Solutions Manual

CHAPTER 20

SHARING FIRM WEALTH:

DIVIDENDS, SHARE REPURCHASES
AND OTHER PAYOUTS

Answer to Questions

1. The marginal principle of retained earnings suggests that the corporation must
do an analysis of whether the corporation or the shareholders can earn the most
on funds associated with retained earnings. Thus, we must consider what the
shareholders can earn on other investments.
2. The shareholder would appear to consider dividends as relevant. Dividends do
resolve uncertainty in the minds of investors and provide information content.
Some shareholders may say that the dividends are relevant, but in a different
sense. Perhaps they prefer to receive little or no dividends because of the
immediate income tax and higher tax rate imposed on cash dividends.
3. The relationship between a company’s growth possibilities and its dividend
policy is that, the greater a company’s growth possibilities, the more funds that
can be justified for profitable internal reinvestment.
4. Management’s desire for control could imply that a closely held firm should
avoid dividends to minimize the need for outside financing. For a larger firm,
management may have to pay dividends in order to maintain their current
position through keeping shareholders happy.
5. The asset base remains the same and the shareholders’ proportionate interest is
unchanged (everyone got the same new share). Earnings per share will go down
by the exact proportion that the number of shares increases. If the P/E ratio
remains constant, the total value of each shareholder’s portfolio will not
increase.
The only circumstances in which a stock dividend may be of some usefulness
and perhaps increase value is when dividends per share remain constant and
total dividends go up, or where substantial information is provided about a
growth company. A stock split may have some functionality in placing the
company into a lower “stock price” trading range.
6. A corporation can make a rational case for purchasing its own equity share as an
alternate to a cash dividend policy. Earnings per share will go up and if the P/E
ratio remains the same, the shareholder will receive the same peso benefit as
through a cash dividend. Because the benefits are in the format of capital gains,
the tax rate will be lower and the tax may be deferred until the equity share is
sold.

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 A corporation also may justify the repurchase of its own equity share because it
is at a very low price, or to maintain constant demand for the shares. Reacquired
shares may be used for employee options or as a part of a tender offer in a
merger or acquisition. Firms may also reacquire part of their equity share as
protection against a hostile takeover.
7. Dividend reinvestment plans allow corporations to raise funds continually from
present shareholders. This reduces the need for some external funds. These plans
allow shareholders to reinvest dividends at low costs and to buy fractional
shares, neither of which can be easily accomplished in the market by an
individual. The strategy of dividend reinvestment plans allows for the
compounding of dividends and the accumulation of ordinary equity share over
time.
8. Dividend policy determines the distribution of a firm’s earnings between
retention and dividend payments to shareholders.
9. The three major arguments favoring the relevance of dividends are: (1) the
“bird-in-the-hand” theory, (2) the informational content effect, and (3) the
clientele effect.
10. The residual theory of dividends states that a firm will pay dividends only if
acceptable investment opportunities for these funds are currently unavailable.
11. Numerous factors influence a firm’s choice of dividend policy, including legal,
contractual, and internal constraints; investment opportunities and growth
prospects; alternative sources of capital; owner considerations, including their
preferences and desire for control; the cost of selling equity share; the earnings
record; and legal listing.
12. Managers generally prefer a stable peso amount of dividends because they
believe that this policy leads to higher equity share prices and avoids erroneous
informational content.
13. Both a stock dividend and a stock split are ways of distributing shares to
ordinary equity shareholders. In theory, they do not increase shareholder wealth.
However, they can convey information to investors. The only real difference
between a stock dividend and a stock split is their accounting treatment. Firms
may issue stock dividends or splits to conserve cash, to supplement cash
dividends, and to broaden the ownership base of their equity share.
14. The decision to repurchase shares may be viewed as an alternative to the
payment of a cash dividend. Firms repurchase their own equity share to increase
their earnings and market price per share. Repurchased shares are also used for
mergers and acquisitions, stock dividends, and equity share option plans.
Management may repurchase shares because they believe that their shares are
currently undervalued.

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 15. Corporations may use dividend reinvestment plans to improve shareholder
goodwill, to provide market support for their equity share, to broaden their
investor base, and to raise new equity capital. Dividend reinvestment plans help
shareholders reinvest dividends at minimal costs.
16. The goal of dividend policy is to maximize its contribution toward increasing
shareholder wealth.
17. Dividend policy deals with the timing of dividend payments, not the amounts
ultimately paid. Dividend policy is irrelevant when the timing of dividend
payments doesn’t affect the present value of all future dividends.
18. A stock repurchase reduces equity while leaving debt unchanged. The debt ratio
rises. A firm could, if desired, use excess cash to reduce debt instead. This is a
capital structure decision.
19. Friday, December 29 is the ex-dividend day. Remember not to count January 1
because it is a holiday, and the exchanges are closed. Anyone who buys the
equity share before December 29 is entitled to the dividend, assuming they do
not sell it again before December 29.
20. The change in price is due to the change in dividends, not due to the change in
dividend policy. Dividend policy can still be irrelevant without a contradiction.

Answer to Problems

Problem 1

The after-tax dividend is the pretax dividend times one minus the tax rate, so:

After-tax dividend = P4.60 (1 – .15)

= P3.91

The equity share price should drop by the after-tax dividend amount, or:

Ex-dividend price = P80.37 – 3.91

= P76.46

Problem 2

(a) The shares outstanding increases by 10 percent, so:

New shares outstanding = 30,000 (1.10)
= 33,000

New shares issued = 3,000

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 Since the par value of the new shares is P1, the capital surplus per share is P29. The
total capital surplus is therefore:

Capital surplus on new shares = 3,000 (P29)

= P87,000

Ordinary equity share (P1 par value) P 33,000

Capital surplus 372,000
Retained earnings 559,180
P964,180

(b) The shares outstanding increases by 25 percent, so:

New shares outstanding = 30,000 (1.25)

= 37,500

New shares issued = 7,500

Since the par value of the new shares is P1, the capital surplus per share is P29. The
total capital surplus is therefore:

Capital surplus on new shares = 7,500 (P29)

= P217,500

Ordinary equity share (P1 par value) P 37,500

Capital surplus 502,500
Retained earnings 424,180
P964,180

Problem 3

(a) To find the new shares outstanding, we multiply the current shares outstanding times
the ratio of new shares to old shares, so:

New shares outstanding = 30,000 (4/1)

= 120,000

The equity accounts are unchanged except the par value of the equity share is
changed by the ratio of new shares to old shares, so the new par value is:

New par value = P1 (1/4)

= P0.25 per share

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(b) To find the new shares outstanding, we multiply the current shares outstanding times
the ratio of new shares to old shares, so:

New shares outstanding = 30,000 (1/5)

= 6,000
The equity accounts are unchanged except the par value of the equity share is
changed by the ratio of new shares to old shares, so the new par value is:

New par value = P1 (5/1)

= P5.00 per share

Problem 4

To find the new equity share price, we multiply the current equity share price by the ratio
of old shares to new shares, so:

(a) P90 (3/5) = P54.00

(b) P90 (1/1.15) = P78.26
(c) P90 (1/1.425) = P63.16
(d) P90 (7/4) = P157.50
(e) To find the new shares outstanding, we multiply the current shares
outstanding times the ratio of new shares to old shares, so:

(a) 350,000 (5/3) = 583,333

(b) 350,000 (1.15) = 402,500
(c) 350,000 (1.425) = 498,750
(d) 350,000 (4/7) = 200,000

Problem 5

(a) Let x be the ordinary income tax rate. The individual receives an after-tax dividend
of:
After-tax dividend = P1,000 (1 – x)

which she invests in Treasury bonds. The Treasury bond will generate after-tax cash
flows to the investor of:

After-tax cash flow from Treasury bonds = P1,000 (1 – x) [1 + .06(1 – x)]

If the firm invests the money, its proceeds are:

Firm proceeds = P1,000 [1 + .06 (1 – .35)]

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 And the proceeds to the investor when the firm pays a dividend will be:

Proceeds if firm invests first = (1 – x) {P1,000[1 + .06(1 – .35)]}

To be indifferent, the investor’s proceeds must be the same whether she invests the
after-tax dividend or receives the proceeds from the firm’s investment and pays taxes
on that amount. To find the rate at which the investor would be indifferent, we can
set the two equations equal, and solve for x. Doing so, we find:

P1,000 (1 – x)[1 + .06(1 – x)] = (1 – x){P1,000[1 + .06(1 – .35)]}

1 + .06(1 – x) = 1 + .06 (1 – .35)
x = .35 or 35%

Note that this argument does not depend upon the length of time the investment is
held.

(b) Yes, this is a reasonable answer. She is only indifferent if the after-tax proceeds from
the P1,000 investment in identical securities are identical. That occurs only when the
tax rates are identical.

(c) Since both investors will receive the same pre-tax return, you would expect the same
answer as in part (a). Yet, because Woodrose enjoys a tax benefit from investing in
equity share (70 percent of income from equity share is exempt from corporate
taxes), the tax rate on ordinary income which induces indifference, is much lower.
Again, set the two equations equal and solve for x:

P1,000 (1 – x)[1 + .09 (1 – x)] = (1 – x) (P1,000{1 + .09[.70 + (1 – .70) (1 – .35)]})

1 + .09 (1 – x) = 1 + .09 [.70 + (1 – .70) (1 – .35)]
x = .1050 or 10.50%

(d) It is a compelling argument, but there are legal constraints, which deter firms from
investing large sums in equity share of other companies.

Problem 6

Assuming no capital gains tax, the after-tax return for the FYI Company is the capital
gains growth rate, plus the dividend yield times one minus the tax rate. Using the
constant growth dividend model, we get:

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 After-tax return = g + D (1 – t)
= .15
Solving for g, we get:

.15 = g + .05 (1 – .35)

g = .1175

The equivalent pretax return for FYI Company, which pays no dividend, is:

Pretax return = g + D
= .1175 + .05
= .1675 or 16.75%

Problem 7

(a) If the company makes a dividend payment, we can calculate the wealth of a
shareholder as:

Dividend per share = P9,000/1,000 shares

= P9.00

The equity share price after the dividend payment will be:

PX = P64 – 9
= P55 per share

The shareholder will have an equity shares worth P55 and a P9 dividend for a total
wealth of P64. If the company makes a repurchase, the company will repurchase:
Shares repurchased = P9,000/P64
= 140.63 shares

If the shareholder lets their shares be repurchased, they will have P64 in cash. If the
shareholder keeps their shares, they are still worth P64.

(b) If the company pays dividends, the current EPS is P1.30, and the P/E ratio is:
P/E = P55/P1.30
= 42.31
If the company repurchases equity share, the number of shares will decrease. The
total net income is the EPS times the current number of shares outstanding. Dividing

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 net income by the new number of shares outstanding, we find the EPS under the
repurchase is:
EPS = P1.30 (1,000) / (1,000  140.63)
= P1.51

The equity share price will remain at P64 per share, so the P/E ratio is:
P/E = P64/P1.51
= 42.31
A share repurchase would seem to be the preferred course of action. Only those
shareholders who wish to sell will do so, giving the shareholder a tax timing option
that he or she does not get with a dividend payment.

Problem 8

Since the P2,000,000 cash is after corporate tax, the full amount will be invested. So, the
value of each alternative is:

Alternative 1:
The firm invests in T-bills or in preferred share, and then pays out as special
dividend in 3 years.

a. 1. If the firm invests in T-Bills:

If the firm invests in T-bills, the after-tax yield of the T-bills will be:

After-tax corporate yield = .05 (1 – .35)

= .0325 or 3.25%

So, the future value of the corporate investment in T-bills will be:

FV of investment in T-bills = P2,000,000 (1 + .0325) 3

= P2,201,406.16

Since the future value will be paid to shareholders as a dividend, the after-tax cash
flow will be:
After-tax cash flow to shareholders = P2,201,406.16 (1 – .15)
= P1,871,195.23

a. 2. If the firm invests in preferred share (Assumption: 30 percent of dividend taxable):

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 If the firm invests in preferred share, the assumption would be that the dividends
received will be reinvested in the same preferred share. The preferred share will
pay a dividend of:
Preferred dividend = .08 (P2,000,000)
= P160,000

Since 70 percent of the dividends are excluded from tax:

Taxable preferred dividends = (1 – .70) (P160,000)
= P48,000
And the taxes the company must pay on the preferred dividends will be:

Taxes on preferred dividends = .35 (P48,000)

= P16,800

So, the after-tax dividend for the corporation will be:

After-tax corporate dividend = P160,000 – 16,800

= P143,200

This means the after-tax corporate dividend yield is:

After-tax corporate dividend yield = P143,200 / P2,000,000

= .0716 or 7.16%

The future value of the company’s investment in preferred share will be:

FV of investment in preferred share = P2,000,000 (1 + .0716) 3

= P2,461,093.48

Since the future value will be paid to shareholders as a dividend, the after-tax cash
flow will be:

After-tax cash flow to shareholders = P2,461,093.48 (1 – .15)

= P2,091,926.46

Alternative 2:

The firm pays out dividend now, and individuals invest on their own. The after-tax
cash received by shareholders now will be:

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 After-tax cash received today = P2,000,000 (1 – .15)
= P1,700,000

The individuals invest in Treasury bills:

If the shareholders invest the current after-tax dividends in Treasury bills, the
after-tax individual yield will be:

After-tax individual yield on T-bills = .05 (1 – .31)

= .0345 or 3.45%

So, the future value of the individual investment in Treasury bills will be:

FV of investment in T-bills = P1,700,000 (1 + .0345)3

= P1,882,090.08

The individuals invest in preferred share:

If the individual invests in preferred share, the assumption would be that the
dividends received will be reinvested in the same preferred share. The preferred
shares will pay a dividend of:

Preferred dividend = .08 (P1,700,000)

= P136,000
And the taxes on the preferred dividends will be:

Taxes on preferred dividends = .31 (P136,000)

= P42,160

So, the after-tax preferred dividend will be:

After-tax preferred dividend = P136,000 – 42,160

= P93,840

This means the after-tax individual dividend yield is:

After-tax corporate dividend yield = P93,840 / P1,700,000

= .0552 or 5.52%

The future value of the individual investment in preferred share will be:

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 FV of investment in preferred share = P1,700,000 (1 + .0552) 3
= P1,997,345.84

The after-tax cash flow for the shareholders is maximized when the firm invests
the cash in the preferred shares and pays a special dividend later.

Problem 9

(a) The earnings per share were:

P3,000,000
EPS = 1,500,000

= P2.00
(b) The dividends per share were:

DPS = (0.20) (P2.00)

= P0.40

Problem 10

The dividend payout is computed by dividing the yearly dividends per share by the
earnings per share.
Dividend (4) (P0.25)
payout ratio = P2.50

= 0.40 or 40%
Problem 11

To maintain the capital structure, the investment must be funded as follows:

Required debt (0.30) (P7,000,000) = P2,100,000

Required equity (0.40) (P7,000,000) = P4,900,000

To provide the P4,900,000 in required equity, Glee Mining Company must retain the
entire P4,000,000 in earnings and issue new equity share for the remaining P900,000. By
following the current dividend policy, the company will pay no cash dividends.

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Problem 12

(a) The legal limit depends on the law. If the capital impairment provisions of law are
limited to the par value of ordinary equity share, the maximum amount of dividends
is P2,500,000, which is the amount of retained earnings (P500,000) plus capital in
excess of par (P2,000,000). Otherwise, the maximum amount of dividends is the
retained earnings of P500,000. Neither amount is realistic because the company
would not have the cash available to pay.

(b) In practice, the company’s dividends could not exceed the balance of the retained
earnings.
Problem 13

(a) With a stable dividend policy, Elena Company will maintain its current P1.50 cash
dividend per share.

(b) With constant dividend payout ratio policy, dividends per share will be P1.75.
Dividends last year = (P1.50) (800,000)
= P1,200,000

P1,200,000
Dividend payout ratio = P3,000,000

= 0.40 or 40%

Dividends this year = (P0.40) (P3,500,000)

= P1,400,000

Dividends per share P1,400,000

this year = P800,000

= P1.75
Problem 14

(a) The peso amount transferred from retained earnings is:

Peso amount transferred

from retained earnings = (200,000) (0.20) (P30)
= P1,200,000
(b) A total of 40,000 shares (0.20 x 200,000) is added to the ordinary equity share
account.

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(c) Of the P1,200,000 transferred from retained earnings, P120,000 (P3 par x 40,000) is
added to the ordinary equity share account, and P1,080,000 (P1,200,000 – P120,000)
is added to the capital in excess of par account. The shareholders’ equity accounts
are as follows:

Ordinary equity share (240,000 shares outstanding at P3 par) P 720,000

Capital in excess of par 2,480,000
Retained earnings 2,800,000
Total shareholders’ equity P6,000,000

Problem 15

With a 3-for-1 stock split, the par value declines from P3 to P1, and the number of
outstanding shares triples to 600,000 shares.

Ordinary equity share (600,000 shares outstanding at P1 par) P 600,000

Capital in excess of par 1,400,000
Retained earnings 4,000,000
Total shareholders’ equity P6,000,000

Problem 16

Dividends = Earnings – Retained funds

= P160 million – P100 million
= P60 million

Dividends
Payout ratio = Earnings

P60 million
= P160 million

= 0.375 or 37.5%
Problem 17

Dividends = (Earnings x Payout ratio)

= (P800 million) (35%)
= P280 million

Addition to
retained earnings = Earnings – Dividends
= 20-13
P800 million – P280 million
=
 P520 million

Problem 18

Grape Co. is not growing very fast so it does not need cash for growth unless it desires to
change its policies. Assuming it does not, Grape Co. should have a high payout ratio.

Cherry Corp. is growing very fast and needs its cash for reinvestment in assets. For this
reason, Cherry should have a low dividend payout.

Problem 19

(a) Plan A (P1.50 + 1.50 + 1.50 + 1.60 + 1.60) = P7.70

Plan B (P.50 + 2.00 +.20 + 4.00 + 1.70) = P8.40

(b) Plan A

Dividend Per X PVIF (10%) PV

Share
1 P1.50 .909 P1.36
2 1.50 .826 1.24
3 1.50 .751 1.13
4 1.60 .683 1.09
5 1.60 .621 .99
Present Value of Future Dividends P5.81

Plan B

Dividend Per X PVIF (12%) PV

Share
1 P .50 .893 P .45
2 2.00 .797 1.59
3 .20 .712 .14
4 4.00 .636 2.54
5 1.70 .567 .96
Present Value of Future Dividends P5.68

Plan A will provide the higher present value of future dividends.

Problem 20

Annual dividend = (6.7%) (P40) = P2.68

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 Quarterly dividend = P2.68 / 4 = P .67

The equity share should go down by P.67 to P39.33.

Problem 21
Retain

Incremental earnings = (15%) (P400,000)

= P60,000

P750,000 + P60,000
Earnings per share = 300,000

P810,000
= 300,000

= P2.70

Price of equity share = (P/E) (EPS)

= (16) (P2.70)
= P43.20

Payout

New P/E = (1.10) (16)

= 17.6

P750,000
Earnings per share = 300,000

= P2.50

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 Price of equity share = (P/E) (EPS)
= (17.6) (P2.50)
= P44.00

The payout option provides the maximum market value.

Problem 22

(a) Eight (8) million shares would be outstanding at a par value of P5 per share.
Everything else will be the same.

(b) Twelve (12) million shares would be outstanding at a par value of P3.33 per
share. Everything else will be the same.

(c) P14,000,000
EPS Before = 4,000,000

= P3.50 EPS

P14,000,000
EPS After 2-1 Split = 8,000,000

= P1.75 EPS

P14,000,000
EPS After 3-1 Split = 12,000,000

= P1.17 EPS

(d) Price = (P/E) (EPS)

Price after 2-1 Split = (20) (P1.75)

= P35.00

Price after 3-1 Split = (20) (P1.17)

= P23.40
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(e) Probably not. A stock split should not change the price-earnings ratio unless
it is combined with a change in dividends to the shareholders. Generally
speaking, nothing of real value has taken place. Only to the limited extent
that new information content from this split increased investor’s expectations
would the stock split possibly have an impact on the P/E ratio.

Problem 23

(a) Price = (P/E) (EPS)

P5,000,000
EPS = 1,000,000

= P5

Price = (10) (P5)

= P50

P4,000,000
Dividends per share = 1,000,000
(b)
= P4

P4,000,000
(c) Shares reacquired = P54

= 74,074

(d) Shares outstanding

after repurchase = 1,000,000 – 74,074
= 925,926

P5,000,000
EPS = 925,926

= P5.40

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(e) Price = (P/E) (EPS)
= (10) (P5.40)
= P54

The equity share price has increased by P4.

(f) No. With the cash dividend:

Market value per share P50

Cash dividend per share 4
Total value P54

With the repurchase of equity share:

Total value per share P54

(g) The (potential) appreciation in value associated with an equity share repurchase
receives preferential capital gains tax treatment whereas a cash dividend is taxed at
the investor’s normal tax rate. The capital gains tax may also be deferred until the
equity share is sold.

(h) The corporation may think its shares are underpriced in the market. The purchase
may stave off further decline and perhaps even trigger a rally. Reacquired shares
may also be used for employee equity share options or as part of a tender offer in a
merger or an acquisition. Firms may also reacquire part of their shares as a protective
device against being taken over as a merger candidate.

Answer to Multiple Choice Questions

1. A 4. B 7. C
2. D 5. D 8. D
3. D 6. A 9. D

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