CHAPTER 25 SOURCES OF LONG-TERM FINANCING
The relationship between a company’s growth possibilities and its dividend policy is that,
I. Questions
1. In 1978, the average manufacturing corporation had its interest covered almost eight times.
By the mid-1990s, the ratio had been cut in half.
2. The bond agreement specifies basic items such as the par value, the coupon rate, and the
maturity date.
3. The priority claims are:
Preferred Share: Senior Secured Debt
Senior Debenture: Subordinated Debenture
Subordinated Debenture: Junior Secured Debt
Senior Secured Debt: Preferred Share
Ordinary Equity Share: Senior Debenture
Junior Secured Debt: Ordinary Equity Share
4. The method of “bond repayment” reduces debt and increases the amount of ordinary
equity share outstanding is called bond conversion.
5. The purpose of serial and sinking fund payments is to provide an orderly procedure for the
retirement of a debt obligation. To the extent bonds are paid off over their life, there is less
risk to the security holder.
6. The different bond yield terms may be defined as follows:
Coupon rate is the stated interest rate divided by par value.
Current yield is the stated interest rate divided by the current price of the bond.
Yield to maturity is the interest rate that will equate future interest payments and payment at
maturity to a current market price.
7. The higher the rating on a bond, the lower the interest payment that will be required to
satisfy the bondholder.
8. Refer to pages 636 through 637.
9. Capitalizing lease payments means computing the present value of future lease payments
and showing them as an asset and liability on the statement of financial position.
10. Founders’ share may carry special voting rights that allow the original founders to
maintain voting privileges in excess of their proportionate ownership.
11. The preemptive right provides current shareholders with a first option to buy new shares.
In this fashion, their voting right and claim to earnings cannot be diluted without their
consent.
12. The actual owners have the last claim to any and all funds that remain. If the firm is
profitable, this could represent a substantial amount. Thus, the residual claim may represent a
privilege as well as a potential drawback.
Generally, other providers of capital may only receive a fixed amount.
13. Preferred share is a “hybrid” or intermediate form of security possessing some of the
characteristics of debt and ordinary equity share. The fixed amount provision is similar to
debt, but the non-contractual obligation is similar to ordinary equity share. Though the
preferred shareholder does not have an ownership interest in the firm, the priority of claim is
higher than that of the ordinary shareholder.
14. Most corporations that issue preferred share do so to achieve a balance in their capital
structure. It is a means of expanding the capital base of the firm without diluting the ordinary
equity share ownership position or incurring contractual debt obligations.
15. Preferred share may offer a slightly lower yield than bonds in spite of greater risk because
corporate recipients of preferred share dividends must add only 30 percent of such dividends
to its taxable income. Thus, 70 percent of such dividends are exempt from taxation.
16. With the cumulative feature, if preferred share dividends are not paid in any one year,
they accumulate and must be paid in total before ordinary equity shareholders can receive
dividends. Even though preferred share dividends are not a contractual obligation as is true of
interest debt, the cumulative feature tends to make corporations very aware of obligations to
preferred shareholders. Preferred shareholders may even receive new securities for
forgiveness of missed dividend payments.
CHAPTER 26 SHARING FIRM WEALTH: DIVIDENDS, SHARE REPURCHASES AND OTHER
PAYOUTS
I. 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 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. 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.
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.