Financial Management

Chapter 15 (13E)

Distributions to Shareholders: Dividends and

Share Repurchases

Answers to End-of-Chapter Questions

15-1 The biggest advantage of having an announced dividend policy is that it would reduce investor uncertainty, and reductions in uncertainty are generally associated with lower capital costs and higher stock prices, other things equal. The disadvantage is that such a policy might decrease corporate flexibility. However, the announced policy would possibly include elements of flexibility. On balance, it would appear desirable for directors to announce their policies.

15-2 While it is true that the cost of outside equity is higher than that of retained earnings, it is not necessarily irrational for a firm to pay dividends and sell stock in the same year. If the firm has been paying a regular dividend, and then cuts it in order to obtain equity capital from retained earnings, there might be an unfavorable effect on the firm’s stock price. If investors lived in the world of certainty and rationality postulated by Miller and Modigliani, then the statement would be true, but it is not necessarily true in an uncertain world.

15-3 Logic suggests that stockholders like stable dividends—many of them depend on dividend income, and if dividends were cut, this might cause serious hardship. If a firm’s earnings are temporarily depressed or if it needs a substantial amount of funds for investment, then it might well maintain its regular dividend using borrowed funds to tide it over until things returned to normal. Of course, this could not be done on a sustained basis—it would be appropriate only on relatively rare occasions.

15-4 a. MM argue that dividend policy has no effect on rs, thus no effect on firm value and cost of capital. On the other hand, GL argue that investors view current dividends as being less risky than potential future capital gains. Thus, GL claim that rs is inversely related to dividend payout.

b. MM could...