Reading 31: Dividends and Share Repurchases: Analysis-LOS a 习 action, contrast, corporate, 2011, class

土豆妮

Session 8: Corporate Finance
Reading 31: Dividends and Share Repurchases: Analysis

LOS a: Compare and contrast theories of dividend policy, and explain the implications of each for share value given a description of a corporate dividend action.

 

 

One year ago, Makato Omura purchased a 6.50% fixed coupon bond for 98.50. Recently, she sold the bond for 99.25 and calculated her return at 7.4%. Her friend, Takanino Takemiya, CFA, reminds Omura that this is the nominal return and that to calculate the real return, she needs to factor in the inflation rate over the holding period. If the price index for the current year is 118.5 and the price index one year ago was 115.9, Omura’s real return is closest to:

A) 9.6%.

B) 6.3%.

C) 5.2%.

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Omura’s real return is approximated by subtracting the inflation rate from the calculated (nominal) return. As indicated in the preliminary reading for Study Session 4, LOS 1.B.e, the inflation rate is calculated using the formula:

Inflation = (Price Index_{this year} – Price Index_{last year}) / Price Index_{last year}

Here, inflation = (118.5 – 115.9) / 115.9 = 0.0224, or approximately 2.2%.

Thus, the real return = 7.4% - 2.2% = 5.2%.

土豆妮

According to Modigliani and Miller’s dividend irrelevancy theory, an investor in a firm that does not pay a dividend can still earn a “dividend” on that company by:

A) selling a portion of the company's stock each year.

B) contacting the firm and asking for a dividend payment.

C) buying additional shares each year.

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Miller and Modigliani’s dividend irrelevancy theory states that shareholders can in theory construct their own dividend policy. If a firm does not pay dividends, a shareholder who wants a 4% dividend can “create” it by selling 4% of his or her stock. Note that Modigliani and Miller’s theory does not allow for transaction costs or taxes. In actuality, shareholders will have to pay a brokerage commission on the sale and tax on any capital gains.

土豆妮

In a world with taxes and brokerage costs:

A) Modigliani and Miller say that dividend policy is irrelevant.

B) Modigliani and Miller say that dividend policy is relevant.

C) dividend policy may be relevant.

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Modigliani and Miller assume a world without taxes and transaction costs. They (correctly) claim that the validity of their theory should be judged on empirical tests, not the realism of their assumptions. Myron Gordon and John Lintner have championed the “bird-in-the-hand” theory, which gives greater value to firms with high dividend yields because investors perceive dividends to be less risky than capital gains.

土豆妮

If Modigliani and Miller’s dividend irrelevancy theory is correct, what is the impact on a firm’s cost of capital and share price if its dividend payout increases?

Cost of Capital

Share Price

A) An increase A decrease

B) None None

C) None A decrease

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If investors do not consider dividends to be relevant, the dividend payout will not affect the required rate of return. If the required rate of return does not change, the value of a firm will be unchanged despite the change in its dividend payout rate.