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words, how necessary is it for them to use dividend policy as a signal?
Who are the marginal stockholdera in this firm? Do they like dividends or

would they prefer stock buybacks?
How well can this firm forecast its future financing needs? How valuable is

preserving flexibility to this firm?
Are there any significant bond covenants that you know of that restrict the

firm™s dividend policy?
How does this firm compare with other firms in the sector in terms of

dividend policy?

Getting Information on dividend policy
You can get information about dividends paid back over time from the financial
statements of the firm. (The statement of changes in cash flows is usually the best




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source.) To find typical dividend payout ratios and yields for the sector in which this firm
operates examine the data set on industry averages on my web site.
Online sources of information:
http://www.stern.nyu.edu/˜adamodar/cfin2E/project/data.htm




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Problems

1. If Consolidated Power is priced at $50.00 with dividend, and its price falls to $46.50
when a dividend of $5.00 is paid, what is the implied marginal rate of personal taxes for
its stockholders? Assume that the tax on capital gains is 40% of the personal income tax.

2. You are comparing the dividend policies of three dividend-paying utilities. You have
collected the following information on the ex-dividend behavior of these firms.
NE Gas SE Bell Western Electric
Price before 50 70 100
Price after 48 67 95
Dividends/share 4 4 5
If you were a tax-exempt investor, which company would you use to make “dividend
arbitrage” profits? How would you go about doing so?

3. Southern Rail has just declared a dividend of $ 1. The average investor in Southern
Rail faces an ordinary tax rate of 50%. While the capital gains rate is also 50%, it is
believed that the investor gets the advantage of deferring this tax until future years (The
effective capital gains rate will therefore be 50% discounted back to the present). If the
price of the stock before the ex-dividend day is $10 and it drops to $9.20 by the end of
the ex-dividend day, how many years is the average investor deferring capital gains
taxes? (Assume that the opportunity cost used by the investor in evaluating future
cashflows is 10%.)

4. LMN Corporation, a real estate corporation, is planning to pay a dividend of $0.50 per
share. Most of the investors in LMN corporation are other corporations that pay 40% of
their ordinary income and 28% of their capital gains as taxes. However, they are allowed
to exempt 85% of the dividends they receive from taxes. If the shares are selling at $10
per share, how much would you expect the stock price to drop on the ex-dividend day?

5. UJ Gas is a utility that has followed a policy of increasing dividends every quarter by
5% over dividends in the prior year. The company announces that it will increase



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quarterly dividends from $1.00 to $ 1.02 next quarter. What price reaction would you
expect to the announcement? Why?

6. Microsoft Corporation, which has had a history of high growth and pays no dividends,
announces that it will start paying dividends next quarter. How would you expect its
stock price to react to the announcement? Why?

7. JC Automobiles is a small auto parts manufacturing firm, which has paid $1.00 in
annual dividends each year for the last 5 years. It announces that dividends will increase
to $ 1.25 next year. What would you expect the price reaction to be? Why? If your
answer is different from the prior problem, explain the reasons for the difference.

8. Would your answer be different for the previous problem, if JC Automobiles were a
large firm followed by 35 analysts? Why or why not?

9. WeeMart Corporation, a retailer of children™s clothes, announces a cut in dividends
following a year in which both revenues and earning dropped significantly. How would
you expect its stock price to react? Explain.

10. RJR Nabisco, in response to stockholder pressure in 1996, announced a significant
increase in dividends paid to stockholders, financed by the sale of some of its assets.
What would you expect the stock price to do? Why?

11. RJR Nabsico also had $ 10 billion in bonds outstanding at the time of the dividend
increase in problem 10. How would you expect Nabisco™s bonds to react to the
announcement? Why?

12. When firms increase dividends, stock prices tend to increase. One reason given for
this price reaction is that dividends operate as a positive signal. What is the increase in
dividends signaling to markets? Will markets always believe the signal? Why or why
not?




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