Corporate Finance - Chp. 23: Dividends

Question 1

5 types of dividends

Answer 1

• Regular cash dividends –
• Extra or special dividends
• Liquidating dividend – return of capital instead of return on capital
• Stock dividend
  
  • P/E stays the same, but EPS goes down and stock price goes down
  • If company continues to pay same regular dividend amount afterwards, they effectively decreases dividend. If paying same dividend per share amount, they increased dividend
• Stock splits

Question 2

Dividend irrelevance

Answer 2

• Policy is irrelevant as shareholder can always sell or buy stock to get cash flow they want
• Assumes no taxes or brokerage costs

Question 3

• Bird in hand (dividend preference theory)

Answer 3

• Return on equity capital decreases as dividend payout increases
• Investors place higher value on dollar of dividend that expected capital gains based on dividend yield component having less risk than growth component

Question 4

• Tax aversion

Answer 4

• Dividends historically taxed at higher rates than capital gains so investors prefer less dividends

Question 5

• Factors affecting dividend policy

Answer 5

• Investment opportunities
• Expected volatility of future earnings
• Financial flexibility
• Tax considerations
• Flotation costs – cost for investment bank when new shares of stock issued
• Contractual and legal restrictions
  
  • Impairment of capital rule
  • Debt covenants

Question 6

equation for effective tax rate for double taxation system

Answer 6

• effective tax rate = corporate tax rate + (1 – corporate tax rate)(individual tax rate

Question 7

Target payout ratio

Answer 7

• adjustment factor =1 / number of years over which the adjustment in dividends will take place

Question 8

3 trends in dividend payments

Answer 8

• A lower proportion of U.S. companies pay dividends as compared to their European counterparts.
• Globally, in developed markets, the proportion of companies paying cash dividends has trended downwards over the long term.
• The percentage of companies making stock repurchases has been trending upwards in the United States since the 1980s and in the United Kingdom and continental Europe since the 1990s

Question 9

change in stock price from stock going ex-dividend:

Answer 9

• ΔP = D * (1-Td) / (1-Tcg)
• Td -> tax rate of dividend
• Tcg -> tax rate of capital gains
  *

Question 10

Dividend safety metric: dividend payout ratio

Answer 10

dividends/net income

Question 11

Dividend coverage ratio

Answer 11

net income/ dividend

Question 12

FCFE coverage ratio

Answer 12

• FCFE / (dividends + share repurchases)

Question 13

Double taxation system

Answer 13

• earnings taxed at the corporate level, and dividends taxed again at the shareholder level
  
  • effective tax rate = corporate tax rate + (1 – corporate tax rate)(individual tax rate

Question 14

Split Rate

Answer 14

• taxes earnings distributed as dividends at lower rate than those retained
  
  • Use corporate tax rate for distributed income
  • Effective tax rate = corporate tax rate distr. income + (1 – corporate tax rate distr. income)(individual tax rate

Question 15

Imputation tax system

Answer 15

• taxes are paid at the corporate level but are attributed to the shareholder, so that all taxes are effectively paid at the shareholder rate.

Question 16

Steps to residual dividends model

Answer 16

• 1. Identify optimal capital budget
• 2. Determine amount of equity needed to finance that budget
• 3. Meet requirements to extent possible with retained earnings
• 4. Pay dividend with residual earnings after needs of budget met