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bma_Chapter17

bma_Chapter17 - CHAPTER 17 Payout Policy Answers to...

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CHAPTER 17 Payout Policy Answers to Practice Questions 8. Newspaper exercise; answers will vary depending on the stocks chosen. 9. 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. 10. 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 17-1

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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: 11. From Question 10, 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. 12. The risk stems from the decision to not invest, and it is not a result of the form of financing. If an investor consumes the dividend instead of re-investing the dividend in the company’s stock, she is also ‘selling’ a part of her stake in the company. In this scenario, she will suffer an equal opportunity loss if the stock price subsequently rises sharply. 17-2 0 \$20,000,00 (1.10) .05) 0 (0.10 \$1,000,000 1.10 \$2,000,000 0) (t PV
13. If the company does not pay a dividend: Cash 0 0 Debt Existing fixed assets 4,500 5,500 + NPV Equity New project 1,000 + NPV \$5,500 + NPV \$5,500 + NPV If the company pays a \$1,000 dividend: Cash 0 0 Debt Existing fixed assets 4,500 1,000 Value of new stock New project 1,000 + NPV 4,500 + NPV Value of original stock \$5,500 + NPV \$5,500 + NPV Because the new stockholders receive stock worth \$1,000, the value of the original stock declines by \$1,000, which exactly offsets the dividends.

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