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MyNotesCh18 - Notes Chapter 18 1 MY NOTES CHAPTER 18...

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Notes Chapter 18 1 MY NOTES - CHAPTER 18 DIVIDEND POLICY: WHY DOES IT MATTER? Chapter Outline [PowerPoint slide 18-1] 18.1 Different Types of Dividends 18.2 Standard Method of Cash Dividend Payment 18.3 The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy 18.4 Repurchase of Stock 18.5 Personal Taxes, Issuance Costs, and Dividends 18.6 Real World Factors Favoring a High Dividend Policy 18.7 The Clientele Effect: A Resolution of Real-World Factors? 18.8 What We Know and Do Not Know About Dividend Policy 18.9 Stock Dividends & Stock Splits (in Appendix) 18.9 Summary and Conclusions Appendix A: Stock Dividends and Stock Splits Different Types of Dividends [PowerPoint slide 18-3] Standard Method of Cash Dividend Payment [PowerPoint slide 18-4] Getting out the calendar clears up the cum and ex date questions. The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy [PowerPoint slide 18-9 through 18-13] The assumptions of the Modigliani-Miller Dividend Model are similar to those we saw in their capital structure model. An additional assumption is that investment policy of the firm is set ahead of time, and not affected by changes in dividend policy . We use the following example to demonstrate that in the MM world, dividend policy is irrelevant, i.e., changes in dividend policy do not affect the value of the firm. Dividend Irrelevance in the MM World To focus on issues concerning dividend policy, our illustration assumes an all-equity firm. Basic accounting principles tell us that sources of cash must equal uses of cash. Sources of cash include cash flows from operations and new external equity . Uses of cash include net increase in assets (e.g. capital spending and increase in NWC) and dividends. If cash flows from operation and planned increase in assets do not change, any increase in cash dividends must be financed by new external equity. Pumpkin Pie Inc. currently has 1,000 shares outstanding with a total market value of $42,000. It expects cash flows from operations to be $10,000 next year. It wants to expand its product lines to include cookies and determines that it is a positive NPV project. The new product line requires a new oven that costs $8,000. 1. Dividend Policy #1 The dividend policy of Pumpkin Pie Inc. is to pay out any cash that is leftover after investing in all positive NPV projects. This policy is often referred to as the residual dividend policy (see slides 32-36) . For next year, Pumpkin Pie Inc. will pay out $2,000 ($10,000 – $8,000) as cash dividend. Pumpkin Pie stock is selling at $42 per share ($42,000 / 1,000 shares) before the cash dividend is paid. If there are no personal taxes and the firm pays a $2000 dividend ($2 per share), the total market value of the firm will fall from $42,000 to $40,000. Ex-dividend share price will be $40,000/1,000 shares = $40 per share.
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Notes Chapter 18 2 2. Dividend Policy #2 (NOT Residual Dividend Policy) Pumpkin Pie is considering a $3,000 cash dividend ($3 per share). Ex-dividend, total assets of the firm will be $39,000 ($42,000 – $3,000) and each share will sell for $39. After paying $3,000 in cash dividend, the firm only has $7,000 for capital expenditure. To maintain the investment policy, the firm
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