Week Solutions Essay Example

Week Solutions Paper Managers often increase dividends temporarily when earnings are unexpectedly high for a year or two. False. Dividends are smoothed. Managers rarely increase regular dividends temporarily. They may pay a special dividend, however, d. Companies undertaking substantial share repurchases usually finance them with a offsetting reduction in cash dividends. False. Dividends are rarely cut when repurchases are being made. 17. Dividends and value Little Oil has outstanding 1 million shares with a total market value Of $20 million. The firm is expected to pay $1 million Of dividends next year, and thereafter the amount paid out is expected to grow by 5% a year n perpetuity. Thus the expected dividend is $1. 05 million in year 2, $1. 105 million in year 3, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next years dividend will be increased to $2 million and that the extra cash will be raised immediately by an issue of shares. After that, the total amount paid out each year will be as previously forecasted, that is, $1. 5 million in year 2 and increasing by 5% in each subsequent year. A. At what price will the new shares be issued in year 1? At t -O each share is worth $20. This value is based on the expected stream of dividends: $1 at t I, and increasing by in each subsequent year _ Thus, we can find the appropriate discount rate for this company as follows: 100% Beginning at t = 2, each share in the company Will enjoy a perpetual stream Of growing dividends: SSL . 05 at t = 2, and increasing by 5% in each subsequent year. We will write a custom essay sample on Week Solutions specifically for you for only $16.38 $13.9/page Order now We will write a custom essay sample on Week Solutions specifically for you FOR ONLY $16.38 $13.9/page Hire Writer We will write a custom essay sample on Week Solutions specifically for you FOR ONLY $16.38 $13.9/page Hire Writer Thus, the total value of the shares ATT= 1 (after the t = 1 dividend is paid and after N new shares have been issued) is given by: If Pl is the price per share ATT = 1, then: and: Pl a N = From the first equation: Substituting from the second equation: so that Pl = 520. 00. B. How many shares will the firm need to issue? With Pl equal to $20 the firm will need to sell 50,000 new shares to raise c. What will be the expected dividend payments on these new shares, and what therefore will be paid out to the old shareholders after year 1? The expected dividends paid at t 2 are $1 increasing by 5% in each subsequent year. With shares outstanding, dividends per share are: $1 ATT = 2, increasing by in each subsequent year. Thus, total dividends paid o old shareholders are: $1 at t 2, increasing by in each subsequent year. D. Show that the present value of the cash flows to current shareholders remains 520 million, Poor the current shareholders: 21. Dividends vs.. Repurchases Here are key financial data for House of Herring, Earnings per share for 2015 55. Number of shares outstanding mm Target payout ratio Planned dividend per share SO. 75 Stock price, year-end 2015 $130 House of Herring plans to pay the entire dividend early in January 2019. All corporate and personal taxes were repealed in 2017. A. Other things equal, what will be House of Herrings stock price after the planned dividend payout? $130 2. 75 = $127. 25. B. Suppose the company cancels the dividend and announces that it will use the money saved to repurchase shares. What happens to the stock price on the announcement date? Assume that investors learn nothing about the companys prospects from the announcement. HOW many shares Will need to be repurchased? Again, assuming investors learn nothing from the announcement about the House Of Herrings prospects. Nothing. The stock price will stay at $130. 46,154 shares will be repurchased. C. Suppose the company increase dividends to $5. 50 per share and then issues new shares to recoup the extra cash paid out as dividends. What happens to the with- and ex-dividend share prices? How many shares will need to be issued Again, assume investors learn nothing from the announcement about House of Herrings prospects, The with-dividend price stays at 5130. Ex-dividend drops to 5124. 50; 883,534 shares will be issued. 25. Payout and the cost of capital Comment briefly on each of the following statements: a. Unlike American firms, which are always being pressured by their shareholders to increase dividends, Japanese companies pay out a much smaller proportion of earnings and so enjoy a lower cost of capital, This statement implicitly equates the cost of equity capital with the stocks dividend yield. If this were true, companies that pay no dividend would have a zero cost Of equity capital, Which is clearly not correct. B. Unlike new capital, Which needs a stream Of new dividends to service it, retained earnings have zero cost. One way to think of retained earnings is that, from an economic standpoint, the many earns money on behalf of the shareholders, who then immediately reinvest the earnings in the company. Thus, retained earnings do not represent free capital. Retained earnings carry the full cost of equity capital (although issue costs associated with raising new equity capital are avoided). C. If a company repurchases stock instead of paying a dividend, the number of shares tails and earnings per share rise. Thus stock repurchase must be always be preferred to paying dividends. Fifth tax on capital gains is less than that on dividends, the conclusion of this statement is correct; i. . , a stock repurchase is always preferred over dividends. This conclusion, however, is strictly because of taxes, Earnings per share is irrelevant. 7. Repurchases and PEPS Many companies use stock repurchases to increase earnings per share. For example, suppose that a company is in the following position: Net profit $10 million Number Of shares before repurchase I million Earnings per share $10 Price-earnings ratio Share price $200 The company now repurchases 200,000 shares at $200 a share, The number of shares declines to 800,000 shares and earnings per share increase to $12. 0. Assuming the price-earnings ratio stays at 20, the share price must rise to SO. Discuss. One problem with this analysis is that it assumes the companys net profit remains constant even though the asset base of the company shrinks by 20%. That is, in order to raise the cash necessary to repurchase the shares, the company must sell assets. If the assets sold are representative of the company as a whole, we would expect net profit to decrease by so that earnings per share and the PIE ratio remain the same. After the repurchase, the company will look like this next year: Net Profit: $8 million Number of Shares: 0. Million Earnings per Share: Price-Earnings Ratio: Share Price: 3200 28, Dividends and taxes The middle-of-the-road party holds that dividend policy doesnt matter because the supply of high-, medium-. And low-payout stocks has already adjusted to satisfy investors demands, Investors who like generous dividends hold stocks that give them all the dividends that they want. Investors vivo want capital gains see ample low-payout stocks to choose from Thus, high-payout firms cannot gain by transforming to low-payout firms, or vice versa. Suppose the government reduces the tax rate on dividends but not on capital gains. Suppose that before this change the supply of dividends matched investor needs. HOW would you expect the tax change to affect the total cash dividends paid by U. S. Corporations and the proportion of high- versus low-payout companies? Would dividend policy still be irrelevant after any dividend supply adjustments are completed? Explain. Even if the middle-of-the-road party is correct about the supply of dividends, we still do not know why investors wanted the dividends they got.