings per share always increase after such an action? Explain.

b. Will the higher earnings per share always translate into a higher stock price? Explain.

c. Under what conditions will such a transaction lead to a higher price?

23.. JR Computers, a firm that manufactures and sell personal computers is an all-equity firm
with 100,000 shares outstanding, $10 million in earnings after taxes and a market value of $ 150
million. Assume that this firm borrows $60 million at an interest rate of 8% and buys back
40,000 shares, using the funds. If the firm's tax rate is 50% estimate

a. the effect on earnings per share of the action.

b. what the interest rate on the debt would have to be, for the earnings per share effect to
disappear.

24. Why are forward contracts to buy equity more risky to firms than repurchase agreements?
Why might firms choose to use these contracts anyway?

25. JK Tobacco, a diversified firm in food and tobacco, concerned about its stock price, which
has dropped almost 25% over the previous two years. The managers of the firm believe that the
price drop has occurred because the tobacco division is the target of lawsuits, which may result
in a large liability for the firm. What action would you recommend to the firm? What might be
some of the barriers to such an action?

26. The stock price of GenChem Corporation, a chemical manufacturing firm with declining
earnings, has dropped from $ 50 to $ 35 over the course of the last year, largely as a consequence
of the market perception that the current management is incompetent. The management is
planning to split off the firm into three businesses, but plans to continue running all of them. Do
you think the split off will cause the stock price to increase? Why or why not? What would you
recommend?
27. Stock prices of firms generally increase when they announce spin offs. How would you
explain this phenomenon? On which types of firms would you expect spin offs to have the
largest positive impact, and why?

28. The managers of PC Software, an electronics mail order firm, have seen the stock price of the
firm increase over the last year from $ 25 to $ 50, and are considering a stock split to bring to
stock price down to what they view as a reasonable trading range. By doing so, they hope to
make the stock more affordable and increase their investor base.

a. Would you agree with this rationale for a stock split? Why or why not?

b. How would you expect the stock price to react to the split? Why?

29. WeeKids, a firm that operates play arenas for children, has paid $ 1 as a dividend per share
each year for the last 5 years. Due to a decline in revenues and increased competition, their
earnings have plummeted this year. They substitute a $ 1 stock dividend for the cash dividend.
What would you expect the market reaction to the stock dividend to be? Why?

30. In 1995, the Limited, the specialty retailing firm, announced that they were splitting up their
businesses into three separate businesses - the Limited stores forming one business, Victoria's
secret and lingerie becoming the second business and their other holdings forming the third
business. The Limited had been struggling over the previous four years with lackluster sales and
operating profits overall, and the market reacted positively to the announcement. What might be
some of the explanations for this reaction?

31. JW Bell, a regulated company, also has extensive holdings in non-regulated businesses and
reports consolidated income from all segments. There are severe restrictions on investment and
financing policy in the regulated component of the business. Can you provide a rationale for
spinning off the non-regulated businesses?

32. An article in a business periodical recently argued that the only reason for spin offs and split
offs was to make it easier for Wall Street to value firms. Why would a spin off or a split off make
it easier to value a firm? Do you agree that this is the only reason for spin offs and split offs? If it
were, what types of firms would you expect to take these actions?

33. JC Conglo Corporation is a firm that was founded in the 1960s and grew to become a
conglomerate through acquisitions. It has substantial corporate costs that get allocated over the
different divisions of the firm. Analysts argue that divesting the firm of these divisions will
increase value, since the buyer will not have to pay the corporate costs. Under what conditions
would spinning off the divisions of the firm add to value of the firm? Conversely, under what
conditions would a spin off have a neutral effect on value.

34. RJR Nabisco, the food and tobacco giant, is waging a battle against dissident stockholders,
who want it to divest itself of its food division and pay a large dividend to the stockholders. RJR
Nabisco offers to spin off the food division, while keeping it under incumbent management. Are
stockholders likely to be satisfied? Why or why not?