Solutions to End of the Chapter Questions Chapter 14 Dividends and Share Repurchases

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					SOLUTIONS TO ASSIGNED QUESTIONS - WEEK 9 CHAPTER 17


SOLUTIONS TO STUDY QUESTIONS

17-1   The dividend payout ratio indicates the amount of dividends paid relative to the earnings
       available to ordinary shareholders, or dividend-per-share (DPS) divided by earnings-per-
       share (EPS).
17-2   A company's net profits can be used to pay dividends and / or to finance new investments.
       As larger dividends are paid, retained earnings available for re-investment are reduced.
       Conversely, as a larger amount of profits are re-invested, the capital available for dividends
       to shareholders is reduced. Management are required to find the appropriate mix that will
       maximise shareholder wealth, whilst recognising that shareholders are likely to have
       divergent interests including capital / income requirements.


17-6   Tax on dividend income is paid when the dividend is received, while tax on capital gains
       will be deferred until the shares are actually sold. In addition, there are concessional tax
       rates available on capital gains that are not applicable to dividend income.

17-7   Statutory restrictions prevent a company from paying dividends from capital invested in the
       company. Restrictions in debt and preference share contracts may also limit dividends.
       These contract provisions may stipulate that dividends are not to be paid from earnings
       prior to the repayment of debt. Also, a certain amount of working capital may be required
       to be maintained by the company. Finally, if any preference dividends remain unpaid, a
       provision may restrict the payment of dividends on ordinary shares.

17-10 (a) Company managers are reluctant to change dividends without being confident that the
      change is reflected in the company's long-term earnings prospects. This is why most
      managers avoid a change in dividends in response to temporary fluctuations in earnings,
      and are especially reluctant to make a dividend cut. They would prefer instead to develop a
      gradually increasing dividend series over time.
       This approach is consistent with the stable-dollar dividend policy method. The smoothing
       of the dividend stream is undertaken in an effort to minimise the effects of other types of
       company reversals.

       (b)    Investors also prefer a stable-dollar dividend policy because they perceive a change in
              the dividend payment to reflect management's view of the company's long-term
              earnings prospects. Also, many investors rely upon dividends for current income, and
              this need is best satisfied by a relatively stable dividend.


17-15 The shareholder will benefit only if the price of the share does not fall in proportion to the
      number of new shares issued. In such circumstances shareholder wealth will be increased.
      An advantage to the company is the conservation of cash for investment opportunities.

17-16 There are many benefits claimed to arise for a company which repurchases its own shares,
      such as :
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                                  Petty: Financial Management 4E
                    by reducing the number of shares, EPS will increase, which in theory should result
                     in a corresponding increase in the company share price, and
                    modifying the target capital structure (perhaps to increase financial leverage, by
                     raising debt to purchase the shares). Particular benefits may arise if debt was seen to
                     be relatively ‘cheap’.

        Potential disadvantages for a company which repurchases its own shares include:
             unfair discrimination between shareholders, and
             increasing the risk of the company's failure because overall capital is reduced.


SOLUTIONS TO STUDY PROBLEMS

Solutions identified by an asterisk * are provided with brief check answers in Appendix A at the
back of the textbook.

17-2.        Akubra Manufacturing - Long Term Dividend Policy :

             Debt ratio                                  35%
             Equity ratio                                65%
             Shares outstanding                        100,000
                             (A)                             (B)                      (C)
                                                                                    Equity
                                                        Funds Available          Contribution
             Year               Investment                Internally               (A x .65)
               1                $ 350,000                 $ 250,000               $ 227,500
               2                  475,000                   450,000                 308,750
               3                  200,000                   600,000                 130,000
               4                  980,000                   650,000                 637,000
               5                  600,000                   390,000                 390,000
                                                         $2,340,000              $1,693,250

    (a) Residual Dividend (per share) :

        Year         Dividend       =        Funds Available – Equity Contribution
                                                     100,000 Shares
         1            $0.23
         2            $1.41
         3            $4.70
         4            $0.13
         5            $0.00

    (b) Target Dividend          = ($2,340,000 – $1,693,250)/5           =   $1.29 per share
                                          100,000 shares

    (c) The target dividend allows for consistency of income to the shareholder and income in all
        years whereas the year-to-year dividend would not pay a dividend in year five.



2       Chapter 17                              Solutions Manual
                                        Petty: Financial Management 4E
  (d) It may not be a good policy because the residual dividend policy would not maximise the
      amount of fully franked dividends that shareholders could receive. To recapture funds
      otherwise paid out as franked dividends, a dividend reinvestment scheme could be
      considered.

17-3.          Snape Ltd. - Dividends in Perfect Markets :

                                           Dividend Plans
               Year                  Plan A               Plan B
               20x7                  $ 0.25                      $ 0.425
               20x8                  $ 0.25                      $ 0.475
               20x9                  $ 4.57                      $ 4.07

               Required rate of return        16%
               Value of share A               $3.33 =       $0.25      / (1 + .16) +
                                                            $0.25      / (1.16)2 +
                                                            $4.57      / (1.16)3
               or 0 CFi 2 2ndF Ni 0 .25 CFi 4.57 CFi 16 i COMP NPV giving $3.33

               Value of share B               $3.33 =       $0.425 / (1.16) +
                                                            $0.475 / (1.16)2 +
                                                            $4.07 / (1.16)3
               or 0 CFi 0 .425 CFi 0.475 CFi 4.07 CFi 16 i COMP NPV giving $3.33

   (a)         There is no effect on the value of the ordinary shares. Both shares provide the same
               present value and thus would maximise shareholder wealth to the same extent.

   (b)         An investor's preference for current income, tax consequences, informational content,
               and transaction costs may change your answer.

17-4*. Number of shares to be issued :

         $10,000,000      =    952,381 shares
          $12-$1.50
         Dollar size of the issue:
         952,381 shares x $12 = $11,428,572
         A proof of this calculation would show total costs of $1,428,572 ($1.50 x 952,381 shares)
         which, when subtracted from the dollar size of the issue ($11,428,572) would net the
         required funds ($10 million).


17-6. Briteright Ltd. - Dividend Policies :

   (a) Year                           Profits After Taxes
           1                              $1,400,000
           2                               2,000,000
           3                               1,860,000
         Chapter 17                           Solutions Manual                                     3
                                      Petty: Financial Management 4E
            4                                   900,000
            5                                 2,800,000
          Total Profits After Taxes          $8,960,000

          Shares Outstanding             =    2,000,000

          (i)          Constant Payout Ratio of 40%

                       Year               Dividend = Profits x Payout Ratio / Shares
                        1                    $0.28      =   $1,400,000 (.4)   /   2,000,000
                        2                    $0.40      =   $2,000,000 (.4)   /   2,000,000
                        3                    $0.37      =   $1,860,000 (.4)   /   2,000,000
                        4                    $0.18      =   $ 900,000 (.4)    /   2,000,000
                        5                    $0.56      =   $2,800,000 (.4)   /   2,000,000

          (ii)         Stable target payout of 50%
                       Target dividend $0.448 = $8,960,000 (.5) /5 years
                                                  2,000,000

          (iii)             Fully franked dividends of 80%
                       Year               Dividend = Profits x Payout Ratio / Shares
                        1                    $0.56      =   $1,400,000 (.8)   /   2,000,000
                        2                    $0.80      =   $2,000,000 (.8)   /   2,000,000
                        3                    $0.74      =   $1,860,000 (.8)   /   2,000,000
                        4                    $0.36      =   $ 900,000 (.8)    /   2,000,000
                        5                    $1.12      =   $2,800,000 (.8)   /   2,000,000

    (b) By using a dividend reinvestment scheme. However, the number of shares on issue will
        increase beyond 2,000,000, changing DPS. The company would need to predict to what
        extent shareholders would use the scheme each year, estimate the additional new shares and
        the DPS for each year.

            Current price                                    $        2.133 = $800,000        x 8

17-9*.      Rainy Corp. - Bonus Issue

            Market price                              $   8.60
            Bonus multiple                              1 for 2
            Shares outstanding                         800,000

    (a)     You own                       0.20 x 800,000 = 160,000 shares
            Position before bonus               $1,376,000 = 160,000 shares x $8.60 per share

            Price after bonus                        $ 5.73 = $8.60 x 2/3
            Your shares after bonus                  240,000
            Position after bonus                  $1,376,000 = 240,000 shares x $5.73 per share
            Net gain                              $           0
4         Chapter 17                             Solutions Manual
                                         Petty: Financial Management 4E
  (b)      Price fall                                20%
           Price after bonus                     $ 6.88 = $8.60 (.8)
           Position after bonus                $1,651,200 = 240,000 shares x $6.88 per share
          Net gain                       $ 275,200 = $1,651,200 - $1,376,000
         2,500 shares worth $10.08 each = $25,200
         Dividends = 2,500 shares at 20 cents DPS = $500
         Total shareholder worth = $25,700 ($25,200 + $500)
         Dollar increase in shareholder worth = $1,380 ($25,700 - $24,320)
         Percentage increase in shareholder worth = 5.67% ($1,380 / $24,320)

  (b) The bonus issue provided the shareholder in this problem with a greater increase in
      shareholder wealth than would have been likely to be the situation if only dividend payment
      was increased. In this example there was a capital value increase of $1,200
      ($25,200 - $24,000)directly arising from the bonus issue.

17-11*. Trexco Company - Share Split :

         Market price             $     98.00
         Split multiple                     2
         Shares outstanding            25,000

  (a) You own                                         0.05      x 25,000
      Investor's shares                           = 1,250
      Position before split                       $122,500      =   1,250 Shares x $98 per share
      Price after split                           $ 49.00       =   $98 / 2
      Your shares after split                        2,500      =   1,250 x 2
      Position after split                        $122,500      =   2,500 shares x $49 per share
         Net gain                                  $        0

  (b) Price fall                                        0.4
      Price after split                           $ 58.80 = $98.00 (1 - .4)
      Position after split                        $147,000 = 2,500 shares x $58.80 per share
         Net gain                                 $ 24,500 = $147,000 - $122,500

17-12.        Maxigo Ltd. - Repurchase of Shares :

         Proposed dividend                               $ 600,000
         Shares outstanding                              6,000,000
         Earnings per share                            $      0.22
              Ex-dividend price                        $      3.50
         Proposed dividend/share                       $      0.10
  (a) Repurchase price                                 $        3.60 = $3.50 + $0.10

  (b) Number of shares
         Chapter 17                           Solutions Manual                                     5
                                      Petty: Financial Management 4E
          repurchased                                       166,667 = $600,000 / $3.60

          The new EPS would be :                     $1320,000                   = 0.2263
                                               6,000,000 – 166,667
          Hence the EPS would increase to 22.63 cents after the repurchase.
    (c) The capital gains to be received by the shareholders would not be equal to the intended
        dividend, thus resulting in a dollar benefit or loss to the shareholders. Unless you have a
        need for current income, you would probably prefer the share repurchase plan. The actual
        number of shares held (5,000) is not of significance in this question.

17-14 Carston Ltd. - Dividend Policies :

                        Year                           Profits After Tax
                            1                              $1,500,000
                            2                               2,000,000
                            3                               1,750,000
                            4                                 950,000
                            5                               2,500,000
               Total Profits After Taxes                   $8,700,000
                Shares Outstanding                          4,000,000

    (a)        Constant Payout Ratio of 50%
                            Year       Dividend       = Profits x Payout Ratio / Shares
                                1         $0.19       =   $1,500,000 (.5)        /   4,000,000
                                2         $0.25       =   $2,000,000 (.5)        /   4,000,000
                                3         $0.22       =   $1,750,000 (.5)        /   4,000,000
                                4         $0.12       =   $ 950,000 (.5)         /   4,000,000
                                5         $0.31       =   $2,500,000 (.5)        /   4,000,000

    (b)        Stable target payout of 60%
                                               $8,700,000(.6)
               Target dividend $0.26 =                                  5years
                                                 4,000,000

    (c)        Small regular dividend of $0.10 plus year-end extra
                       Base profits                       1,500,000
                       % of extra profits                      80%
                       Year         Dividend
                        1             0.10
                        2             0.20     = .10 + ($2,000,000 - $1,500,000)(.8) / 4,000,000
                        3             0.15     = .10 + ($1,750,000 - $1,500,000)(.8) / 4,000,000
                        4             0.10
                        5             0.30     = .10 + ($2,500,000 - $1,500.,000)(.8) / 4,000,000




6         Chapter 17                           Solutions Manual
                                       Petty: Financial Management 4E

				
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