464 Part 5 Capital Structure and Dividend Policy
suddenly and permanently with materially lower growth expectations and relatively few
attractive new investment opportunities. Unfortunately, there was no way to replace the
founder’s contributions to the firm. Previously, CMC found it necessary to plow back
most of its earnings to finance growth, which averaged 12% per year. Future growth at a
6% rate is considered realistic, but that level would call for an increase in the dividend
payout. Further, it now appears that new investment projects with at least the 14% rate of
return required by CMC’s stockholders (rs! 14%) would amount to only $800,000 for
2009 compared to a projected $2,000,000 of net income. If the existing 20% dividend pay-
out was continued, retained earnings would be $1.6 million in 2009; but as noted, invest-
ments that yield the 14% cost of capital would amount to only $800,000.
The one encouraging point is that the high earnings from existing assets are expected
to continue, and net income of $2 million is still expected for 2009. Given the dramatically
changed circumstances, CMC’s management is reviewing the firm’s dividend policy.
a. Assuming that the acceptable 2009 investment projects would be financed entirely by
earnings retained during the year and assuming that CMC uses the residual dividend
model, calculate DPS in 2009.
b. What payout ratio does your answer to Part a imply for 2009?
c. If a 60% payout ratio is maintained for the foreseeable future, what is your estimate of
the present market price of the common stock? How does this compare with the mar-
ket price that should have prevailed under the assumptions existing just before the
news about the founder’s retirement? If the two values of P 0 are different, comment
on why.
d. What would happen to the stock price if the old 20% payout was continued? Assume
that if this payout is maintained, the average rate of return on the retained earnings
will fall to 7.5% and the new growth rate will be as follows:g! (1.0 " Payout ratio)(ROE)
! (1.0 " 0.2)(7.5%)
! (0.8)(7.5%)! 6.0%Discuss the pros and cons of having the directors formally announce what a firm’s
dividend policy will be in the future.
The cost of retained earnings is less than the cost of new outside equity capital.
Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay
dividends during the same year. Discuss the meaning of those statements.
Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.
Modigliani and Miller (MM) on the one hand and Gordon and Lintner (GL) on the other
hand have expressed strong views regarding the effect of dividend policy on a firm’s cost
of capital and value.
a. In essence, what are MM’s and GL’s views regarding the effect of dividend policy on
the cost of capital and stock prices?
b. How could MM use the information content, or signaling, hypothesis to counter their
opponents’ arguments? If you were debating MM, how would you counter them?
c. How could MM use the clientele effect concept to counter their opponents’
arguments? If you were debating MM, how would you counter them?
How would each of the following changes tend to affect aggregate (that is, the average for
all corporations) payout ratios, other things held constant? Explain your answers.
a. An increase in the personal income tax rate
b. A liberalization of depreciation for federal income tax purposes—that is, faster tax
write-offs
c. A rise in interest rates
d. An increase in corporate profits
e. A decline in investment opportunities