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

a. b. c. d. Distributes a relatively low proportion of current earnings to offset fluctuations in operational cash flow; lower P/ ratio. Distributes a relatively high proportion of current earnings since the decline is unexpected; higher P/ ratio. Distributes a relatively low proportion of current earnings in order to offset anticipated declines in earnings; lower P/ ratio. Distributes a relatively low proportion of current earnings in order to fund expected growth; higher P/ ratio. # t $ " each share is worth %&". 'his value is based on the expected strea( of dividends) %! at t $ !* and increasing by +, in each subse-uent year. 'hus* we can find the appropriate discount rate for this co(pany as follows)
P" = D./! r g

!".

a.

! %&" = r "."+

r $ ".!" $ !".",

0eginning at t $ &* each share in the co(pany will en1oy a perpetual strea( of growing dividends) %!."+ at t $ &* and increasing by +, in each subse-uent year. 'hus* the total value of the shares at t $ ! 2after the t $ ! dividend is paid and after N new shares have been issued3 is given by)
/! = %!."+ (illion = %&! (illion ".!" " ."+

.f P! is the price per share at t $ !* then) /! $ P! 2!*"""*""" 4 N3 $ %&!*"""*""" and) P! N $ %!*"""*"""

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7ro( the first e-uation) 2!*"""*""" P!3 4 2N P!3 $ %&!*"""*""" 8ubstituting fro( the second e-uation) 2!*"""*""" P!3 4 %!*"""*""" $ %&!*"""*""" so that P! $ %&"."" b. c. 9ith P! e-ual to %&"* and %!*"""*""" to raise* the fir( will sell +"*""" new shares. 'he expected dividends paid at t $ & are %!*"+"*"""* increasing by +, in each subse-uent year. 9ith !*"+"*""" shares outstanding* dividends per share are) %! at t $ &* increasing by +, in each subse-uent year. 'hus* total dividends paid to old shareholders are) %!*"""*""" at t $ &* increasing by +, in each subse-uent year. 7or the current shareholders)
P/ 2t = "3 = %&*"""*""" %!*"""*""" + = %&"*"""*"" " !.!" 2".!" " ."+3 2!.!"3

d.

!!.

7ro( :uestion !"* the fair issue price is %&" per share. .f these shares are instead issued at %!" per share* then the new shareholders are getting a bargain* i.e.* the new shareholders win and the old shareholders lose. #s pointed out in the text* any increase in cash dividend (ust be offset by a stock issue if the fir(;s invest(ent and borrowing policies are to be held constant. .f this stock issue cannot be (ade at a fair price* then shareholders are clearly not indifferent to dividend policy.

!&.

'he risk ste(s fro( the decision to not invest* and it is not a result of the for( of financing. .f an investor consu(es the dividend instead of re6investing the dividend in the co(pany;s stock* she is also <selling; a part of her stake in the co(pany. .n this scenario* she will suffer an e-ual opportunity loss if the stock price subse-uently rises sharply.

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!=.

.f the co(pany does not pay a dividend) >ash " " xisting fixed assets ?*+"" +*+"" 4 NP/ New pro1ect !*""" 4 NP/ %+*+"" 4 NP/ .f the co(pany pays a %!*""" dividend) >ash xisting fixed assets New pro1ect " ?*+"" !*""" 4 NP/ %+*+"" 4 NP/ " !*""" ?*+"" 4 NP/ %+*+"" 4 NP/ %+*+"" 4 NP/

Debt -uity

Debt /alue of new stock /alue of original stock

0ecause the new stockholders receive stock worth %!*"""* the value of the original stock declines by %!*"""* which exactly offsets the dividends. !?. @ne proble( with this analysis is that it assu(es the co(pany;s net profit re(ains constant even though the asset base of the co(pany shrinks by &",. 'hat is* in order to raise the cash necessary to repurchase the shares* the co(pany (ust sell assets. .f the assets sold are representative of the co(pany as a whole* we would expect net profit to decrease by &", so that earnings per share and the P/ ratio re(ain the sa(e. #fter the repurchase* the co(pany will look like this next year) Net profit) Nu(ber of shares) arnings per share) Price6earnings ratio) 8hare price) !+. a. %8 (illion ".8 (illion %!" &" %&""

.f we ignore taxes and there is no infor(ation conveyed by the repurchase when the repurchase progra( is announced* then share price will re(ain at %8". 'he regular dividend has been %? per share* and so the co(pany has %?""*""" cash on hand. 8ince the share price is %8"* the co(pany will repurchase +*""" shares.

b.

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c.

'otal asset value 2before each dividend pay(ent or stock repurchase3 re(ains at %8*"""*""". 'hese assets earn %?""*""" per year* under either policy. Old Policy) 'he annual dividend is %?* which never changes* so the stock price 2i((ediately prior to the dividend pay(ent3 will be %8" in all years. New Policy) very year* %?""*""" is available for share repurchase. #s noted above* +*""" shares will be repurchased at t $ ". #t t $ !* i((ediately prior to the repurchase* there will be 9+*""" shares outstanding. 'hese shares will be worth %8*"""*"""* or %8?.&! per share. 9ith %?""*""" available to repurchase shares* the total nu(ber of shares repurchased will be ?*5+". Asing this reasoning* we can generate the following table) 'i(e t$" t$! t$& t$= 8hares @utstanding !""*""" 9+*""" 9"*&+" 8+*5=5 8hare Price %8"."" %8?.&! %88.C? %9=.=! 8hares Bepurchased +*""" ?*5+" ?*+!= ?*&85

Note that the stock price is increasing by +.&C, each year. 'his is consistent with the rate of return to the shareholders under the old policy* whereby every year assets worth %5*C""*""" 2the asset value i((ediately after the dividend3 earn %?""*"""* or a return of +.&C,. !C. .f (arkets are efficient* then a share repurchase is a Dero6NP/ invest(ent. 8uppose that the trade6off is between an invest(ent in real assets or a share repurchase. @bviously* the shareholders would prefer a share repurchase to a negative6NP/ pro1ect. 'he -uoted state(ent see(s to i(ply that fir(s have only negative6NP/ pro1ects available. #nother possible interpretation is that (anagers have inside infor(ation indicating that the fir(;s stock price is too low. .n this case* share repurchase is detri(ental to those stockholders who sell and beneficial to those who do not. .t is difficult to see how this could be beneficial to the fir(* however.

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!5.

a.

'his state(ent i(plicitly e-uates the cost of e-uity capital with the stock;s dividend yield. .f this were true* co(panies that pay no dividend would have a Dero cost of e-uity capital* which is clearly not correct. @ne way to think of retained earnings is that* fro( an econo(ic standpoint* the co(pany earns (oney on behalf of the shareholders* who then i((ediately re6invest the earnings in the co(pany. 'hus* retained earnings do not represent free capital. Betained earnings carry the full cost of e-uity capital 2although issue costs associated with raising new e-uity capital are avoided3. .f the tax on capital gains is less than that on dividends* the conclusion of this state(ent is correct; i.e.* a stock repurchase is always preferred over dividends. 'his conclusion* however* is strictly because of taxes. arnings per share is irrelevant. 0ecause this is a regular dividend* the announce(ent is not news to the stock (arket. Eence* the stock price will ad1ust only when the stock begins to trade without the dividend and* thus* the stock price will fall on the ex6dividend date. 9ith no taxes* the stock price will fall by the a(ount of the dividend* here %!. 9ith taxes on dividends but no taxes on capital gains* investors will re-uire the sa(e after6tax return fro( two co(parable co(panies* one of which pays a dividend* the other* a capital gain of the sa(e (agnitude. 'he stock price will thus fall by the a(ount of the after6tax dividend* here) %! 2! F ".="3 $ %".5". .f dealers are taxed e-ually on capital gains and dividends* then they should not de(and any extra return for holding stocks that pay dividends. 'hus* if shareholders are able to freely trade securities around the ti(e of the dividend pay(ent* there should be no tax effects associated with dividends.

b.

c.

!8.

a.

b. c.

d.

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!9.

a.

.f you own !"" shares at %!"" per share* then your wealth is %!"*""". #fter the dividend pay(ent* each share will be worth %99 and your total wealth will be the sa(e) !"" shares at %99 per share plus %!"" in dividends* or %!"*""". 9ith no taxes* it does not (atter how the co(pany transfers wealth to the shareholders; that is* you are indifferent between a dividend and a share repurchase progra(. .n either case* your total wealth will re(ain at %!"*""".

b.

&".

After-tax Return on Share A) #t t $ !* a shareholder in co(pany # will receive a dividend of %!"* which is sub1ect to taxes of =",. 'herefore* the after6tax gain is %5. 8ince the initial invest(ent is %!""* the after6tax rate of return is 5,. After-tax Return on Share B) .f an investor sells share 0 after & years* the price will be) 2!"" !.!"&3 $ %!&!. 'he capital gain of %&! is taxed at the =", rate* and so the after6tax gain is %!?.5". @n an initial invest(ent of %!""* over a &6 year ti(e period* this is an after6tax annual rate of return of 5.!",. .f an investor sells share 0 after !" years* the price will be) 2!"" !.!"!"3 $ %&+9.=5. 'he capital gain of %!+9.=5 is taxed at the =", rate* and so the after6tax gain is %!!!.+C. @n an initial invest(ent of %!""* over a !"6 year ti(e period* this is an after6tax annual rate of return of 5.58,.

&!.

a.

2i3 'he tax6free investor should buy on the with6dividend date because the dividend is worth %! and the price decrease is only %".9". 2ii3 'he dividend is worth only %".C" to the taxable investor who is sub1ect to a ?", (arginal tax rate. 'herefore* this investor should buy on the ex6dividend date.

G#ctually* the taxable investor;s proble( is a little (ore co(plicated. 0y buying at the ex6dividend price* this investor increases the capital gain that is eventually reported upon the sale of the asset. #t (ost* however* this will cost) 2".!C ".9"3 $ %".!? 'his is not enough to offset the tax on the dividend.H b. 'he (arginal investor* by definition* (ust be indifferent between buying with6dividend or ex6dividend. .f we let ' represent the (arginal tax rate on dividends* then the (arginal tax rate on capital gains is 2".?'3. .n order for the net extra return fro( buying with6dividend 2instead of ex6dividend3 to be Dero) F xtra invest(ent 4 #fter6tax dividend 4 Beduction in capital gains tax $ " 'herefore* per dollar of dividend) F".8+ 4 G2! F '3 !.""H 4 G".?' ".8+H $ " ' $ ".&&5 $ &&.5,

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c.

9e would expect the high6payout stocks to show the largest decline per dollar of dividends paid because these stocks should be held by investors in low* or perhaps even Dero* (arginal tax brackets. 8o(e investors 2e.g.* pension funds and security dealers3 are indifferent between %! of dividends and %! of capital gains. 'hese investors should be prepared to buy any a(ount of stock with6dividend as long as the fall6off in price is fractionally less than the dividend. lton and Iruber;s result suggests that there (ust be so(e i(pedi(ent to such tax arbitrage 2e.g.* transactions costs or .B8 restrictions3. 0ut* in that case* it is difficult to interpret their result as indicative of (arginal tax rates. 'he tax advantage to capital gains has been reduced. .f investors are now indifferent between dividends and capital gains* we would expect that the pay(ent of a %! dividend would result in a %! decrease in price.

d.

e.

&&.

ven if the (iddle6of6the6road party is correct about the supply of dividends* we still do not know why investors wanted the dividends they got. 8o* it is difficult to be sure about the effect of the tax change. .f there is so(e non6tax advantage to dividends that offsets the apparent tax disadvantage* then we would expect investors to de(and (ore dividends after the govern(ent reduces the tax rate on dividends. .f the apparent tax disadvantage were irrelevant because there were too (any loopholes in the tax syste(* then the reduction in the tax rate on dividends would not affect the de(and for dividends. .n any case* the (iddle6of6 the6roaders would argue that once co(panies ad1usted the supply of dividends to the new e-uilibriu(* dividend policy would again beco(e irrelevant.

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Challenge Questions &=. Beducing the a(ount of earnings retained each year will* of course* reduce the growth rate of dividends. #lso* the fir( will have to issue new shares each year in order to finance co(pany growth. Ander the original dividend policy* we expect next year;s stock price to be) 2%+" !."83 $ %+?. .f N is the nu(ber of shares previously outstanding* the value of the co(pany at t $ ! is 2+?N3. Ander the new policy* n new shares will be issued at t $ ! to (ake up for the reduction in retained earnings resulting fro( the new policy. 'his decrease is) 2%? 6 %&3 $ %& per original share* or an aggregate reduction of &N. .f P ! is the price of the co((on stock at t $ ! under the new policy* then) &N $ nP! #lso* because the total value of the co(pany is unchanged) +?N $ 2N 4 n3P! 8olving* we find that P! $ %+&. .f g is the expected growth rate under the new policy and P " the price at t $ "* we have) +& $ 2! 4 g3P" and)
P" = ? ".!& g

8ubstituting the second e-uation above for P " in the first e-uation and then solving* we find that g $ ?, and P" $ %+"* so that the current stock price is unchanged.

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#ssu(e that all taxpayers pay a &", tax on dividend inco(e and !", tax on capital gains. 7ir( # pays no dividends but investors expect the price of 7ir( # stock to increase fro( %?" to %+" per share. 7ir( 0 pays a dividend of %+ per share and investors expect the price of 7ir( 0 stock to be %?+ next year. Besults for 7ir( # are) 0efore6tax rate of return 'ax on dividend at &", 'ax on capital gains at !", 'otal after6tax inco(e 2dividends plus capital gains less taxes3 #fter6tax rate of return %!"/%?" $ &+."", %"."" ".!" %!"."" $ %!."" %" 4 %!" 6 %! $ %9."" %9/%?" $ &&.+",

'he price of 7ir( 0 stock today (ust ad1ust so as to provide an after6tax return e-ual to that of 7ir( #. Jet K e-ual the current price of 7ir( 0 stock. 'hen* for 7ir( 0) Next year;s price Dividend 'oday;s stock price >apital gain 0efore6tax rate of return 'ax on dividend at &", 'ax on capital gains at !", 'otal after6tax inco(e 2dividends plus capital gains less taxes3 %?+."" %+."" K %?+ F K G%+ 4 2%?+ F K3H/K ".&" %+."" $ %!."" ".!" 2%?+ F K3 G%+ 4 2%?+ F K3H F G%! 4 ".!" 2%?+ F K3H

'he price of 7ir( 0 stock ad1usts so that the after6tax rate of return for 7ir( 0 is e-ual to &&.+,* the after6tax rate of return for 7ir( #. 'o find today;s price for 7ir( # stock* solve the following for K) G%+ + 2%?+ 6 K3H 6 { %! + G".!" 2%?+ 6 K3H} = ".&&+ K = $=9.+C K &+. .t is true that researchers have been consistent in finding a positive association between price6earnings (ultiples and payout ratios. 0ut si(ple tests like this one do not isolate the effects of dividend policy* so the evidence is not convincing. 8uppose that Ling >oal >o(pany* which custo(arily distributes half its earnings* suffers a strike that cuts earnings in half. 'he setback is regarded as te(porary* however* so (anage(ent (aintains the nor(al dividend. 'he payout ratio for that year turns out to be !"" percent* not +" percent.

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'he te(porary earnings drop also affects Ling >oal;s price6earnings ratio. 'he stock price (ay drop because of this year;s disappointing earnings* but it does not drop to one6half its pre6strike value. .nvestors recogniDe the strike as te(porary* and the ratio of price to this year;s earnings increases. 'hus* Ling >oal;s labor troubles create both a high payout ratio and a high price6earnings ratio. .n other words* they create a spurious association between dividend policy and (arket value. 'he sa(e thing happens whenever a fir( encounters te(porary good fortune* or whenever reported earnings underesti(ate or overesti(ate the true long6run earnings on which both dividends and stock prices are based. # second source of error is o(ission of other factors affecting both the fir(;s dividend policy and its (arket valuation. 7or exa(ple* we know that fir(s seek to (aintain stable dividend rates. >o(panies whose prospects are uncertain therefore tend to be conservative in their dividend policies. .nvestors are also likely to be concerned about such uncertainty* so that the stocks of such co(panies are likely to sell at low (ultiples. #gain* the result is an association between the price of the stock and the payout ratio* but it ste(s fro( the co((on association with risk and not fro( a (arket preference for dividends. #nother reason that earnings (ultiples (ay be different for high6payout and low6 payout stocks is that the two groups (ay have different growth prospects. 8uppose* as has so(eti(es been suggested* that (anage(ent is careless in the use of retained earnings but exercises appropriately stringent criteria when spending external funds. Ander such circu(stances* investors would be correct to value stocks of high6payout fir(s (ore highly. 0ut the reason would be that the co(panies have different invest(ent policies. .t would not reflect a preference for high dividends as such* and no co(pany could achieve a lasting i(prove(ent in its (arket value si(ply by increasing its payout ratio. &C. a. b. 'he (arginal investors are the institutions. Price of low6payout stock) Price of (ediu(6payout stock) Price of high6payout stock)
P" = P" = P" = %&" = %!CC.C5 ".!& %!" = %8=.== ".!& %=" = %&+"."" ".!&

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c.

7or corporations* after6tax return is !&, for each type of stock. 7or individuals* after6tax returns are) 7or low6payout stock) 7or (ediu(6payout stock) 7or high6payout stock)
2".+" %+3 + 2".8+ $!+3 = 9.!+, %!CC.C5 2".+" %+3 + 2".8+ $+3 = 8.!", %8=.== 2".+" %="3 + 2".8+ %"3 = C."", %&+".""

7or corporations* after6tax returns are) 7or low6payout stock) 7or (ediu(6payout stock) 7or high6payout stock) d. .ndividuals >orporations .nstitutions Jow Payout %8" billion %&" billion Mediu( Payout %+" billion Eigh Payout %!" billion %!!" billion
2".9+ %+3 + 2".C+ $!+3 = 8.5", %!CC.C5 2".9+ %+3 + 2".C+ $+3 = 9.C", %8=.== 2".9+ %="3 + 2".C+ %"3 = !!.?", %&+".""

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