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CH16

# Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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CHAPTER 16 The Dividend Controversy Answers to Practice Questions 1. Newspaper exercise; answers will vary depending on the stocks chosen. 2. The available evidence is consistent with the observation that managers believe shareholders prefer a steady progression of dividends. For managers of risky companies whose earnings have high variability, it is easy to show, using the Lintner model, that a lower target payout (e.g., zero) and a lower adjustment rate (e.g., zero) reduce the variance of dividend changes. 3. 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. 4. 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 - = g 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 = - = 141

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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 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: 5. From Question 4, 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.
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CH16 - CHAPTER 16 The Dividend Controversy Answers to...

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