Answers to Warm-Up Exercises

E14-1.

Relevant dividend dates

Answer: The firm will need $260,000 of cash to pay the dividend. Because a weekend intervenes, the
stock will begin selling ex-dividend on Friday, April 28, which is 4 days before the date of
record.
E14-2.

Residual theory of dividend payout

Answer: 1. New investments

$2,700,000

2. Retained earnings available

1,200,000

3. Equity needed (40% of 1)

1,080,000

4. Dividends [(2) (3)]

5. Dividend payout ratio [(4)
E14-3.

120,000
(2)]

10%

Legal constraints on dividend payout

Answer: If legal capital is defined solely as the par value of common stock, Ashkenazi will be able to
pay out paid-in capital in excess of par plus all retained earnings.
Paid-in capital in excess of par

2,500,000

Retained earnings

750,000

Total available for dividends

$3,250,000

Potential dividend per share (divide total available by 350,000 shares)

$9.29

If legal capital is defined as both the par value of common stock and paid-in capital in excess
of par, Ashkenazi will only be able to pay out the retained earnings.
Total available for dividends

$750,000

Potential dividend per share (divide total available by 350,000 shares)

$2.14

E14-4.

Constant dividend payout ratio

Answer: The first step in analyzing the Kopi scenario is to determine the historical payout ratio.
Year

EPS

Dividend/Share

2009
2010
2011
2012

$1.75
1.95
2.05
2.25

$0.95
1.20
1.25
1.30

Dividend Payout Ratio

54.29%
61.54
60.98
57.78

Discussion: Kopi Companies historical dividend payout ratio has been fairly consistent and
near the 60% constant payout ratio that the board is considering. So in terms of dollar
amounts, the new policy would not significantly change the dividend payout to the
shareholders in the future. Once the dividend is tied to a constant percentage, the dividends
will be tied to Kopis future earnings and could fluctuate from year to year. However, the
evidence from the past
4 years shows that Kopis earnings have increased from 5% to 11% per year with no down
years.
E14-5.

Stock dividend

Answer: After the 10% stock dividend, Hilos stockholders equity account is as follows:
Common stock (55,000 shares at $3 par)

$165,000

Paid-in capital in excess of par

335,000

Retained earnings

350,000

Total stockholders equity

$850,000

Solutions to Problems

P14-1. Dividend payment procedures

LG 1; Basic
a.

Debit

Retained earnings (Dr.)

$330,000

Dividends payable (Cr.)

$330,000

b.

Ex dividend date is Thursday, July 6.

c.

Cash

$170,000

Credit

Dividends payable
Retained earnings

$0
$2,170,000

d. The dividend payment will result in a decrease in total assets equal to the amount of the
payment.
e. Notwithstanding general market fluctuations, the stock price would be expected to drop by
the amount of the declared dividend on the ex dividend date.
P14-2. Personal finance: Dividend payment
LG 1; Intermediate
a. Friday, May 7

b. Monday, May 10
c. The price of the stock should drop by the amount of the dividend ($0.80).
d. She would be better off buying the stock at $35 and taking the dividend. Her $0.80 dividend
would be taxed at the maximum rate of 15% and her $4 short-term capital gain would be
taxed at the ordinary marginal tax rate, which is probably higher than the 15%. If she bought
the stock post dividend for $34.20 she would pay her marginal ordinary tax rate on the full
$4.80 of short-term capital gains.
P14-3. Residual dividend policy
LG 2; Intermediate
a. Residual dividend policy means that the firm will consider its investment opportunities first.
If after meeting these requirements there are funds left, the firm will pay the residual out in
the form of dividends. Thus, if the firm has excellent investment opportunities, the dividend
will be smaller than if investment opportunities are limited.
b. Proposed
Capital budget
Debt portion (40%)
Equity portion (60%)
Available retained earnings
Dividend
Dividend payout ratio
c.

$2,000,000
800,000
1,200,000
$2,000,000
800,000
40%

$3,000,000
1,200,000
1,800,000
$2,000,000
200,000
10%

$4,000,000
1,600,000
2,400,000
$2,000,000
0
0%

The amount of dividends paid is reduced as capital expenditures increase. Thus, if the firm
chooses larger capital investments, dividend payments will be smaller or nonexistent.

P14-4. Dividend constraints

LG 3; Intermediate
a.

Maximum dividend:

$1,900,000
400,000

$4.75 per share

b. Largest dividend without borrowing:

$160,000
400,000

$0.40 per share

c.

In part a, cash and retained earnings each decrease by $1,900,000.

In part b, cash and retained earnings each decrease by $160,000.
d. Retained earnings (and hence stockholders equity) decrease by $80,000.
P14-5. Dividend constraints
LG 3; Intermediate
a.

Maximum dividend:

$40,000
25,000

$1.60 per share

b. A $20,000 decrease in cash and retained earnings is the result of a $0.80 per share dividend.
c. Cash is the key constraint, because a firm cannot pay out more in dividends than it has in
cash, unless it borrows.

P14-6. Low-regular-and-extra dividend policy

LG 4; Intermediate
a.

Year

Payout %

Year

2007
2008
2009

25.4
23.3
17.9

2010
2011
2012

Payout %
22.7
20.8
16.7

b.
Year

25%
Payout

Actual
Payout

$ Diff.

Year

25%
Payout

Actual
Payout

$ Diff.

2007

$0.49

0.50

0.01

2010

0.55

0.50

0.05

2008
2009

0.54
0.70

0.50
0.50

0.04
0.20

2011
2012

0.60
0.75

0.50
0.50

0.10
0.25

c.

In this example the firm would not pay any extra dividend since the actual dividend did not
fall below the 25% minimum by $1.00 in any year. When the extra dividend is not paid
due to the $1.00 minimum, the extra cash can be used for additional investment by placing
the funds in a short-term investment account.
d. If the firm expects the earnings to remain above the earnings per share (EPS) of $2.20 the
dividend should be raised to $0.55 per share. The 55 cents per share will retain the 25%
target payout but allow the firm to pay a higher regular dividend without jeopardizing the
cash position of the firm by paying too high of a regular dividend.
P14-7. Alternative dividend policies
LG 4; Intermediate
Year

Dividend

Year

Dividend

2003

$0.10

2008

$1.28

2004

0.00

2009

1.12

2005

0.72

2010

1.28

2006
2007

0.48
0.96

2011
2012

1.52
1.60

2003
2004
2005
2006
2007

$1.00
1.00
1.00
1.00
1.00

2008
2009
2010
2011
2012

$1.10
1.20
1.30
1.40
1.50

a.

b.

(Continued)

Year

Dividend

Year

Dividend

2003
2004
2005
2006
2007

$0.50
0.50
0.50
0.50
0.50

2008
2009
2010
2011
2012

$0.66
0.50
0.66
1.14
1.30

c.

d. With a constant-payout policy, if the firms earnings drop or a loss occurs the dividends will
be low or nonexistent. A regular dividend or a low-regular-and-extra dividend policy reduces
owner uncertainty by paying relatively fixed and continuous dividends.
P14-8. Alternative dividend policies
LG 4; Challenge
Year

Dividend

Year

Dividend

2005
2006

$0.22
0.50

2009
2010

$0.00
0.60

2007

0.30

2011

0.78

2008

0.53

2012

0.70

2005

$0.50

2009

$0.50

2006

0.50

2010

0.50

2007

0.50

2011

0.60

2008

0.50

2012

0.60

2005

$0.50

2009

$0.50

2006

0.50

2010

0.50

2007

0.50

2011

0.88

2008

0.50

2012

0.78

2005

$0.50

2009

$0.50

2006

0.50

2010

0.62

2007

0.50

2011

0.88

2008

0.53

2012

0.78

a.

b.

c.

e.

Part a uses a constant-payout-ratio dividend policy, which will yield low or no dividends if
earnings decline or a loss occurs. Part b uses a regular dividend policy, which minimizes the
owners uncertainty of earnings. Part c uses a low-regular-and-extra dividend policy, giving
investors a stable income which is necessary to build confidence in the firm. Part d still
provides the stability of parts b and c and provides an extra $0.04 per year.

P14-9. Stock dividendfirm

LG 5; Intermediate
(a) 5%
Stock Dividend

(b) (1) 10%

Stock Dividend

Preferred stock
Common stock (xx,xxx shares
@$2.00 par)

$100,000

Paid-in capital in excess of par

294,000

308,000

336,000

85,000

70,000

40,000

$500,000

$500,000

$500,000

21,0001

Retained earnings
Stockholders equity

$100,000

(b) (2) 20%

Stock Dividend
$100,000

22,0002

24,0003

10,500 shares
11,000 shares
3
12,000 shares
2

c.

Stockholders equity has not changed. Funds have only been redistributed between the
stockholders equity accounts.

P14-10. Cash versus stock dividend

LG 5; Intermediate
a.
Cash Dividend
$0.01

$0.05

$0.10

$0.20

$ 100,000

$ 100,000

$100,000

$100,000

400,000

400,000

400,000

400,000

Paid-in capital in
excess of par

200,000

200,000

200,000

200,000

Retained earnings

316,000

300,000

280,000

240,000

$1,016,000

$1,000,000

$980,000

$940,000

Preferred stock
Common stock
(400,000 shares
@$1.00 par)

Stockholders equity

b.
Stock Dividend
1%

5%

10%

$ 100,000

$ 100,000

$ 100,000

$ 100,000

404,000

420,000

440,000

480,000

Paid-in capital in
excess of par

212,000

260,000

320,000

440,000

Retained earnings

304,000

240,000

160,000

$1,020,000

$1,020,000

$1,020,000

$1,020,000

Preferred stock
Common stock
(xxx,xxx shares
@$1.00 par)

Stockholders equity

20%

c. Stock dividends do not affect stockholders equity; they only redistribute retained earnings
into common stock and additional paid-in capital accounts. Cash dividends cause a decrease
in retained earnings, and hence in overall stockholders equity.
P14-11. Personal finance: Stock dividendinvestor
LG 5; Intermediate
$80,000
$2.00
a. EPS
40,000
400
1.0%
40,000
c. Percent ownership after stock dividend: 440 44,000 1%; stock dividends maintain the
same ownership percentage. They do not have a real value.
d. Market price: $22 1.10 $20 per share
e. Her proportion of ownership in the firm will remain the same, and as long as the firms
earnings remain unchanged, so, too, will her total share of earnings.

b.

Percent ownership

P14-12. Personal finance: Stock dividendinvestor

LG 5; Challenge
$120,000
$2.40 per share
a. EPS
50,000
b.

c.

500
1.0%
50,000
His proportionate ownership remains the same in each case
Percent ownership

$40
$38.10
1.05
$40
Market price
$36.36
1.10
The market price of the stock will drop to maintain the same proportion, since more shares
are being used.
Market price

d.

e.
f.

$2.40
$2.29 per share
1.05
$2.40
EPS
$2.18 per share
1.10
Value of holdings: $20,000 under each plan.
As long as the firms earnings remain unchanged, his total share of earnings will be the same.
The investor should have no preference because the only value is of a psychological nature.
After a stock split or dividend, however, the stock price tends to go up faster than before.
EPS

P14-13. Stock splitfirm

LG 6; Intermediate
a. CS $1,800,000
(1,200,000 shares @ $1.50 par)
b. CS $1,800,000
(400,000 shares
@ $4.50 par)
c. CS $1,800,000
(1,800,000 shares @ $1.00 par)
d. CS $1,800,000
(3,600,000 shares @ $0.50 par)
e. CS $1,800,000
(150,000 shares
@ $12.00 par)
P14-14. Stock splits
LG 1; Easy
a. 400 2 800 shares will be owned by Nathan after the split.
b. $75.14 2 $37.57 per share of General Mills after the 2:1 split.
c. Value of General Mills in Nathans portfolio shares owned price per share.
400 $75.14 $30,056 value before the split
800 $37.57 $30,056 value after the split
d. Nathan does not experience a gain or a loss, and hence his financial conditions does not
change. Nathan still owns the same percentage of all Apple shares.
e. Even if there was a gain or loss attributable to the split, Nathan would not have any tax
liability unless he actually sold the stock and realized that change for tax purposes.
P14-15. Stock split versus stock dividendfirm
LG 5, 6; Challenge
a. There would be a decrease in the par value of the stock from $3 to $2 per share. The shares
outstanding would increase to 150,000. The common stock account would still be $300,000
(150,000 shares at $2 par).
b. The stock price would decrease by one-third to $80 per share.
c. Before stock split: $100 per share ($10,000,000 100,000)
After stock split: $66.67 per share ($10,000,000 150,000)
d. (1) A 50% stock dividend would increase the number of shares to 150,000 but would not
entail a decrease in par value. There would be a transfer of $150,000 into the common
stock account and $5,850,000 in the paid-in capital in excess of par account from the
retained earnings account, which decreases to $4,000,000.
(2) The stock price would change to approximately the same level.
(3) Before dividend: $100 per share ($10,000,000 100,000)
After dividend: $26.67 per share ($4,000,000 150,000)

e. Stock splits cause an increase in the number of shares outstanding and a decrease in the par
value of the stock with no alteration of the firms equity structure. However, stock dividends
cause an increase in the number of shares outstanding without any decrease in par value.
Stock dividends cause a transfer of funds from the retained earnings account into the common
stock account and paid-in capital in excess of par account.
P14-16. Stock dividend versus stock splitfirm
LG 5, 6; Challenge
a. A 20% stock dividend would increase the number of shares to 120,000 but would not entail a
decrease in par value. There would be a transfer of $20,000 into the common stock account
and $580,000 [($30 $1) 20,000] in the paid-in capital in excess of par account from the
retained earnings account. The per-share earnings would decrease since net income remains
the same but the number of shares outstanding increases by 20,000.
EPS stock dividend

$360,000
120,000

$3.00

b. There would be a decrease in the par value of the stock from $1 to $0.80 per share. The
shares outstanding would increase to 125,000. The common stock account would still be
$100,000 (125,000 shares at $0.80 par). The per-share earnings would decrease since net
income remains the same but the number of shares outstanding increases by 25,000.
EPS stock split

$360,000
125,000

$2.88

c. The option in part b the stock split will accomplish the goal of reducing the stock price while
maintaining a stable level of retained earnings. A stock split does not cause any change in
retained earnings but reduces the price of the shares in the same proportion as the split ratio.
d. The firm may be restricted in the amount of retained earnings available for dividend payments,
whether cash or stock dividends. Stock splits do not have any impact on the firms retained
earnings.
P14-17. Stock repurchase
LG 6; Intermediate
a. Shares to be repurchased
b. EPS

$800,000
(400,000 19,047)

$400,000
19,047 shares
$21.00
$800,000
380,953

$2.10 per share

If 19,047 shares are repurchased, the number of common shares outstanding will decrease
and earnings per share will increase.
c. Market price: $2.10 10 $21.00 per share.
d. The stock repurchase results in an increase in earnings per share from $2.00 to $2.10.
e. The pre-repurchase market price is different from the post-repurchase market price by the
amount of the cash dividend paid. The post-repurchase price is higher because there are fewer
shares outstanding.

Cash dividends are taxable to the stockholder when they are distributed and are taxed at a
maximum 15% tax rate. If the firm repurchases stock, taxes on the increased value resulting
from the purchase are also due at the time of the repurchase. The additional $1 gain would be
taxed at either the long-term capital gains rate of 15%, the same as the dividend, unless the
stock was held for less than 1 year; then the gain would be short term and taxed at the higher
marginal ordinary income rate. Which alternative is preferred by the shareholders would
depend on the investors holding period for the stock at the time the repurchase is made.
Taxes would not have to be paid on the repurchase gains until the shares are sold.
P14-18. Stock repurchase
LG 6; Challenge
a. Shares outstanding needed
b. 300,000 240,000

($1,200,000 0.40)
$2.00

$480,000
$2.00

240,000

60,000 shares to repurchase

P14-19. Ethics problem

LG 6; Intermediate
Students should argue that all of the methods being contemplated by the chief financial officer
(CFO) are legal and therefore not unethical. Others may argue that even if legal, the actions are
unethical and should not be pursued. The final question tries to address how firm the students
convictions are. It is one thing to demonstrate a course of action and make a recommendation.
Acting in the face of an opposing view by a superior is a bit more difficult, but should not
discourage the student from maintaining their viewpoint.