IFM10 Ch17 Solutions Manual.docx

1、IFM10 Ch17 Solutions ManualChapter 17Distributions to Shareholders:Dividends and RepurchasesANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS17-1 Investors who prefer a high payout policy would generally (a) need current cash income and (b) be in a low income tax bracket. Those who prefer a low payout would

2、 not need cash currently and would be in a high tax bracket. Universities and other tax-exempt institutions, and many retirees, are examples of those who prefer cash dividends, while people in their peak earning years often prefer low payouts. If someone holds a low payout stock and wants more cash

3、income, he or she can sell the stock and buy a high payout stock, but that would result in brokerage costs and possibly capital gains taxes. If you owned a high payout stock and wanted less dividends, you could (1) sell out and switch to a low dividend stock, (2) try to get the company to lower its

4、payout (while possibly starting a stock repurchase program), or (3) join a dividend reinvestment plan. Selling would involve brokerage costs and possibly capital gains taxes. The dividend reinvestment plan would avoid brokerage fees, but you would have to pay taxes currently even if you reinvest the

5、 dividends. You would have a good chance of getting the company to follow your advice under Point 2 if your name were Warren Buffett. 17-2 Here are the three theories, which are illustrated in the BOC model. They should be thought of as applying to investors in the aggregate and not to each individu

6、al investor, because, obviously, different individuals will certainly have different preferences. MM Indifference. Investors in the aggregate dont care. Those who like dividends are offset by those who do not want them. Bird in hand, or dividend preference. Most investors prefer cash dividends to re

7、tained earnings and possible future growth. Tax preference, or dividend dislike. Most investors prefer to have companies retain and reinvest earnings in order to generate earning growth and capital gains. MM Indifference. MM argue that argue that only a stocks earnings and business risk determine it

8、s price. Suppose stocks H and L have the same risk and the same earnings, but H pays more of its earnings out as dividends and has the higher price. MM argue that investors could sell H and buy L. Ls share price should rise faster than Hs because it is plowing back more of its earnings. Ls investors

9、 who want more dividends could sell enough of their shares to make up for the dividend shortfall. They prove that this would result in higher cash flows. They then argue that arbitrage would occur until H and L sold at the same price. Had Ls stock had the higher price, then its holders who did not w

10、ant dividends could sell it, buy H, and then use the excess dividends to buy more of Hs stock. MMs argument assumes that there are no transactions costs involved in stock transactions. They also assume no taxes. The existence of differential taxes on dividends versus capital gains, and transactions

11、costs, make perfect arbitrage impossible, and in this situation an individual investor could prefer one type stock or the other. Then, if there are more of the investors who prefer either high or low payouts, the indifference theory will not be true in the aggregate. Bird in the Hand. Theres an old

12、proverb that says “a bird in the hand is worth two in the bush.” Myron Gordon, who developed the Discounted Dividend Model, argued that investors think a dividend in the hand is less risky than a potential capital gain in the bush. This leads to the conclusion that rs falls as the payout ratio is in

13、creased. MM criticized Gordon and called his position “the bird in the hand fallacy.” MM argued that most investors take dividends and then reinvest them in the stock of the same or similar companies, which exposes them to the same risk as if the companies had simply kept the dividends and invested

14、the proceeds without passing them through investors hands. Tax Preference. Others have argued that lower taxes on capital gains cause the majority of investors to prefer retention and capital gains to higher dividends and higher taxes. Empirical tests have tried to relate stock prices or P/E ratios

15、to dividend payout. If we could find a sample of companies that varied only with respect to their payout policies, then we could plot P/Es and prices against payout, and if the pattern that emerged was like one of those shown in the following graphs, then this would support one of the theories. Howe

16、ver, it is impossible to find companies that vary only in their payouts.Gordon (Bird in the Hand) Things other than payout are simply never held constant. In particular expected growth rates vary across companies, so a high price could be associated with a high expected growth rate, not necessarily

17、a high payout ratio. Also, we cant measure either rs or expected g precisely. So, the tests have not been conclusive. Note too that if different firms cater to different clienteles, and if the clienteles are all happy, then different companies might have different payouts but similar prices and P/E

18、ratios, which would confuse the empirical tests.17-3 Historically, companies have been reluctant to cut their dividends-they dont cut dividends unless things really look horrible to management. Moreover, investors know about managements reluctance to cut dividends. Therefore, if a firm cuts its divi

19、dends, investors take this as a negative signala sign that the firm is in grave danger-and the stock tanks. As a result, firms are reluctant to raise their dividend unless they are confident that future earnings and cash flows will be strong enough to support the higher dividend rate, hence that the

20、 company wont be forced to cut the dividend. Therefore, an increase in the dividend is taken as a signal that management is optimistic about the future. Prior to MM, people saw that stocks tend to rise when dividends are increased and to fall when dividends are cut. This led to a belief that investo

21、rs preferred a high payout. For example, in their classic investments text, Graham and Dodd stated that investors valued a dollar of dividends as much as three dollars of retained earnings. All this was used to refute MMs indifference theory. However, MM argued that the apparent preference for divid

22、ends was really just the effects of signaling, hence not valid evidence that refuted their indifference hypothesis. The clientele effect means that a firm, through its dividend policy, attracts a set of investors who wants the particular policy the firm follows. For example, if a firm follows a poli

23、cy of paying out most of its earnings as dividends, it will attract a clientele of investors who are in low tax brackets and who desire high current cash income rather than future capital gains. A company with a low payout policy would attract high tax bracket investors who wanted to save rather tha

24、n spend currently their corporate income. MM argued that firms can change dividend policies, and investors who dislike the new policy can switch stocks to some other company with their favorite payout policy. But MM assume away the transaction costs and capital gains taxes that would be incurred as

25、a result of the switch. MM also assume that in the aggregate there is a perfect match between companies policies and investors desires, so if a company changed policies and thus drove off some of its existing stockholders, there would be exactly enough investors who desired the new policy to replace

26、 the departing stockholders. However, taxes and transactions costs do exist, and there may be a shortage of replacement investors, so it is possible that a companys stock price might be higher under one dividend policy than another. Signaling and clientele effects make empirical tests more difficult

27、they make it harder to sort out whether investors in the aggregate prefer dividends or retention. Note too that different investors are likely to prefer different policies. Therefore, if a firm changes its policy, some will like it while others will dislike it, and it may look like investors are ind

28、ifferent when they really care, but in opposite directions. Of course, if this exact offset occurred, then this would be consistent with MMs views about aggregate investor preferences. In addition, stockholders like the relative certainty that comes from a stable policyinvestors like to know how muc

29、h dividends will be coming on a specific date because that facilitates planning and reduces uncertainty. For this reason, plus the fact that its costly for investors to switch companies if a given company changes its dividend policy, a company should maintain a stable policy unless it has a truly co

30、mpelling reason for making a change. Moreover, if a change is to be made, the company should make the reasons for the change quite clear to investors so as to avoid sending a false signal, and they should make the change fairly gradually in order to help investors through the move.17-4 Residual impl

31、ies left over, and the residual dividend policy implies that dividends are paid only after the company has used all necessary earnings to finance its capital budget. Note in the following graph that the firm has a cost of capital schedule and an investment opportunity schedule, and the optimal capit

32、al budget is found at the intersection of those two curves, at $*. Multiply $* times the optimal equity ratio to get the required equity (with the balance being new debt). Then subtract the required new equity from the dollars of net income, and the result, if positive, is the dividends to be paid out under the residual policy.$* = Cap. Bud. The dividends as thus determined would vary from year to year as the IOS and MCC curves shift, and as net income varies. That would lead to fluctuating dividends, which woul