13-10  Keown/Martin/Petty Instructor’s Manual with Solutions

SOLUTIONS TO END-OF-CHAPTER STUDY PROBLEMS 13-1. Phosphorus Technologies paid €1.12 per share in dividends to the holders of 1 million shares for a total of €1.12 million. Given the firm’s €3 million in earnings, this means that the firm paid out 37.33 percent of its earnings. 13-2. The firm needs to raise $10 million ($12 in planned capital expenditures − $2 million in retained earnings), of which 40 percent or $4.8 million will be borrowed. The remaining $7.2 million must be raised through the issuance of new shares of stock. The firm had earnings of $4 million, of which only half, or $2 million, could contribute to the planned capital expenditures. This means that the firm must issue equity in the amount of $5.2 million, (i.e., Total Equity Financing Needed ($7.2 million = 0.60 × $12 million) less the predicted change in retained earnings for the year ($2 million)). 13-3. A perfect capital market is an abstract representation of what a market might look like with the following characteristics: (1) There are many buyers and sellers (none of whom are large enough for their transactions to have an impact on market prices); (2) there are no transaction costs such as brokerage fees; (3) there are no corporate or personal taxes; and (4) complete information is readily available at little or no cost. The astute student will recall from economics class that this idea is the same as that of a perfectly competitive market. In finance, we often refer to such a market as an efficient market in the sense that information is quickly and efficiently acted upon by investors, whose actions push prices toward full reflection of the value of that information. 13-4. This is often a difficult concept for students to grasp. In essence, it would seem that the act of paying a cash dividend reduces the uncertainty that investors have about a firm’s future cash flows. However, the confusion arises from the fact that dividend policy decisions are independent of the firm’s investment and capital mix decisions. The firm’s investment decisions generate cash flows with their particular amounts and expected variability. The percentage of these cash flows that is paid as dividends does not affect the amount or variability of the original investment. Thus, dividend policy will not affect the firm’s stock price. But what about the investor’s position, is she better off with money-in-hand? Note that the investor’s portfolio has changed: her equity position has become a less-equity-plus-more-cash position. However, this portfolio combination is already available to the investor. If that is the portfolio that the investor wanted, she could have just sold some of her stock. Consequently, she would not value a stock more highly simply because it paid a higher dividend. 13-5. a. FarmCo follows a residual dividend payout policy. Sixty percent of the total new investment comes from retained earnings; earnings not needed to fund investments are then paid in dividends. The firm earned $12 million, so if it deployed all of its earnings (ignoring dividend policy for the moment as the capital expenditure budget has not yet been set), the firm could provide equity financing for new projects totaling $20 million ($12 million/0.6).

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Foundations of Finance, Ninth Edition, Global Edition  13-11 b. If the firm’s capital budget were $10 million, company policy would allow 60 percent of this amount ($6 million) to be funded from its earnings for equity. This leaves $6 million ($12 million in net income − $6 million in reinvested earnings) to be paid out as dividends, implying a payout ratio of 50 percent ($6 million in dividends/$12 million net income). 13-6. Legal restrictions on the payment of dividends come in two basic forms. The first consist of statutory restrictions. These limitations vary by state. Examples of these restrictions are limitations on dividend payments, such as a dividend cannot be paid due to the following: (1) the firm’s liabilities exceed its assets, (2) the amount of the dividend exceeds the firm’s accumulated earnings, or (3) the dividend is paid from capital invested in the firm. The second type of legal restriction is unique to each firm and results from the restrictions in debt and preferred stock contracts. For example, to minimize their risk, investors in the firm’s debt and preferred stock may include specific restrictions on the firm’s ability to pay out cash dividends. 13-7. The first possible constraints are legal restrictions on the payment of dividends. Kensington Enterprises should check if there are any state restrictions on the payment of dividends such as those listed in Study Problem 13-6 above. Kensington Enterprises should also check if its existing bond or loan agreements contain any covenants restricting the payment of dividends. In addition, the firm should consider earnings predictability in determining the amount of the dividend and the size of the dividend payout ratio. Firms with stable earnings tend to pay out a larger portion of earnings in dividends. Firms with greater variability in earnings are likely to retain larger amounts to ensure that money is available when needed. Kensington Enterprises needs to determine how variable its income stream is and whether it can continue the planned payout ratio in the future. (Cutting dividends is often construed to mean the company’s fortunes have taken a turn for the worse.) Finally, management should consider whether paying a dividend will lead to the need to raise equity capital in the future, which could dilute control of the firm by its current owners. 13-8. Year 1 2 3 4 5 Total profit after taxes Shares outstanding

Profit after taxes $18,000,000 21,000,000 19,000,000 23,000,000 25,000,000 $106,000,000 7,500,000

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13-12  Keown/Martin/Petty Instructor’s Manual with Solutions a.

Stable target payout of 40% Target dividend: $1.13

b.

$106,000,000 (0.4) / 5 years 7,500,000

Small regular dividend of $0.60 plus year-end extra dividend Base profit $20,000,000 % of extra profit 50.00% Year 1 2 3 4 5

c.

=

Dividend $0.60 $0.67 = $0.60 $0.80 = $0.93 =

$0.60 + ($21,000,000 – $20,000,000)(0.5)/7,500,000 $0.60 + ($23,000,000 – $20,000,000)(0.5)/7,500,000 $0.60 + ($25,000,000 – $20,000,000)(0.5)/7,500,000

Constant payout ratio of 40 percent Year 1 2 3 4 5

Dividend $0.96 $1.12 $1.01 $1.23 $1.33

= = = = = =

Profits × Payout Ratio $18,000,000(0.4) $21,000,000(0.4) $19,000,000(0.4) $23,000,000(0.4) $25,000,000(0.4)

     

Shares 7,500,000 7,500,000 7,500,000 7,500,000 7,500,000

13-9. a.

The firm needs a total of €10 million to fund its expansion plans, which means it needs €5 million (50 percent of €10 million) in equity funding to maintain its desired capital structure. With €4 million in earnings and a 30 percent payout ratio, the firm will have only €2.8 million in equity funds from the retention of earnings, leaving €2.2 million to be raised by the sale of common stock.

b.

If the firm does not want to sell new shares and only has €2.8 million in equity financing from its earnings, then its maximum capital budget is €5.6 million.

13-10. a.

To finance the required £3 million, assuming the firm maintains a 40 percent debt to assets ratio, a total of £1.8 million in equity financing will be required. Since the firm pays a dividend of £0.8 million and earns £1.2 million, it can retain only £0.4 million to help defray the cost of the investment. This leaves £1.4 million to be raised by the sale of common stock.

b.

If the firm retains £1.2 million and maintains a 40 percent debt to assets ratio, then it will be able to invest only £2 million (£1.2 million is 60 percent of £2 million).

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Foundations of Finance, Ninth Edition, Global Edition  13-13 13-11. The declaration date is the date that the dividend is formally authorized by the board of directors. The ex-dividend date is the date when the right of ownership to the dividend is terminated. The ex-dividend date is set by stock brokerage companies as two days prior to the record date. Investors shown to own the stock on the date of record receive the dividends. The payment date is when dividends are distributed to shareholders. 13-12. a.

Earnings per share (pre) = €11,521,235.81/4,710,253 shares = €2.45

b.

Earnings per share (post) = €11,521,235.81/(4,710,253 + 123,826) shares = €2.38

c.

Fraction of earnings (pre) = (1,000/4,710,253) × €11,521,235.81 = €2450 = (1,000 shares) × (€2.45/share) Number of shares = (1,000/4,710,253 × (4,710,253 + 123,826) = 1027 shares Fraction of earnings (post) = (1027/(4,710,253 + 123,826) × €11,521,235.81 = €2450 = (1,027 shares) × (€2.38/share). This example illustrates that the “illusion” of gain from a stock dividend is truly an illusion.

13-13. a.

With 615 million shares outstanding and €12,135 million in earnings, the earnings per share is €19.73.

b.

The total number of shares increases four-fold with the split from 615 million to 2,460 billion shares.

c.

After the split the earnings are still €12,135 million; but with 2,460 billion shares, the earnings per share drop to €4.93.

d.

Before the split of your 100 shares: 100 × €19.73 per share or €1973 in firm earnings. After the split, you own 400 shares, but earnings per share are only €4.93, so the total earnings associated with your investment are still €1973. There is no change in your ownership percentage of the firm. However, considering that more investors can now afford to purchase the firm’s shares at the new lower prices, your shares may indeed appreciate in value.

13-14. a.

If a 10 percent stock dividend is issued, the financial statement would appear as follows: Debt Common equity Par (€10; 615 × 1.10 million shares) Paid-in-capital (€21,150 + 190 × 615 million shares) Retained earnings (€18,950 – 200 × 615 million shares)

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€ 14,175 € 6,765 € 32,835 € 6,650 € 60,425

13-14  Keown/Martin/Petty Instructor’s Manual with Solutions b.

A four-for-one split would result in an increase in the number of shares to 2,460 million. Since the total par value remains at €6,150 million, the new par value per share is €2.5 (€6,150,000,000/2,460,000,000 shares). The new financial statement would be as follows: Debt Common equity Par (€2.5; 2,460 million shares) Paid-in-capital Retained earnings

€ 14,175 € 6,150 € 21,150 € 18,950 € 60,425

13-15. .

Dunn Corporation—Repurchase of Stock Proposed dividend Shares outstanding Earnings per share Ex-dividend price Proposed dividend/share

$ 500,000 250,000 $ 5.00 $ 50.00 $2.00

a.

Repurchase price

$ 52.00 = $50 + $2

b.

Number of shares repurchased

c.

If the repurchase price is set below the price suggested in part (a), it is unlikely that shareholders would tender their shares to the firm because the firm is offering less than the market price for each share. If the repurchase price is set above the price suggested in part (a), then the repurchase offer would be oversubscribed and a method of determining which shares will be repurchased must be determined. In either of these cases, the capital gains to the stockholder would not be equal to the intended dividend, thus resulting in a dollar benefit or loss to the stockholders.

d.

Unless you have a need for current income, you would probably prefer the stock repurchase plan. However, the tax code could affect your decision depending on the current tax rate for dividend versus capital gain income.

13-16. a.

If the firm purchases $5 million of its stock for a price per share of $50, then it will be able to acquire 100,000 shares. This represents 100,000/20,000,000 = 0.50 percent of the firm’s shares.

b.

Following the repurchase, the firm will have 19.9 million shares outstanding. If the firm were to again earn $5 million earnings per share would be $0.25126.

9,615 = $500,000 ÷ ($50 + $2)

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