FM12 Ch 18 Solutions Manual - Chapter 18 Distributions to...

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Chapter 18 Distributions to Shareholders: Dividends and Repurchases ANSWERS TO END-OF-CHAPTER QUESTIONS 18-1 a. The optimal distribution policy is one that strikes a balance between dividend yield and capital gains so that the firm’s stock price is maximized. b. The dividend irrelevance theory holds that dividend policy has no effect on either the price of a firm’s stock or its cost of capital. The principal proponents of this view are Merton Miller and Franco Modigliani (MM). They prove their position in a theoretical sense, but only under strict assumptions, some of which are clearly not true in the real world. The “bird-in-the-hand” theory assumes that investors value a dollar of dividends more highly than a dollar of expected capital gains because the dividend yield component, D1/P0, is less risky than the g component in the total expected return equation r S = D1/P0 + g. The tax preference theory proposes that investors prefer capital gains over dividends, because capital gains taxes can be deferred into the future, but taxes on dividends must be paid as the dividends are received. c. The information content of dividends is a theory which holds that investors regard dividend changes as “signals” of management forecasts. Thus, when dividends are raised, this is viewed by investors as recognition by man- agement of future earnings increases. Therefore, if a firm’s stock price increases with a dividend increase, the reason may not be investor preference for dividends, but expectations of higher future earnings. Conversely, a dividend reduction may signal that management is forecasting poor earnings in the future. The clientele effect is the attraction of companies with specific dividend policies to those investors whose needs are best served by those policies. Thus, companies with high dividends will have a clientele of investors with low marginal tax rates and strong desires for current income. Similarly, companies with low dividends will attract a clientele with little need for current income, and who often have high marginal tax rates. d. The residual distribution model states that firms should make distributions only when more earnings are available than needed to support the optimal capital budget. An extra dividend is a dividend paid, in addition to the regular dividend, when earnings permit. Firms with volatile earnings may have a low regular dividend that can be maintained even in low-profit (or high capital investment) years, and then supplement it with an extra dividend when excess funds are available. Answers and Solutions: 18 - 1
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e. The declaration date is the date on which a firm’s directors issue a statement declaring a dividend. If a company lists the stockholder as an owner on the holder-of- record date, then the stockholder receives the dividend. The ex-dividend date is the date when the right to the dividend leaves the stock. This date was established by stockbrokers to avoid confusion and is 2 business days prior to the holder of record
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FM12 Ch 18 Solutions Manual - Chapter 18 Distributions to...

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