Chapter 16

Dividend and Share Repurchase Policy

) ≡ E t , and its payout ratio, ( Ett ) , we can find the dividend

NI D
16-1. Given a firm’s earnings per share, ( # shares
t

per share, D t , by simply multiplying the two together:

D 
Dt = Et ∗  t ,
 Et 

(where the “t” subscript refers to time t and the payout ratio is the dividend paid at time t from
earnings per share at time t). Thus, for our three companies, we have:

A B C = A*B
payout earnings dividend
company ratio per share per share
Emerson Electric Co. 85% $2.23 $1.90
Intel Corporation 40% $2.43 $0.97
Wal-Mart Stores 43% $4.53 $1.95

For example, Wal-Mart chose to pay out 43% of its earnings as dividends (reinvesting the other
57%), so it paid out $1.95 from EPS of $4.53 [($1.95/$4.53) = 0.43].

16-2. We can calculate the pay-out ratio by dividing total divided by its net income:

Total dividends
Dividend Payout Ratio =
Net income
€3,800,000
=
€15,320,000
= 24.80%

In order to maintain the same dividend pay-out ratio in the year ending February 2017, they
need to pay-out 24.80% of their net income as dividend.
Total Dividend = €38,560,000 * 24.80% = € 9,562,880
The overall dividend payment for the financial year ended in February 2017 is significantly
more than what it was in the previous year. This is due to the significant increase in profit
during the same period, which is leading to this increase in dividend payment to maintain the
dividend pay-out ratio.

388
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 Solutions to End-of-Chapter Problems—Chapter 16 389

16-3. As James bought shares well before the record date, he has bought “cum-dividend” shares and will
be eligible for dividend on the payment date.
If Fox Metal’s shares are trading at £32 each “cum-dividend,” then the share prices are likely to
drop by the same amount as the dividend once they go ex-dividend. So, after a dividend payment
of £1.30 per share, the share prices are likely to drop to £30.70.
Referring to the dividend discount model for stock pricing, we can say that for Fox Metal,
Stock price just before the dividend day = PV of all dividends paid from now to infinity,
Or £32 = PV of next dividend of £1.30 + PV of all future dividends.
Once the share goes ex-dividend,
Stock price just after ex-day = PV of all future dividends.
The difference in prices for Fox Metal shares before and after ex-day will be the difference of PV
of £1.30 dividend. As that dividend will be paid out in a very short period of time, the PV of £1.30
will be very close to £1.30. Therefore, we can expect the share price to drop by £1.30 once it goes
ex-dividend.

16-4. Kingwood Corporation’s management is considering paying a one-time $40 special

cash dividend. Its current share price is $120. Using the same logic as in Problem 16-3, and again
applying equation 16-1, we would expect, all else equal, for the firm’s stock price to fall by $40 to
$80 once the dividend’s ex-date passes.
Management asserts that its reason for the special dividend is that the firm has more cash than it
can profitably invest, and that the large cash balance “would adversely affect the incentives of the
workforce to strive to create shareholder value.” Given these incentives, is it possible that the
stock price would not fall by $40, as expected? Do these incentives undermine our “all else equal”
assumption?
The answer depends upon the message that investors draw from the special dividend. This could
go either way:
(a) Investors view the dividend as good news, and stock price falls by less than $40.
Possible explanations for this outcome include:
• Investors see that managers want to maximize shareholder value, and that managers are
willing to voluntarily divest themselves of free cash flow, as finance theory says they should,
so that investors can more profitably invest that cash elsewhere. This improves investors’ view
of management and their expectations about future good decisions by management.
• Investors note that by releasing the free cash flow, managers remove their incentives to invest
the cash for perquisites or other negative net present value projects. Firm value rises as the
expected probability of future negative NPV investments falls.
• By eliminating the “excess” cash, managers eliminate a prime motivation for a takeover,
saving investors from a potentially expensive takeover battle (and preserving good current
management).
• As posited by management, employees are now more motivated to work, enhancing
shareholder value.
• The huge dividend returns the stock to its preferred trading range, as discussed in section 16.2
of the text. (However, this is not a likely interpretation here, given management’s story about
the dividend.)

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390 Titman/Keown/Martin • Financial Management, Thirteenth Edition, Global Edition

• The dividend attracts attention, so it can’t be bad. (Again, this is a rationale discussed in
section 16.2.)
(b) Investors view the dividend as bad news, and stock price falls by more than $40.
Possible explanations for this outcome include:
• Investors focus on the big picture here, which is that the firm can no longer find enough
positive net present value projects. The firm has left its “growth” phase and entered maturity.
Future growth will be lower; as the lower growth rate is impounded in price, price falls.
Growth investors will need to leave the firm to find growth firms, incurring transactions costs
from selling their shares. Those who stay can count on higher (taxed!) dividends in the future,
as the mature firm—now a cash cow—continues to disgorge cash.
• There is no compensating increase in employee motivation, since lower-level employees are
primarily motivated by their paychecks. It’s management whose hands are tied by the lack of
free cash flow, not employees.
• There is now a lower probability of a value-enhancing takeover, given that one attraction for
acquirers is large amounts of free cash flow. The extent to which a poor current management
is entrenched has increased. (However, the decision to disgorge the cash in the first place
suggests that this negative assessment of management does not apply in Kingwood
Corporation’s case.)
• If (currently unforeseen) positive NPV projects arise, Kingwood may now have to resort to
(more expensive) outside financing to finance them, reducing their value.
• Kingwood Corporation has reduced its financial slack. To the extent that such slack is valuable,
Kingwood Corporation has lost value.
Given all these possible interpretations, the price may fall by more than $40. This firm has just
admitted that its growth days are over. Its expected future earnings, and its P/E ratio, will fall
as a result.

16-5. While bonus issue does not change the value of the firm, it only changes the number of the
outstanding shares. Thus, bonus issue leads to a proportionate decline in share prices.
For Great Outdoor Tweed Company, before the bonus issue we can note that:

Market Value of firm

Current stock price = = £8
number of existing shares

Or Market Value of firm = £8 * number of existing shares

After the bonus issue, the number of shares will increase. As they are issuing 1 for 4 bonus issue,
there will be 1 new share for each of the 4 existing shares. So, the ex-bonus shares will be 25%
more than the existing shares.
Assuming that the ex-bonus market price is x, we can say that:
Market value of the firm = x * (# of ex-bonus shares)
Or, market value of the firm = x * (# of existing shares) * (1.25)
As the market value of the firm will not change, we get the following:
£8 * (# of existing shares) = x * (# of existing shares) * 1.25
Or x = £8 /1.25 = £6.40.
So, the ex-bonus price of the share should be £6.40.

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 Solutions to End-of-Chapter Problems—Chapter 16 391

16-6. The required dilution in share price from ₹ 6,400 to ₹ 1,500–1,000 level requires a price drop by at
least one-fifth of its original value. Since bonus issue will not affect the firm value, we can
conclude that the value of one share has to be divided among the five new shares to achieve the
required reduction in price.
So, Eastern bank will need a bonus issue of “4 for 1” or for each existing share it will issue four
new shares.
Such a bonus issue is large enough to be classified as a stock split by the Eastern Bank. The
economic impact for the shareholders will remain the same in either case. However, the
accounting treatment will be very different depending on what the management decides to call it.

16-7. Since Eastern Bank Limited needs to have five times as many shares outstanding after the share
split, the firm will need a 5 for 1 split. We can see this as:
New firm value = old firm value
(New price) * (new # of shares) = (old price) * (old # of shares)
[(New price) * (old # of shares)] * 5 = (₹ 6,400) * (old # of shares)
Or, new price of share = ₹ 6,400/5
= ₹ 1,280, which is within the required range.

16-8. For each of the three decisions, we need to calculate the value of the firm before and after the
issue/split and the number of shares before/after the split. This will provide us with the expected
change in the given share price.
As the share capital is $1,600,000 with a face value of 20 cents, the numberof issued shares are
$1,600,000/$0.20 = 8,000,000 shares.
a. A “1 for 5” bonus offer – The market value of the firm will not change but the number of
shares will change.
Market value of the firm = (# of shares) * (Market price of shares)
Or, market value of the firm = 8,000,000 * $15 = $120,000,000.
As there will be one new share for each of the five shares, the number of shares will go up by
20%. New number of shares after the bonus issue = 1.2 * 8,000,000 = 9,600,000.Value of each
share after the bonus issue ($120,000,000/9,600,000) = $12.50 per share.
b. A “1 for 5” rights issue at the issue price of $11 per right share – Both the value of the firm
and the number of shares will change.
Number of new rights issue = 1,600,000 (since 1 new share will be issued for each of the 5
existing shares, as we have calculated in part (a) of this question.
New capital infusion due to rights issue = 1,600,000 * Issue Price ($11) = $17,600,000. So, the
new value of the firm will be $120,000,000 (existing value) + $17,600,000 (new capital) =
$137,600,000.
The new number of shares will be = 9,600,000 (as we calculated in part [a]).
So, the new share price will be ($137,600,000/ 9,600,000) = $14.33.
c. A “3-for-1” stock split – The market value of the firm will not change but the number of
shares will change.

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392 Titman/Keown/Martin • Financial Management, Thirteenth Edition, Global Edition

Number of new shares = 8,000,000 * 3 = 24,000,000 new shares. As the market value remains
the same at $120,000,000, the new value of each share will be ($120,000,000/24,000,000) =
$5 per share.

16-9. Here is the initial balance sheet for Marshall Pottery Barn:
initial situation
MARSHALL POTTERY BARN
BALANCE SHEET (as of mm/dd/yy)
Cash $18,000 Accounts Payable $22,000
Accounts Receivable $22,000 Notes Payable $5,000
Inventory $30,000 Current Liabilities $27,000
Current Assets $70,000 Long-term Debt $33,000
Net Fixed Assets $130,000 Equity $140,000
Total Assets $200,000 Total D&E $200,000
The total dividend that Marshall is considering is ($1.50/share)*(5,000 shares) = $7,500:
notes
# of shares = 5,000 A
dividend per share = $1.50 B
total dividends paid = $7,500 C = A*B
a. When the firm pays its cash dividend, it obviously will lower cash. It will also lower equity:
Dividends paid come out of the equity stake of the company. Investors are essentially “cashing
out” some of their equity. The accounting entry would be to debit equity and credit cash:

equity $7,500
cash $7,500
(payment of cash dividend)

Thus, Marshall’s balance sheet will look like this after the dividend payment:

after dividend
MARSHALL POTTERY BARN
BALANCE SHEET (as of mm/dd/yy)
Cash $10,500 Accounts Payable $22,000
Accounts Receivable $22,000 Notes Payable $5,000
Inventory $30,000 Current Liabilities $27,000
Current Assets $62,500 Long-term Debt $33,000
Net Fixed Assets $130,000 Equity $132,500
Total Assets $192,500 Total D&E $192,500

Note that total firm value has fallen by the amount of the dividend.
b. If this were interpreted as a market-value balance sheet, there would be no difference. The firm
would still have $7500 less in cash. Since the value of each share of stock would have fallen

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 Solutions to End-of-Chapter Problems—Chapter 16 393

by $1.50 after the dividend payment, the total market value of stock held by all investors would
still fall by $7500. Thus, there would be no difference in our post-dividend balance sheet.
Of course, equityholders are not worse off, ignoring taxes. Their holding of the firm used to be
worth $140,000; now it’s worth only $132,500, but they also have $7500 in cash. Either way,
they have $140,000 worth of financial assets.
16-10. The total capital gain or profit earned by Boris is:
(Sell price – Buy price) * Number of shares
= (£20 - £12) * 3000
= £24,000
As the tax-free allowances on capital gains are £11,100, he will not need to pay taxes on the first
£11,400. So, his taxable capital gain will be £24,000 − £11,400 = £12,600. On this taxable capital
gain, he will be liable to pay 20% of tax, which will be: 20% of £12,600 = £2,520.
16-11. In order to minimize his tax incidence, Boris can divide his capital gains across the two accounting
tax years (ending on April 5), so that his income or capital gain gets distributed across two years
and he becomes eligible for exemptions in each year separately. So, if he sells half his shares on
March 31 and the remaining half on April 10, he will make a capital gain of £12,000 on each
transaction. However, these capital gains will be accounted in different tax years. So, his taxable
capital gain in each year will be £12,000 − £11,400 = £600. His tax liability will be:
£600 * 20% = £120.
Or, across the two years the total tax liability will be £240.
16-12. a. If Caraway Seed Company pays $200,000 today and $1.2 million in one year to its
equityholders, and if those equityholders require a 10% return, then the value of the equity
must be the present value of those two payments. (The value of stockholders’ equity is the PV
of all future dividends, and, for Caraway’s equityholders, these are the only two dividends
they will receive. After the t = 1 dividend, the firm shuts down.) Thus, we have:
value of Caraway’s equity = PV(all future dividends)
= [PV of t = 0 dividend] + [PV of t = 1 dividend]
$1,200,000
= $200,000 +
(1.10)1
= $200,000 + $1,090,909
= $1,290,909.
(Compare our work to equation 16-1, and the related calculations for Clinton Enterprises from
the text, as well as Northwest Wire and Cable from Checkpoint 16.1.)
Now if Caraway decided to pay $600,000 in t = 0 dividends ($400,000 more than it has
available), it needs to raise $400,000 in new stock. The holders of this new stock also require a
10% return, so they will demand $400,000 ∗ (1.10) = $440,000. Paying $440,000 at t = 1
leaves only ($1,200,000 − $440,000) = $760,000 for the “old” shareholders. Thus, the value
of the “old” shareholders’ equity is now:
value of “old” equity = PV(all future dividends to original shareholders)
[PV of t = 0 dividend] + [PV of t = 1 dividend]
$760,000
= $600,000 +
(1.10)1

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394 Titman/Keown/Martin • Financial Management, Thirteenth Edition, Global Edition

= $600,000 + $690,909
= $1,290,909.
It’s the same either way! The old shareholders either get more money now or more money
later, but the PRESENT VALUE of these payments is unchanged. How could it be otherwise?
The PV is simply the value of the firm, which is not affected by these alternatives.
The situation of Caraway’s old shareholders is pictured below. Under either alternative #1
(payment today of $200,000; payment in 1 year of $1.2 million) or alternative #2 (payment
today of $600,000; payment in 1 year of $760,000), these shareholders receive payments
whose PRESENT VALUES (which are what is pictured below) are worth $1,290,909. The
packaging doesn’t matter; the value is the same.
$1,400,000

$1,290,909

$1,200,000

$1,000,000
$690,909

$800,000
$1,090,909
t=1 payment
t=0 payment
$600,000

$400,000

$600,000

$200,000

$200,000

$0
alternative #1 alternative #2

This result depends upon the new shareholders’ getting what they paid for, and on their having
the same 10% required return as our current shareholders. That is, when they give us $400,000
today, they are getting shares worth $400,000 today. The new shares’ owners receive
$440,000 in one year; this payment is worth $440,000/(1.10)1 = $400,000. When the old
shareholders choose this alternative, they receive something today worth $600,000, in return
for something in one year that is worth $760,000, which is currently worth $690,909. Thus,
there is no effect on current shareholders.
We can also think of this as follows. Under alternative #1, just after the t = 0 dividend is paid,
we have:
firm value = value of old shareholders’ shares = $1,090,909.
The old shareholders also have $200,000 in cash, so their total worth is $1,290,909.
Under alternative #2, it looks like this:
firm value = value of old shareholders’ shares + value of new shareholders’ shares
= $690,909 + $400,000
= $1,090,909.

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 Solutions to End-of-Chapter Problems—Chapter 16 395

The old shareholders also have $600,000 in cash, so their total worth is $1,290,909, just as it is
under alternative #1.
16-13. a. If the Tyler Brick Manufacturing Company pays its shareholders $125,000 today and $14
million in one year, then the all-equity firm’s value (given a required return to equity of 15%)
is found as follows:
value of Tyler’s equity = PV(all future dividends)
= [PV of t = 0 dividend] + [PV of t = 1 dividend]
$14,000,000
= $125,000 +
(1.15)1
= $125,000 + $12,173,913
= $12,298,913.
b. If, however, the firm raises new equity at a required return of 15% in order to increase
today’s dividend to $1,000,000, the value of the existing shares of stock is:
value of “old” equity = PV(all future dividends to original shareholders)
= [PV of t = 0 dividend] + [PV of t = 1 dividend]
$12,993,750
= $1,000,000 +
(1.15)1
= $1,000,000 + $11,298,913
= $12,298,913,
the same as with alternative #1.
The payment to old shareholders under the second alternative equals the $14 million available,
less the payment required by the new shareholders. Since the new shareholders provided
$875,000 at t = 0 (the $1 million dividend − $125,000 available), they will require [($875,000)
∗ (1.15)] = $1,006,250 at t = 1. This leaves ($14,000,000 − $1,006,250) = $12,993,750 for the
old shareholders at t = 1.
Thus, under either alternative, the old shares are worth $12,298,913 at t = 0 (including the t =
0 dividend). The new shares under alternative #2 are worth what they cost, $875,000.
We can see this, as shown below:

$12,298,913
$12,000,000

$10,000,000

$8,000,000

$11,298,913
t=1 payment
$6,000,000
$12,173,913
t=0 payment

$4,000,000

$2,000,000

$125,000 $1,000,000
$0
alternative #1 alternative #2

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396 Titman/Keown/Martin • Financial Management, Thirteenth Edition, Global Edition

Under either alternative, the old shares are worth $12,298,913: the old shareholders either get
more money at t = 0 (alternative #2) or more money at t = 1 (alternative #1); either way, the
PRESENT VALUE of both of their payments is $12,298,913.

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