IFM10 Ch17 Solutions Manual.docx

IFM10 Ch17 Solutions Manual.docx

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IFM10Ch17SolutionsManual

Chapter17

DistributionstoShareholders:

DividendsandRepurchases

ANSWERSTOBEGINNING-OF-CHAPTERQUESTIONS

17-1Investorswhopreferahighpayoutpolicywouldgenerally（a）needcurrentcashincomeand（b）beinalowincometaxbracket.Thosewhopreferalowpayoutwouldnotneedcashcurrentlyandwouldbeinahightaxbracket.Universitiesandothertax-exemptinstitutions,andmanyretirees,areexamplesofthosewhoprefercashdividends,whilepeopleintheirpeakearningyearsoftenpreferlowpayouts.

Ifsomeoneholdsalowpayoutstockandwantsmorecashincome,heorshecansellthestockandbuyahighpayoutstock,butthatwouldresultinbrokeragecostsandpossiblycapitalgainstaxes.

Ifyouownedahighpayoutstockandwantedlessdividends,youcould

（1）selloutandswitchtoalowdividendstock,

（2）trytogetthecompanytoloweritspayout（whilepossiblystartingastockrepurchaseprogram）,or（3）joinadividendreinvestmentplan.Sellingwouldinvolvebrokeragecostsandpossiblycapitalgainstaxes.Thedividendreinvestmentplanwouldavoidbrokeragefees,butyouwouldhavetopaytaxescurrentlyevenifyoureinvestthedividends.YouwouldhaveagoodchanceofgettingthecompanytofollowyouradviceunderPoint2ifyournamewereWarrenBuffett.

17-2Herearethethreetheories,whichareillustratedintheBOCmodel.Theyshouldbethoughtofasapplyingtoinvestorsintheaggregateandnottoeachindividualinvestor,because,obviously,differentindividualswillcertainlyhavedifferentpreferences.

MMIndifference.Investorsintheaggregatedon’tcare.Thosewholikedividendsareoffsetbythosewhodonotwantthem.

Birdinhand,ordividendpreference.Mostinvestorsprefercashdividendstoretainedearningsandpossiblefuturegrowth.

Taxpreference,ordividenddislike.Mostinvestorsprefertohavecompaniesretainandreinvestearningsinordertogenerateearninggrowthandcapitalgains.

MMIndifference.MMarguethatarguethatonlyastock’searningsandbusinessriskdetermineitsprice.SupposestocksHandLhavethesameriskandthesameearnings,butHpaysmoreofitsearningsoutasdividendsandhasthehigherprice.MMarguethatinvestorscouldsellHandbuyL.L’ssharepriceshouldrisefasterthanH’sbecauseitisplowingbackmoreofitsearnings.L’sinvestorswhowantmoredividendscouldsellenoughoftheirsharestomakeupforthedividendshortfall.Theyprovethatthiswouldresultinhighercashflows.TheythenarguethatarbitragewouldoccuruntilHandLsoldatthesameprice.

HadL’sstockhadthehigherprice,thenitsholderswhodidnotwantdividendscouldsellit,buyH,andthenusetheexcessdividendstobuymoreofH’sstock.

MM’sargumentassumesthattherearenotransactionscostsinvolvedinstocktransactions.Theyalsoassumenotaxes.Theexistenceofdifferentialtaxesondividendsversuscapitalgains,andtransactionscosts,makeperfectarbitrageimpossible,andinthissituationanindividualinvestorcouldpreferonetypestockortheother.Then,iftherearemoreoftheinvestorswhoprefereitherhighorlowpayouts,theindifferencetheorywillnotbetrueintheaggregate.

BirdintheHand.There’sanoldproverbthatsays“abirdinthehandisworthtwointhebush.”MyronGordon,whodevelopedtheDiscountedDividendModel,arguedthatinvestorsthinkadividendinthehandislessriskythanapotentialcapitalgaininthebush.Thisleadstotheconclusionthatrsfallsasthepayoutratioisincreased.MMcriticizedGordonandcalledhisposition“thebirdinthehandfallacy.”MMarguedthatmostinvestorstakedividendsandthenreinvesttheminthestockofthesameorsimilarcompanies,whichexposesthemtothesameriskasifthecompanieshadsimplykeptthedividendsandinvestedtheproceedswithoutpassingthemthroughinvestors’hands.

TaxPreference.Othershavearguedthatlowertaxesoncapitalgainscausethemajorityofinvestorstopreferretentionandcapitalgainstohigherdividendsandhighertaxes.

EmpiricaltestshavetriedtorelatestockpricesorP/Eratiostodividendpayout.Ifwecouldfindasampleofcompaniesthatvariedonlywithrespecttotheirpayoutpolicies,thenwecouldplotP/E’sandpricesagainstpayout,andifthepatternthatemergedwaslikeoneofthoseshowninthefollowinggraphs,thenthiswouldsupportoneofthetheories.However,itisimpossibletofindcompaniesthatvaryonlyintheirpayouts.

Gordon（BirdintheHand）

Thingsotherthanpayoutaresimplyneverheldconstant.Inparticularexpectedgrowthratesvaryacrosscompanies,soahighpricecouldbeassociatedwithahighexpectedgrowthrate,notnecessarilyahighpayoutratio.Also,wecan’tmeasureeitherrsorexpectedgprecisely.So,thetestshavenotbeenconclusive.

Notetoothatifdifferentfirmscatertodifferentclienteles,andiftheclientelesareallhappy,thendifferentcompaniesmighthavedifferentpayoutsbutsimilarpricesandP/Eratios,whichwouldconfusetheempiricaltests.

17-3Historically,companieshavebeenreluctanttocuttheirdividends--theydon’tcutdividendsunlessthingsreallylookhorribletomanagement.Moreover,investorsknowaboutmanagement’sreluctancetocutdividends.Therefore,ifafirmcutsitsdividends,investorstakethisasanegativesignal—asignthatthefirmisingravedanger--andthestocktanks.Asaresult,firmsarereluctanttoraisetheirdividendunlesstheyareconfidentthatfutureearningsandcashflowswillbestrongenoughtosupportthehigherdividendrate,hencethatthecompanywon’tbeforcedtocutthedividend.Therefore,anincreaseinthedividendistakenasasignalthatmanagementisoptimisticaboutthefuture.

PriortoMM,peoplesawthatstockstendtorisewhendividendsareincreasedandtofallwhendividendsarecut.Thisledtoabeliefthatinvestorspreferredahighpayout.Forexample,intheirclassicinvestmentstext,GrahamandDoddstatedthatinvestorsvaluedadollarofdividendsasmuchasthreedollarsofretainedearnings.AllthiswasusedtorefuteMM’sindifferencetheory.However,MMarguedthattheapparentpreferencefordividendswasreallyjusttheeffectsofsignaling,hencenotvalidevidencethatrefutedtheirindifferencehypothesis.

Theclienteleeffectmeansthatafirm,throughitsdividendpolicy,attractsasetofinvestorswhowantstheparticularpolicythefirmfollows.Forexample,ifafirmfollowsapolicyofpayingoutmostofitsearningsasdividends,itwillattractaclienteleofinvestorswhoareinlowtaxbracketsandwhodesirehighcurrentcashincomeratherthanfuturecapitalgains.Acompanywithalowpayoutpolicywouldattracthightaxbracketinvestorswhowantedtosaveratherthanspendcurrentlytheircorporateincome.

MMarguedthatfirmscanchangedividendpolicies,andinvestorswhodislikethenewpolicycanswitchstockstosomeothercompanywiththeirfavoritepayoutpolicy.ButMMassumeawaythetransactioncostsandcapitalgainstaxesthatwouldbeincurredasaresultoftheswitch.MMalsoassumethatintheaggregatethereisaperfectmatchbetweencompanies’policiesandinvestorsdesires,soifacompanychangedpoliciesandthusdroveoffsomeofitsexistingstockholders,therewouldbeexactlyenoughinvestorswhodesiredthenewpolicytoreplacethedepartingstockholders.However,taxesandtransactionscostsdoexist,andtheremaybeashortageofreplacementinvestors,soitispossiblethatacompany’sstockpricemightbehigherunderonedividendpolicythananother.

Signalingandclienteleeffectsmakeempiricaltestsmoredifficult—theymakeithardertosortoutwhetherinvestorsintheaggregatepreferdividendsorretention.Notetoothatdifferentinvestorsarelikelytopreferdifferentpolicies.Therefore,ifafirmchangesitspolicy,somewilllikeitwhileotherswilldislikeit,anditmaylooklikeinvestorsareindifferentwhentheyreallycare,butinoppositedirections.Ofcourse,ifthisexactoffsetoccurred,thenthiswouldbeconsistentwithMM’sviewsaboutaggregateinvestorpreferences.

Inaddition,stockholdersliketherelativecertaintythatcomesfromastablepolicy—investorsliketoknowhowmuchdividendswillbecomingonaspecificdatebecausethatfacilitatesplanningandreducesuncertainty.Forthisreason,plusthefactthatit’scostlyforinvestorstoswitchcompaniesifagivencompanychangesitsdividendpolicy,acompanyshouldmaintainastablepolicyunlessithasatrulycompellingreasonformakingachange.Moreover,ifachangeistobemade,thecompanyshouldmakethereasonsforthechangequitecleartoinvestorssoastoavoidsendingafalsesignal,andtheyshouldmakethechangefairlygraduallyinordertohelpinvestorsthroughthemove.

17-4Residualimpliesleftover,andtheresidualdividendpolicyimpliesthatdividendsarepaidonlyafterthecompanyhasusedallnecessaryearningstofinanceitscapitalbudget.Noteinthefollowinggraphthatthefirmhasacostofcapitalscheduleandaninvestmentopportunityschedule,andtheoptimalcapitalbudgetisfoundattheintersectionofthosetwocurves,at$*.Multiply$*timestheoptimalequityratiotogettherequiredequity（withthebalancebeingnewdebt）.Thensubtracttherequirednewequityfromthedollarsofnetincome,andtheresult,ifpositive,isthedividendstobepaidoutundertheresidualpolicy.

$*=Cap.Bud.

ThedividendsasthusdeterminedwouldvaryfromyeartoyearastheIOSandMCCcurvesshift,andasnetincomevaries.Thatwouldleadtofluctuatingdividends,whichwoul