Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Dividends and Dividend
Policy
© The McGraw−Hill^651
Companies, 2002One option the company is considering is a $300,000/100,000 $3 per share extra
cash dividend. Alternatively, the company is thinking of using the money to repurchase
$300,000/10 30,000 shares of stock.
If commissions, taxes, and other imperfections are ignored in our example, the stock-
holders shouldn’t care which option is chosen. Does this seem surprising? It shouldn’t,
really. What is happening here is that the firm is paying out $300,000 in cash. The new
balance sheet is represented here.If the cash is paid out as a dividend, there are still 100,000 shares outstanding, so each
is worth $7.
The fact that the per-share value fell from $10 to $7 isn’t a cause for concern. Con-
sider a stockholder who owns 100 shares. At $10 per share before the dividend, the to-
tal value is $1,000.
After the $3 dividend, this same stockholder has 100 shares worth $7 each, for a to-
tal of $700, plus 100 $3 $300 in cash, for a combined total of $1,000. This just il-
lustrates what we saw early on: a cash dividend doesn’t affect a stockholder’s wealth if
there are no imperfections. In this case, the stock price simply fell by $3 when the stock
went ex dividend.
Also, because total earnings and the number of shares outstanding haven’t changed,
EPS is still 49 cents. The price-earnings ratio, however, falls to $7/.49 14.3. Why we
are looking at accounting earnings and PE ratios will be apparent in just a moment.
Alternatively, if the company repurchases 30,000 shares, there are 70,000 left out-
standing. The balance sheet looks the same.The company is worth $700,000 again, so each remaining share is worth $700,000/70,000
$10. Our stockholder with 100 shares is obviously unaffected. For example, if they
were so inclined, they could sell 30 shares and end up with $300 in cash and $700 in stock,
just as they have if the firm pays the cash dividend. This is another example of a home-
made dividend.
In this second case, EPS goes up because total earnings remain the same while the
number of shares goes down. The new EPS is $49,000/70,000 $.70. However, the im-
portant thing to notice is that the PE ratio is $10/.70 14.3, just as it was following the
dividend.
This example illustrates the important point that, if there are no imperfections, a cash
dividend and a share repurchase are essentially the same thing. This is just another il-
lustration of dividend policy irrelevance when there are no taxes or other imperfections.624 PART SIX Cost of Capital and Long-Term Financial Policy
Market Value Balance Sheet
(after paying out excess cash)
Excess cash $ 0 Debt $ 0
Other assets 700,000 Equity 700,000
Total $700,000 Total $700,000Market Value Balance Sheet
(after share repurchase)
Excess cash $ 0 Debt $ 0
Other assets 700,000 Equity 700,000
Total $700,000 Total $700,000