FIN2101 BUSINESS FINANCE II
MODULE 10 - DIVIDEND POLICY
QUESTION 1
Malkor Instruments Ltd,which has an all-equity capital structure,treats dividends as a residual decision,It expects to generate $2 million in after-tax earnings in the coming year,The company has estimated that its cost of equity capital is 10 per cent,and that new issue costs would be about 9 per cent (of the current market price of its shares),if it sought to raise new equity through a placement.
(a) How much should be paid in dividends if the company has $1.5 million in new projects whose expected returns exceed 10 per cent?
(b) How much should be paid in dividends if it has $2 million of new projects whose expected returns exceed 10 per cent?
(c) How much should be paid in dividends if it has $3 million of new projects whose expected returns exceed 10 per cent? What else should Malkor do?
QUESTION 2
Terra Cotta finances new investments by 40 per cent debt and 60 per cent equity,The firm needs $640 000 for financing new investments,If retained earnings available for reinvestment equal $400 000,how much money will be available for dividends in accordance with the residual-dividend theory?
QUESTION 3
The management of Harris Company is considering two dividend policies for the years 20X1 and 20X2,one and two years away,In 20X3 the management is planning to liquidate the firm,One plan would pay a dividend of 25 cents in 20X1 and 20X2 and a liquidating dividend of $4.57 in 20X3,The alternative would be to pay out 42.5 cents in dividends in 20X1,47.5 cents in 20X2,and a final dividend of $4.07 in 20X3,The required rate of return for the ordinary shareholders is 18 per cent,Management is concerned about the effect of the two dividend streams on the value of the ordinary shares.
Assuming perfect markets,what would be the effect?
(b) What factors in the real world might change your conclusion reached in part (a)?
QUESTION 4
Over the past ten years,a firm has had the EPS shown in the following table:
Year
EPS ($)
2001
4.00
2000
3.80
1999
3.20
1998
2.80
1997
3.20
1996
2.40
1995
1.20
1994
1.80
1993
-0.50
1992
0.25
If the firm’s dividend policy was based on a constant payout ratio of 40 per cent for all years with positive earnings and a zero payout otherwise,determine the annual dividend for each year.
If the firm had a dividend payout of $1 per share,increasing by $0.10 per share whenever the dividend payout fell below 50 per cent for two consecutive years,what annual dividend did the firm pay each year?
If the firm’s policy was to pay $0.50 per share each period except when EPS exceed $3,when an extra dividend equal to 80 per cent of earnings beyond $3 would be paid,what annual dividend did the firm pay each year?
Discuss the pros and cons of each dividend policy exhibited in (a) to (c) above.
QUESTION 5
The earnings for the Crystal Cargo Company have been predicted for the next five years and are listed below,There are 1 million shares outstanding,Determine the yearly dividend per share to be paid if the following policies are enacted:
Constant dividend payout ratio of 50 per cent.
Each year,90 per cent of profits after tax are issued as fully franked dividends.
Year
After-tax Profits ($)
1
1 400 000
2
2 000 000
3
1 860 000
4
900 000
5
2 800 000
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 10 - DIVIDEND POLICY
QUESTION 1
(a) Funds Available for Dividends = Net Cash Flows - Investments
= $2 000 000 - $1 500 000
= $500 000
(b) Funds Available for Dividends = $2 000 000 - $2 000 000
= $0
(c) Funds Available for Dividends = $2 000 000 - $3 000 000
= $0
The company should raise an additional $1 million through the sale of ordinary shares.
QUESTION 2
Total financing needed $640 000
Retained earnings $400 000
Debt ratio 40 per cent
Equity ratio 60 per cent
Equity financing needed $384 000 (60 per cent of $640 000)
Dividends $16 000 ($400 000 - $384 000)
QUESTION 3
(a) There is no effect on the value of the ordinary shares.
(b) An investor’s preference for current income,tax consequences,information content,and transaction costs may change your answer.
QUESTION 4
a.
Year
Dividend
Year
Dividend
1992
$0.10
1997
$1.28
1993
0.00
1998
1.12
1994
0.72
1999
1.28
1995
0.48
2000
1.52
1996
0.96
2001
1.60
b.
Year
Dividend
Year
Dividend
1992
$1.00
1997
$1.10
1993
1.00
1998
1.20
1994
1.00
1999
1.30
1995
1.00
2000
1.40
1996
1.00
2001
1.50
c.
Year
Dividend
Year
Dividend
1992
$0.50
1997
$0.66
1993
0.50
1998
0.50
1994
0.50
1999
0.66
1995
0.50
2000
1.14
1996
0.50
2001
1.30
d. With a constant-payout policy,if the firm’s earnings drop or a loss occurs,the dividends will be low or non-existent,A regular dividend or a low-regular-and-extra dividend policy reduces owner uncertainty by paying relatively fixed and continuous dividends.
QUESTION 5
(a) Constant Payout Ratio of 50 per cent
Year
(Profit × Payout Ratio) ( Shares
Dividend Per Share
1
(1 400 000 × 0.5) ( 1 000 000
$0.70
2
(2 000 000 × 0.5) ( 1 000 000
$1.00
3
(1 860 000 × 0.5) ( 1 000 000
$0.93
4
(900 000 × 0.5) ( 1 000 000
$0.45
5
(2 800 000 × 0.5) ( 1 000 000
$1.40
(b) Fully Franked Dividends of 90 per cent
Year
(Profit × Payout Ratio) ( Shares
Dividend Per Share
1
(1 400 000 × 0.9) ( 1 000 000
$1.26
2
(2 000 000 × 0.9) ( 1 000 000
$1.80
3
(1 860 000 × 0.9) ( 1 000 000
$1.67
4
(900 000 × 0.9) ( 1 000 000
$0.81
5
(2 800 000 × 0.9) ( 1 000 000
$2.52
MODULE 10 - DIVIDEND POLICY
QUESTION 1
Malkor Instruments Ltd,which has an all-equity capital structure,treats dividends as a residual decision,It expects to generate $2 million in after-tax earnings in the coming year,The company has estimated that its cost of equity capital is 10 per cent,and that new issue costs would be about 9 per cent (of the current market price of its shares),if it sought to raise new equity through a placement.
(a) How much should be paid in dividends if the company has $1.5 million in new projects whose expected returns exceed 10 per cent?
(b) How much should be paid in dividends if it has $2 million of new projects whose expected returns exceed 10 per cent?
(c) How much should be paid in dividends if it has $3 million of new projects whose expected returns exceed 10 per cent? What else should Malkor do?
QUESTION 2
Terra Cotta finances new investments by 40 per cent debt and 60 per cent equity,The firm needs $640 000 for financing new investments,If retained earnings available for reinvestment equal $400 000,how much money will be available for dividends in accordance with the residual-dividend theory?
QUESTION 3
The management of Harris Company is considering two dividend policies for the years 20X1 and 20X2,one and two years away,In 20X3 the management is planning to liquidate the firm,One plan would pay a dividend of 25 cents in 20X1 and 20X2 and a liquidating dividend of $4.57 in 20X3,The alternative would be to pay out 42.5 cents in dividends in 20X1,47.5 cents in 20X2,and a final dividend of $4.07 in 20X3,The required rate of return for the ordinary shareholders is 18 per cent,Management is concerned about the effect of the two dividend streams on the value of the ordinary shares.
Assuming perfect markets,what would be the effect?
(b) What factors in the real world might change your conclusion reached in part (a)?
QUESTION 4
Over the past ten years,a firm has had the EPS shown in the following table:
Year
EPS ($)
2001
4.00
2000
3.80
1999
3.20
1998
2.80
1997
3.20
1996
2.40
1995
1.20
1994
1.80
1993
-0.50
1992
0.25
If the firm’s dividend policy was based on a constant payout ratio of 40 per cent for all years with positive earnings and a zero payout otherwise,determine the annual dividend for each year.
If the firm had a dividend payout of $1 per share,increasing by $0.10 per share whenever the dividend payout fell below 50 per cent for two consecutive years,what annual dividend did the firm pay each year?
If the firm’s policy was to pay $0.50 per share each period except when EPS exceed $3,when an extra dividend equal to 80 per cent of earnings beyond $3 would be paid,what annual dividend did the firm pay each year?
Discuss the pros and cons of each dividend policy exhibited in (a) to (c) above.
QUESTION 5
The earnings for the Crystal Cargo Company have been predicted for the next five years and are listed below,There are 1 million shares outstanding,Determine the yearly dividend per share to be paid if the following policies are enacted:
Constant dividend payout ratio of 50 per cent.
Each year,90 per cent of profits after tax are issued as fully franked dividends.
Year
After-tax Profits ($)
1
1 400 000
2
2 000 000
3
1 860 000
4
900 000
5
2 800 000
FIN2101 BUSINESS FINANCE II
SOLUTIONS TO TUTORIAL QUESTIONS
MODULE 10 - DIVIDEND POLICY
QUESTION 1
(a) Funds Available for Dividends = Net Cash Flows - Investments
= $2 000 000 - $1 500 000
= $500 000
(b) Funds Available for Dividends = $2 000 000 - $2 000 000
= $0
(c) Funds Available for Dividends = $2 000 000 - $3 000 000
= $0
The company should raise an additional $1 million through the sale of ordinary shares.
QUESTION 2
Total financing needed $640 000
Retained earnings $400 000
Debt ratio 40 per cent
Equity ratio 60 per cent
Equity financing needed $384 000 (60 per cent of $640 000)
Dividends $16 000 ($400 000 - $384 000)
QUESTION 3
(a) There is no effect on the value of the ordinary shares.
(b) An investor’s preference for current income,tax consequences,information content,and transaction costs may change your answer.
QUESTION 4
a.
Year
Dividend
Year
Dividend
1992
$0.10
1997
$1.28
1993
0.00
1998
1.12
1994
0.72
1999
1.28
1995
0.48
2000
1.52
1996
0.96
2001
1.60
b.
Year
Dividend
Year
Dividend
1992
$1.00
1997
$1.10
1993
1.00
1998
1.20
1994
1.00
1999
1.30
1995
1.00
2000
1.40
1996
1.00
2001
1.50
c.
Year
Dividend
Year
Dividend
1992
$0.50
1997
$0.66
1993
0.50
1998
0.50
1994
0.50
1999
0.66
1995
0.50
2000
1.14
1996
0.50
2001
1.30
d. With a constant-payout policy,if the firm’s earnings drop or a loss occurs,the dividends will be low or non-existent,A regular dividend or a low-regular-and-extra dividend policy reduces owner uncertainty by paying relatively fixed and continuous dividends.
QUESTION 5
(a) Constant Payout Ratio of 50 per cent
Year
(Profit × Payout Ratio) ( Shares
Dividend Per Share
1
(1 400 000 × 0.5) ( 1 000 000
$0.70
2
(2 000 000 × 0.5) ( 1 000 000
$1.00
3
(1 860 000 × 0.5) ( 1 000 000
$0.93
4
(900 000 × 0.5) ( 1 000 000
$0.45
5
(2 800 000 × 0.5) ( 1 000 000
$1.40
(b) Fully Franked Dividends of 90 per cent
Year
(Profit × Payout Ratio) ( Shares
Dividend Per Share
1
(1 400 000 × 0.9) ( 1 000 000
$1.26
2
(2 000 000 × 0.9) ( 1 000 000
$1.80
3
(1 860 000 × 0.9) ( 1 000 000
$1.67
4
(900 000 × 0.9) ( 1 000 000
$0.81
5
(2 800 000 × 0.9) ( 1 000 000
$2.52
