Brealey. Myers. Allen Chapter 16 Solution

# Brealey. Myers. Allen Chapter 16 Solution - CHAPTER 16 The...

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125 CHAPTER 16 The Dividend Controversy Answers to Practice Questions 1. Newspaper exercise; answers will vary depending on the stocks chosen. 2. 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. 3. 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 = 0.05 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: million \$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

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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: 4. From Question 3, 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. 5. a. Since both dividends and capital gains are not taxable, the share price will decrease by the amount of the dividend, HK\$5. b. The share price will not be affected. The value is unaffected by whether the firm issues a dividend or uses the equivalent amount of cash to repurchase stock. 0 \$20,000,00
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Brealey. Myers. Allen Chapter 16 Solution - CHAPTER 16 The...

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