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Unformatted text preview: 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- = 0.05 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 0.10 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 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....
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This note was uploaded on 10/11/2011 for the course FINANCE 300 taught by Professor zhou during the Spring '08 term at Rutgers.
- Spring '08