DIVIDEND POLICY-Week 6
ACTIVITY
Source: pg. 479, Brigham, E.F. and Houston, J.F., 2015. Fundamentals of financial management.
Cengage
1. Define each of the following terms:
a. Target payout ratio; optimal dividend policy
b. Dividend irrelevance theory; bird-in-the-hand fallacy
c. Information content (signaling) hypothesis; clientele effect; signal; clienteles
d. Residual dividend model
e. Low-regular-dividend-plus-extras
f. Declaration date; holder-of-record date; ex-dividend date; payment date
g. Dividend reinvestment plan (DRIP)
h. Stock split; stock dividend
i. Stock repurchase
Source: pg. 480, Brigham, E.F. and Houston, J.F., 2015. Fundamentals of financial management.
Cengage
1. Components Manufacturing Corporation (CMC) has an all-common-equity capital
structure. It has 200,000 shares of $2 par value common stock outstanding. When CMC’s
founder, who was also its research director and most successful inventor, retired
unexpectedly to the South Pacific in late 2008, CMC was left suddenly and permanently
with materially lower growth expectations and relatively few attractive new investment
opportunities. Unfortunately, there was no way to replace the founder’s contributions to
the firm. Previously, CMC found it necessary to plow back most of its earnings to finance
growth, which averaged 12% per year. Future growth at a 6% rate is considered realistic,
but that level would call for an increase in the dividend payout. Further, it now appears
that new investment projects with at least the 14% rate of return required by CMC’s
stockholders (rs ¼ 14%) would amount to only $800,000 for 2009 compared to a
projected $2,000,000 of net income. If the existing 20% dividend payout was continued,
retained earnings would be $1.6 million in 2009; but as noted, investments that yield the
14% cost of capital would amount to only $800,000. The one encouraging point is that
the high earnings from existing assets are expected to continue, and net income of $2
million is still expected for 2009. Given the dramatically changed circumstances, CMC’s
management is reviewing the firm’s dividend policy.
a. Assuming that the acceptable 2009 investment projects would be financed entirely by
earnings retained during the year and assuming that CMC uses the residual dividend
model, calculate DPS in 2009.
b. What payout ratio does your answer to Part a imply for 2009? c. If a 60% payout ratio
is maintained for the foreseeable future, what is your estimate of the present market price
of the common stock? How does this compare with the market price that should have
prevailed under the assumptions existing just before the news about the founder’s
retirement? If the two values of P0 are different, comment on why.
d. What would happen to the stock price if the old 20% payout was continued? Assume
that if this payout is maintained, the average rate of return on the retained earnings will
fall to 7.5% and the new growth rate will be as follows:
Solution:
Please refer to book Appendix
