Reading 30: Dividends and Dividend Policy LOS n～ Q1-9

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LOS n: Demonstrate how the initiation of a regular dividend payout might affect the price-to-earnings multiple.

Q1. The annual meeting is fast approaching for Spartan Industries, and the board of directors is gathered together prior to the meeting to discuss dividend policy. The firm is currently following a target payout ratio approach, and shareholders are questioning whether this is maximizing the value of their investment.

The following data applies to Spartan for the most recent fiscal year:

Dividends Paid	$1.26
Earnings Per Share	$2.10
Long-term Normal Growth Rate	3.0%
Required Return on Equity	8.0%
Target Payout Ratio	60%
Adjustment Factor	1/1

One of the directors, Giselle Jung, has come out in favor of switching to a residual approach. This, she says, will free the firm up to increase capital investment when there is a relative abundance of good projects. The result, she believes, is that the firm will be accorded a higher value in the market following the switch.

Independent director, Dr. Sunil Patel, is an adherent to the bird-in-the-hand theory regarding dividends. The findings of his research strongly suggest that shareholders tend to view dividends as being less risky than returns from capital gains, and that this has a direct impact upon the cost of equity. As a result, he would like to switch to a dividend stability approach, and increase the target payout ratio.

What really matters to the firm’s shareholders, suggests board member Jason Zweig, is how much they get to keep after the dividends are received. Since shareholders are forced to realize income when dividends are paid out to them, increases in payout increase their tax liabilities. His suggestion is that the firm should pay out the minimum required to keep shareholders happy, and focus instead upon expanding the firm’s investment opportunities, possibly by entering into new markets or product lines.

Chairman, Mario Bertocci, says that he wonders if the firm can really affect its share value by altering the dividend policy. He thinks the firm should pay out a nominal amount, and use the rest to repurchase shares. He notes that Wall Street analysts consistently tell him that repurchasing shares should have a positive impact on the firm’s valuation. He asks the rest of the board to consider how a share repurchase program might be integrated with one of the proposed options for a cash dividend policy.

Which of the following statements concerning the residual dividend approach is least accurate?

A) Investors may perceive a firm following the approach as riskier than those with stable payout policies.

B) Determination of the amount of residual funds is typically difficult.

C) Investment opportunities can be considered independently of dividends.

Q2. With respect to the various approaches to dividend policy, which of the following statements is most accurate? A dividend stability approach:

A) usually means that dividends are slowly growing, while a target payout approach results in a floor value for dividends even if earnings fall.

B) means that dividends are a stable percentage of earnings, while a target payout approach can result in dividends decreasing if earnings fall.

C) usually means that dividends are slowly growing, while a target payout approach can result in dividends decreasing if earnings fall.

Q3. Suppose that Spartan continues to follow the target payout ratio approach. What is the expected cash dividend for the upcoming year?

A) $1.30.

B) $1.26.

C) $1.27.

Q4. Which of the following statements with respect to Spartan repurchasing its own shares is least accurate?

A) Repurchases will send a signal to investors that the outlook for Spartan is good.

B) Shares that are repurchased can be used to fund the firm’s ESOP without EPS dilution.

C) Repurchases will force the firm’s existing shareholders to incur capital gains tax liabilities.

Q5. An increase in the size of dividend payments will cause the value of the firm to increase if the:

A) bird-in-the-hand theory holds.

B) tax aversion theory holds.

C) increase causes the required return on equity to increase.

Q6. Assume that current market expectations are consistent with the data presented in the table above. Now suppose that the firm were to increase the target payout ratio to 70 percent, and that this results in the required return on equity falling to 7.5 percent. All else being equal, how would this affect the firm’s share price and P/E ratio?

Share Price P/E Ratio

A) Increase Increase

B) Decrease Decrease

C) Increase Decrease

Q7. Layne Publishing currently trades at $20.00 per share and has historically reinvested all of its earnings. Looking at strategic plan of its future investment opportunities, Layne’s management believes that the company’s investors would be better off if the company paid a dividend to its shareholders. Layne expects to make $2.00 per share in the next year, and expects to grow at a stable rate of 5.6%. Currently, investors require an 8.0% return on Layne stock, but management believes that after initiating a dividend, investors will perceive the firm as having a lower risk profile and lower their required return to 7.2%. If Layne currently trades at 10 times next year’s expected earnings, what will be the price of the stock if Layne initiates a $0.40 per share dividend?

A) $25.00.

B) $20.00.

C) $22.50.

Q8. If a company initiates a regular dividend payment, it may lead to the company having a higher price-to-earnings ratio. Which of the following dividend theories supports this phenomenon?

A) Residual dividend theory.

B) Tax aversion theory.

C) Bird-in-the-hand theory.

Q9. Westendorf Equipment is considering initiating a regular dividend payment to its shareholders. Westendorf’s P/E ratio has ranged between 12-13 times earnings over the last 5 years, but Deb Chafin, the company’s CFO, believes that the P/E ratio may increase when the company initiates its dividend. Chafin has compiled the following information.