Chapter 18 Discussion Questions 18-1 How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on fund s associated with retained earnings. Thus we must consider what the stockholders can earn on other investments 18-2 Discuss the difference between a passive and an active dividend policy a passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at ternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, stockholder preference for cash dividend s is considered very early in the decision process 18-3 How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content Some stockholders may say that the dividends are relevant, but in a different ense. Perhaps they prefer to receive little or no dividends because of the immediate income tax 18-4 Explain the relationship between a company's growth possibilities and its dividend policy The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show four-year growth rates for selected U.S corporations and their associated dividend payout percentages. This is also d iscussed in the life cycle of the firm S-627 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-627 Chapter 18 Discussion Questions 18-1. How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on funds associated with retained earnings. Thus, we must consider what the stockholders can earn on other investments. 18-2. Discuss the difference between a passive and an active dividend policy. A passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at alternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, stockholder preference for cash dividends is considered very early in the decision process. 18-3. How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some stockholders may say that the dividends are relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the immediate income tax. 18-4. Explain the relationship between a company's growth possibilities and its dividend policy. The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show four-year growth rates for selected U.S. corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm
18 are there legal restrictions on paying out the funds to the stockholders why Since initial contributed capital theoretically belongs to the stockholders Cred itors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place 18-6 Discuss how desire for control may influence a firm,s willingness to pay dividends Management's desire for control could imply that a closely held firm should avoid dividends to minimize the need for outside financing. For a larger firm posion nrowor y have to pay dividends in order to maintain their current keeping stockholders happy If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend 18-8 How is a stock split(versus a stock dividend )treated on the financial statements of a corporation? For a stock split, there is no transfer of funds, but merely a-reduction in par value and a-proportionate increase in the number of shares outstanding I mpact of a Stock Split efo After Common stock(1,000,000 shares at $10 par)(2,000,000 shares at $5 par) CopyrightC 2005 by The McGran-Hill Companies, Inc. S-628
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-628 18-5. Since initial contributed capital theoretically belongs to the stockholders, why are there legal restrictions on paying out the funds to the stockholders? Creditors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place. 18-6. Discuss how desire for control may influence a firm's willingness to pay dividends. Management's desire for control could imply that a closely held firm should avoid dividends to minimize the need for outside financing. For a larger firm, - management may have to pay dividends in order to maintain their current position through keeping stockholders happy. 18-7. If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 18-8. How is a stock split (versus a stock dividend) treated on the financial statements of a corporation? For a stock split, there is no transfer of funds, but merely a –reduction in par value and a –proportionate increase in the number of shares outstanding. Impact of a Stock Split Before After Common stock (1,000,000 shares at $10 par) (2,000,000 shares at $5 par)
Why might a stock dividend or a stock split be of limited value to an investor The asset base remains the same and the stockholders' proportionate interest unchanged (everyone got the same new share ). Earnings per share will go down by the exact proportion that the number of shares increases. If the P/E ratio remains constant, the total value of each shareholders portfolio will not Increase The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value is when dividends per share remain constant and total dividends go up, or where substantial information is provided about a growth company. A stock split may have some functionality in placing the company into a lower"stock price" trading range 18-10 Does it make sense for a corporation to repurchase its own stock? Explain A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as through a cash dividend Because the benefits are in the format of capital gains the tax may be deferred until the stock is sold A corporation also may justify the repurchase of its own stock 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 stock as protection against a hostile takeover What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders to reinvest dividends at low costs and to buy fractional individual. The strategy of dividend reinvestment plans allows forto shares, neither of which can be easily accomplished in the market by compound ing of dividends and the accumulation of common stock over time S-629 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-629 18-9. Why might a stock dividend or a stock split be of limited value to an investor? The asset base remains the same and the stockholders' proportionate interest is unchanged (everyone got the same new share). Earnings per share will go down by the exact proportion that the number of shares increases. If the P/E ratio remains constant, the total value of each shareholder's portfolio will not increase. The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value is when dividends per share remain constant and total dividends go up, or where substantial information is provided about a growth company. A stock split may have some functionality in placing the company into a lower "stock price" trading range. 18-10. Does it make sense for a corporation to repurchase its own stock? Explain. A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as through a cash dividend. Because the benefits are in the format of capital gains the tax may be deferred until the stock is sold. A corporation also may justify the repurchase of its own stock 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 stock as protection against a hostile takeover. 18-11. What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders 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 common stock over time
Problems 18-1 Moon and Sons, Inc, earned $120 million last year and retained $72 million What is the payout ratio? Solution: Moon and sons. Inc Dividends earnings- retained fur $120mil.-$72mil.=$48mil Payout ratio dividends/earnings $48mil/$120mil.=40.0% Ralston Gourmet Foods, Inc. earned $360 million last year and retained $252 million. What is the payout ratio? Solution: Ralston gourmet foods Inc Dividends (earnings -retained funds) ($360m.-$252mi.=$108m Payout ratio dividends/earnings $l80mil/$360mil.=30% CopyrightC 2005 by The McGran-Hill Companies, Inc. S-630
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-630 Problems 18-1. Moon and Sons, Inc., earned $120 million last year and retained $72 million. What is the payout ratio? Solution: Moon and Sons, Inc. Dividends = (earnings – retained fund) = $120 mil. – $72 mil. = $48 mil. Payout ratio = dividends/earnings = $48 mil./$120 mil. = 40.0% 18-2. Ralston Gourmet Foods, Inc. earned $360 million last year and retained $252 million. What is the payout ratio? Solution: Ralston Gourmet Foods, Inc. Dividends = (earnings – retained funds) = ($360 mil. – $252 mil. = $108 mil. Payout ratio = dividends/earnings = $180 mil./$360 mil. = 30%
Swank Clothiers earned $640 million last year and had a 30 percent payout ratio. How much d id the firm add to its retained earnings? Solution: Swank Clothiers Addition to retained earnings Earnings-Dividends Dividends =30%X$640.000,000 $192000,000 Addition to retained earnings = $640,000, 000-$192, 000,000 $448,00000 18-4 Springsteen Music Company earned $820 million last year and paid out 20 percent of earnings in dividends a. How much did retained earnings increase by? b. With 100 million shares outstanding and a stock price of $50, what was the dividend yield?(Hint: first compute dividends per share. Solution: Springsteen Music Company a. Addition to retained earnings earnings -dividends Dividends 20%X$820,000,000 Dividends $164000.000 Earnings -dividends $820.000000-$164000000 Addition to retained earnings =$656.000.000 b Dividends/shares $164.000.000/100000.000 $164 Dividend yield Dividend per share/stock price $164/$50=3,28 percent S-631 Copyright C2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-631 18-3. Swank Clothiers earned $640 million last year and had a 30 percent payout ratio. How much did the firm add to its retained earnings? Solution: Swank Clothiers Addition to retained earnings = Earnings – Dividends Dividends = 30% x $640,000,000 = $192,000,000 Addition to retained earnings = $640,000,000 – $192,000,000 = $448,000,000 18-4. Springsteen Music Company earned $820 million last year and paid out 20 percent of earnings in dividends. a. How much did retained earnings increase by? b. With 100 million shares outstanding and a stock price of $50, what was the dividend yield? (Hint: first compute dividends per share.) Solution: Springsteen Music Company a. Addition to retained earnings = Earnings – Dividends Dividends = 20% x $820,000,000 Dividends = $164,000,000 Earnings – dividends = $820,000,000 – $164,000,000 Addition to retained earnings = $656,000,000 b. Dividends/shares = $164,000,000/100,000,000 = $1.64 Dividend yield = Dividend per share/stock price = $1.64/$50 = 3.28 percent
The following companies have different financial statistics. What dividend policies would you recommend for them? Explain your reasons Matthews Co. Aaron Corp Growth rate in sales and earnings 20% Cash as a percentage of total assets 15% Solution: Mathews is not growing very fast so it doesn't need cash for growth unless it desires to change its policies. Assuming it doesn't, Mathews should have a high payout ratio Aaron is growing very fast and needs its cash for reinvestment in assets. For this reason, aaron should have a low dividend payout 18-6 A financial analyst is attempting to assess the future dividend policy of Interactive Technology by examining its life cycle. She anticipates no payout of earnings in the form of cash dividends during the development stage(). During the growth stage (II), she anticipates 10 percent of earnings will be distribut as dividends. As the firm progresses to the expansion stage (IIf), the payout ratio will go up to 40 percent, and eventually reach 60 percent during the maturity stage (IV a. Assuming earnings per share will be the following during each of the four stages, ind icate the cash dividend per share(if any) during each stage Stage I $.20 Stage Ill 22 StageⅣV 3.00 b. Assume in Stage IV that an investor owns 425 shares and is in a 15 percent tax bracket for dividends what will be his or her total aftertax income from the cash d ividend? In what two stages is the firm most likely to utilize stock dividends or stock CopyrightC 2005 by The McGran-Hill Companies, Inc. S-632
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-632 18-5. The following companies have different financial statistics. What dividend policies would you recommend for them? Explain your reasons. Matthews Co. Aaron Corp. Growth rate in sales and earnings .................. 5% 20% Cash as a percentage of total assets ............... 15% 2% Solution: Mathews is not growing very fast so it doesn't need cash for growth unless it desires to change its policies. Assuming it doesn't, Mathews should have a high payout ratio. Aaron is growing very fast and needs its cash for reinvestment in assets. For this reason, Aaron should have a low dividend payout. 18-6. A financial analyst is attempting to assess the future dividend policy of Interactive Technology by examining its life cycle. She anticipates no payout of earnings in the form of cash dividends during the development stage (I). During the growth stage (II), she anticipates 10 percent of earnings will be distributed as dividends. As the firm progresses to the expansion stage (III), the payout ratio will go up to 40 percent, and eventually reach 60 percent during the maturity stage (IV). a. Assuming earnings per share will be the following during each of the four stages, indicate the cash dividend per share (if any) during each stage. Stage I $ .20 Stage II 2.00 Stage III 2.80 Stage IV 3.00 b. Assume in Stage IV that an investor owns 425 shares and is in a 15 percent tax bracket for dividends; what will be his or her total aftertax income from the cash dividend? c. In what two stages is the firm most likely to utilize stock dividends or stock splits?
18-6. Continued Solution: Interactive Technology Earnings Payout Ratio Dividends Stage $.20 Stage 2.00 10% $20 Stage Ill 2.80 40% $l.12 Stage Iv 3.00 60% $l.80 b. Total dividends shares x dividends per share 425x1.80=$765 Aftertax income total dividends x(1-t) $765X 15 $765X(85)=$650.25 c. Stock dividends or stock splits are most likely to be utilized during stage II(growth or stage Ill(expansion) Squash Delight, Inc has the following balance sheet Assets $100,000 Accounts receivable 300.000 Fixed assets 600000 Total assets l.000.000 Liabilities Accounts payabl 150.000 50,000 Capital Common stock(50,000 shares @ $2 par) 100,000 Accounts Capital in excess of par 200.000 Retained earnings 500.000 S-633 Copyright o 2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-633 18-6. Continued Solution: Interactive Technology a. Earnings Payout Ratio Dividends Stage I $ .20 0 0 Stage II 2.00 10% $ .20 Stage III 2.80 40% $1.12 Stage IV 3.00 60% $1.80 b. Total Dividends = shares x dividends per share = 425 x 1.80 = $765 Aftertax income = total dividends x (1 – T) = $765 x (1 – .15) = $765 x (.85) = $650.25 c. Stock dividends or stock splits are most likely to be utilized during stage II (growth) or stage III (expansion). 18-7. Squash Delight, Inc. has the following balance sheet: Assets Cash........................................................................................ $ 100,000 Accounts receivable................................................................ 300,000 Fixed Assets........................................................................... 600,000 Total Assets...................................................................... $1,000,000 Liabilities Accounts payable ........................................... $ 150,000 Notes payable ................................................. 50,000 Capital Common stock (50,000 shares @ $2 par)...... 100,000 Accounts Capital in excess of par.................................. 200,000 Retained earnings........................................... 500,000 $1,000,000
18-7. Continued The firms stock sells for $10 a share a. Show the effect on the capital account(s)of a two-for-one stock split b. Show the effect capital accounts of a 10 percent stock divided Part b is separate from part a. In part b do not assume the stock split has taken place c. Based on the balance in retained earnings, which of the two dividend plans is more restrictive on future cash dividends? Solution: Squash delight, Inc. a. 2 for l stock split Common stock(100,000 shares $l par)$100,000 Capital ex cess of par 200000 Retained earnings 500.000 The only account affected b. 10% stock dividend Common stock(55,000 shares @$2 par)$110,000 Capital in excess of par 245000 Retained earning 445000 *$20000+500($10-$1)=$200,000+$45000 $245000 *$500,000-10,000-45,000=$500000-55,000 =$445000 c. The stock dividend Cash dividends cannot exceed the balance in retained earnings and the balance is lower with the stock dividend ($445,000 versus$500,000) CopyrightC 2005 by The McGran-Hill Companies, Inc. S-634
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-634 18-7. Continued The firm's stock sells for $10 a share. a. Show the effect on the capital account(s) of a two-for-one stock split. b. Show the effect on the capital accounts of a 10 percent stock divided. Part b is separate from part a. In part b do not assume the stock split has taken place. c. Based on the balance in retained earnings, which of the two dividend plans is more restrictive on future cash dividends? Solution: Squash Delight, Inc. a. 2 for 1 stock split * Common stock (100,000 shares @ $1 par)$100,000 Capital excess of par 200,000 Retained earnings 500,000 * The only account affected b. 10% stock dividend Common stock (55,000 shares @ $2 par) $110,000 * Capital in excess of par 245,000 ** Retained earnings 445,000 * $200,000 + 5,000 ($10 – $1) = $200,000 + $45,000 = $245,000 ** $500,000 – 10,000 – 45,000 = $500,000 – 55,000 = $445,000 c. The stock dividend. Cash dividends cannot exceed the balance in retained earnings and the balance is lower with the stock dividend ($445,000 versus $500,000)
18-8 In doing a five-year analysis of future dividends, Newell Labs, Inc, is considering the following two plans. The values represent dividends per share Year Plan a Plan b 1 $2.50 2 2. 3.30 2.50 35 2.65 2.80 2.65 a. How much in total dividends per share will be paid under each plan over the b. Ms. Carter, the vice president of finance, suggests that stockholders often prefer a stable dividend policy to a highly variable one. She will assume that stockholders apply a lower discount rate to dividends that are stable The discount rate to be used for Plan a is 10 percent; the discount rate for Plan B is 12 percent. Which plan will provide the higher present value for the future dividends? (Round to two places to the right of the decima Solution: Newell labs Inc a. Plan a($250+255+250+265+265)=$1285 PanB($80+3.30+35+280+660)=$1385 b. plan a Dividend Per share PⅤIF(10%) PⅤ $2.50 909 $227 2.55 826 2.11 2.50 188 2.65 683 1.8 2.65 621 Present Value of future dividends $9.72 S-635 Copyright o 2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-635 18-8. In doing a five-year analysis of future dividends, Newell Labs, Inc., is considering the following two plans. The values represent dividends per share. Year Plan A Plan B 1.......... $2.50 $ .80 2.......... 2.55 3.30 3.......... 2.50 .35 4.......... 2.65 2.80 5.......... 2.65 6.60 a. How much in total dividends per share will be paid under each plan over the five years? b. Ms. Carter, the vice president of finance, suggests that stockholders often prefer a stable dividend policy to a highly variable one. She will assume that stockholders apply a lower discount rate to dividends that are stable. The discount rate to be used for Plan A is 10 percent; the discount rate for Plan B is 12 percent. Which plan will provide the higher present value for the future dividends? (Round to two places to the right of the decimal point.) Solution: Newell Labs, Inc. a. Plan A ($2.50 + 2.55 + 2.50 + 2.65 + 2.65) = $12.85 Plan B ($.80 + 3.30 + .35 + 2.80 + 6.60) = $13.85 b. Plan A Dividend Per Share x PVIF (10%) PV 1 $2.50 .909 $2.27 2 2.55 .826 2.11 3 2.50 .751 1.88 4 2.65 .683 1.81 5 2.65 .621 1.65 Present Value of future dividends $9.72
18-8. Continued Plan b Dividend Per share PVIF 2%) PⅤ $.80 893 $71 3.30 797 2.63 712 25 4 2.80 636 6.60 567 3.74 Present Value of future dividends $9.11 Plan a will provide the higher present value of future dividends 18-9 The stock of Pills Berry Company is selling at $60 per share. The firm pays a dividend of $1. 80 per share a. What is the annual dividend yield? b. If the firm has a payout rate of 50 percent, what is the firms P/E ratio? Solution: Pills Berry Company a. annual dividend yield cash dividend/price =$180/s60=3.00% b. Earnings per share cash dividends/5 $l80/.5=$3 P/E ratio Price/earnings per share $60/$3.60=1667X CopyrightC 2005 by The McGran-Hill Companies, Inc. S-636
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-636 18-8. Continued Plan B Dividend Per Share x PVIF (12%) PV 1 $ .80 .893 $ .71 2 3.30 .797 2.63 3 .35 .712 .25 4 2.80 .636 1.78 5 6.60 .567 3.74 Present Value of future dividends $9.11 Plan A will provide the higher present value of future dividends. 18-9. The stock of Pills Berry Company is selling at $60 per share. The firm pays a dividend of $1.80 per share. a. What is the annual dividend yield? b. If the firm has a payout rate of 50 percent, what is the firm's P/E ratio? Solution: Pills Berry Company a. Annual dividend yield = cash dividend/price = $1.80/$60 = 3.00% b. Earnings per share = cash dividends/.5 = $1.80/.5 = $3.60 P/E ratio = Price/earnings per share = $60/$3.60 = 16.67x