1 investment opportunities schedules item ios1 ios2

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Unformatted text preview: idends to Overbrook Industries for Each of Three IOSs (Shown in Figure 13.1) Investment opportunities schedules Item IOS1 IOS2 IOS3 (1) New financing or investment (Fig. 13.1) $1,500,000 $2,400,000 $3,200,000 (2) Retained earnings available (given) $1,800,000 $1,800,000 $1,800,000 1,050,000 1,680,000 $ 750,000 $ 120,000 41.7% 6.7% (3) Equity needed [70% (4) Dividends [(2) (1)] (3)] (5) Dividend payout ratio [(4) (2)] aIn this case, additional new common stock in the amount of $440,000 ($2,240,000 needed available) would have to be sold; no dividends would be paid. 2,240,000 0a $ 0% $1,800,000 Arguments for Dividend Irrelevance dividend irrelevance theory Miller and Modigliani’s theory that in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. informational content The information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm’s stock. clientele effect The argument that a firm attracts shareholders whose preferences for the payment and stability of dividends correspond to the payment pattern and stability of the firm itself. The residual theory of dividends implies that if the firm cannot invest its earnings to earn a return (IRR) that is in excess of cost (WMCC), it should distribute the earnings by paying dividends to stockholders. This approach suggests that dividends represent an earnings residual rather than an active decision variable that affects the firm’s value. Such a view is consistent with the dividend irrelevance theory put forth by Merton H. Miller and Franco Modigliani (M and M).1 They argue that the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. M and M’s theory suggests that in a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends. However, studies have shown that large changes in dividends do affect share price. Increases in dividends result in increased share price, and decreases in dividends result in decreased share price. In response, M and M argue that these effects are attributable not to the dividend itself but rather to the informational content of dividends with respect to future earnings. In other words, say M and M, it is not the preference of shareholders for current dividends (rather than future capital gains) that is responsible for this behavior. Instead, investors view a change in dividends, up or down, as a signal that management expects future earnings to change in the same direction. An increase in dividends is viewed as a positive signal, and investors bid up the share price; a decrease in dividends is a negative signal that caus...
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This document was uploaded on 01/19/2014.

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