BFF5250 Corporate Treasury Management

Week 6 Dividend decisions

Activity 6.1

Berk & deMarzo Chp 17 (Payout Policy)

Questions 1, 3, 4-6, 11, 21, 25-26, 28-29

Suggested solutions
Berk & deMarzo Chp 17 (Payout Policy)
Questions 1, 3, 4-6, 11, 21, 25-26, 28-29

17-1. What options does a firm have to spend its free cash flow (after it has satisfied all
interest obligations)?
It can retain them and use them to make investment, or hold them in cash. It can pay
them out to equity holders, either by issuing a dividend or by repurchasing shares.

17-3. Describe the different mechanisms available to a firm to use to repurchase shares
There are three mechanisms. 1) In an open-market repurchase, the firm repurchases
the shares in the open market. This is the most common mechanism in the United
States. 2) In a tender offer the firm announces the intention to all shareholders to
repurchase a fixed number of shares for a fixed price, conditional on shareholders
agreeing to tender their shares. If not enough shares are tendered, the deal can be
cancelled. 3) A targeted repurchase is similar to a tender offer except it is not open
to all shareholders; only specific shareholder can tender their shares in a targeted
repurchase.

17-4. RFC Corp. has announced a $1 dividend. If RFCs price last price cum-dividend is
$50, what should its first ex-dividend price be (assuming perfect capital markets)?
Assuming perfect markets, the first ex-dividend price should drop by exactly the
dividend payment. Thus, the first ex-dividend price should be $49 per share. In a
perfect capital market, the first price of the stock on the ex-dividend day should be
the closing price on the previous day less the amount of the dividend.

17-5. EJH Company has a market capitalization of $1 billion and 20 million shares
outstanding. It plans to distribute $100 million through an open market
repurchase. Assuming perfect capital markets:
a. What will the price per share of EJH be right before the repurchase?
b. How many shares will be repurchased?
c. What will the price per share of EJH be right after the repurchase?

a. $1 billion/20 million shares = $50 per share.

b. $100 million/$50 per share = 2 million shares.
c. If markets are perfect, then the price right after the repurchase should be the
same as the price immediately before the repurchase. Thus, the price will be $50
per share.

17-6. KMS Corporation has assets with a market value of $500 million, $50 million of
which are cash. It has debt of $200 million, and 10 million shares outstanding.
Assume perfect capital markets.
a. What is its current stock price?
b. If KMS distributes $50 million as a dividend, what will its share price be after
the dividend is paid?
c. If instead, KMS distributes $50 million as a share repurchase, what will its share
price be once the shares are repurchased?
d. What will its new market debt-equity ratio be after either transaction?

a. (500 200)/10 = 30
b. (450 200)/10 = 25
c. (450 200)/(10 1.667) = 30
d. 200/250 = 0.8

17-11. The HNH Corporation will pay a constant dividend of $2 per share, per year, in
perpetuity. Assume all investors pay a 20% tax on dividends and that there is no
capital gains tax. Suppose that other investments with equivalent risk to HNH stock
offer an after-tax return of 12%.
a. What is the price of a share of HNH stock?
b. Assume that management makes a surprise announcement that HNH will no
longer pay dividends but will use the cash to repurchase stock instead. What is
the price of a share of HNH stock now?

a. P = $1.60/0.12 = $13.33
b. P = $2/0.12 = $16.67

17-21. Clovix Corporation has $50 million in cash, 10 million shares outstanding, and a
current share price of $30. Clovix is deciding whether to use the $50 million to pay
an immediate special dividend of $5 per share, or to retain and invest it at the riskfree rate of 10% and use the $5 million in interest earned to increase its regular
annual dividend of $0.50 per share. Assume perfect capital markets.
a. Suppose Clovix pays the special dividend. How can a shareholder who would
prefer an increase in the regular dividend create it on her own?
b. Suppose Clovix increases its regular dividend. How can a shareholder who
would prefer the special dividend create it on her own?

a. Invest the $5 special dividend, and earn interest of $0.50 per year.
b. Borrow $5 today, and use the increase in the regular dividend to pay the interest
of $0.50 per year on the loan.

17-25. Redo Problem 21, but assume the following:

a. Investors pay a 15% tax on dividends but no capital gains taxes or taxes on
interest income, and Kay does not pay corporate taxes.
b. Investors pay a 15% tax on dividends and capital gains, and a 35% tax on
interest income, while Kay pays a 35% corporate tax rate.

a. Assuming investors pay a 15% tax on dividends but no capital gains taxes nor
taxes on interest income, and Kay does not pay corporate taxes:
a. The value of Kay will remain the same (dividend taxes dont affect cost of
retaining cash, as they will be paid either way).
b. The value of Kay will fall by $85 million (100 (1 15%)) to reflect after-tax
dividend value.
c. It will neither benefit nor hurt investors.
b. Assuming investors pay a 15% tax on dividends and capital gains, and a 35% tax
on interest income, while Kay pays a 35% corporate tax rate
a. Effective tax disadvantage of cash is 1 (1 tc)(1 tg)/(1 ti) = 1 (1
35%)(1 15%)/(1 35%) = 15%, the equity value of Kay would go up by
15%*100 = 15 million on announcement.
b. The value of Kay will fall by $100 million on ex-div date (since tg = td, t*_d =
0).
c. Given these price reactions, this decision will benefit investors by $15 million

17-26. Raviv Industries has $100 million in cash that it can use for a share repurchase.
Suppose instead Raviv invests the funds in an account paying 10% interest for one
year.
a. If the corporate tax rate is 40%, how much additional cash will Raviv have at
the end of the year net of corporate taxes?
b. If investors pay a 20% tax rate on capital gains, by how much will the value of
their shares have increased, net of capital gains taxes?
c. If investors pay a 30% tax rate on interest income, how much would they have
had if they invested the $100 million on their own?
d. Suppose Raviv retained the cash so that it would not need to raise new funds
from outside investors for an expansion it has planned for next year. If it did
raise new funds, it would have to pay issuance fees. How much does Raviv
need to save in issuance fees to make retaining the cash beneficial for its
investors? (Assume fees can be expensed for corporate tax purposes.)
a. 100 10% (1 40%) = $6 m

b. $6 (1 0.20) = $4.8 million

c. 100*10% (1 0.30) = $7 million
d. $1 spent on fees = $1 (1 0.40) (1 0.20) = $0.48 to investors after corporate
and cap gain tax. To make up the shortfall, fees = (7 4.8)/0.48 = $4.583 million.

17-28. Explain under which conditions an increase in the dividend payment can be
interpreted as a signal of the following:
a. Good news
b. Bad news

a. By increasing dividends managers signal that they believe that future earnings
will be high enough to maintain the new dividend payment.
b. Raising dividends signals that the firm does not have any positive NPV
investment opportunities, which is bad news.

17-29. Why is an announcement of a share repurchase considered a positive signal?

By choosing to do a share repurchase, management credibly signals that they believe
the stock is undervalued.