Chapter 18 Discussion Questions 18-1 How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on fund s associated with retained earnings. Thus we must consider what the stockholders can earn on other investments 18-2 Discuss the difference between a passive and an active dividend policy a passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at ternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, stockholder preference for cash dividend s is considered very early in the decision process 18-3 How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content Some stockholders may say that the dividends are relevant, but in a different ense. Perhaps they prefer to receive little or no dividends because of the immediate income tax 18-4 Explain the relationship between a company's growth possibilities and its dividend policy The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show four-year growth rates for selected U.S corporations and their associated dividend payout percentages. This is also d iscussed in the life cycle of the firm S-627 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-627 Chapter 18 Discussion Questions 18-1. How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on funds associated with retained earnings. Thus, we must consider what the stockholders can earn on other investments. 18-2. Discuss the difference between a passive and an active dividend policy. A passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at alternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, stockholder preference for cash dividends is considered very early in the decision process. 18-3. How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some stockholders 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. 18-4. Explain the relationship between a company's growth possibilities and its dividend policy. The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show four-year growth rates for selected U.S. corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm
18 are there legal restrictions on paying out the funds to the stockholders why Since initial contributed capital theoretically belongs to the stockholders Cred itors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place 18-6 Discuss how desire for control may influence a firm,s willingness to pay dividends 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 posion nrowor y have to pay dividends in order to maintain their current keeping stockholders happy If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend 18-8 How is a stock split(versus a stock dividend )treated on the financial statements of a corporation? For a stock split, there is no transfer of funds, but merely a-reduction in par value and a-proportionate increase in the number of shares outstanding I mpact of a Stock Split efo After Common stock(1,000,000 shares at $10 par)(2,000,000 shares at $5 par) CopyrightC 2005 by The McGran-Hill Companies, Inc. S-628
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-628 18-5. Since initial contributed capital theoretically belongs to the stockholders, why are there legal restrictions on paying out the funds to the stockholders? Creditors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place. 18-6. Discuss how desire for control may influence a firm's willingness to pay dividends. 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 stockholders happy. 18-7. If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 18-8. How is a stock split (versus a stock dividend) treated on the financial statements of a corporation? For a stock split, there is no transfer of funds, but merely a –reduction in par value and a –proportionate increase in the number of shares outstanding. Impact of a Stock Split Before After Common stock (1,000,000 shares at $10 par) (2,000,000 shares at $5 par)
Why might a stock dividend or a stock split be of limited value to an investor The asset base remains the same and the stockholders' proportionate interest 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 shareholders 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 18-10 Does it make sense for a corporation to repurchase its own stock? Explain A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as through a cash dividend Because the benefits are in the format of capital gains the tax may be deferred until the stock is sold A corporation also may justify the repurchase of its own stock 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 stock as protection against a hostile takeover What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders to reinvest dividends at low costs and to buy fractional individual. The strategy of dividend reinvestment plans allows forto shares, neither of which can be easily accomplished in the market by compound ing of dividends and the accumulation of common stock over time S-629 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-629 18-9. Why might a stock dividend or a stock split be of limited value to an investor? The asset base remains the same and the stockholders' 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. 18-10. Does it make sense for a corporation to repurchase its own stock? Explain. A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as through a cash dividend. Because the benefits are in the format of capital gains the tax may be deferred until the stock is sold. A corporation also may justify the repurchase of its own stock 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 stock as protection against a hostile takeover. 18-11. What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders 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 common stock over time
Problems 18-1 Moon and Sons, Inc, earned $120 million last year and retained $72 million What is the payout ratio? Solution: Moon and sons. Inc Dividends earnings- retained fur $120mil.-$72mil.=$48mil Payout ratio dividends/earnings $48mil/$120mil.=40.0% Ralston Gourmet Foods, Inc. earned $360 million last year and retained $252 million. What is the payout ratio? Solution: Ralston gourmet foods Inc Dividends (earnings -retained funds) ($360m.-$252mi.=$108m Payout ratio dividends/earnings $l80mil/$360mil.=30% CopyrightC 2005 by The McGran-Hill Companies, Inc. S-630
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-630 Problems 18-1. Moon and Sons, Inc., earned $120 million last year and retained $72 million. What is the payout ratio? Solution: Moon and Sons, Inc. Dividends = (earnings – retained fund) = $120 mil. – $72 mil. = $48 mil. Payout ratio = dividends/earnings = $48 mil./$120 mil. = 40.0% 18-2. Ralston Gourmet Foods, Inc. earned $360 million last year and retained $252 million. What is the payout ratio? Solution: Ralston Gourmet Foods, Inc. Dividends = (earnings – retained funds) = ($360 mil. – $252 mil. = $108 mil. Payout ratio = dividends/earnings = $180 mil./$360 mil. = 30%
Swank Clothiers earned $640 million last year and had a 30 percent payout ratio. How much d id the firm add to its retained earnings? Solution: Swank Clothiers Addition to retained earnings Earnings-Dividends Dividends =30%X$640.000,000 $192000,000 Addition to retained earnings = $640,000, 000-$192, 000,000 $448,00000 18-4 Springsteen Music Company earned $820 million last year and paid out 20 percent of earnings in dividends a. How much did retained earnings increase by? b. With 100 million shares outstanding and a stock price of $50, what was the dividend yield?(Hint: first compute dividends per share. Solution: Springsteen Music Company a. Addition to retained earnings earnings -dividends Dividends 20%X$820,000,000 Dividends $164000.000 Earnings -dividends $820.000000-$164000000 Addition to retained earnings =$656.000.000 b Dividends/shares $164.000.000/100000.000 $164 Dividend yield Dividend per share/stock price $164/$50=3,28 percent S-631 Copyright C2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-631 18-3. Swank Clothiers earned $640 million last year and had a 30 percent payout ratio. How much did the firm add to its retained earnings? Solution: Swank Clothiers Addition to retained earnings = Earnings – Dividends Dividends = 30% x $640,000,000 = $192,000,000 Addition to retained earnings = $640,000,000 – $192,000,000 = $448,000,000 18-4. Springsteen Music Company earned $820 million last year and paid out 20 percent of earnings in dividends. a. How much did retained earnings increase by? b. With 100 million shares outstanding and a stock price of $50, what was the dividend yield? (Hint: first compute dividends per share.) Solution: Springsteen Music Company a. Addition to retained earnings = Earnings – Dividends Dividends = 20% x $820,000,000 Dividends = $164,000,000 Earnings – dividends = $820,000,000 – $164,000,000 Addition to retained earnings = $656,000,000 b. Dividends/shares = $164,000,000/100,000,000 = $1.64 Dividend yield = Dividend per share/stock price = $1.64/$50 = 3.28 percent