Corporate Finance

Questions and Practice problems_Chapter 19

Chapter 19:
Concept questions (page 614 textbook): 4, 7, 9, 19, 20
Questions and Problems (page 616 textbook): 1, 3, 4, 5, 6, 7

Concept questions

Q4: On Tuesday, December 8, Hometown Power Co.’s board of directors declares a

dividend of 75 cents per share payable on Wednesday, January 17, to shareholders of
record as of Wednesday, January 3. When is the ex-dividend date? If a shareholder buys
stock before that date, who gets the dividends on those shares—the buyer or the seller?
=> Ex-dividend date is Friday, December 29 because we don’t count 1st January as it is a
holiday, and the exchanges are closed. If a shareholder buys stock before that date is entitled to
the devidend, the buyer will get the dividend as long as he does not sell the stock until the ex-
dividend date or later.

Q7: Last month, Central Virginia Power Company, which had been having trouble
with cost overruns on a nuclear power plant that it had been building, announced that it
was “temporarily suspending dividend payments due to the cash flow crunch associated
with its investment program.” The company’s stock price dropped from $28.50 to $25
when this announcement was made. How would you interpret this change in the stock
price? (That is, what would you say caused it?
=> A decline in anticipated dividend payments in the future caused the stock price to fall.
The stock price will decrease if the anticipated future dividend payments are lower as the stock
price represents the present value of all future dividend payments.

Q9: For initial public offerings of common stock, 2007 was a relatively slow year,
with only about $35.6 billion raised by the process. Relatively few of the 159 firms involved
paid cash dividends. Why do you think that most chose not to pay cash dividends?
 => If these companies simply went public, it was most likely due to their growth and
need for more funding. When growth companies do issue a dividend, it's usually relatively little
in cash. This is because they have numerous projects available, and they reinvest the earnings in
the firm instead of paying cash dividends.

Q19: In spite of the theoretical argument that dividend policy should be irrelevant,
the fact remains that many investors like high dividends. If this preference exists, a firm
can boost its share price by increasing its dividend payout ratio. Explain the fallacy in this
argument.
=> A company cannot increase its share price by changing policies unless there is a
dissatisfied high dividend clientele. The number of persons desiring high dividend payout
equities should precisely match the quantity of stocks that are offered if the market is in
equilibrium. Every customer's supplies and demands will be precisely satisfied in a balanced
manner. If the market is not in equilibrium, the supply of high dividend payout stocks may be
less than the demand. Only in such a situation could a firm benefit from a policy shift.

Q20: Empirical research has found that there have been significant increases in
stock price on the day an initial dividend (i.e., the first time a firm pays a cash dividend) is
announced. What does this finding imply about the information content of initial
dividends?
=> This research suggests that companies "signal" to the stock market their potential for
growth and positive net present value (NPV) by paying out first dividends. The initiation of
regular cash dividends also serves to persuade the market that their elevated present profits are
nsot transitory.

Problem questions

Q1: Lee Ann, Inc., has declared a $9.50 per-share dividend. Suppose capital gains
are not taxed, but dividends are taxed at 15 percent. New IRS regulations require that
taxes be withheld when the dividend is paid. Lee Ann sells for $115 per share, and the stock
is about to go exdividend. What do you think the ex-dividend price will be?
 => After-tax dividend = $9.5*(1-0.15) = $8.075
Ex-dividend price = $115 - $8.075 = $106.925

Q3: For the company in Problem 2, show how the equity accounts will change if:
a. Hexagon declares a four-for-one stock split. How many shares are outstanding now?
What is the new par value per share?
b. Hexagon declares a one-for-five reverse stock split. How many shares are out- standing
now? What is the new par value per share?
=> 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 that the par value of the stock is changed by the ratio
of new shares to old shares, so the new par value is:
New par value = $1*(1/4) = $0.25 per share.
b. New shares outstanding = $30,000* (1/5) = 6,000.
New par value = $1*(5/1) = $5.00 per share.

Q4: Roll Corporation (RC) currently has 330,000 shares of stock outstanding that
sell for $64 per share. Assuming no market imperfections or tax effects exist, what will the
share price be after:
a. RC has a five-for-three stock split?
b. RC has a 15 percent stock dividend?
c. RC has a 42.5 percent stock dividend?
d. RC has a four-for-seven reverse stock split?
=> The new shares outstanding:
a. 330,000*5/3 = 550,000
b. 330,000*(1+15%) = 379,500
c. 330,000*(1+42.5%) = 470,250
d. 330,000 *4/7 = 188,571
The new stock price:
 a. 64*3/5 = $38.4
b. (64*330,000)/379,500 = $55.65 or 64/1.15 = $55.65
c. 64/(1+42.5%) = $44.91
d. 64*7/4 = $112

Q5: The company has declared a dividend of $1.90 per share. The stock goes ex
dividend tomorrow. Ignoring any tax effects, what is the stock selling for today? What will
it sell for tomorrow? What will the balance sheet look like after the dividends are paid?
=> The stock price today:
P0 = market value of equity/ share outstanding
= $465,000 equity/12,000 shares = $38.75 per share
Ignoring tax effects, the stock price will drop by the amount of the dividend, so:
P1 = $38.75 – 1.90 = $36.85
The total dividends paid will be: $1.9*12,000 = $22,800
The equity and cash accounts will both decline by $22,800.
Cash account = 55,000 – 22,800 = $32,200
Equity = 465,000 – 22,800 = $442,200

Q6: In the previous problem, suppose Levy has announced it is going to repurchase
$22,800 worth of stock. What effect will this transaction have on the equity of the firm?
How many shares will be outstanding? What will the price per share be after the
repurchase? Ignoring tax effects, show how the share repurchase is effectively the same as
a cash dividend.
=> Repurchasing the shares will reduce shareholders’ equity by $22,800. The shares
repurchased will be the total purchase amount divided by the stock price, so:
Shares bought = $22,800/$38.75 = 588 shares
The new shares outstanding will be: 12,000 – 588 = 11,412 shares
After the repurchase, the new stock price is:
Share price = $(32,200 + 410,000) /11,412 shares = $38.75
The repurchase is effectively the same as the cash dividend because you either hold a share
worth $38.75 or a share worth $36.85 and $1.90 in cash. Therefore, you participate in the
repurchase according to the dividend payout percentage; you are unaffected.

Or For cash dividend, we hold the share with the price 36.85 and receive 1.9 dividend. For stock
repurchase, we hold the share with the price 38.75.

Q7: The market value balance sheet for Outbox Manufacturing is shown here.
Outbox has declared a stock dividend of 25 percent. The stock goes exdividend tomorrow
(the chronology for a stock dividend is similar to that for a cash dividend). There are
20,000 shares of stock outstanding. What will the ex-dividend price be?
=> The stock price is the total market value of equity divided by the shares outstanding, so:
P0 = 655,000/20,000 = $32.75 per share
The shares outstanding will increase by 25 percent, so:
New shares outstanding = 20,000*(1+25%) = 25,000 shares
The new stock price is the market value of equity divided by the new shares outstanding, so:
PX = 655,000/ 25,000 = $26.20

Q10: The Mann Company belongs to a risk class for which the appropriate discount
rate is 10 percent. Mann currently has 220,000 outstanding shares selling at $110 each. The
firm is contemplating the declaration of a $4 dividend at the end of the fiscal year that just
began. Assume there are no taxes on dividends. Answer the following questions based on
the Miller and Modigliani model, which is discussed in the text.
a. What will be the price of the stock on the ex-dividend date if the dividend is declared?
b. What will be the price of the stock at the end of the year if the dividend is not declared?
c. If Mann makes $4.5 million of new investments at the beginning of the period, earns net
income of $1.9 million, and pays the dividend at the end of the year, how many shares of
new stock must the firm issue to meet its funding needs?
d. Is it realistic to use the MM model in the real world to value stock? Why or why not?

=> a. P(ex) = $110 - $4 = $106

b. Not declared -> No change, P = $110
c. Amount of dividend: $4 * 220,000 shares = $880,000
Net income = $1,900,000
For the purpose of funding, the remaining funds out of left over net income after paying dividend
is not sufficient.
So, Mann Company should finance by selling his shares. It must sell:
4,500,000/110 = 40,909 shares
d. The MM model is not realistic since it does not account for taxes, brokerage fees,
uncertainty over future cash flows, investors’ preferences, signaling effects, and agency
costs.

Q11: You own 1,000 shares of stock in Avondale Corporation. You will receive a
dividend of $1.10 per share in one year. In two years, Avondale will pay a liquidating
dividend of $56 per share. The required return on Avondale stock is 14 percent. What is
the current share price of your stock (ignoring taxes)? If you would rather have equal
dividends in each of the next two years, show how you can accomplish this by creating
homemade dividends. (Hint: Dividends will be in the form of an annuity.)
=> Current share price = 1.10/(1+14%) + 56/(1+14%)2 = $44.06
Equal dividend in each of the next twp years:
44.06 = D/1.14 + D/(1.14)2 => D = 26.75
For 1,000 shares => Dividend = 26.75*1000 = $26,754

Amount of dividend: $4 * 220,000

shares = $880,000
Net income = $1,900,000
For the purpose of funding, the
remaining funds out of left over
net income after
paying dividend is not sufficient.
So, Mann Company should finance
by selling his shares