Week 12 Solutions
Week 12 Questions
Chapter 16
2. Dividend policy – Here are several “facts” about typical corporate dividend policies. Which are true and which are false?
a. Companies decided each year’s dividend by looking at their capital expenditure requirements and then distributing whatever cash is left over.
False. The dividend depends on past dividends and current and forecasted earnings.
b. Managers and investors seem more concerned with dividend changes than with dividend levels.
True. Dividend changes convey information to investors.
c. Managers often increase dividends temporarily when earnings are unexpectedly high for a year or two.
False. Dividends are “smoothed.” Managers rarely increase regular dividends temporarily. They may pay a special dividend, however.
d. Companies undertaking substantial share repurchases usually finance them with a offsetting reduction in cash dividends.
False. Dividends are rarely cut when repurchases are being made.
17. Dividends and value – Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5% a year in perpetuity. Thus the expected dividend is $1.05 million in year 2, $1.105 million in year 3, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year’s dividend will be increased to $2 million and that the extra cash will be raised immediately by an issue of shares. After that, the total amount paid out each year will be as previously forecasted, that is, $1.05 million in year 2 and increasing by 5% in each subsequent year.
a. At what price will the new shares be issued in year 1?
At t = 0 each share is worth $20. This value is based on the expected stream of dividends: $1 at t = 1, and increasing by 5% in each subsequent year. Thus, we can find the appropriate discount rate for
Chapter 16
2. Dividend policy – Here are several “facts” about typical corporate dividend policies. Which are true and which are false?
a. Companies decided each year’s dividend by looking at their capital expenditure requirements and then distributing whatever cash is left over.
False. The dividend depends on past dividends and current and forecasted earnings.
b. Managers and investors seem more concerned with dividend changes than with dividend levels.
True. Dividend changes convey information to investors.
c. Managers often increase dividends temporarily when earnings are unexpectedly high for a year or two.
False. Dividends are “smoothed.” Managers rarely increase regular dividends temporarily. They may pay a special dividend, however.
d. Companies undertaking substantial share repurchases usually finance them with a offsetting reduction in cash dividends.
False. Dividends are rarely cut when repurchases are being made.
17. Dividends and value – Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5% a year in perpetuity. Thus the expected dividend is $1.05 million in year 2, $1.105 million in year 3, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year’s dividend will be increased to $2 million and that the extra cash will be raised immediately by an issue of shares. After that, the total amount paid out each year will be as previously forecasted, that is, $1.05 million in year 2 and increasing by 5% in each subsequent year.
a. At what price will the new shares be issued in year 1?
At t = 0 each share is worth $20. This value is based on the expected stream of dividends: $1 at t = 1, and increasing by 5% in each subsequent year. Thus, we can find the appropriate discount rate for