Question 1
A. Yes. The dividend policy of the company is paying a constant dividend, which is occasionally increased as the company grows. For instance, in the financial years ended 1999 and 2000, the company’s dividend per share was $ 1.36 when it made net income of $ 650,100,000 and $ 861,200,000 respectively. However, in the two subsequent years when the company’s net income began to increase steady, the company has increased its dividends and paid their shareholders $ 1.48 and $ 1.70 respectively. Further, in the fiscal years 2003 and 2004, the company paid $ 1.76 as dividend to its shareholders. In the year 2005, the company increased its dividend by $ 0.2 due to its increased profitability.
B. All the Montgomery’s competitors in the retailing industry use the constant dividend policy with an occasional increase attributed to the growth in the business growth. For instance, from 1999-2005, Dillard Department Stores paid dividends of $ 0.05, $ 0.05, $ 0.08, $ 0.09, $ 0.10, $ 0.12 and $ 0.13 respectively. All the firms in this industry have a similar dividend payment policy. Therefore, none of these companies use the residual dividend payment policy.
Question 2
- Expected return, Ks = D1Po + g
D1 = 2.10
g = 7.1% = 0.071
P0 = 35
Expected return = 2.135 + 0.071
= 0.06 + 0.071
= 0.1310
= 13.10%
- Next year’s net income = 1.14 × 1,700 = 1,938
Common shares outstanding = 378.0
Earnings per share = 1,938378 = 5.1270
Market price per share = 35
Price/Earnings ratio = 355.1270 = 6.8266
Earnings yield = 5.127035 = 0.1465
Expected return = 14.65%
Question 3
Total retained earnings for 2005 11,319.60
Add back common dividends 725.00
12,044.60
If the proposal of Don is accepted, the company can finance capital projects internally up to the tune of $12,044, which is the total retained earnings. Common dividends are added back since no common dividends under this proposal. The residual policy implies that dividends will only be paid when the company has financed all capital projects with a positive NPV or whose internal rate of return is more than the company’s cost of capital.
Question 4
- The firm’s cost of internal equity financing is equal to the expected return calculated in 1A above. Given the next year’s dividends as $2.10, growth rate as 7.1% and the price of shares as $21, the cost of internal equity financing for the company will be 13.1%. Cost of internal equity financing is equal to the rate of return shareholders require/expect from their investment in the company’s shares.
- Yield on bonds = 13%
Tax rate = 25%
After tax cost of debt = kd (1 – t)
= 13% (1 – 0.25)
= 9.75%
- As shown by the above two figures, the after-tax cost of debt is less than the cost of internal equity financing. Borrowing is, therefore, more economical for the firm to borrow than to use equity financing. However, borrowing to finance capital projects and paying dividends will raise the company’s leverage thereby raising the financial risk in the company.
Question 5
No, I do not agree with Clarence Autry’s stand of adhering to the will of shareholders. This is because the company’s managers and board of directors are tasked with the responsibility of not only safeguarding the shareholders interest, but also to increase the firm’s profitability. The primary goal of the agency theory is to enable the executives of the company to maximize the shareholders’ wealth. The total rate of return will be advantageous to the company. This is because when the net income is reinvested back into the business through a project with higher returns as compared to the total dividends payable, the company will raise more profits from the shareholders’ wealth. Although the directors would be willing to please the shareholders, issuing a constant dividend annually when some viable investment opportunities are available will not maximize the shareholders’ wealth.
Question 6
Yes, I do agree with Barbara Reynolds’s suggestion that the stock dividend can be used as a substitute to the cash dividend suppose cash is needed for the capital budget. I think that the shareholders are likely to be opposed to this idea since the company has a constant dividend payment policy which is subject to increase with the business growth. Therefore, they will be expecting dividend payment. Whichever the reaction of the shareholders may be, stock dividend is an equal substitute to a cash dividend. Issuing out a stock dividend implies that the amount of the cash dividend that was initially supposed to be paid to a shareholder in the form of cash is converted into the current cost of a company share. A shareholder who is still interested in cash can trade in the share into cash.
Question 7
The dividend policy of each and every company matters. Montgomery Corporation should, therefore, consider changing its dividend policy by adopting a residual dividend policy. In this policy, dividends are only payable when a company does not have profitable reinvestment opportunities. This will help the company in maximizing the shareholders’ wealth.
