Chapter 16

Dividend Policy

NI t D
16-1. Given a firm’s earnings per share, ( # shares )  Et, and its payout ratio, ( Ett ) , we can find the dividend
per share, Dt, by simply multiplying the two together:

 Dt 
Dt  Et   ,
 Et 

(where the “t” subscript refers to time t and the payout ratio is the dividend paid at time t from
earnings per share at time t). Thus, for our three companies, we have:

A B C = A*B
payout earnings dividend
company ratio per share per share
Emerson Electric Co. 85% $2.23 $1.90
Intel Corporation 40% $2.43 $0.97
Wal-Mart Stores 43% $4.53 $1.95

For example, Wal-Mart chose to pay out 43% of its earnings as dividends (reinvesting the other
57%), so it paid out $1.95 from EPS of $4.53 [($1.95/$4.53) = 0.43].

16-2. The Welmar Corporation paid total dividends in 2016 of $265,029,000, from its net income of
$1,282,725,000.
a. We can therefore simply find its payout ratio by dividing its total dividends by its net income:

 dividend per share t 

payout ratio t   
 earnings per share t 
 total dividendst /(#of shares) 
 
 net income t /(# of shares) 
 total dividendst 
 .
 net income t 

$265,029,000
Thus, for 2016, we find a payout ratio of 20.66%, or ( $1,282,725,000 ).

388
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 Solutions to End-of-Chapter Problems—Chapter 16 389
b. We can then find 2017’s total dividends by multiplying this payout ratio by 2017’s net
income, as shown below:

2016 notes
total cash dividends = $265,029,000 A
net income = $1,282,725,000 B
payout ratio = 20.66% C = A/B

2017
net income = $1,500,000,000 D (given)
payout ratio = 20.66% C (as before)
total cash dividends = $309,921,066 E = D*C
% change in net income = 16.94% F = (D - B)/B
% change in dividends = 16.94% G = (E - A)/A

Since Welmar Corporation’s net income rises, but its payout ratio remains the same, the firm
is paying out the same proportion of a larger whole. The firm’s total dividend payment
therefore rises, and by the same percentage as its net income. We can verify this statement
about percentage changes by noting that:
% divs  [(divs2017  divs2016)/divs2016]
 [(NI2017  payout2017)  (NI2016  payout2016)]/(NI2016  payout2016)
 [(NI2017  NI2016)/NI2016],
as long as payout2017  payout2016.

16-3. If the stock of Dimmick Skate Boarding Enterprises is selling for $40 one day before the ex-date
(so that investors who buy the stock then will receive the $3 dividend), it should sell for ($40 
$3) after the ex-date (when investors then buying will not receive the dividend).
Investors who won’t receive a $3 dividend will not pay as much for Dimmick’s shares as will
investors who will receive the dividend; therefore, the stock price will fall on the ex-day.
Remembering the dividend discount model for stock pricing, we see:

stock price just before ex-day  PV(all dividends to be paid from now to infinity)
$40  PV(next dividend of $3  all other future dividends)
$40  PV(next dividend of $3)  PV(all other future dividends),
whereas:

stock price just after ex-day  $0  PV(all other future dividends).

(See equation 16-1 in Checkpoint 16.1.) The difference in the prices before and after the ex-day is
therefore the PV of the $3 dividend. The present value of that dividend is very nearly $3, since it’s
so close to being paid, so the difference between the stock prices will be very close to $3. Thus,
we expect the stock’s price to fall by approximately $3 on the ex-day.

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390  Titman/Keown/Martin  Financial Management, Thirteenth Edition
16-4. Kingwood Corporation’s management is considering paying a one-time $40 special
cash dividend. Its current share price is $120. Using the same logic as in Problem 16-3, and again
applying equation 16-1, we would expect, all else equal, for the firm’s stock price to fall by $40 to
$80 once the dividend’s ex-date passes.
Management asserts that its reason for the special dividend is that the firm has more cash than it
can profitably invest, and that the large cash balance “would adversely affect the incentives of the
workforce to strive to create shareholder value.” Given these incentives, is it possible that the
stock price would not fall by $40, as expected? Do these incentives undermine our “all else equal”
assumption?
The answer depends upon the message that investors draw from the special dividend. This could
go either way:
(a) Investors view the dividend as good news, and stock price falls by less than $40.
Possible explanations for this outcome include:
 Investors see that managers want to maximize shareholder value, and that managers are
willing to voluntarily divest themselves of free cash flow, as finance theory says they should,
so that investors can more profitably invest that cash elsewhere. This improves investors’ view
of management and their expectations about future good decisions by management.
 Investors note that by releasing the free cash flow, managers remove their incentives to invest
the cash for perquisites or other negative net present value projects. Firm value rises as the
expected probability of future negative NPV investments falls.
 By eliminating the “excess” cash, managers eliminate a prime motivation for a takeover,
saving investors from a potentially expensive takeover battle (and preserving good current
management).
 As posited by management, employees are now more motivated to work, enhancing
shareholder value.
 The huge dividend returns the stock to its preferred trading range, as discussed in section 16.2
of the text. (However, this is not a likely interpretation here, given management’s story about
the dividend.)
 The dividend attracts attention, so it can’t be bad. (Again, this is a rationale discussed in
section 16.2.)
(b) Investors view the dividend as bad news, and stock price falls by more than $40.
Possible explanations for this outcome include:
 Investors focus on the big picture here, which is that the firm can no longer find enough
positive net present value projects. The firm has left its “growth” phase and entered maturity.
Future growth will be lower; as the lower growth rate is impounded in price, price falls.
Growth investors will need to leave the firm to find growth firms, incurring transactions costs
from selling their shares. Those who stay can count on higher (taxed!) dividends in the future,
as the mature firm—now a cash cow—continues to disgorge cash.
 There is no compensating increase in employee motivation, since lower-level employees are
primarily motivated by their paychecks. It’s management whose hands are tied by the lack of
free cash flow, not employees.
 There is now a lower probability of a value-enhancing takeover, given that one attraction for
acquirers is large amounts of free cash flow. The extent to which a poor current management
is entrenched has increased. (However, the decision to disgorge the cash in the first place
suggests that this negative assessment of management does not apply in Kingwood
Corporation’s case.)

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 Solutions to End-of-Chapter Problems—Chapter 16 391
 If (currently unforeseen) positive NPV projects arise, Kingwood may now have to resort to (more
expensive) outside financing to finance them, reducing their value.
 Kingwood Corporation has reduced its financial slack. To the extent that such slack is valuable,
Kingwood Corporation has lost value.
Given all these possible interpretations, the price may fall by more than $40. This firm has just
admitted that its growth days are over. Its expected future earnings, and its P/E ratio, will fall
as a result.

16-5. Stock dividends do not change firm value; they only change the number of shares outstanding. If
the number of shares increases but aggregate value does not, it must be that stock dividends cause
stock price to fall.
We can see this as follows. First, note that:

 firm value 
current stock price   .
 # of shares 

Now, if:

 firm value 
initial stock price     $40,
 old # of shares 

then:

firm value  $40  (old # of shares).

Now assume that the firm pays a 10% stock dividend, so that there will be 10% more shares
outstanding. This gives us the following:

new firm value  old firm value

(new price)  (new # of shares)  ($40)  (old # of shares)
(new price)  [(1.10)  (old # of shares)]  ($40)  (old # of shares),
so that:
new price  ($40)/(1.10)  $36.36.
If the stock dividend were larger, the dilution would be even greater. For a 20% dividend, the new
price is ($40)/(1.20)  $33.33.

notes
current stock price = $40.00 A
stock dividend % = 10% B
stock price after stock dividend = $36.36 C = A/(1+B)

current stock price = $40.00 D

stock dividend % = 20% E
stock price after stock dividend = $33.33 F = D/(1+E)

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392  Titman/Keown/Martin  Financial Management, Thirteenth Edition
16-6. As we saw in Problem 16-5, if a firm wants its stock price to fall, it can issue a stock dividend,
which will dilute price. If Templeton Care Facilities wants its stock price to fall from $150 to $50,
it would need to cut the price to 1/3 its current value. Since this won’t affect firm value, we can
solve for the necessary stock dividend percentage as follows:

new firm value  old firm value

(new price)  (new # of shares)  (old price)  (old # of shares)
($50)  [(1  x)  (old # of shares)]  ($150)  (old # of shares)
(1  x)  ($150)/($50)  3
x  2  200%.
Templeton would therefore have to issue a 200% stock dividend—a proportion so large that it’s
really not a stock dividend but a stock split. (As described in the text’s footnote 1, the accounting
response would be affected by the name Templeton gives to this transaction. However, the
economic impact is the same either way.)

16-7. Since Templeton Care Facilities needs to have three times as many shares outstanding after than
event (so that price will fall to 1/3 of its current value), the firm would need a 3-for-1 split. We can
see this as:

new firm value  old firm value

(new price)  (new # of shares)  (old price)  (old # of shares)
 old price   [(old # of shares)  3]  (old price)  (old # of shares).
 
 3 

Thus, the new number of shares must be three times as large as the old number of shares: Each old
share must be exchanged for three new ones.
16-8. The important thing to remember for this problem is that stock splits and stock dividends do not
change firm value. Once we know that, the problem simply boils down to determining how many
new shares the firm will issue.

a. – d. For stock dividends, the new number of shares is simply (# of old shares)  (1  stock
dividend percentage). Thus a 20% dividend means that the number of shares rises by 20%, so
that the new number of shares equals (# of old shares)  (1.20).
For an x-for-1 stock split, we simply multiply the old number of shares by x. For example, a 2-
for-1 split doubles the number of shares; a 4-for-1 multiplies it by 4.
Given that the firm value will not change, and that the number of shares outstanding will be
increased, it must be true that stock price will fall. For the three changes we were given for
B/D. Chaney’s Fat burner Gyms, we therefore have the following:

A B C = 8,000,000*(1+B) D = A/C
% change in
event firm value # of shares # shares price
initial situation $96,000,000 8,000,000 $12.00
20% stock dividend $96,000,000 20% 9,600,000 $10.00
4-for-1 split $96,000,000 300% 32,000,000 $3.00
32.5% stock dividend $96,000,000 32.5% 10,600,000 $9.06

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 Solutions to End-of-Chapter Problems—Chapter 16 393
(Note that for the 4-for-1 split, we have quadrupled the number of shares outstanding. Thus,
column B, which shows the percentage change in shares outstanding, shows [32 million  8
million]/8 million  24 million/8 million  3, or 300%.)
The chart below shows the relationships between the split/dividend percentage, the resulting
stock price, and the new number of shares outstanding.
$12.00

$11.00

28,000,000

$10.00

$9.00
23,000,000

$8.00

price per share

$7.00
18,000,000 # of shares

$6.00

$5.00
13,000,000

$4.00

$3.00 8,000,000
0% 50% 100% 150% 200% 250% 300%

percentage change in number of shares

16-9. Here is the initial balance sheet for Marshall Pottery Barn:
initial situation
MARSHALL POTTERY BARN
BALANCE SHEET (as of mm/dd/yy)
Cash $18,000 Accounts Payable $22,000
Accounts Receivable $22,000 Notes Payable $5,000
Inventory $30,000 Current Liabilities $27,000
Current Assets $70,000 Long-term Debt $33,000
Net Fixed Assets $130,000 Equity $140,000
Total Assets $200,000 Total D&E $200,000
The total dividend that Marshall is considering is ($1.50/share)*(5,000 shares) = $7,500:
notes
# of shares = 5,000 A
dividend per share = $1.50 B
total dividends paid = $7,500 C = A*B
a. When the firm pays its cash dividend, it obviously will lower cash. It will also lower equity:
Dividends paid come out of the equity stake of the company. Investors are essentially “cashing
out” some of their equity. The accounting entry would be to debit equity and credit cash:

equity $7,500
cash $7,500
(payment of cash dividend)

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394  Titman/Keown/Martin  Financial Management, Thirteenth Edition
Thus, Marshall’s balance sheet will look like this after the dividend payment:

after dividend
MARSHALL POTTERY BARN
BALANCE SHEET (as of mm/dd/yy)
Cash $10,500 Accounts Payable $22,000
Accounts Receivable $22,000 Notes Payable $5,000
Inventory $30,000 Current Liabilities $27,000
Current Assets $62,500 Long-term Debt $33,000
Net Fixed Assets $130,000 Equity $132,500
Total Assets $192,500 Total D&E $192,500

Note that total firm value has fallen by the amount of the dividend.
b. If this were interpreted as a market-value balance sheet, there would be no difference. The
firm would still have $7500 less in cash. Since the value of each share of stock would have
fallen by $1.50 after the dividend payment, the total market value of stock held by all investors
would still fall by $7500. Thus, there would be no difference in our post-dividend balance
sheet.
Of course, equityholders are not worse off, ignoring taxes. Their holding of the firm used to be
worth $140,000; now it’s worth only $132,500, but they also have $7500 in cash. Either way,
they have $140,000 worth of financial assets.
16-10. In Section 16.2 of the text, we learn about “Individual Wealth Effects—Personal Taxes.” Fact #2
in that subsection tells us that a stock seller only pays capital gains taxes on the difference between
the selling price and the buying price (i.e., the capital gain). Since Stan bought his shares for $8 and
will sell them for $10, he will only need to pay tax on his ($10  $8)  $2/share capital gain. Thus:
notes
current stock price = $10 A (given)
Stan's initial price = $8 B (given)
Stan's capital gain per share = $2 C=A-B
# of shares that Stan will sell = 2,000 D (given)
Stan's total proceeds = $20,000 E = A*D
Stan's total capital gain = $4,000 F = C*D
capital gains rate = 15% G (given)
Stan's tax bill = $600 H = F*G
Stan's after-tax proceeds = $19,400 I=E-H
Stan sells 2000 shares at $10/share, for a total of $20,000. However, he doesn’t pay tax on this full
amount; instead, he pays tax on only his $2/share capital gain, or [($2/share)  (2000 shares)] 
$4000. Tax on $4000 at 15% is [(15%)  ($4000)]  $600, so Stan ends up with ($20,000 total
proceeds  $600 tax)  $19,400.
An important point here is that a capital gain is not a cash flow. Instead, a capital gain is an
accounting value that determines a tax bill (the tax bill, of course, is a cash flow). We never
receive checks for capital gains; we only receive checks for total proceeds (and then write checks
for taxes). Thus, when we’re finding a cash flow, like after-tax proceeds, we combine only other
cash flows: total proceeds and taxes.

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 Solutions to End-of-Chapter Problems—Chapter 16 395
16-11. In Section 16.2 of the text, we learn about “Individual Wealth Effects—Personal Taxes.” Fact #1
tells us that 100% of cash dividends are taxable in the year they are received. Thus, if Stan owns
10,000 shares, and the firm pays a dividend of $2/share, Stan will receive [(10,000 shares) 
($2/share)]  $20,000. This full amount is taxed at 15%, so Stan’s tax bill will be [($20,000) 
(15%)]  $3000—a much more severe tax hit than Stan faced in Problem 16-10. When Stan
received the $20,000 from share sales, he was taxed only on the $2/share capital gain on the 2000
shares he sold. Even then he had a choice: He did not have to sell. In this case, however, the
dividend is paid on all 10,000 shares, the full amount received is taxable, and Stan has no choice
about receiving the cash flow (unless he sells the shares in the market at $10 before they go ex-
dividend).
notes
# of shares owned by Stan = 10,000 A (given)
dividend per share = $2 B (given)
total dividends received by Stan = $20,000 C = A*B
dividend tax rate = 15% D (given)
Stan's tax bill = $3,000 E = C*D
Stan's after-tax proceeds = $17,000 F=C-E
Of course, Stan’s tax situation would have been even worse if dividends were still taxed as
ordinary income—at rates up to 35%.
16-12. a. If Caraway Seed Company pays $200,000 today and $1.2 million in one year to its
equityholders, and if those equityholders require a 10% return, then the value of the equity
must be the present value of those two payments. (The value of stockholders’ equity is the PV
of all future dividends, and, for Caraway’s equityholders, these are the only two dividends
they will receive. After the t  1 dividend, the firm shuts down.) Thus, we have:
value of Caraway’s equity  PV(all future dividends)
= [PV of t  0 dividend]  [PV of t  1 dividend]
$1,200,000
 $200,000 
(1.10)1
 $200,000  $1,090,909
 $1,290,909.
(Compare our work to equation 16-1, and the related calculations for Clinton Enterprises from
the text, as well as Northwest Wire and Cable from Checkpoint 16.1.)
Now if Caraway decided to pay $600,000 in t  0 dividends ($400,000 more than it has
available), it needs to raise $400,000 in new stock. The holders of this new stock also require a
10% return, so they will demand $400,000  (1.10)  $440,000. Paying $440,000 at t  1
leaves only ($1,200,000  $440,000)  $760,000 for the “old” shareholders. Thus, the value
of the “old” shareholders’ equity is now:
value of “old” equity  PV(all future dividends to original shareholders)
[PV of t  0 dividend]  [PV of t  1 dividend]
$760,000
 $600,000 
(1.10)1
 $600,000  $690,909
 $1,290,909.

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396  Titman/Keown/Martin  Financial Management, Thirteenth Edition
It’s the same either way! The old shareholders either get more money now or more money
later, but the PRESENT VALUE of these payments is unchanged. How could it be otherwise?
The PV is simply the value of the firm, which is not affected by these alternatives.
The situation of Caraway’s old shareholders is pictured below. Under either alternative #1
(payment today of $200,000; payment in 1 year of $1.2 million) or alternative #2 (payment
today of $600,000; payment in 1 year of $760,000), these shareholders receive payments
whose PRESENT VALUES (which are what is pictured below) are worth $1,290,909. The
packaging doesn’t matter; the value is the same.
$1,400,000

$1,290,909

$1,200,000

$1,000,000
$690,909

$800,000
$1,090,909
t=1 payment
t=0 payment
$600,000

$400,000

$600,000

$200,000

$200,000

$0
alternative #1 alternative #2

This result depends upon the new shareholders’ getting what they paid for, and on their having
the same 10% required return as our current shareholders. That is, when they give us $400,000
today, they are getting shares worth $400,000 today. The new shares’ owners receive
$440,000 in one year; this payment is worth $440,000/(1.10)1  $400,000. When the old
shareholders choose this alternative, they receive something today worth $600,000, in return
for something in one year that is worth $760,000, which is currently worth $690,909. Thus,
there is no effect on current shareholders.
We can also think of this as follows. Under alternative #1, just after the t  0 dividend is paid,
we have:
firm value  value of old shareholders’ shares  $1,090,909.
The old shareholders also have $200,000 in cash, so their total worth is $1,290,909.
Under alternative #2, it looks like this:
firm value  value of old shareholders’ shares + value of new shareholders’ shares
 $690,909  $400,000
 $1,090,909.
The old shareholders also have $600,000 in cash, so their total worth is $1,290,909, just as it is
under alternative #1.
16-13. a. If the Tyler Brick Manufacturing Company pays its shareholders $125,000 today and $14
million in one year, then the all-equity firm’s value (given a required return to equity of 15%)
is found as follows:

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 Solutions to End-of-Chapter Problems—Chapter 16 397
value of Tyler’s equity  PV(all future dividends)
 [PV of t  0 dividend]  [PV of t  1 dividend]
$14,000,000
 $125,000 
(1.15)1
 $125,000  $12,173,913
 $12,298,913.
b. If, however, the firm raises new equity at a required return of 15% in order to increase
today’s dividend to $1,000,000, the value of the existing shares of stock is:
value of “old” equity  PV(all future dividends to original shareholders)
 [PV of t  0 dividend]  [PV of t  1 dividend]
$12,993,750
 $1,000,000 
(1.15)1
 $1,000,000  $11,298,913
 $12,298,913,
the same as with alternative #1.
The payment to old shareholders under the second alternative equals the $14 million available,
less the payment required by the new shareholders. Since the new shareholders provided
$875,000 at t  0 (the $1 million dividend  $125,000 available), they will require [($875,000)
 (1.15)]  $1,006,250 at t  1. This leaves ($14,000,000  $1,006,250)  $12,993,750 for the
old shareholders at t = 1.
Thus, under either alternative, the old shares are worth $12,298,913 at t  0 (including the t 
0 dividend). The new shares under alternative #2 are worth what they cost, $875,000.
We can see this, as shown below:

$12,298,913
$12,000,000

$10,000,000

$8,000,000

$11,298,913
t=1 payment
$6,000,000 $12,173,913
t=0 payment

$4,000,000

$2,000,000

$125,000 $1,000,000
$0
alternative #1 alternative #2

Under either alternative, the old shares are worth $12,298,913: the old shareholders either get
more money at t  0 (alternative #2) or more money at t  1 (alternative #1); either way, the
PRESENT VALUE of both of their payments is $12,298,913.

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