⇐⋅⇒∉⊄∨⊆ 

∉ƒ°♠↔ ∉°≥∂…ƒ
⇐•↓↔≡↑ ⊂ƒ±°↓←∂←
〉 ⇔∂←↔↑∂♠↔∂°±← ↔° ⊂•↑≡•°≥≈≡↑←
A corporation’s payout policy determines if and when it will distribute cash to its shareholders
by issuing a dividend or undertaking a stock repurchase.
To issue a dividend, the firm’s board of directors must authorize the amount per share that
will be paid on the declaration date. The firm pays the dividend to all shareholders of record
on the record date. Because it takes three business days for shares to be registered, only
shareholders who purchase the stock at least three days prior to the record date receive the
dividend. As a result, the date two business days prior to the record date is known as the ex-
dividend date; anyone who purchases the stock on or after the ex-dividend date will not
receive the dividend. Finally, on the payable (or distribution) date, which is generally about a
month after the record date, the firm pays the dividend.
Just before the ex-dividend date, the stock is said to trade cum-dividend. After the stock goes
ex-dividend, new buyers will not receive the current dividend, and the share price will reflect
only the dividends in subsequent years. In a perfect capital market, when a dividend is paid,
the share price drops by the amount of the dividend when the stock begins to trade ex-
dividend.
Most dividend-paying corporations pay them at quarterly intervals. Companies typically
increase the amount of their dividends gradually, with little variation. Occasionally, a firm may
pay a one-time, special dividend that is usually much larger than a regular dividend.
An alternative way to pay cash to investors is through a share repurchase, in which a firm
uses cash to buy shares of its own outstanding stock. These shares are generally held in the
corporate treasury and can be resold in the future.
An open market repurchase, in which a firm buys its own shares in the open market, is
the most common way that firms repurchase shares.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition

A firm can also use a tender offer repurchase in which it offers to buy shares at a pre-
specified price during a short time period at typically a 10% to 20% premium.
In a Dutch auction repurchase, a firm lists different prices at which it is prepared to buy
shares, and shareholders indicate how many shares they are willing to sell at each price.
The firm then pays the lowest price at which it can buy back the desired number of
shares.
A firm may also negotiate a purchase of shares directly from a major shareholder in a
targeted repurchase.

〉 ⇐°″↓↑∂←°± °≠ ⇔∂♥∂≈≡±≈← ±≈ ⊂•↑≡ ⊆≡↓♠↑…•←≡←

In perfect capital markets, a stock’s price will fall by the amount of the dividend when a
dividend is paid, and a share repurchase has no effect on the stock price. In addition, by
selling shares or reinvesting dividends, an investor can effectively create any cash dividend
desired and can sell stock in the open market without a share repurchase. As a result,
investors are indifferent between the various payout methods the firm might employ.
The Modigliani and Miller dividend irrelevance proposition states that in perfect capital
markets, holding the investment policy of a firm fixed, the firm’s choice of dividend policy is
irrelevant and does not affect share value.

〉 ⊄•≡ ⊄♣ ⇔∂←≈♥±↔÷≡ °≠ ⇔∂♥∂≈≡±≈←

Taxes are an important market imperfection that affects dividend policy.
When the tax rate on dividend exceeds the tax rate on capital gains, the optimal dividend
policy is for firms to pay no dividends and use share repurchases for all payouts.
Recent changes to the tax code have equalized the tax rates on dividends and capital
gains. However, long-term investors can defer the capital gains tax until they sell, so
there is still a tax advantage for share repurchases over dividends for most investors.
The fact that firms continue to issue dividends despite their tax disadvantage is often
referred to as the dividend puzzle.

〉 ⇔∂♥∂≈≡±≈ ⇐↓↔♠↑≡ ±≈ ⊄♣ ⇐≥∂≡±↔≡≥≡←

While many investors have a tax preference for share repurchases rather than dividends, the
strength of that preference depends on the difference between the dividend tax rate and the
capital gains tax rate that each investor faces. The effective dividend tax rate, *d , which
measures the net tax cost to the investor per dollar of dividend income received, is equal to:

* d g
d =
1 g

*
where d is the tax on dividend income and g is the tax rate on capital gains. When d 0,
investors would be better off with a share repurchase instead of dividends.
The effective dividend tax rate varies across investors for several reasons such as income
level, investment horizon, tax jurisdiction, and type of investment account. Different investor
tax rates create clientele effects. For example, individuals in the highest tax brackets have a
preference for stocks that pay low or no dividends, whereas corporations, which are only
taxed on 30% of dividend income, generally have a preference for stocks with high dividends.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition 

〉 ∉ƒ°♠↔ ⊃≡↑←♠← ⊆≡↔≡±↔∂°± °≠ ⇐←•

With perfect capital markets, Modigliani and Miller payout policy irrelevance holds that as
long as a firm without positive NPV projects invests excess cash flows in financial securities,
the firm’s choice of payout versus retention is irrelevant and does not affect the value of the
firm.
However, in the presence of corporate taxes, it is generally costly for a firm to retain excess
cash because the interest is taxable income for the corporation. Stockholders are better off if
the corporation pays the cash out so it can be invested by the investors before taxable
interest is incurred. After accounting for investor taxes, there remains a substantial tax
disadvantage for retaining excess cash.
Nevertheless, firms may want to hold cash balances in order to help minimize the transaction
costs of raising new capital when they have future potential cash needs. However, there is no
benefit to shareholders for firms to hold cash in excess of future investment needs.
In addition to the tax disadvantage of holding cash, agency costs may arise, as managers
may be tempted to spend excess cash on inefficient investments and perks. Thus, dividends
and share repurchases may help minimize the agency problem of wasteful spending when a
firm has excess cash. Without pressure from shareholders, managers may also choose to
horde cash in order to reduce the firm’s leverage and increase their job security.

〉 ⊂∂÷±≥∂±÷ ♦∂↔• ∉ƒ°♠↔ ∉°≥∂…ƒ

When managers have better information than investors do regarding the future prospects of
a firm, their payout decisions may signal this information.
Firms typically undertake dividend smoothing by maintaining relatively constant dividends,
and they increase dividends much more frequently than they cut them. If a firm uses dividend
smoothing, its dividend choice may contain information regarding management’s
expectations of future earnings.
When a firm increases its dividend, it sends a positive signal to investors that
management expects to be able to afford the higher dividend for the foreseeable future.
When a firm cuts its dividend, it may signal that there it is necessary to reduce the
dividend to save cash.
The idea that dividend changes reflect managers’ views about a firm’s future earnings
prospects is called the dividend signaling hypothesis.
Studies of the market’s reaction to dividend changes are consistent with this hypothesis. For
example, during the period 1967–1993, firms that raised their dividend by 10% or more saw
their stock prices rise by 1.3% after the announcement, while those that cut their dividend by
10% or more experienced a price decline of 23.71%.

〉 ⊂↔°…× ⇔∂♥∂≈≡±≈←⌠ ⊂↓≥∂↔←⌠ ±≈ ⊂↓∂±∫°≠≠←

In a stock split, shareholders receive additional shares in the firm and the stock price
generally falls proportionally with the size of the split. For example, in a 2-for-1 stock split, the
firm’s stock price will fall by half or 50%. The typical motivation for a stock split is to keep the
share price in a range thought to be attractive to small investors. If the stock price is deemed
too low, firms can use a reverse stock split, which decreases the number of shares
outstanding and results in a higher share price.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition

Stock splits are generally accomplished using a stock dividend. When shareholders receive
additional shares of stock in the firm itself, the stock dividend has the same effect as s stock
split; when they receive shares of a subsidiary, it is called a spin-off.

⊂≡≥≡…↔≡≈ ⇐°±…≡↓↔← ±≈ ≡ƒ ⊄≡↑″←

⇑∂↑≈ ∂± ↔•≡ ⋅±≈ ⋅ƒ↓°↔•≡←∂←
Paying higher current dividends will lead to a higher stock price because shareholders prefer
current dividends to future ones with the same present value. However, with perfect capital
markets, shareholders can generate an equivalent cash flow at any time by selling shares.
Thus, the dividend choice of the firm should not matter, and this hypothesis is generally
believed to be a fallacy.

⇐≥∂≡±↔≡≥≡ ∨≠≠≡…↔
Individuals in the highest tax brackets have a preference for stocks that pay low or no
dividends, whereas tax-free investors and corporations have a stronger preference for stocks
with high dividends. Thus, a firm’s dividend policy may be optimized for the tax preference of
its investor clientele.

⇔≡…≥↑↔∂°± ⇔↔≡
The date a corporation announces that it will pay dividends to all shareholders of record on
the record date.

⇔∂♥∂≈≡±≈ ∉♠∞∞≥≡
The fact that firms continue to issue dividends despite their general tax disadvantage.

⇔∂♥∂≈≡±≈ ⊂∂÷±≥∂±÷ ⋅ƒ↓°↔•≡←∂←

The idea that dividend changes reflect managers’ views about a firm’s future earnings
prospects. When a firm increases its dividend, it sends a positive signal to investors that
management expects to be able to afford the higher dividend for the foreseeable future.
When a firm cuts its dividend, it may be signaling that it is necessary to reduce the dividend
to save cash.

⇔∂♥∂≈≡±≈∫⇐↓↔♠↑≡ ⊄•≡°↑ƒ
The theory that, absent transaction costs, investors can trade shares at the time of the
dividend so that non-taxed investors receive the dividend. Thus, non-taxed investors need not
hold the high-dividend-paying stocks all the time; it is only necessary that they hold them
when the dividend is actually paid.

⇔♠↔…• ⇒♠…↔∂°± ⊂•↑≡ ⊆≡↓♠↑…•←≡

A method of repurchasing shares in which a firm lists different prices at which it is prepared
to buy shares, and shareholders indicate how many shares they are willing to sell at each
price. The firm then pays the lowest price at which it can buy back its desired number of
shares.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition 

∨♣∫⇔∂♥∂≈≡±≈ ⇔↔≡
The date two business days prior to the record date; anyone who purchases the stock on or
after the ex-dividend date will not receive the dividend.

¬↑≡≡±″∂≥
A targeted share repurchase from an investor threatening a takeover.

∉ƒ≥≡ ⇔↔≡⌠ ⇔∂←↔↑∂♠↔∂°± ⇔↔≡

The date the firm mails dividend checks to the registered shareholders. Generally about a
month after the record date.

∉ƒ°♠↔ ∉°≥∂…ƒ
The procedure a firm uses to distribute cash to its shareholders by either issuing a dividend
or undertaking a stock repurchase.

⊆≡…°↑≈ ⇔↔≡
The date a stockholder must own a stock in order receive the dividend.

⊂↓≡…∂≥ ⇔∂♥∂≈≡±≈
A one-time dividend that is usually much larger than a regular dividend.

⊂↓∂±∫∠≠≠
The distribution of shares of stock in a subsidiary to existing shareholders on a pro rata basis
as a stock dividend.

⊂↔°…× ⇔∂♥∂≈≡±≈
A payment to shareholders in which each shareholder that owns the stock before it goes ex-
dividend receives additional shares of stock of the firm itself (a stock split) or of a subsidiary
(a spin-off ).

⊂↔°…× ⊂↓≥∂↔
A transaction in which shareholders receive additional shares in the firm. The stock price
generally falls proportionally with the size of the split. For example, in a 2-for-1 stock split, the
firm’s stock price will fall by 50%. The typical motivation for a stock split is to keep the share
price in a range thought to be attractive to small investors. If the stock price is deemed too
low, firms can use a reverse stock split, which decreases the number of shares outstanding
resulting in a higher share price.

⇐°±…≡↓↔ ⇐•≡…× ∈♠≡←↔∂°±← ±≈ ⇒±←♦≡↑←

17.1.1. How is a stock’s ex-dividend date determined, and what is its significance?
Because it takes three business days for shares to be registered, only shareholders who
purchase the stock at least three days prior to the record date receive the dividend. As a
result, the date two business days prior to the record date is known as the ex-dividend
date; anyone who purchases the stock on or after the ex-dividend date will not receive the
dividend.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition

17.1.2. What is a Dutch auction share repurchase?

In the Dutch auction share repurchase, a firm lists different prices at which it is prepared to
buy and shareholders indicate how many shares they are willing to sell at each price. The
firm then pays the lowest price at which it can buy back its desired number of shares.
17.2.1. True or False: When a firm repurchases its own shares, the price rises due to the decrease
in the supply of shares outstanding.
False. When a firm repurchases its own shares, the supply of shares is reduced, but the
value of the firm’s assets declines when it spends its cash to buy the shares. If the firm
repurchases its shares at their market prices, these two effects offset each other, and the
share price is unchanged.
17.2.2. In a perfect capital market, how important is the firm’s decision to pay dividends versus
repurchase shares?
As Modigliani and Miller make clear, the value of a firm ultimately derives from its
underlying free cash flow. A firm’s free cash flow determines the level of payouts that it can
make to its investors. In a perfect capital market, whether these payouts are made through
dividends or share repurchases does not matter.
17.3.1. What is the optimal dividend policy when the dividend tax rate exceeds the capital gain tax
rate?
The optimal dividend policy when the dividend tax rate exceeds the capital gain tax rate is
to pay no dividends at all.
17.3.2. What is the dividend puzzle?
The dividend puzzle refers to the fact that firms continue to pay dividends despite their tax
disadvantage.
17.4.1. Under what conditions will investors have a tax preference for share repurchases rather
than dividends?
While many investors have a tax preference for share repurchases rather than dividends,
the strength of that preference depends on the difference between the dividend tax rate
and the capital gains tax rate that they face. Tax rates vary across investors for several
reasons, including income level, investment horizon, tax jurisdiction, and type of
investment account.
17.4.2. What does the dividend-capture theory imply about the volume of trade in a stock around
the ex-dividend day?
The dividend-capture theory states that absent transaction costs, investors can trade
shares at the time of the dividend so that non-taxed investors receive the dividend. An
implication of this theory is that we should see large volumes of trade in a stock around the
ex-dividend day, as high-tax investors sell and low tax-investors buy the stock in
anticipation of the dividend, and then reverse those trades just after the ex-dividend date.
17.5.1. Is there an advantage for a firm to retain its cash instead of paying it out to shareholders in
perfect capital markets?
No. In perfect capital markets, if a firm invests excess cash flows in financial securities, the
firm’s choice of payout versus retention is irrelevant and does not affect the initial share
price.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition 

17.5.2. How do corporate taxes affect the decision of a firm to retain excess cash?
Corporate taxes make it costly for a firm to retain excess cash. When the firm receives
interest from its investment in financial securities, it owes taxes on the interest. Thus, cash
is equivalent to negative leverage, and the tax advantage of leverage implies a tax
disadvantage to holding cash.
17.6.1. What possible signals does a firm give when it cuts its dividend?
According to the dividend signaling hypothesis, when a firm cuts the dividend, it gives a
negative signal to investors that the firm does not expect that earnings will rebound in the
near term and so it needs to reduce the dividend to save cash. Also, a firm might cut its
dividend to exploit new positive-NPV investment opportunities. In this case, the dividend
decrease might lead to a positive stock price reaction.
17.6.2. Would managers acting in the interests of long-term shareholders be more likely to
repurchase shares if they believe the stock is undervalued or overvalued?
If managers believe the stock is currently undervalued, a share repurchase is a positive-
NPV investment. Managers will clearly be more likely to repurchase shares if they believe
the stock to be undervalued.
17.7.1. What is the difference between a stock dividend and a stock split?
Stock dividends of 50% or higher are generally referred to as stock splits. In both cases, a
firm does not pay out any cash to shareholders.
17.7.2. What is the main purpose of a reverse split?
The main purpose of a reverse split is to increase the stock price by reducing the number of
shares outstanding. If the price of the stock falls too low, a company can use a reverse split
to bring the price in any range the company desires.

∨♣″↓≥≡← ♦∂↔• ⊂↔≡↓∫ƒ∫⊂↔≡↓ ⊂°≥♠↔∂°±←

⊂°≥♥∂±÷ ∉↑°≥≡″←
Problems in this chapter may involve determining the effects of a dividend payment or a
share repurchase on the value of a corporation’s shares in perfect capital markets. They may
also require determining the effects for different types of investors (or clientele) when
personal taxes are considered. You should also understand why there is generally a tax
disadvantage to holding excess cash and be able to account for the effects of a stock split on
share values.

∨♣″↓≥≡←
1. Arizona Public Service Corporation (APS) expects to generate $50 million in free cash flow
next year, and this amount is expected to grow by 3% indefinitely. APS has no debt and has
accumulated $200 million of excess cash on its balance sheet. The firm’s unlevered cost of
equity is 8%, and it has 40 million shares outstanding. Would shareholders be better off if
the cash was paid out as a dividend or if the cash was used to repurchase shares? There are
no taxes or other market imperfections.
Step 1. The value per share before a dividend or repurchase must be determined.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition

Since there is no debt, the value per share equals:

PV(Future FCFs)
Excess Cash
$50 million
+ $200 million
Enterprise value (0.08-0.03)
P $30
40 million shares 40 million
Step 2. Determine the value to an investor that holds a share until the ex-dividend date.
$200 million
They could pay a $5 dividend.
40 million
PV(Future FCFs)
$50 million
Enterprise value (0.08-0.03)
The ex-dividend price equals = $25.
40 million shares 40 million
So the value to an investor that holds a share until the ex-dividend date is $5 + $25 =$30.
Step 2. Determine the value per share after the proposed repurchase.
Assuming the shares are repurchased at the current value of $30, the firm can repurchase:
$200 million
6.666 million shares.
$30
PV(Future FCFs)
$50 million
Enterprise value (0.08 0.03)
The post-repurchase price equals = $30.
40 million shares 33.333 million
Step 4. Determine what the firm should do.
Since capital markets are perfect, the stock price falls by the amount of the dividend when a
dividend is paid and a share repurchase has no effect on the stock price. Thus, the firm’s
choice of dividend policy is irrelevant, and the value per share is $30 in any case.
2. Arizona Public Service Corporation (APS) expects to generate $50 million in free cash flow
next year, and this amount is expected to grow by 3% indefinitely. APS has no debt and has
accumulated $200 million of excess cash on its balance sheet. The firm’s unlevered cost of
equity is 8%, and it has 40 million shares outstanding. Would shareholders be better off if
the cash was paid out as a dividend or if the cash was used to repurchase shares? The only
market imperfections are personal taxes on dividends (at 15%) and capital gains (also at
15%). The average investor bought the shares at the initial public offering price of $15.
Step 1. The value per share before a dividend or repurchase must be determined.
Since there is no debt, the value per share equals:
PV(Future FCFs)
Excess Cash
$50 million
+ $200 million
Enterprise value (0.08-0.03)
P = $30
40 million shares 40 million

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition 

Step 2. Determine the value to an investor that holds a share until the ex-dividend date.
$200 million
They could pay a $5 dividend, with an after-tax value of $5(1 – 0.15) =
40 million
$4.25.
PV(Future FCFs)
$50 million
Enterprise value (0.08 0.03)
The ex-dividend price equals = $25.
40 million shares 40 million
So, the value to an investor that holds a share until the ex-dividend date is:
$4.25 + $25 = $29.25 and total taxes paid is 40 million $5 0.15 = $30 million.
Step 3. Determine the value per share after the repurchase.
Assuming the shares are repurchased at the current value of $30, the firm can repurchase:
$200 million
6.666 million shares.
$30
PV(Future FCFs)
$50 million
Enterprise value (0.08 0.03)
The post-repurchase price equals = $30.
40 million shares 33.333 million
However the value to the value to the 6.666 million investors that sold is:
$30 – ($30 – $15)0.15 = $27.75, and total taxes paid is 6.666 ($30 – $15)0.15 = $15
million.
Step 4. Determine what the firm should do.
The optimal payout policy is to neither pay dividends nor repurchase shares. However,
repurchasing shares is preferred to paying dividends because investors are only taxed on the
capital gain and incur $15 million less in taxes.
3. Microsoft has $30 billion in excess cash, which is invested in Treasury bills paying 5%
interest. The board of directors is considering either paying a dividend immediately or paying
a dividend in one year.
[A] In a perfect capital market, which option will shareholders prefer?
[B] If the corporate tax rate on interest is 35%, individual investors pay a tax rate on
dividends of 15% and a tax rate of 30% on interest income, and institutional investors
pay no taxes, which option will shareholders prefer?
Step 1. Determine the value of each option to shareholders in perfect markets.
If Microsoft pays an immediate dividend, the shareholders receive $30 billion today.
If it pays the dividend in one year, it will be able to pay:
$30 billion (1.05) = $31.5 billion.
This is the same value as if shareholders had received a $30 billion dividend and invested
the $30 billion in Treasury bills themselves.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition

Thus, shareholders are indifferent about whether the firm pays the dividend immediately or
retains the cash.
Step 2. Determine the value of each option with taxes if all investors are individual investors.
If Microsoft pays an immediate dividend, shareholders receive $30 billion today, but they only
receive $30 billion (1 – 0.15) = $25.50 billion after taxes.
If it invests the cash for one year, it will earn 0.05(1 – 0.35) = 3.25% and it will be able to
pay:
$30 billion (1.0325) = $30.975 billion and shareholders would receive:
$30.975 billion (1 – 0.15) = $26.33 billion in a year 1 dividend after taxes.
Investors would have been able to earn 0.05(1 – 0.3) = 3.5% on their $25.5 after-tax
dividend payment and thus have $25.5(1.035) = $26.39 billion.
Thus, individual investors would be slightly better off with the immediate dividend.
Step 3. Determine the value of each option with taxes if all investors are institutional
investors.
If Microsoft pays an immediate dividend, shareholders receive $30 billion today.
If it invests the cash for one year, it will earn 0.05(1 – 0.35) = 3.25% and it will be able to
pay:
$30 billion (1.0325) = $30.975 billion in a year 1 dividend.
Investors would have been able to earn 5% on their $30 dividend payment and thus have
$30(1.05) = $31.5 billion.
Thus, institutional investors would be better off by $525 million with the immediate dividend.

∈♠≡←↔∂°±← ±≈ ∉↑°≥≡″←

1. Below are the current tax rates for different investors: an individual investor who holds stocks
for one year; a pension fund; and a corporation, which can exclude 70% of dividend income
from taxes.
Investor Dividend Tax Rate Capital Gain Tax Rate
Individual investors 15% 15%
Pension funds 0% 0%
Corporations 0.35%(1 – 0.7)=10.5% 35%
Calculate the effective dividend tax rates each type of investor, and explain what this means
for each investor’s preference for dividends.
2. Suppose that Apple computer, which is currently trading for $90 per share, has the following
types of stock splits.
[A] A 3-for-1 stock split.
[B] A 1-for-4 reverse split.
[C] A 50% stock dividend.
Calculate the value of 1,000 shares before and after the split.

©2011 Pearson Education

 Berk/DeMarzo • Corporate Finance, Second Edition 

3. An unlevered corporation has $100 million of excess cash and 50 million shares outstanding
with a current market price of $20 per share. The board of directors has declared a special
dividend of $100 million.
[A] What is the ex-dividend price of a share in a perfect capital market?
[B] If the board instead decided to use the cash to do a one-time share repurchase, what is
the price of the shares once the repurchase is complete in a perfect capital market?
[C] What do stockholders want the firm to do?
4. Southwest Natural Gas is expected to pay a constant dividend of $4 per share per year in
perpetuity. All investors require an 8% return on the stock. Individual investors pay a 20% tax
on dividends, but there is no capital gains tax. Institutional investors pay no taxes on
dividends or capital gains.
[A] What is the value of a share of a share of the stock?
[B] What kinds of investors would be expected to hold the stock?
5. How can firms use dividends to signal information about the firm’s value?

⊂°≥♠↔∂°±← ↔° ∈♠≡←↔∂°±← ±≈ ∉↑°≥≡″←

* d g 0.15 0.15
1. Individual investor d = 0%
1 g 1 0.15

Thus, they are indifferent between receiving dividends or capital gains. However, paying
dividends forces all stockholders to pay taxes on the income—even if they do not want the
income now. In addition, long-term investors can defer the capital gains tax until they sell, so
there is still a tax advantage for share repurchases over dividends for most investors. Thus,
stockholders would still generally prefer selling shares to recognize taxable income on their
own.

0
Pension fund d*
d g
0%
1 g 1 0

So pension funds are indifferent between receiving dividends or capital gains.

0.105 0.35
Corporation *
d =
d g
38%
1 g 1 0.35

Thus, corporations prefer to receive dividends due to their advantageous taxation.

2. The value is 1,000 $90 = $90,000 before the splits.
[A] Since the number of shares increases threefold, the value per share must be one-third
its pre-split value.
1
P= $90 = $30
3
There are now 3,000 shares, so V = 3,000 $30 = $90,000.
[B] Since the number of shares decreases by one-fourth, the value per share must be four
times its pre-split value.
P = 4 $90 = $360
There are now 250 shares, so V = 250 $360 = $90,000.

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 Berk/DeMarzo • Corporate Finance, Second Edition

[C] Since the number of shares increases by 50%, the value per share must be 1/1.5 =
2/3 its pre-split value.
2
P= $90 = $60
3
There are now 1,500 shares, so V = 1,500 $60 = $90,000.
$100 million
3. [A] They could pay a $2 dividend
50 million

Excess Cash
PV(Future cash flows)+ $100 million
P $20 PV(Future cash flows) = $900 million
50 million

The ex-dividend price is:

PV(Future cash flows) $900 million
P $18
50 million 50 million
Since $20 = $18 + $2, the shareholders are no better off.
[B] Assuming the shares are repurchased at the current value of $20, the firm can
repurchase:
$100 million
5 million shares.
$20
PV(Future FCFs)
Enterprise value $900 million
The post-repurchase price equals = $20.
45 million shares 45 million
So shareholders are no better off.
[C] The firm’s choice of dividend policy is irrelevant, and the value per share is $20 in any
case.
$4(1 0.20)
4. [A] P Individual Investors $40
0.08
$4
P Institutional Investors $50
0.08
[B] The clientele for the stock is likely to be institutional investors such as pension funds,
insurance companies, and endowments.
5. The idea that dividend changes reflect managers’ views about a firm’s future earnings
prospects is called the dividend signaling hypothesis.
When a firm increases its dividend, it sends a positive signal to investors that
management expects to be able to afford the higher dividend for the foreseeable future.
When a firm cuts its dividend, it may signal that there it is necessary to reduce the
dividend to save cash.
Studies of the market’s reaction to dividend changes are consistent with this hypothesis. For
example, during the period 1967–1993, firms that raised their dividend by 10% or more saw
their stock prices rise by 1.34% after the announcement, while those that cut their dividend
by 10% or more experienced a price decline of 23.71%.

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