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Reading 30: Dividends and Dividend Policy LOS k~ Q1-10

 

LOS k: Calculate a company’s expected dividend using the variables in the target payout approach.

Q1. Sonny Costin, CFA, is a portfolio manager for Summit Partners, an investment firm whose clients are primarily high net worth individuals. Costin has conducted considerable research on a possible investment in the common shares of ATCO, a major manufacturer of pharmaceuticals in the U.S. and Europe. Costin feels that the potential for capital appreciation for the shares of ATCO is high, given the fact that the company is preparing to release later this year a new “breakthrough” drug for the prevention of diabetes. According to his analysis, the shares of ATCO are currently undervalued by approximately 15 to 20%, but Costin attributes the price depression to a negative broad market sentiment rather than the fundamentals of the company itself. He believes that once investors’ sentiment favors the market again, the shares should be poised for significant appreciation.

With the successful introduction of the new drug, Costin anticipates that ATCO’s gross revenues and net income will rise substantially in the near term. One critical question in the evaluation of the purchase of ATCO shares is the most probable dividend policy that will be enacted by the company’s management team. Costin is reviewing the past financial statements of ATCO, examining the company’s past dividend policies for possible clues that would be helpful in the prediction of the company’s future dividend policy. ATCO’s management stated in the most recent financial statements that it intends to continue paying out a cash dividend to the common shareholders for the foreseeable future. In addition, management outlined a dividend plan, to be initiated this year, that has a 25% target payout ratio and with the plan to bring the dividend up to the target payout ratio over the next three years. Costin believes that management will most likely abide by its stated policy, but wants to evaluate other possible dividend policy scenarios and their effect on the common shares of the company.

According to his analysis, Costin predicts that next year, ATCO’s earnings will rise from last year’s $2.25 per share to $4.10 per share in 2008. Last year, in 2007, the company paid $.55 in the form of a cash dividend to all common shareholders. There are 15,000,000 common shares outstanding, and the current market price is $26.00 per share. The company has a committed line of credit that provides up to $25,000,000 at a 9.25% after-tax cost of borrowing.

Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, calculate next year’s expected dividend.

A)   $0.46 per share.

B)   $0.70 per share.

C)   $1.02 per share.

 

Q2. Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, which of the following statements is most accurate? While next year’s earnings are expected to increase 54%, next year’s payout ratio:

A)   will incrementally increase as well.

B)   is expected to remain at the stated 25% target.

C)   will actually decrease.

 

Q3. Management of a corporation may consider the implications of its actions on shareholders when establishing a dividend policy. One school of thought is that in general, shareholders prefer the payout of a cash dividend “today” rather an anticipated capital gain “tomorrow”. This theory of investor preference toward dividend policy is called:

A)   the dividend preference theory, because today’s dividend has less risk than tomorrow’s capital gain.

B)   the dividend irrelevance theory, because dividend policy has no effect whatsoever on the price of a company’s stock or its cost of capital.

C)   tax aversion theory, because typically dividends are taxed at a lower rate than capital gains.

 

Q4. Assume that ATCO management now changes its stated dividend policy, and announces that instead of paying a cash dividend, it intends to utilize the same dollar amount to repurchase outstanding shares of ATCO common stock. Ignoring potential tax consequences, which of the following statements concerning the share repurchase is most accurate?

A)   Shareholders will prefer the share repurchase to a cash dividend because the book value per share will increase by the amount of the investment in company shares.

B)   A share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equivalent amount.

C)   A share repurchase program would be to the greatest benefit to those current shareholders who have the lowest basis in the stock.

 

Q5. Assume that ATCO management now changes it stated dividend policy, and announces that it intends to borrow $19,500,000 to repurchase 750,000 shares. Calculate the approximate 2008 EPS after the stock buyback.

A)   $4.31

B)   $4.19

C)   $4.10

         

Q6. Assume that after a share repurchase, the resulting EPS of a company’s stock is lower than the pre-repurchase EPS. Which of the following statements is most accurate?

A)   The pre-tax borrowing cost is greater than the earnings yield of the shares.

B)   The after-tax borrowing cost is greater than the earnings yield of the shares.

C)   The after-tax borrowing cost is less than the earnings yield of the shares.

 

Q7. Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.39, what time period is Calfee most likely using in order to bring its dividend up to the target payout?

A)   8 years.

B)   4 years.

C)   3 years.

 

Q8. Manthey Studios uses a target payout adjustment approach in paying its annual dividend. Last year, Manthey had earnings per share (EPS) of $2.50 and paid a dividend of $0.30 per share. This year, Manthey estimates its EPS will be $3.20. Manthey has a target payout ratio of 28% and uses a 5 year period to adjust its dividend. Which of the following is closest to Manthey’s expected dividend per share?

A)   $0.59.

B)   $0.42.

C)   $0.34.

 

Q9. Rombauer Metals uses a target payout adjustment approach in paying its annual dividend. Last year, Rombauer had earnings per share (EPS) of $0.60 and paid a dividend of $0.08 per share. This year, Rombauer estimates its EPS will be $0.90. What is Rombauer’s expected dividend per share if the firm has a target payout ratio of 40% and uses a 4 year period to adjust its dividend?

A)   $0.15.

B)   $0.09.

C)   $0.11.

 

Q10. Lazenby Home Builders has a target dividend payout ratio of 25%. Last year, Lazenby earned $2.00 per share and paid a dividend of $0.25. This year, new home starts are expected to decline significantly and Lazenby expects to earnings to decline to $1.80 per share. Which of the following scenarios is least likely? Lazenby Home Builders:

A)   maintains its dividend at $0.25 per share.

B)   cuts its dividend by 10%.

C)   increases its dividend by 50%.

[2009] Session 8 -Reading 30: Dividends and Dividend Policy LOS k~ Q1-10

 

 

LOS k: Calculate a company’s expected dividend using the variables in the target payout approach.fficeffice" />

Q1. Sonny Costin, CFA, is a portfolio manager for Summit Partners, an investment firm whose clients are primarily high net worth individuals. Costin has conducted considerable research on a possible investment in the common shares of ATCO, a major manufacturer of pharmaceuticals in the ffice:smarttags" />U.S. and Europe. Costin feels that the potential for capital appreciation for the shares of ATCO is high, given the fact that the company is preparing to release later this year a new “breakthrough” drug for the prevention of diabetes. According to his analysis, the shares of ATCO are currently undervalued by approximately 15 to 20%, but Costin attributes the price depression to a negative broad market sentiment rather than the fundamentals of the company itself. He believes that once investors’ sentiment favors the market again, the shares should be poised for significant appreciation.

With the successful introduction of the new drug, Costin anticipates that ATCO’s gross revenues and net income will rise substantially in the near term. One critical question in the evaluation of the purchase of ATCO shares is the most probable dividend policy that will be enacted by the company’s management team. Costin is reviewing the past financial statements of ATCO, examining the company’s past dividend policies for possible clues that would be helpful in the prediction of the company’s future dividend policy. ATCO’s management stated in the most recent financial statements that it intends to continue paying out a cash dividend to the common shareholders for the foreseeable future. In addition, management outlined a dividend plan, to be initiated this year, that has a 25% target payout ratio and with the plan to bring the dividend up to the target payout ratio over the next three years. Costin believes that management will most likely abide by its stated policy, but wants to evaluate other possible dividend policy scenarios and their effect on the common shares of the company.

According to his analysis, Costin predicts that next year, ATCO’s earnings will rise from last year’s $2.25 per share to $4.10 per share in 2008. Last year, in 2007, the company paid $.55 in the form of a cash dividend to all common shareholders. There are 15,000,000 common shares outstanding, and the current market price is $26.00 per share. The company has a committed line of credit that provides up to $25,000,000 at a 9.25% after-tax cost of borrowing.

Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, calculate next year’s expected dividend.

A)   $0.46 per share.

B)   $0.70 per share.

C)   $1.02 per share.

Correct answer is B)         

The expected dividend can be calculated as:

Previous dividend + [(expected increase in EPS) × (target payout ratio) × (adjustment factor)]

Therefore, ATCO’s projected dividend for next year is:

$.55 + [($4.10 ? 2.25) × 0.25 × (1 / 3)] = $0.70 per share

 

Q2. Assuming that ATCO has a 25% target payout ratio and plans to bring the dividend up to the target payout ratio over the next three years, which of the following statements is most accurate? While next year’s earnings are expected to increase 54%, next year’s payout ratio:

A)   will incrementally increase as well.

B)   is expected to remain at the stated 25% target.

C)   will actually decrease.

Correct answer is C)

Because management has stated that the dividend will move toward the targeted payout ratio over three years, the dividend will not increase as much as earnings increase next year. Under this approach, the payout ratio will move towards it target over the long term, though not necessarily over the short term.

 

Q3. Management of a corporation may consider the implications of its actions on shareholders when establishing a dividend policy. One school of thought is that in general, shareholders prefer the payout of a cash dividend “today” rather an anticipated capital gain “tomorrow”. This theory of investor preference toward dividend policy is called:

A)   the dividend preference theory, because today’s dividend has less risk than tomorrow’s capital gain.

B)   the dividend irrelevance theory, because dividend policy has no effect whatsoever on the price of a company’s stock or its cost of capital.

C)   tax aversion theory, because typically dividends are taxed at a lower rate than capital gains.

Correct answer is A)

The dividend preference theory is sometimes called the bird-in-the-hand theory, based on the expression that a “bird in the hand” (dividend) is worth “two in the bush” (expected capital gains). The argument is that investors prefer the certainty of receiving a dividend today over the uncertainty of future capital gains.

 

Q4. Assume that ATCO management now changes its stated dividend policy, and announces that instead of paying a cash dividend, it intends to utilize the same dollar amount to repurchase outstanding shares of ATCO common stock. Ignoring potential tax consequences, which of the following statements concerning the share repurchase is most accurate?

A)   Shareholders will prefer the share repurchase to a cash dividend because the book value per share will increase by the amount of the investment in company shares.

B)   A share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equivalent amount.

C)   A share repurchase program would be to the greatest benefit to those current shareholders who have the lowest basis in the stock.

Correct answer is B)         

Ignoring tax consequences, a share repurchase is economically identical to a cash dividend of an equal amount. Either way, the result is that the shareholder has the same total wealth, whether in the form of common shares plus cash or common shares that have increased in value by an equivalent amount.

 

Q5. Assume that ATCO management now changes it stated dividend policy, and announces that it intends to borrow $19,500,000 to repurchase 750,000 shares. Calculate the approximate 2008 EPS after the stock buyback.

A)   $4.31

B)   $4.19

C)   $4.10

Correct answer is B)         

Total earnings

= $4.10 x 15,000,000 = $61,500,000

 

 

EPS after buyback

= (total earnings – after-tax cost of funds) / shares outstanding after buyback

 

= ($61,500,000 – [750,000 shares x $26 x .0925]) / (15,000,000 – 750,000) shares

 

= ($61,500,000 – $1,803,750) / 14,250,000 shares

 

= $4.19 / share

 

Q6. Assume that after a share repurchase, the resulting EPS of a company’s stock is lower than the pre-repurchase EPS. Which of the following statements is most accurate?

A)   The pre-tax borrowing cost is greater than the earnings yield of the shares.

B)   The after-tax borrowing cost is greater than the earnings yield of the shares.

C)   The after-tax borrowing cost is less than the earnings yield of the shares.

Correct answer is B)       

EPS is always calculated on an after-tax basis. If the company’s cost of funds is greater the earnings yield per share (E/P), then the resulting EPS will decrease.

 

Q7. Last year, Calfee Multimedia had earnings of $4.00 per share and paid a dividend of $0.30. In the current year, the company expects to earn $5.20 per share. Calfee has a 30% target payout ratio. If the expected dividend for this year is $0.39, what time period is Calfee most likely using in order to bring its dividend up to the target payout?

A)   8 years.

B)   4 years.

C)   3 years.

Correct answer is B)         

The formula to determine the expected dividend in a target payout approach is:

Expected dividend = (previous dividend) + [(expected increase in EPS) × (target payout ratio) × (adjustment factor)], where the adjustment factor is 1 / number of years over which the adjustment will take place.

Using the numbers given:

$0.39 = $0.30 + [($5.20 - $4.00) × (0.30) × (1 / n)]
$0.39 = $0.30 + [($1.20) × (0.30) × (1 / n)]
$0.09 = $0.36 × (1 / n)
0.25 = (1 / n)
n = 4

 

Q8. Manthey Studios uses a target payout adjustment approach in paying its annual dividend. Last year, Manthey had earnings per share (EPS) of $2.50 and paid a dividend of $0.30 per share. This year, Manthey estimates its EPS will be $3.20. Manthey has a target payout ratio of 28% and uses a 5 year period to adjust its dividend. Which of the following is closest to Manthey’s expected dividend per share?

A)   $0.59.

B)   $0.42.

C)   $0.34.

Correct answer is C)
Expected dividend = $0.30 + [($3.20 ? $2.50) × 0.28 × (1/5)]

Expected dividend = $0.30 + $0.0392 = $0.3392 ≈ $0.34

 

Q9. Rombauer Metals uses a target payout adjustment approach in paying its annual dividend. Last year, Rombauer had earnings per share (EPS) of $0.60 and paid a dividend of $0.08 per share. This year, Rombauer estimates its EPS will be $0.90. What is Rombauer’s expected dividend per share if the firm has a target payout ratio of 40% and uses a 4 year period to adjust its dividend?

A)   $0.15.

B)   $0.09.

C)   $0.11.

Correct answer is C)
Expected dividend = $0.08 + [($0.90 ? $0.60) × 0.40 × (1/4)]

Expected dividend = $0.08 + $0.03 = $0.11

 

Q10. Lazenby Home Builders has a target dividend payout ratio of 25%. Last year, Lazenby earned $2.00 per share and paid a dividend of $0.25. This year, new home starts are expected to decline significantly and Lazenby expects to earnings to decline to $1.80 per share. Which of the following scenarios is least likely? Lazenby Home Builders:

A)   maintains its dividend at $0.25 per share.

B)   cuts its dividend by 10%.

C)   increases its dividend by 50%.

Correct answer is B)

Despite falling earnings, a company will be reluctant to cut its dividend. With a target payout ratio of 25%, earnings per share of $1.80 would call for a dividend of $0.45. Even an increase of 50% over the prior year’s dividend would still put the dividend below the target payout.

 

 

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