Session 12: Payout Policy
Read: Chapter 17: Payout Policy
1. Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is
expected to pay $1 million of dividends next year, and thereafter the amount paid out is
expected to grow by 5 percent a year in perpetuity. However, the company has heard that
the value of a share depends on the flow of dividends, and therefore it announces that next
year’s dividend will be increased to $2 million and that the extra cash will be raised
immediately by an issue of shares. After that, the total amount paid out each year will be as
previously forecasted, that is, $1.05 million in year 2 and increasing by 5 percent in each
subsequent year.
a. At what price will the new shares be issued in year 1?
b. How many shares will the firm need to issue?
c. What will be the expected dividend payments on these new shares, and what therefore
will be paid out to the old shareholders after year 1?
d. Show that the present value of the cash flows to current shareholders remains $20
million.
e. Assume that new shares are issued in year 1 at $10 a share. Show who gains and who
loses. Is dividend policy still irrelevant? Why or why not?
2. Hong Kong has an unusual tax system. Dividends and capital gains are not taxable. The
Peng Corporation currently pays a quarterly dividend of HK$5 per share. It has 5 million
shares outstanding at a price of HK$267.
a. What will happen to the share price on the first day when registered owners are no
longer eligible to receive the quarterly dividend?
b. What will happen to the share price if Peng announces that in the future it will cut
quarterly dividends by HK$2 per share and use the cash to repurchase shares instead?
c. What if Peng keeps the dividend at HK$5 but uses excess cash to repurchase shares in
the open market at the current market price of HK$267?
3. In the UK, the top personal income tax rate is 40 percent. This rate applies to interest and
dividends. Capital gains are tax free, providing that realized gains do not exceed an annual
allowance of about £8,000.
All the individual stockholders of John Peel Group are in the top UK tax bracket, but manage
their portfolios so that realized capital gains never exceed their annual allowances. Suppose
that the Group’s effective corporate tax rate is 30 percent. How does the sum of corporate and
personal taxes change if the Group:
a. Operates at a higher or lower debt ratio?
b. Increase or reduces cash dividend payout, holding capital investment and debt
constant?
Given your answers to (a) and (b), how would you advise the Group about debt and dividend
policy?
4. AMC Corporation currently has an enterprise value of $400 million and $100 million in
excess cash. The firm has 10 million shares outstanding and no debt. Suppose AMC uses
its excess cash to repurchase shares. After the share repurchase, news will come out that
will change AMC’s enterprise value to either $600 million or $200 million.
a. What is AMC’s share price prior to the share repurchase?
