CHAPTER 16
The Dividend Controversy
Answers to Practice Questions
1.
Newspaper exercise; answers will vary depending on the stocks chosen.
2.
The available evidence is consistent with the observation that managers
believe shareholders prefer a steady progression of dividends.
For
managers of risky companies whose earnings have high variability, it is
easy to show, using the Lintner model, that a lower target payout (e.g.,
zero) and a lower adjustment rate (e.g., zero) reduce the variance of
dividend changes.
3.
a.
Distributes a relatively low proportion of current earnings to offset
fluctuations in operational cash flow; lower P/E ratio.
b.
Distributes a relatively high proportion of current earnings since the
decline is unexpected; higher P/E ratio.
c.
Distributes a relatively low proportion of current earnings in order to offset
anticipated declines in earnings; lower P/E ratio.
d.
Distributes a relatively low proportion of current earnings in order to fund
expected growth; higher P/E ratio.
4.
a.
A t = 0 each share is worth $20.
This value is based on the expected
stream of dividends: $1 at t = 1, and increasing by 5% in each subsequent
year.
Thus, we can find the appropriate discount rate for this company as
follows:
g
r
DIV
P
1
0

=
g
r
1
20

=
⇒
r = 0.10 = 10.0%
Beginning at t = 2, each share in the company will enjoy a perpetual
stream of growing dividends: $1.05 at t = 2, and increasing by 5% in each
subsequent year.
Thus, the total value of the shares at t = 1 (after the
t = 1 dividend is paid and after N new shares have been issued) is given
by:
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$21
.05
0
0.10
million
1.05
V
1
=

=
If P
1
is the price per share at t = 1, then:
V
1
= P
1
×
(1,000,000 + N) = $21,000,000
and:
P
1
×
N = $1,000,000
From the first equation:
(1,000,000
×
P
1
) + (N
×
P
1
) = 21,000,000
Substituting from the second equation:
(1,000,000
×
P
1
) + 1,000,000 = 21,000,000
so that P
1
= $20.00
b.
With P
1
equal to $20, and $1,000,000 to raise, the firm will sell 50,000 new
shares.
c.
The expected dividends paid at t = 2 are $1,050,000, increasing by 5% in
each subsequent year.
With 1,050,000 shares outstanding, dividends per
share are: $1 at t = 2, increasing by 5% in each subsequent year.
Thus,
total dividends paid to old shareholders are: $1,000,000 at t = 2,
increasing by 5% in each subsequent year.
d.
For the current shareholders:
5.
From Question 4, the fair issue price is $20 per share.
If these shares are
instead issued at $10 per share, then the new shareholders are getting a
bargain, i.e., the new shareholders win and the old shareholders lose.
As pointed out in the text, any increase in cash dividend must be offset by a
stock issue if the firm’s investment and borrowing policies are to be held
constant.
If this stock issue cannot be made at a fair price, then shareholders
are clearly not indifferent to dividend policy.
6.
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 Spring '09
 myers
 Dividends, Corporate Finance, Dividend, Dividend yield

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