Chapter 06: Dividend Decision: ................ Md. Jobayair Ibna Rafiq.............

Chapter 06: Dividend Decision
................Md. Jobayair Ibna Rafiq..............
The Great Recession of 2007: Will Dividends Ever Be the Same?
The Great Recession of 2007 had dramatic effects on dividend policies. According to Standard
& Poor’s, companies announcing dividend increases exceeded those announcing decreases by a
factor of 15 to 1 since 1955—at least until the first 5 months of 2009. Out of 7,000 publicly
traded companies, only 283 announced dividend increases in the first quarter of 2009, while
367 cut dividends, a stunning reversal in the normal ratio of increasers to decreasers. Even the
S&P 500 companies weren’t immune to the crisis, with only 74 increasing dividends as compared
with 54 cutting dividends and 9 suspending dividend payments altogether. To put this in
perspective, only one S&P 500 company cut its dividend during the first quarter of 2007. The
dividend decreases in 2009 aren’t minor cuts, either. Howard Silverblatt, a Senior Index
Analyst at Standard & Poor’s, estimates the cuts add up to $77 billion.
How did the market react to cuts by these companies? JPMorgan Chase’s stock price went up
on the announcement, presumably because investors thought a stronger balance sheet at JPM
would increase its intrinsic value by more than the loss investors incurred because of the lower
dividend. On the other hand, GE’s stock fell by more than 6% on the news of its 68% dividend
cut, perhaps because investors feared this was a signal that GE’s plight was worse than they
had expected.
One thing is for certain: The days of large “permanent” dividends are over!
Sources: “S&P: Q1 Worst Quarter for Dividends Since 1955; Companies Reduce Shareholder Payments by $77 Billion,”
press release, April 7, 2009: www.prnewswire.com/news-releases /sp-q1-worst-quarter-for-dividends-since-1955-
companies -reduce-shareholder-payments-by-77-billion-61763892.html. For annual updates, see:
https://us.spindices.com/documents/additional-material/sp-500-indicated-rate-change.xlsx?force _download5true.
Chapter
Dividend Decision
6
LEARNING OBJECTIVES
Chapter Outline
Dividend
Factors Affecting Dividend Decision
Stock Dividend
Stock Split
Reverse Stock Split
Stock Repurchase
Right Share
Dividend Irrelevance Theory
Dividend Relevance Theory
Problems and Solutions
6.1. Dividend
Cash Dividends
The term dividend usually refers to cash paid out of earnings. If a payment is made from
sources other than current or accumulated retained earnings, the term distribution, rather than
dividend, is used. However, it is acceptable to refer to a distribution from earnings as a dividend
and a distribution from capital as a liquidating dividend. More generally, any direct payment by
the corporation to the shareholders may be considered a dividend or a part of dividend policy.
Dividends come in several different forms. The basic types of cash dividends are these:
1. Regular cash dividends. The most common type of dividend is a cash dividend. Commonly,
public companies pay regular cash dividends four times a year. As the name suggests, these are
cash payments made directly to shareholders, and they are made in the regular course of
business. In other words, management sees nothing unusual about the dividend and no reason
why it won’t be continued
2. Extra dividends. Sometimes firms will pay a regular cash dividend and an extra cash
dividend. By calling part of the payment “extra,” management is indicating that the “extra” part
may or may not be repeated in the future.
3. Special dividends. A special dividend is similar, but the name usually indicates that this is
viewed as a truly unusual or one-time event and won’t be repeated. For example, in December
2004, Microsoft paid a special dividend of $3 per share. The total payout of $32 billion was the
largest one-time corporate dividend in history. Founder Bill Gates received about $3 billion,
which he pledged to donate to charity.
4. Liquidating dividends. Finally, the payment of a liquidating dividend usually means that some
or all of the business has been liquidated—that is, sold off.
However it is labeled, a cash dividend payment reduces corporate cash and retained earnings,
except in the case of a liquidating dividend (which may reduce paid-in capital).
Standard Method of Cash Dividend Payment
The decision to pay a dividend rests in the hands of the board of directors of the corporation.
When a dividend has been declared, it becomes a debt of the firm and cannot be rescinded
easily. Sometime after it has been declared, a dividend is distributed to all shareholders as of
some specific date.
Dividend Per Share. The amount of the cash dividend is expressed in terms of dollars per
share.
Dividend Yield. It is also expressed as a percentage of the market price.
Dividend Payout. Dividend payout is expressed as a percentage of net income or earnings per
share.
Cash Dividend Payment Procedures
Declaration Date: When a firm’s directors declare a dividend, they issue a statement indicating
the dividend amount and setting three other important dates.
Ex-dividend Date: To make sure that dividend checks go to the right people, brokerage firms
and stock exchanges establish an ex-dividend date. This date is two business days before the
date of record. If you buy the stock before this date, then you are entitled to the dividend. If
you buy on this date or after, then the previous owner will get the dividend. The ex-dividend
date convention removes any ambiguity about who is entitled to the dividend. Because the
dividend is valuable, the stock price will be affected when the stock goes “ex.”
Date of Record: All persons whose names are recorded as stockholders on the date of record
receive the dividend. These stockholders are often referred to as holders of record.
Payment Date. The payment date is the actual date on which the firm mails the dividend
payment to the holders of record. It is generally a few weeks after the record date.
Types of Dividend Policies
The firm’s dividend policy must be formulated with two objectives in mind: providing for
sufficient financing and maximizing the wealth of the firm’s owners. Three different dividend
policies are described in the following sections. A particular firm’s cash dividend policy may
incorporate elements of each.
Constant-Payout-Ratio Dividend Policy
One type of dividend policy involves use of a constant payout ratio. The dividend payout ratio
indicates the percentage of each dollar earned that the firm distributes to the owners in the
form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings per
share. With a constant-payout-ratio dividend policy, the firm establishes that a certain
percentage of earnings is paid to owners in each dividend period.
The problem with this policy is that if the firm’s earnings drop or if a loss occurs in a given
period, the dividends may be low or even nonexistent. Because dividends are often considered an
indicator of the firm’s future condition and status, the firm’s stock price may be adversely
affected.
Regular Dividend Policy
The regular dividend policy is based on the payment of a fixed-dollar dividend in each period.
Often, firms that use this policy increase the regular dividend once a sustainable increase in
earnings has occurred. Under this policy, dividends are almost never decreased.
Often, a regular dividend policy is built around a target dividend-payout ratio. Under this policy,
the firm attempts to pay out a certain percentage of earnings, but rather than let dividends
fluctuate, it pays a stated dollar dividend and adjusts that dividend toward the target payout as
proven earnings increases occur. For instance, Woodward Laboratories appears to have a target
payout ratio of around 35 percent. The payout was about 35 percent ($1.00, $2.85) when the
dividend policy was set in 2004, and when the dividend was raised to $1.50 in2013, the payout
ratio was about 33 percent ($1.50, $4.60).
Low-Regular-And-Extra Dividend Policy
Some firms establish a low-regular-and-extra dividend policy, paying a low regular dividend,
supplemented by an additional (“extra”) dividend when earnings are higher than normal in a given
period. By calling the additional dividend an extra dividend, the firm avoids setting expectations
that the dividend increase will be permanent. This policy is especially common among companies
that experience cyclical shifts in earnings.
By establishing a low regular dividend that is paid each period, the firm gives investors the
stable income necessary to build confidence in the firm, and the extra dividend permits them to
share in the earnings from an especially good period. Firms using this policy must raise the level
of the regular dividend once proven increases in earnings have been achieved. The extra
dividend should not be a regular event; otherwise, it becomes meaningless. The use of a target
dividend-payout ratio in establishing the regular dividend level is advisable.
Review Questions
 What is cash dividend? Explain the standard method of cash dividend payment.
 Explain the cash dividend payment procedure or the dividend payment date chronology.
 Describe a constant-payout-ratio dividend policy, a regular dividend policy, and a low-
regular-and-extra dividend policy. What are the effects of these policies?
 Explain the types of dividend policies.
6.2. Factors Affecting Dividend Decision
The firm’s dividend policy represents a plan of action to be followed whenever it makes a
dividend decision. Firms develop policies consistent with their goals. Before we review some of
the popular types of dividend policies, we discuss five factors that firms consider in
establishing a dividend policy. They are legal constraints, contractual constraints, the firm’s
growth prospects, owner considerations, and market considerations.
In this section, we discuss several other factors that affect the dividend decision. These
factors may be grouped into two broad categories: (1) constraints on dividend payments and (2)
availability and cost of alternative sources of capital.
Constraints
Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan
agreement. Generally, these constraints prohibit the payment of cash dividends until the firm
achieves a certain level of earnings, or they may limit dividends to a certain dollar amount or
percentage of earnings. Constraints on dividends help to protect creditors from losses due to
the firm’s insolvency. Constraints on dividend payments can affect distributions, as the following
examples illustrate.
1. Bond indentures. Debt contracts often limit dividend payments to earnings generated after
the loan was granted. Also, debt contracts often stipulate that no dividends can be paid unless
the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums.
2. Preferred stock restrictions. Typically, common dividends cannot be paid if the company has
omitted its preferred dividend. The preferred arrearages must be satisfied before common
dividends can be resumed.
3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item
“retained earnings.” This legal restriction, known as the “impairment of capital rule,” is designed
to protect creditors. Without the rule, a company in trouble might distribute most of its assets
to stockholders and leave its debt-holders out in the cold. Liquidating dividends can be paid out
of capital, but they must be indicated as such and must not reduce capital below the limits
stated in debt contracts.
Most states prohibit corporations from paying out as cash dividends any portion of the firm’s
“legal capital,” which is typically measured by the par value of common stock. Other states
define legal capital to include not only the par value of the common stock but also any paid-in
capital in excess of par. These capital impairment restrictions are generally established to
provide a sufficient equity base to protect creditors’ claims. An example will clarify the
differing definitions of capital.
Firms sometimes impose an earnings requirement limiting the amount of dividends. With this
restriction, the firm cannot pay more in cash dividends than the sum of its most recent and past
retained earnings. However, the firm is not prohibited from paying more in dividends than its
current earnings.
Example: The stockholders’ equity account of Miller Flour Company, a large grain processor, is
presented in the following table
In states where the firm’s legal capital is defined as the par value of its common stock, the
firm could pay out $340,000 ($200,000 + $140,000) in cash dividends without impairing its
capital. In states where the firm’s legal capital includes all paid-in capital, the firm could pay
out only $140,000 in cash dividends.
Assume that Miller Flour Company, from the preceding example, in the year just ended has
$30,000 in earnings available for common stock dividends. As the table in Example indicates,
the firm has past retained earnings of $140,000. Thus, it can legally pay dividends of up to
$170,000.
If a firm has overdue liabilities or is legally insolvent or bankrupt, most states prohibit its
payment of cash dividends. In addition, the Internal Revenue Service prohibits firms from
accumulating earnings to reduce the owners’ taxes. If the IRS can determine that a firm has
accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on
dividends received, it may levy an excess earnings accumulation tax on any retained earnings
above $250,000 for most businesses.
During the recent financial crisis, a number of financial institutions received federal financial
assistance. Those firms had to agree to restrictions on dividend payments to shareholders until
they repaid the money that they received from the government. Bank of America, for example,
had more than 30 years of consecutive dividend increases before accepting federal bailout
money. As part of its bailout, Bank of America had to cut dividends to $0.01 per share.
4. Availability of cash. Cash dividends can be paid only with cash, so a shortage of cash in the
bank can restrict dividend payments. However, the ability to borrow can offset this factor.
5. Penalty tax on improperly accumulated earnings. To prevent wealthy individuals from using
corporations to avoid personal taxes, the Tax Code provides for a special surtax on improperly
accumulated income. Thus, if the IRS can demonstrate that a firm’s dividend payout ratio is
being deliberately held down to help its stockholders avoid personal taxes, the firm is subject
to heavy penalties. This factor is generally relevant only to privately owned firms.
Alternative Sources of Capital
The second factor that influences the dividend decision is the cost and availability of
alternative sources of capital.
1. Cost of selling new stock. If a firm needs to finance a given level of investment, it can
obtain equity by retaining earnings or by issuing new common stock. If flotation costs (including
any negative signaling effects of a stock offering) are high, then the required return on new
equity, re , will be well above the required return on internally generated equity, r s, making it
better to set a low payout ratio and to finance through retention rather than through the sale
of new common stock. On the other hand, a high dividend payout ratio is more feasible for a
firm whose flotation costs are low. Flotation costs differ among firms—for example, the
flotation percentage is generally higher for small firms, so they tend to set low payout ratios.
2. Ability to substitute debt for equity. A firm can finance a given level of investment with
either debt or equity. As just described, low stock flotation costs permit a more flexible
dividend policy because equity can be raised either by retaining earnings or by selling new stock.
A similar situation holds for debt policy: If the firm can adjust its debt ratio without raising
the cost of capital sharply, then it can pay the expected dividend—even if earnings fluctuate—
by increasing its debt ratio.
3. Control. If management is concerned about maintaining control, it may be reluctant to sell

new stock; hence, the company may retain more earnings than it otherwise would. However, if
stockholders want higher dividends and a proxy fight looms, then the dividend will be increased.
Effects of Other Issues
Growth Prospects. The firm’s financial requirements are directly related to how much it
expects to grow and what assets it will need to acquire. It must evaluate its profitability and
risk to develop insight into its ability to raise capital externally. In addition, the firm must
determine the cost and speed with which it can obtain financing. Generally, a large, mature firm
has adequate access to new capital, whereas a rapidly growing firm may not have sufficient
funds available to support its acceptable projects. A growth firm is likely to have to depend
heavily on internal financing through retained earnings, so it is likely to pay out only a very small
percentage of its earnings as dividends. A more established firm is in a better position to pay
out a large proportion of its earnings, particularly if it has ready sources of financing.
Owner Considerations. The firm must establish a policy that has a favorable effect on the
wealth of the majority of owners. One consideration is the tax status of a firm’s owners. If a
firm has a large percentage of wealthy stockholders who have sizable incomes, it may decide to
pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes
until they sell the stock. Because cash dividends are taxed at the same rate as capital gains, this
strategy benefits owners through the tax deferral rather than as a result of a lower tax rate.
Lower-income shareholders, however, who need dividend income, will prefer a higher payout of
earnings.
A second consideration is the owners’ investment opportunities. A firm should not retain funds
for investment in projects yielding lower returns than the owners could obtain from external
investments of equal risk. If it appears that the owners have better opportunities externally,
the firm should pay out a higher percentage of its earnings. If the firm’s investment
opportunities are at least as good as similar-risk external investments, a lower payout is
justifiable.
A final consideration is the potential dilution of ownership. If a firm pays out a high percentage
of earnings, new equity capital will have to be raised with common stock. The result of a new
stock issue may be dilution of both control and earnings for the existing owners. By paying out a
low percentage of its earnings, the firm can minimize the possibility of such dilution.
Market Considerations. One of the more recent theories proposed to explain firms’ payout
decisions is called the catering theory. According to the catering theory, investors’ demands
for dividends fluctuate over time. For example, during an economic boom accompanied by a rising
stock market, investors may be more attracted to stocks that offer prospects of large capital
gains. When the economy is in recession and the stock market is falling, investors may prefer
the security of a dividend. The catering theory suggests that firms are more likely to initiate
dividend payments or to increase existing payouts when investors exhibit a strong preference
for dividends. Firms cater to the preferences of investors.
Review Questions
 What constraints affect dividend policy?
 How do the availability and cost of outside capital affect dividend policy?
 What factors do firms consider in establishing dividend policy? Briefly describe each of
them.
 Explain the alternative sources of capital.
6.3. Stock Dividend
Stock Dividend
Another type of dividend is paid out in shares of stock. This dividend is referred to as a stock
dividend. It is not a true dividend, because no cash leaves the firm. Rather, a stock dividend
increases the number of shares outstanding, thereby reducing the value of each share. A stock
dividend is commonly expressed as a ratio; for example, with a 2 percent stock dividend a
shareholder receives one new share for every 50 currently owned.
Reasons for Stock Dividend
A corporation might issue a stock dividend instead of paying a cash dividend for the following
reasons:
1. To increase the number of shares of stock outstanding
2. To reduce the market price per share of stock
3. To transfer some of the corporation's retained earnings to paid-in capital
4. To minimize distributing the corporation's cash to its stockholders
5. To convey positive information to market about future prospect about firm
6. To delay any tax payments on stock dividends until they sell the shares
7. To substitute for an existing or contemplated cash dividend
8. To get advantage by not adjusting stock price fully on the ex-dividend date
Exercise-01:
Balance Sheet (Equity Position)

Share capital (Paid up Capital) (100000 @ 10 Per) Tk. 1000000
Share Premium Tk. 1500000
Retained Earnings Tk. 800000
Total Shareholder’s equity Tk. 3300000
Other information
P/E Ratio--- ? Rate of Return----- 10%
Market Price/Share---- Tk. 30 Cost of Capital------ 8%
Earnings Per Share (EPS) ----? Dividend Per Share ---- ?
Dividend Payout Ratio---- Tk. 40% Net Income ----- 300000
Requirement:
 Show all the possible the effect after declaring 10% Stock Dividend
Solution:
Effect in Balance Sheet (Equity Position) declaring 10% stock dividend
Old Number of Share outstanding = 100000 Shares
Total New Number of Share outstanding = 100000 + (100000 × 10%)
= 110000 Shares
Market Value of New total Share = (100000 × 30)
= 300000

Paid up Capital (110000 @ 10 Per) Tk. 1100000
Share Premium [1500000 + (10000 ×20)] Tk. 1700000
Retained Earnings (800000-300000) Tk. 500000
Effect on Accounting Data
Particulars Before Stock Dividend After Stock Dividend Effect

Shares outstanding 100000 (100000 + 10000) Increase
= 110000
Book value per Tk. 10 Tk. 10 same
share
Paid up Capital (100000 × 10) = Tk. (110000 × 10) = Tk. Increase
1000000 1100000
Share premium (100000 × 15) = Tk. 1500000 + (10000 ×20) Increase
1500000 = Tk. 1700000
Retained Earnings Tk. 800000 (800000-300000) = Tk. Decrease
500000
Ownership Value Tk. 3300000 Tk. 3300000 Same
Market Value per TK. 30 [(Tk. 100000 × 30)/ Decrease
share 110000] = 27.273
Earnings per share (300000/100000) =Tk. 3 (300000/110000) = Tk. Decrease
2.727
P/E ratio (30/3) = 10 times (27.273/2.7273) = Tk. Same
10 times
Market (30 × 100000) = Tk. (110000 × 27.27273) = Same
capitalization 3000000 Tk. 3000000
Dividend Per share (300000 × 0.4)/ 100000 = (300000 × 0.4)/ 110000 Decrease
1.2 = 1.0909
Dividend Payout 40% 40% Same
Ratio
Dividend Yield (12/30) = 0.04 (1.2/ 27.27373) = 0.044 Same
Review Question
 What is stock dividend? What are the reasons for stock dividend?
6.4. Stock Split
Stock Split
Although not a type of dividend, stock splits have an effect on a firm’s share price similar to
that of stock dividends. A stock split is a method commonly used to lower the market price of a
firm’s stock by increasing the number of shares belonging to each shareholder. Because each
share is now entitled to a smaller percentage of the firm’s cash flow, the stock price should fall.
In a 2-for-1 split, for example, two new shares are exchanged for each old share, with each new
share being worth half the value of each old share. A stock split has no effect on the firm’s
capital structure and is usually nontaxable.
Reasons for Stock Split
 Stock splits can improve trading liquidity and make the stock seem more affordable.
 In a stock split the number of outstanding shares increases and the price per share
decreases proportionately, while the market capitalization and the value of the company do
not change.
 Stock splits boost valuations
 Stock splits reduce companies' capital costs
 Stock splits help investors, customers and staff.
Exercise-02:

Other information
Requirement:
• Show the all possible effect after declaring 5:3 Stock Split
Effect in Balance Sheet (Equity Position) declaring 5:3 Stock Split
Total New Number of Share outstanding = (100000/3) × 5
= 166666.67 Shares
Book value per share = (10/5) × 3
= Tk. 6

Paid up Capital (166666.67 @ Tk. 6 Per) Tk. 1000000

Shares outstanding 100000 (100000/3) × 5= 166666.67 Increase
Book value per Tk. 10 (10/5) × 3 = Tk. 6 Decrease
share
Paid up Capital (100000 × 10) = Tk. (166666.67 × Tk. 6) = Tk. Same
1000000 1000000
Share premium (100000 × 15) = Tk. 1500000 Same
1500000
Retained Earnings Tk. 800000 Tk. 800000 Same
Market Value per TK. 30 [(Tk. 100000 × 30)/ Decrease
share 166666.67] = Tk. 18
Earnings per share (300000/100000) =Tk. 3 (300000/166666.67) = Decrease
Tk. 1.8
P/E ratio (30/3) = 10 times (18/1.8) = Tk. 10 times Same
Market (30 × 100000) = Tk. (166666.67 × 18) = Tk. Same
capitalization 3000000 3000000
Dividend Per share (300000 × 0.4)/ 100000 = (300000 × 0.4)/ Decrease
1.2 166666.67 = 0.72
Ratio
Dividend Yield (12/30) = 0.04 (0.72/ 18) = 0.04 Same
Review Question
 What is stock Split? What are the reasons for stock Split?
6.5. Reverse Stock Split
Reverse Stock Split
Reverse split is situation in which shareholders exchange a particular number of shares of stock
for a smaller number of new shares. A method used to raise the market price of a firm’s stock
by exchanging a certain number of outstanding shares for one new share.
Reasons for Reverse Stock Split
1. A company may declare a reverse stock split in an effort to increase the trading price of its
shares
2. Companies looking to create spin-offs at attractive prices may use reverse splits.
3. Major stock exchanges have minimum dollar amounts for the price of the stocks they list.
So, to stay listed, a low-priced stock may reverse split in order to push its price to those
minimums.
4. A reverse split may just be an attempt to extend the life of a slipping stock.
Exercise-03

Other information
Requirement:
Show the all possible effect after declaring 1:4Reverse Stock Split
Effect in Balance Sheet (Equity Position) declaring 5:3 Stock Split
Total New Number of Share outstanding = (100000/4) × 1
= 25000 Shares
Book value per share = (10 × 4)
= Tk. 40

Paid up Capital (25000 @ Tk. 40 Per) Tk. 1000000

Shares outstanding 100000 (100000/4) × 1 Decrease
= 25000
Book value per share Tk. 10 10 × 4 = Tk. 40 Increase
Paid up Capital (100000 × 10) = Tk. (25000 × Tk. 40) = Tk. Same
1000000 1000000
Share premium (100000 × 15) = Tk. 1500000 Same
1500000
Retained Earnings Tk. 800000 Tk. 800000 Same
Market Value per TK. 30 [(Tk. 100000 × 30)/ Increase
share 25000] = Tk. 120
Earnings per share (300000/100000) =Tk. 3 (300000/25000) = Tk. 12 Increase
P/E ratio (30/3) = 10 times (120/12) = Tk. 10 times Same
Market capitalization (30 × 100000) = Tk. (120 × 25000) = Tk. Same
3000000 3000000
Dividend Per share (300000 × 0.4)/ 100000 (300000 × 0.4)/25000 = Increase
= 1.2 4.8
Ratio
Dividend Yield (12/30) = 0.04 (4.8/ 120) = 0.04 Same
Review Question
 What is reverse stock split? What are the reasons for reverse stock split?
6.6. Stock Repurchase
Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby
decreasing the number of shares but leaving the stock price unchanged.
Reasons for Stock Repurchase
1. company has Lots of cash but few projects to invest in

2. Buybacks are a more tax-effective means of rewarding shareholders
3. Theoretically buybacks tend to improve valuations of companies
4. Company can signal that the stock is undervalued
5. Returns cash to the shareholders of the company
6. It can help the promoters to consolidate their stake in the company
Effective of Repurchase
Let us consider a hypothetical company X whose financial position is described by the data in
the following table:
Earnings after taxes Tk. 3000000

No of Share Outstanding Tk. 1000000
Earnings per share (EPS) Tk. 3
Price –earnings (P/E) ratio 10 times
Market price per share Tk. 30
Excess Cash Tk. 2000000
The firm wants to use the excess cash Tk. 2000000 either to pay cash dividend of Tk. 2 per
share (Tk. 2000000/ 1000000 shares) or to repurchase 62500 of its shares (2000000/ 32) at
Tk. 32 per share.
The effect of the repurchase on the EPS and market price per share of the remaining stock can
be analyzed in the following way:
Current EPS = Tk. 3000000/ 1000000 = Tk. 3 per share
P/E ratio = Tk. 30/ Tk. 3 = 10
EPS after repurchase = TK. 3000000/ 937500 = Tk. 3.20 per share
Expected market price after repurchase = P/E ratio × EPS = 10 × Tk. 3.20 = Tk. 32
Again, the total values for the two alternatives are:
Funds used for cash dividend Taka Funds used to repurchase stock Taka
Market value per share Tk. 30 Market value per share TK. 32
Cash dividend per share Tk. 2
Review Question
 What is stock repurchase or treasury stock? What are the reasons for stock repurchase?
6.7. Right Share
When new shares of common stock are sold to the general public, the proportional ownership of
existing shareholders is likely to be reduced. However, if a preemptive right is contained in the
firm’s articles of incorporation, the firm must first offer any new issue of common stock to
existing shareholders. If the articles of incorporation do not include a preemptive right, the
firm has a choice of offering the issue of common stock directly to existing shareholders or to
the public.
An issue of common stock offered to existing stockholders is called a rights offering (or offer,
for short) or a privileged subscription. In a rights offering, each shareholder is issued rights to
buy a specified number of new shares from the firm at a specified price within a specified time,
after which the rights are said to expire. The terms of the rights offering are evidenced by
certificates known as share warrants or rights. Such rights are often traded on securities
exchanges or over the counter.
Rights offerings have some interesting advantages relative to cash offers. For example, they
appear to be cheaper for the issuing firm than cash offers. In fact, a firm can do a rights
offering without using an underwriter; whereas, as a practical matter, an underwriter is almost a
necessity in a cash offer. Despite this, rights offerings are fairly rare in the United States;
however, in many other countries, they are more common than cash offers. Why this is true is a
bit of a mystery and the source of much debate; but to our knowledge, no definitive answer
exists.
Reasons Offering for Right Share
The main reasons to make a Rights issue by a company are as follows:

1. In times of inflation, the replacement costs of assets will be high, unless the company can
retain cash from substantial profits, the only alternative is to raise cash from a fresh issue
of shares.
2. For funding expansion projects, a company may make rights issue.
3. If a company has a proportion of interest bearing loan capital, the company can suffer from
a squeeze on profits. The company can improve the capital structure position by obtaining
extra share capital.
4. At a time when the share prices were relatively high, companies found it easy to persuade
their shareholders to subscribe cash for new issues with a view to expansion by takeover.
The Mechanics of a Rights Offering

To illustrate the various considerations a financial manager faces in a rights offering, we will
examine the situation faced by the National Power Company, whose abbreviated initial financial
statements are given in Table.
National Power Company Financial Statements before Rights Offering

NATIONAL POWER COMPANY
Balance Sheet
Assets Shareholders’ Equity
Assets $15,000,000 Common stock $ 5,000,000
Retained earnings 10,000,000
Total $15,000,000 Total $15,000,000
Income Statement
Earnings before taxes $ 3,030,303
Taxes (34%) $ 1,030,303
Net income $ 2,000,000
Shares outstanding 1,000,000
Earnings per share $2
Market price per share $ 20
Total market value $20,000,000
As indicated in Table, National Power earns $2 million after taxes and has 1 million shares
outstanding. Earnings per share are thus $2, and the stock sells for $20, or 10 times earnings
(that is, the price–earnings ratio is 10). To fund a planned expansion, the company intends to
raise $5 million worth of new equity funds through a rights offering.
To execute a rights offering, the financial management of National Power will have to answer
the following questions:
1. What should the price per share be for the new stock?
2. How many shares will have to be sold?
3. How many shares will each shareholder be allowed to buy?
Also, management will probably want to ask this:
4. What is likely to be the effect of the rights offering on the per-share value of the existing
stock?
It turns out that the answers to these questions are highly interrelated. We will get to them in
just a moment.
The early stages of a rights offering are the same as those for the general cash offer. The
difference between a rights offering and a general cash offer lies in how the shares are sold.
In a rights offer, National Power’s existing shareholders are informed that they own one right
for each share of stock they own. National Power will then specify how many rights a
shareholder needs to buy one additional share at a specified price.
To take advantage of the rights offering, shareholders have to exercise the rights by filling out
a subscription form and sending it, along with payment, to the firm’s subscription agent (the
subscription agent is usually a bank). Shareholders of National Power will actually have several
choices: (1) Exercise their rights and subscribe for some or all of the entitled shares, (2) order
some or all of the rights sold, or (3) do nothing and let the rights expire. As we will discuss, this
third course of action is inadvisable.
Number of Rights Needed to Purchase a Share

National Power wants to raise $5 million in new equity. Suppose the subscription price is set at
$10 per share. How National Power arrives at that price we will discuss later; but notice that
the subscription price is substantially less than the current $20 per share market price. At $10
per share, National Power will have to issue 500,000 new shares. This can be determined by
dividing the total amount of funds to be raised by the subscription price:
Funds ¿ be raised ¿
Number of new shares =
Subscription price
5000000
= = 500,000 shares
10
Because stockholders always get one right for each share of stock they own, 1 million rights will
be issued by National Power. To determine how many rights will be needed to buy one new share
of stock, we can divide the number of existing outstanding shares of stock by the number of
new shares:
OldShares
Number of rights needed to buy a share of stock =
New Shares
1000000
= = 2 shares
500000
Thus, a shareholder will need to give up two rights plus $10 to receive a share of new stock. If
all the stockholders do this, National Power will raise the required $5 million. It should be clear
that the subscription price, the number of new shares, and the number of rights needed to buy
a new share of stock are interrelated. For example, National Power can lower the subscription
price. If it does, more new shares will have to be issued to raise $5 million in new equity. Several
alternatives are worked out here:
Subscription Number of Number of Rights Needed

Price New Shares to Buy a Share of Stock
$20 250,000 4
10 500,000 2
5 1,000,000 1
The Value of a Right

Rights clearly have value. In the case of National Power, the right to buy a share of stock worth
$20 for $10 is definitely worth something. In fact, if you think about it, a right is essentially a
call option, and our discussion of such options in later chapters (in the alternate edition of the
text) applies here. The most important difference between a right and an ordinary call option is
that rights are issued by the firm, so they more closely resemble warrants. In general, the
valuation of options, rights, and warrants can be fairly complex, so we defer discussion of this
subject to a later chapter. However, we can discuss the value of aright just prior to expiration
to illustrate some important points.
Suppose a shareholder of National Power owns two shares of stock just before the rights
offering is about to expire. This situation is depicted in Table. Initially, the price of National
Power is $20 per share, so the shareholder’s total holding is worth 2× $20 = $40. The National
Power rights offer gives shareholders with two rights the opportunity to purchase one
additional share for $10. The additional share does not carry a right.
The stockholder who has two shares will receive two rights. The holding of the shareholder who
exercises these rights and buys the new share will increase to three shares. The total
investment will be $40 +10 =$50 (the $40 initial value plus the $10 paid to the company).
The Value of Rights: The Individual Shareholder

Initial Position
Number of shares 2
Share price $20
Value of holding $40
Terms of Offer
Subscription price $10
Number of rights issued 2
Number of rights for a new share 2
After Offer
Number of shares 3
Value of holding $50
Share price $16.67
Value of one right: Old price -New price $20 - 16.67 = $3.33
National Power Company Rights Offering

Initial Position
Number of shares 1 million
Share price $20
Value of firm $20 million
Terms of Offer
Subscription price $10
Number of rights issued 1 million
Number of rights for a new share 2
After Offer
Number of shares 1.5 million
Share price $16.67
Value of firm $25 million
Value of one right $20 - 16.67 = $3.33
The stockholder now holds three shares, all of which are identical because the new share does
not have a right and the rights attached to the old shares have been exercised. Because the
total cost of buying these three shares is $40 +10 =$50, the price per share must end up at
$50/3 =$16.67 (rounded to two decimal places).
Table summarizes what happens to National Power’s stock price. If all shareholders exercise
their rights, the number of shares will increase to 1 million +.5 million =1.5 million. The value of
the firm will increase to $20 million +5 million =$25 million. The value of each share will thus
drop to $25 million/1.5 million =$16.67 after the rights offering.
The difference between the old share price of $20 and the new share price of $16.67 reflects
the fact that the old shares carried rights to subscribe to the new issue. The difference must
be equal to the value of one right—that is, $20 -16.67 =$3.33.
An investor holding no shares of outstanding National Power stock who wants to subscribe to
the new issue can do so by buying some rights. Suppose an outside investor buys two rights. This
will cost $3.33 ×2 =$6.67 (to account for previous rounding). If the investor exercises the
rights at a subscription price of $10, the total cost will be $10 + 6.67 =$16.67. In return for
this expenditure, the investor will receive a share of the new stock, which, as we have seen, is
worth $16.67.
Exercise: In the National Power example, suppose the subscription price is set at $8. How
many shares will have to be sold? How many rights will you need to buy a new share? What is
the value of a right? What will the price per share be after the rights offer?
To raise $5 million, $5 million/8 =625,000 shares will need to be sold. There are 1 million
shares outstanding, so it will take 1 million/625,000 =8/5 =1.6 rights to buy a new share of
stock (you can buy five new shares for every eight you own). After the rights offer, there will
be 1.625 million shares, worth $25 million altogether, so the per-share value will be $25/1.625
=$15.38. The value of a right in this case is the $20 original price less the $15.38 ending price,
or $4.62.
Ex-Rights
National Power’s rights have a substantial value. In addition, the rights offering will have a large
impact on the market price of National Power’s stock. That price will drop by $3.33 on the ex-
rights date. Ex-rights date is the beginning of the period when stock is sold without a recently
declared right, normally two trading days before the holder-of-record date.
The standard procedure for issuing rights involves the firm’s setting a holder-of-record date.
Holder-of-record date is the date on which existing shareholders on company records are
designated as the recipients of stock rights. Also, the date of record. Following stock exchange
rules, the stock typically goes ex rights two trading days before the holder-of-record date. If
the stock is sold before the ex-rights date—“rights on,”“with rights,” or “cum rights”—the new
owner will receive the rights. After the ex-rights date, an investor who purchases the shares
will not receive the rights. This is depicted for National Power in Figure.
As illustrated, on September 30, National Power announces the terms of the rights offering,
stating that the rights will be mailed on, say, November 1 to stockholders of record as of
October 15. Because October 13 is the ex-rights date, only shareholders who own the stock on
or before October 12 will receive the rights.
Exercise: The Lagrange Point Co. has proposed a rights offering. The stock currently sells for
$40 per share. Under the terms of the offer, stockholders will be allowed to buy one new
share for every five that they own at a price of $25 per share. (a) What is the value of a
right? What is the ex-rights price? (b) Suppose the rights sell for only $2 instead of the
$2.50 we calculated. What can you do?
(a) You can buy five rights-on shares for 5 ×$40 =$200 and then exercise the rights for
another $25. Your total investment is $225, and you end up with six ex-rights shares. The ex-
rights price per share is $225/6 =$37.50. The rights are thus worth $40 - 37.50 =$2.50
apiece.
(b) You can get rich quickly because you have found a money machine. Here’s the recipe: Buy
five rights for $10. Exercise them and pay $25 to get a new share. Your total investment to
get one ex-rights share is (5 ×$2)+25 =$35. Sell the share for $37.50 and pocket the $2.50
difference. Repeat as desired.
Figure: Ex-Rights Stock Prices
The Underwriting Arrangements

Rights offerings are typically arranged using standby underwriting. Standby underwriting is the
type of underwriting in which the underwriter agrees to purchase the unsubscribed portion of
the issue.
In standby underwriting, the issuer makes a rights offering, and the underwriter makes a firm
commitment to “take up” (that is, purchase) the unsubscribed portion of the issue. The
underwriter usually gets a standby fee and additional amounts based on the securities taken up.
Standby fee is an amount paid to an underwriter participating in a standby underwriting
agreement.
Standby underwriting protects the firm against under-subscription, which can occur if investors
throw away rights or if bad news causes the market price of the stock to fall below the
subscription price.
In practice, only a small percentage (fewer than 10 percent) of shareholders fail to exercise
valuable rights. This failure can probably be attributed to ignorance or vacations. Furthermore,
shareholders are usually given an oversubscription privilege, which enables them to purchase
unsubscribed shares at the subscription price. The oversubscription privilege makes it unlikely
that the corporate issuer would have to turn to its underwriter for help. Oversubscription
privilege is a privilege that allows shareholders to purchase unsubscribed shares in a rights
offering at the subscription price.
Effects on Shareholders
Shareholders can exercise their rights or sell them. In either case, the stockholder will neither
win nor lose because of the rights offering. The hypothetical holder of two shares of National
Power has a portfolio worth $40. If the shareholder exercises the rights, she or he ends up
with three shares worth a total of $50. In other words, with an expenditure of $10, the
investor’s holding increases in value by $10, which means the shareholder is neither better nor
worse off. On the other hand, if the shareholder sells the two rights for $3.33 each, he or she
would obtain $3.33 ×2 =$6.67 and end up with two shares worth $16.67 and the cash from
selling the right:
Shares held =2 ×$16.67 =$33.33
Rights sold =2 ×$3.33 =6.67
Total =$40.00
The new $33.33 market value plus $6.67 in cash is exactly the same as the original holding of
$40. Thus, stockholders cannot lose or gain by exercising or selling rights. It is obvious that
after the rights offering, the new market price of the firm’s stock will be lower than the price
before the rights offering. As we have seen, however, stockholders have suffered no loss
because of the rights offering. The lower the subscription price, the greater is the price
decline resulting from a rights offering. Because shareholders receive rights equal in value to
the price drop, the rights offering does not hurt stockholders.
There is one last issue. How do we set the subscription price in a rights offering? If you think
about it, you will see that the subscription price really does not matter. It has to be below the
market price of the stock for the rights to have value; but beyond this, the price is arbitrary.
In principle, it could be as low as we cared to make it as long as it was not zero. In other words,
it is impossible to underprice a rights offer.
Concept Questions
 How does a rights offering work? What are the reasons for right share?
 What questions must financial managers answer in a rights offering?
 How is the value of a right determined?
 When does a rights offering affect the value of a company’s shares?
 Does a rights offering cause share prices to decrease? How are existing shareholders
affected by a rights offering?
6.8. Dividend Irrelevance Theory

The residual theory of dividends implies that if the firm cannot invest its earnings to earn a
return that exceeds the cost of capital, it should distribute the earnings by paying dividends to
stockholders. This approach suggests that dividends represent an earnings residual rather than
an active decision variable that affects the firm’s value. Such a view is consistent with the
dividend irrelevance theory put forth by Merton H. Miller and Franco Modigliani (M and M).
They argue that the firm’s value is determined solely by the earning power and risk of its assets
(investments) and that the manner in which it splits its earnings stream between dividends and
internally retained (and reinvested) funds does not affect this value. M and M’s theory suggests
that in a perfect world (certainty, no taxes, no transactions costs, and no other market
imperfections), the value of the firm is unaffected by the distribution of dividends.
Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani and
Miller’s original theory. One market imperfection that may be important is taxation. Historically,
dividends have usually been taxed at higher rates than capital gains. A firm that pays out its
earnings as dividends may trigger higher tax liabilities for its investors than a firm that retains
earnings. As a firm retains earnings, its share price should rise, and investors enjoy capital
gains. Investors can defer paying taxes on these gains indefinitely simply by not selling their
shares. Even if they do sell their shares, they may pay a relatively low tax rate on the capital
gains. In contrast, when a firm pays dividends, investors receive cash immediately and pay taxes
at the rates dictated by then-current tax laws.
Even though this discussion makes it seem that retaining profits rather than paying them out as
dividends may be better for shareholders on an after-tax basis, Modigliani and Miller argue that
this assumption may not be the case. They observe that not all investors are subject to income
taxation. Some institutional investors, such as pension funds, do not pay taxes on the dividends
and capital gains that they earn. For these investors, the payout policies of different firms have
no impact on the taxes that investors have to pay. Therefore, Modigliani and Miller argue, there
can be a clientele effect in which different types of investors are attracted to firms with
different payout policies due to tax effects. Tax-exempt investors may invest more heavily in
firms that pay dividends because they are not affected by the typically higher tax rates on
dividends. Investors who would have to pay higher taxes on dividends may prefer to invest in
firms that retain more earnings rather than paying dividends. If a firm changes its payout
policy, the value of the firm will not change; instead, what will change is the type of investor
who holds the firm’s shares. According to this argument, tax clienteles mean that payout
policies cannot affect firm value, but they can affect the ownership base of the company.
In summary, M and M and other proponents of dividend irrelevance argue that, all else being
equal, an investor’s required return—and therefore the value of the firm—is unaffected by
dividend policy. In other words, there is no “optimal” dividend policy for a particular firm.
Residual Dividend Policy
The residual theory of dividends is a school of thought that suggests that the dividend paid by a
firm should be viewed as a residual, that is, the amount left over after all acceptable investment
opportunities have been undertaken. Using this approach, the firm would treat the dividend
decision in three steps as follows:
Step 1 Determine its optimal level of capital expenditures, which would be the level that
exploits all a firm’s positive NPV projects.
Step 2 Using the optimal capital structure proportions, estimate the total amount of equity
financing needed to support the expenditures generated in Step 1.
Step 3 Because the cost of retained earnings, rr , is less than the cost of new common stock, r n ,
use retained earnings to meet the equity requirement determined in Step 2.
If retained earnings are inadequate to meet this need, sell new common stock. If the available
retained earnings are in excess of this need, distribute the surplus amount—the residual—as
dividends. According to this approach, as long as the firm’s equity need exceeds the amount of
retained earnings, no cash dividend is paid. The argument for this approach is that it is sound
management to be certain that the company has the money it needs to compete effectively. This
view of dividends suggests that the required return of investors, r s , is not influenced by the
firm’s dividend policy, a premise that in turn implies that dividend policy is irrelevant in the
sense that it does not affect firm value.
Review Question
 Explain dividend irrelevance theory.
 Explain clientele effect.
 What is residual dividend policy?
Modigliani and Miller Model of Dividend
Modigliani-Miller’s theory is a major proponent of the ‘dividend irrelevance’ notion. According to

this concept, investors do not pay any importance to the dividend history of a company, and
thus, dividends are irrelevant in calculating the valuation of a company. MM theory on dividend
policy is in direct contrast to the ‘dividend relevance’ theory which deems dividends to be
important in the valuation of a company.
(i) Crux of Modigliani-Miller Model
Modigliani-Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They
were the pioneers in suggesting that dividends and capital gains are equivalent when an investor
considers returns on investment. The only thing that impacts the valuation of a company is its
earnings, which are a direct result of the company’s investment policy and future prospects. So,
according to this theory, once the investor knows the investment policy, he will not need any
additional input on the company’s dividend history. The investment decision is, thus, dependent
on the investment policy of the company and not on the dividend policy.
MM theory goes a step further and illustrates the practical situations where dividends are not
relevant to investors. Irrespective of whether a company pays a dividend or not, the investors
are capable enough to make their own cash flows from the stocks depending on their need for
the cash. If the investor needs more money than the dividend he received, he can always sell a
part of his investments to make up for the difference. Likewise, if an investor has no present
cash requirement, he can always reinvest the received dividend in the stock. Thus, the MM
theory on dividend policy firmly states that a company’s dividend policy does not influence the
investment decisions of the investors.
This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic,
external financing offsets the dividend’s distribution to shareholders. Due to the distribution
of dividends, the stock price decreases and will nullify the gain made by the investors because
of the dividends.
(ii) Assumptions of the Model
Modigliani-Miller’s theory is based on the following assumptions:
Perfect Capital Markets. This theory believes in the existence of “perfect capital markets.” It
assumes that all the investors are rational, they have access to free information, there are no
flotation or transaction costs, and no large investor to influence the market price of the share.
No Taxes. There is no existence of taxes. Alternatively, the tax rate for both dividends and
capital gains is the same.
Fixed Investment Policy. The company does not change its existing investment policy. It means
whatever may be the dividend payment, the company will invest as it has already decided upon.
If the company is going to pay more amount of dividends, then it will have more equity shares
and vice versa.
No-Risk of Uncertainty. All the investors are certain about the future market prices and the
dividends. This means that the same discount rate is applicable for all types of stocks in all time
periods.
Investor is Indifferent between Dividend Income and Capital Gain Income. It is assumed
that investor is indifferent between dividend income and capital gain income. It means if he
requires the total return of Rs. 500, he may get Rs. 200 dividend income and Rs. 300 as capital
gain income or reverse. In either of the case, he gets equal satisfaction.
(iii) Valuation Formula and its Denotations
MM theory on dividend policy is based on the assumption of the same discount rate/rate of
return applicable to all the stocks.
P1 = Market price of the share at the

Expected Market
end of a period
price of the share at
P1=[ P 0 × ( 1+ K e ) ]−D1 P0 = market price of the share at the
the end of a period beginning of a period
ke= cost of capital
D1 = dividends received at the end of
a period
I = Investment to be made at the
Number of additional I−( E−n D1)
∆ n= end of the year
shares to be issued P1
E = Earning
n = Number of Outstanding Equity
shares at the beginning of the year
D1= Dividend Paid to existing
shareholders at the end of the year
Value of the firm ( n+ ∆ n ) P 1−I + E ∆n = number of additional shares to

n P 0=
(1+ K e ) be issued
(iv) Criticism of Modigliani Miller’s Model
MM theory on dividend policy suffers from the following limitations:
 Perfect capital markets do not exist. Taxes are present in the capital markets.
 According to this theory, there is no difference between internal and external financing.
However, on considering the flotation costs of new issues, it is false.
 This theory believes that the dividends do not affect the shareholder’s wealth.
However, there are transaction costs associated with the selling of shares to make cash
inflows. This makes the investors prefer dividends.
 The assumption of no uncertainty is unrealistic. The dividends are relevant under certain
conditions as well.
Modigliani – Miller’s theory of dividend policy is an interesting and different approach to the
valuation of shares. It is a popular model that believes in the irrelevance of dividends. However,
the policy suffers from various important limitations and thus, is critiqued regarding its
assumptions. The bird in hand theory by Myron Gordon and John Lintner is in response to this
theory and talks about investors’ concern in preferring dividends rather than capital gains.
(v)Homemade Dividends
Investors are able to transform the corporation’s dividend policy into a different policy by
buying or selling on their own. The result is that investors are able to create a homemade
dividend policy. This means that dissatisfied stockholders can alter the firm’s dividend policy to
suit themselves. As a result, there is no particular advantage to any one dividend policy the firm
might choose.
Many corporations actually assist their stockholders in creating homemade dividend policies by
offering automatic dividend reinvestment plans (ADRs or DRIPs). McDonald’s, Wal-Mart, Sears,
and Procter & Gamble, plus over 1,000 more companies, have set up such plans, so they are
relatively common. As the name suggests, with such a plan, stockholders have the option of
automatically reinvesting some or all of their cash dividend in shares of stock. In some cases,
they actually receive a discount on the stock, which makes such a plan very attractive.
Example:
Suppose individual investor X prefers dividends per share of $100 at both Dates 1 and 2. Would
she be disappointed if informed that the firm’s management was adopting the alternative
dividend policy (dividends of $110 and $89 on the two dates, respectively)? Not necessarily,
because she could easily reinvest the $10 of unneeded funds received on Date 1 by buying some
more Wharton stock. At 10 percent, this investment would grow to $11 by Date 2. Thus, X would
receive her desired net cash flow of $110 - 10 = $100 at Date 1 and $89 + 11 = $100 at Date 2.
Conversely, imagine that an investor Z, preferring $110 of cash flow at Date 1 and $89 of cash
flow at Date 2, finds that management will pay dividends of $100 at both Dates 1 and 2. This
investor can simply sell $10 worth of stock to boost his total cash at Date 1 to $110. Because
this investment returns 10 percent, Investor Z gives up $11 at Date 2 ($10 × 1.1), leaving him
with $100 - 11 = $89.
Concept Questions:
 How can an investor create a homemade dividend?
 Are dividends irrelevant?
 What is MM model of dividend? What is the assumption and criticism of MM model of
dividend?
 What is homemade dividend policy?
Example:
A company belongs to the risk class for which the appropriate capitalization rate is 10%. It
currently has 25,000 shares outstanding selling at Rs. 100 each. The firm is contemplating the
declaration of dividend of Rs. 5 per share at the end of the current financial year. The
company expects to have a net income of Rs. 2.5 lacs and a proposal for making new
investments of Rs. 5 lacs. Show that under MM assumptions the payment of dividend does not
affect the value of the firm.
Solution:
a. Value of the firm when dividends are paid
1. Expected Market price of the share at the end of a period
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.10)] – Tk. 5 = Tk. 105
2. Amount Required to be raised from the issue of new shares
∆ n P1=¿I-(E-nD1) = Tk. 500000 – (Tk. 250000 – Tk. 125000) = 375000
3. Number of additional shares to be issued
I −(E−n D1) 375000

∆ n= = = 3571.43
P1 105
4. Value of the firm
( n+ ∆ n ) P 1−I+ E ( 25000+3571.43 ) 105−500000+250000

n P 0= = = 2500000
(1+ K e ) 1.10
b. Value of the firm when dividends are not paid

P1=[ P 0 × ( 1+ K e ) ]−D1 = [Tk. 100 + (1 + 0.10)] - 0 = Tk. 110

2. Amount Required to be raised from the issue of new shares
∆ n P1=¿ I-(E-nD1) = Tk. 500000 – (Tk. 250000 – Tk. 25000 × 0) = 250000

I −(E−n D1) 250000

∆ n= = = 2272.73
P1 110
( n+ ∆ n ) P 1−I+ E ( 25000+2272.73 ) 110−500000+250000

n P 0= = = 2500000
(1+ K e ) 1.10
6.9. Dividend Relevance Theory
Modigliani and Miller’s assertion that dividend policy was irrelevant was a radical idea when it
was first proposed. The prevailing wisdom at the time was that payout policy could improve the
value of the firm and therefore was relevant. The key argument in support of dividend relevance
theory is attributed to Myron J. Gordon and John Lintner, who suggest that there is
a direct relationship between the firm’s dividend policy and its market value. Fundamental to
this proposition is their bird-in-the-hand argument, which suggests that investors see current
dividends as less risky than future dividends or capital gains: “A bird in the hand is worth two in
the bush.” Gordon and Lintner argue that current dividend payments reduce investor
uncertainty, causing investors to discount the firm’s earnings at a lower rate and, all else being
equal, to place a higher value on the firm’s stock. Conversely, if dividends are reduced or are not
paid, investor uncertainty will increase, raising the required return and lowering the stock’s
value.
Studies have shown that large changes in dividends do affect share price. Increases in dividends
result in increased share price, and decreases in dividends result in decreased share price. One
interpretation of this evidence is that it is not the dividends per se that matter but rather the
informational content of dividends with respect to future earnings. In other words, investors
view a change in dividends, up or down, as a signal that management expects future earnings to
change in the same direction. Investors view an increase in dividends as a positive signal, and
they bid up the share price. They view a decrease in dividends as a negative signal that causes
investors to sell their shares, resulting in the share price decreasing.
Another argument in support of the idea that dividends can affect the value of the firm is the
agency cost theory. Recall that agency costs are costs that arise due to the separation between
the firm’s owners and its managers. Managers sometimes have different interests than owners.
Managers may want to retain earnings simply to increase the size of the firm’s asset base.
There is greater prestige and perhaps higher compensation associated with running a larger
firm. Shareholders are aware of the temptations that managers face, and they worry that
retained earnings may not be invested wisely. The agency cost theory says that a firm that
commits to paying dividends is reassuring shareholders that managers will not waste their
money. Given this reassurance, investors will pay higher prices for firms that promise regular
dividend payments.
Although many other arguments related to dividend relevance have been put forward, empirical
studies have not provided evidence that conclusively settles the debate about whether and how
payout policy affects firm value. As we have already said, even if dividend policy really matters,
it is almost certainly less important than other decisions that financial mangers make, such as
the decision to invest in a large new project or the decision about what combination of debt and
equity the firm should use to finance its operations. Still, most financial managers today,
especially those running large corporations, believe that payout policy can affect the value of
the firm.
Bird in the Hand Theory (Gordon Model)
Myron Gordon and John Lintner both argued that a stock’s risk declines as dividends increase: A
return in the form of dividends is a sure thing, but a return in the form of capital gains is risky.
In other words, a bird in the hand is worth more than two in the bush. Therefore, shareholders
prefer dividends and are willing to accept a lower required return on equity. The key argument in
support of dividend relevance theory is attributed to Myron J. Gordon and John Lintner, who
suggest that there is a direct relationship between the firm’s dividend policy and its market
value. Fundamental to this proposition is their bird-in-the-hand argument, which suggests that
investors see current dividends as less risky than future dividends or capital gains: “A bird in
the hand is worth two in the bush.” Gordon and Lintner argue that current dividend payments
reduce investor uncertainty, causing investors to discount the firm’s earnings at a lower rate
and, all else being equal, to place a higher value on the firm’s stock. Conversely, if dividends are
reduced or are not paid, investor uncertainty will increase, raising the required return and
lowering the stock’s value.
The presence of agency costs leads to a similar conclusion. First, high payouts reduce the risk
that managers will squander cash because there is less cash on hand. Second, a high-payout
company must raise external funds more often than a low-payout company, all else held equal. If
a manager knows that the company will receive frequent scrutiny from external markets, then
the manager will be less likely to engage in wasteful practices. Therefore, high payouts reduce
the risk of agency costs. With less risk, shareholders are willing to accept a lower required
return on equity.
(i) Crux of Gordon’s Model

Myron Gordon’s model explicitly relates the company’s market value to its dividend policy. The
determinants of the market value of the share are the perpetual stream of future dividends to
be paid, the cost of capital, and the expected annual growth rate of the company.
(ii) Assumption:
Gordon’s model is based on the following assumptions:
No Debt. The model assumes that the company is an all-equity company, with no proportion of
debt in the capital structure.
No External Financing. The model assumes that retained earnings finance all investments of the
company, and no external financing is required.
Constant IRR. The model assumes a constant Internal Rate of Return (r), ignoring the
diminishing marginal efficiency of the investment.
Constant Cost of Capital. The model is based on the assumption of a constant cost of capital
(k), implying the business risk of all the investments to be the same.
Perpetual Earnings. Gordon’s model believes in the theory of perpetual earnings for the
company.
Corporate Taxes. This model does not account for corporate taxes.
Constant Retention Ratio. The model assumes a constant retention/plowback ratio (b) once it is
decided by the company. Since the growth rate (g) = b*r, the growth rate is also constant by
this logic.
k>g. Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for
obtaining the meaningful value of the company’s share.
(iii) Valuation Formula of Gordon’s Model and its Denotations

Gordon’s formula to calculate the market price per share (P)
EPS = Earnings Per Share
is
Ks =Cost of Equity
D1 EPS (1−b) EPS(1−b) r = Internal Rate of Return
P0= = = b = Retention Ratio
k s−g K s−g K s−b × r
D1= Expected Dividend
(iv) Relation of Dividend Decision and Value of a Firm
Gordon’s theory on dividend policy states that the
company’s dividend payout policy and the relationship between its rate of return (r) and the cost
of capital (k) influence the market price per share of the company.
Relationship between r and k Increase in Dividend Payout
r>k Price per share decreases
r<k Price per share increases
r=k No change in the price per share
(v) Implications of Gordon’s Model

Gordon’s model believes that the dividend policy impacts the company in various scenarios as
follows:
Growth Firm (A growth firm’s internal rate of return (r) > cost of capital (k)). It benefits
the shareholders more if the company reinvests the dividends rather than distributing them.
So, the optimum payout ratio for growth firms is zero.
Normal Firm (A normal firm’s internal rate of return (r) = cost of the capital (k)).So, it
does not make any difference if the company reinvests the dividends or distributes them to its
shareholders. So, there is no optimum dividend payout ratio for normal firms. However, Gordon
later revised this theory and stated that the firm’s dividend policy impacts the market value
even when r=k. Investors will always prefer a share with more current dividend payments.
Declining Firm (The internal rate of return (r) < cost of the capital (k) in the declining
firms).The shareholders will get more benefits if the company distributes the dividends rather
than reinvesting them. So, the optimum dividend payout ratio for declining firms is 100%.
Growth Firm Normal firm Declining firm
r>k r=k r<k
r = 0.15 r = 0.10 r = 0.08
k = 0.10 k = 0.10 k = 0.10
EPS = Tk. 10 EPS = Tk. 10 EPS = Tk. 10
Payout ratio = 40% & Retention ratio = 60%
g = b × r = 0.6 × 0.15 = 0.09 g = b × r = 0.6 × 0.10 = 0.06 g = b × r = 0.6 × 0.08 = 0.048
P= 10 (1-0.6)/(0.10-0.09) P= 10 (1-0.6)/(0.10-0.06) P= 10 (1-0.6)/(0.10-0.048)
= Tk. 400 = Tk. 100 = Tk. 76.92
g = b × r = 0.4 × 0.15 = 0.06 g = b × r = 0.4 × 0.10 = 0.04 g = b × r = 0.4 × 0.08 = 0.032
P= 10 (1-0.4)/(0.10-0.06) P= 10 (1-0.4)/(0.10-0.04) P= 10 (1-0.4)/(0.10-0.032)
= Tk. 150 = Tk. 100 = Tk. 88.24
g = b × r = 0.1 × 0.15 = 0.015 g = b × r = 0.1 × 0.10 = 0.01 g = b × r = 0.1 × 0.08 = 0.008
P= 10 (1-0.1)/(0.10-0.015) P= 10 (1-0.1)/(0.10-0.01) P= 10 (1-0.1)/(0.10-0.008)
= Tk. 105 = Tk. 100 = Tk. 97.83
For a growth firm, the lowest payout gives the highest stock price of the company. So, the
growth firm should retain all of its profits
For a normal firm, dividend payout has the no impact on stock price.
For a declining firm, the highest payout gives the highest stock price of the company. So,
declining firm should pay all of its profits.
Criticism of Gordon’s Model

The main criticism of Gordon’s theory on dividend policy is due to unrealistic assumptions made
in the model.
Constant Internal Rate of Return and Cost of Capital. The model is inaccurate in assuming
that r and k always remain constant. A constant r means that the wealth of the shareholders is
not optimized. A constant k means the business risks are not accounted for while valuing the
firm.
No External Financing. Gordon’s belief that all investments being financed by retained earnings
is faulty. This reflects the sub-optimum investment and dividend policies.
(vi) Modigliani and Miller View of Gordon Model

Modigliani and Miller argued that the bird-in-the-hand theory was a fallacy. They said that
investors who want immediate cash flow from a firm that did not pay dividends could simply sell
off a portion of their shares. Remember that the stock price of a firm that retains earnings
should rise over time as cash builds up inside the firm. By selling a few shares every quarter or
every year, investors could, according to Modigliani and Miller, replicate the same cash flow
stream that they would have received if the firm had paid dividends rather than retaining
earnings.
Review Questions
 Contrast the basic arguments about dividend policy advanced by Miller and Modigliani (M
and M) and by Gordon and Lintner.
 Explain Gordon’s Model with its Assumptions and Criticisms.
 What is Relation of Dividend Decision and Value of a Firm in case of Gordon model? What
are the implications of Gordon’s Model?
 What is Modigliani and Miller View of Gordon Model?
Walter Model
According to the Walter’s Model, given by Professor James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be
separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal rate
of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects
the overall value of the firm. The efficiency of dividend policy can be shown through a
relationship between returns and the cost.
If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The firms with
more returns than a cost are called the “Growth firms” and have a zero payout ratio.
If r<K, the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout ratio is 100%.
If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent
towards how much is to be retained and how much is to be distributed among the shareholders.
The payout ratio can vary from zero to 100%.
(i) Assumptions of Walter’s Model
1. All the financing is done through the retained earnings; no external financing is used.
2. The rate of return (r) and the cost of capital (K) remain constant irrespective of any
changes in the investments.
3. All the earnings are either retained or distributed completely among the shareholders.
4. The earnings per share (EPS) and Dividend per share (DPS) remains constant.
5. The firm has a perpetual life.
Formula: EPS = Earnings Per Share
Ks =Cost of capital/ Capitalization Rate
P0=
DPS + ( kr )( EPS−DPS ) r = Internal Rate of Return
b = Retention Ratio
k D1= Expected Dividend
(ii) Implications of Walter Model
Growth Firm Normal firm Declining firm

r>k r=k r<k
r = 0.15 r = 0.10 r = 0.08
k = 0.10 k = 0.10 k = 0.10
EPS = Tk. 10 EPS = Tk. 10 EPS = Tk. 10
DPS = TK. 0 DPS = TK. 0 DPS = TK. 0
P 0=
0+ ( 0.15
0.10 )
( 10−0 )
P0=
0+ ( 0.10
0.10 )
( 10−0 )
P0=
0+ ( 0.08
0.10 )
( 10−0 )
0.10 0.10 0.10

= Tk. 150 = Tk. 100 = Tk. 80
P 0=
4+ ( 0.15
0.10 )
(10−4 )
P0=
4+ ( 0.10
0.10 )
(10−4 )
P 0=
4+ ( 0.08
0.10 )
(10−4 )
0.10 0.10 0.10

= Tk. 130 = Tk. 100 = Tk. 88
P 0=
10+ ( 0.15
0.10 )
(10−10 )
P0=
10+ ( 0.10
0.10 )
(10−10 )
P0=
10+ ( 0.08
0.10 )
(10−10 )
0.10 0.10 0.10

= Tk. 100 = Tk. 100 = Tk. 100
For a growth firm, 0 payout gives the highest stock price of the company. So, the growth firm
should retain all of its profits
For a normal firm, dividend payout has the no impact on stock price.
And for a declining firm, the highest payout gives the highest stock price of the company. So,
declining firm should pay all of its profits.
(iii) Criticism of Walter’s Model
1. It is assumed that the investment opportunities of the firm are financed through the
retained earnings and no external financing such as debt, or equity is used. In such a case
either the investment policy or the dividend policy or both will be below the standards.
2. The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of
return (r) is constant, but, however, it decreases with more investments.
3. It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic
since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
Review Questions
 Explain Walter Model with its Assumptions and Criticisms.
 What are the implications of Walter Model?
 Differentiate between Gordon model and Walter model.
Tax Effect Theory: Capital Gains Are Preferred
Before 2003, individual investors paid ordinary income taxes on dividends but lower rates on
long-term capital gains. The Jobs and Growth Act of 2003 changed this, reducing the tax rate
on dividend income to the same as on long-term capital gains.
However, there are two reasons why stock price appreciation still is taxed more favorably
than dividend income.
First, an increase in a stock’s price isn’t taxable until the investor sells the stock, whereas a
dividend payment is taxable immediately; a dollar of taxes paid in the future has a lower
effective cost than a dollar paid today because of the time value of money. So even when
dividends and gains are taxed equally, capital gains are never taxed sooner than dividends.
Second, if a stock is held until the shareholder dies, then no capital gains tax is due at all: The
beneficiaries who receive the stock can use its value on the date of death as their cost basis
and thus completely escape the capital gains tax.
If dividends are taxed more highly than capital gains, there is a dividend tax penalty, causing
investors to require a higher pre-tax rate of return on dividend paying stocks relative to non-
dividend stocks. All else equal, investors should be willing to pay more for low-payout companies
than for otherwise similar high-payout companies. Therefore, the tax effect theory states
that investors prefer that companies minimize dividends.
Dividend Signaling Theory
When MM set forth their dividend irrelevance theory, they assumed that everyone— investors
and managers alike—has identical information regarding a firm’s future earnings and dividends.
In reality, however, different investors have different views on both the level of future
dividend payments and the uncertainty inherent in those payments, and managers have better
information about future prospects than public stockholders.
It has been observed that an increase in the dividend is often accompanied by an increase in the
price of a stock and that a dividend cut generally leads to a stock price decline. Some have
argued this indicates that investors prefer dividends to capital gains. However, MM saw this
differently. They noted the well-established fact that corporations are reluctant to cut
dividends, which implies that corporations do not raise dividends unless they anticipate higher
earnings in the future.
MM argued that a higher-than-expected dividend increase is a signal to investors that the
firm’s management forecasts good future earnings. Conversely, a dividend reduction, or a
smaller-than-expected increase, is a signal that management is forecasting poor earnings in the
future. Thus, MM argued that investors’ reactions to changes in dividend policy do not
necessarily show that investors prefer dividends to retained earnings. Rather, they argue that
price changes following dividend actions simply indicate that dividend changes convey
information. This is called the dividend signaling hypothesis; it is also called the dividend
information content hypothesis.
The initiation of a dividend by a firm that formerly paid no dividend is certainly a significant
change in distribution policy. It appears that initiating firms’ future earnings and cash flows are
less risky than before the initiation. However, the evidence is mixed regarding the future
profitability of initiating firms: Some studies find slightly higher earnings after the initiation
but others find no significant change in earnings.
All in all, there is clearly some information content in dividend announcements: Stock prices
tend to fall when dividends are cut, even if they don’t always rise when dividends are increased.
However, this doesn’t necessarily validate the signaling hypothesis, because it is difficult to tell
whether any stock price change following a change in dividend policy reflects only signaling
effects or reflects both signaling and dividend preferences.
 What happens when firms with existing dividends unexpectedly increase or decrease the
dividend?
Early studies, using small data samples, concluded that unexpected dividend changes did not
provide a signal about future earnings. However, more recent data with larger samples provide
mixed evidence. On average, firms that cut dividends had poor earnings in the years directly
preceding the cut but actually improved earnings in subsequent years. Firms that increased
dividends had earnings increases in the years preceding the increase but did not appear to have
subsequent earnings increases. However, neither did they have subsequent declines in earnings,
so it appears that the increase in dividends is a signal that past earnings increases were not
temporary. Also, a relatively large number of firms that expect a large permanent increase in
cash flow (as opposed to earnings) do in fact increase their dividend payouts in the year prior to
the cash flow increase.
Review Questions
 Explain tax effect theory in detail.
 What is dividend signalling theory?
 What happens when firms with existing dividends unexpectedly increase or decrease the
dividend?
6.10. Problems and Solutions
Stock Dividend, Stock Split and Reverse Stock Split

P-01 (NU BBA Hon's)- 2014:The ABC Ltd. Shareholders equity account (book value) of Dec. 31,
2005 is as follows:
Details Taka
Common stock capital (Tk. 5 per value) 50,00,000
Additional paid in capital 50,00,000
Retained earnings 1,50,00,000
Total shareholders' equity 2,50,00,000
Currently the company is under pressure from shareholders to pay some dividends. Company cash
balance is Tk. 5,00,000 all of which is needed for transactions purpose. The current market price
of common stock is Tk. 7 per share.
Required: (a) Reformulated the company equity accounts if company pay 25% stock dividends.
(b) Reformulated the company equity accounts if company declares 2 for 1 stock split;
Solution:
(a) Old Number of Share outstanding = (5000000/5) = 1000000
Total New Number of Share outstanding after 15% Stock dividend
= 100000 + (100000 × 25%)
= 1250000 Shares
= Tk. 1750000

Common stock (5000000 + (250000 × 5) Tk. 6250000
Additional paid in capital (5000000 + (250000 × 2) Tk. 5500000
Retained earnings (15000000 - 1750000) Tk. 1,3250000
Total shareholder's’ equity Tk. 25000000
(b) Old number of shares = 1000000

New number of shares = (1000000/1) × 2 = 2000000
Old book value per share = 5
New book value per share = (5/2) × 1 = 2.5
Equity Position after 2:1 Stock Split

Details Taka
Common stock capital (2000000× Tk. 2.5) 50,00,000
Additional paid in capital 50,00,000
Total shareholders' equity 2,50,00,000
Market price per share = (1000000 × 7)/2000000 = Tk. 3.5

P-02 (BBA Professional-2016):Bd Thai Ltd. Stock holder's equity account is as follows:
Common stock Capital (5,00,000 share @Tk 10) Tk. 50,00,000
Additional paid in capital Tk. 50,00,000
Retained earnings Tk. 1,00,00,00
Total shareholders' equity Tk.2,00,00,000
The company has a cash balance of Tk. 10,00,000. The current market price of share is Tk. 12
each.
(a) Reformulate shareholders equity account if the company pay a 25% stock dividend.
(b) Reformulate the shareholders equity account if the company declares a 4 for 2 stock split.
Solutions:
(a) 25% stock dividend
Old Number of Share outstanding = 5000000
= 500000 + (500000 × 25%)
= 6250000 Shares
= Tk. 1500000

Common stock (5000000 + (125000 × 10) Tk. 6250000
Retained earnings (10000000 - 1500000) Tk. 8500000

New book value per share = (10/4) × 2 = 5

Common stock Capital (1000000 share ×Tk. 5) Tk. 5000000
Additional paid in capital Tk. 5000000
Retained earnings Tk. 1000000
Total shareholders' equity Tk.20000000
Market price per share = (12× 500000)/1000000 = Tk. 6
P-03 (BBA Professional-2019): Anand Computers Ltd. Has the following equity capital account.
Particulars Tk.
Common stock (@ Tk. 20 each) 40,00 000
Additional Paid in capital 50,00,000
Total capital 8,90,00,000
The current market price per share is Tk. 40, what would happen to the equity capital account: (a)
If the company declare 10% stock dividend (b) If the company declared 3 for 2 stock split. (c)If
there were reverse stock split of 1 for 4.
Solution:
(a)Old Number of Share outstanding = 4000000/20 = 200000
= 200000 + (200000 × 10%)
= 220000 Shares
= Tk. 800000

Common stock (4000000 + (20000 × 20) Tk. 4400000


Particulars Tk.
Common stock (300000 × Tk. 13.33333) 40,00 000
(C) 1 for 4 reverse stock split

Old number of shares = 200000
Equity Position after 1:4Reverse Stock Split
Particulars Tk.
Common stock (50000 × Tk. 80) 40,00 000
Market price per share = (200000 × 40)/50000 = Tk. 160
P-04: You are supplied with the following capital structure of ABC company limited:
Common stock (Tk. 100 per share) Tk. 10,00,000
Retained earnings TK. 40,00,000
Total capital Tk. 54,00,000
The current market price per share Tk. 300.What will be the account and the number of shares
outstanding with (1) 10% stock dividend (2) 2 for 1 stock split (3) 1 for 2 reverse stock split.
Solution:
(a) Old Number of Share outstanding = 1000000/100 = 10000
= 10000 + (10000 × 10%)
= 11000 Shares
= Tk. 300000

Common stock (1000000 + (1000 × 100) Tk. 1100000
(b)2 for 1 stock split


Common stock (20000 ×Tk. 50) Tk. 10,00,000
(C) 1 for 2 reverse stock split

Equity Position after 1:2Reverse Stock Split

Common stock (5000 ×Tk. 200) Tk. 10,00,000
P-05: MIM company Ltd. has 20,00,000 shares of common stock outstanding in market and present
market price is Tk. 125. Its equity structure is as follows:
Common stock (Tk. 50 each) Tk. 10,00,00,000
Paid in capital Tk. 15,00,00,000
Total fund Tk. 65,00,00,000
Requirement: (a) If company declares 10% stock dividend, what would happen to these equity
structure? (b)What would happen to the account if the company declares 3 for 2 stock split? (c)
What would happen if there is a reverse stock split of 1 for 4?
Solution:
(a) Old Number of Share outstanding = 100000000/50 = 200000
= 2000000 + (2000000 × 10%)
= 2200000 Shares
= Tk. 25000000

Common stock (100000000 + 10000000) Tk. 110000000
Paid in capital (150000000 + 15000000) Tk. 165000000
Total fund Tk. 650000000


Common stock (3000000 × Tk. 50) Tk. 10,00,00,000
(c) Old number of shares = 2000000

Equity Position after 1:4 Reverse Stock Split

Common stock (500000 × Tk. 200) Tk. 10,00,00,000

P-06: Karnafuli paper Mills Ltd. has the following shareholders equity statement:-
Sources of Capital Amount/Taka
Preferred stock 5,00,000
Common stock (10,000 shares at Tk. 100) 10,00,000
Additional paid up capital 12,00,000
Total 29,30,000
Show the effect of:(a) 5% stock dividend;(b) 10% stock dividend, on the equity statement of
Karnafuli paper.
Solution:(a)5% Stock dividend

(a) Old Number of Share outstanding = 10000
Total New Number of Share outstanding after declaring 5% Stock dividend
= 10000 + (10000 × 5%)
= 10500 Shares
Market Value of New total Share = (500 × 107.25)
= Tk. 53625
New Common Stock = 500 × 100 = 50000
Additional Paid in Capital = 500 × 7.25 = 3625

Preferred stock Tk. 500000
Common stock (50000 + 1000000) Tk. 1050000
Additional paid up capital (1200000 + 3625) Tk. 1203625
Total Tk. 2930000
(b) 10% Stock dividend effect on Balance Sheet

Old Number of Share outstanding = 10000
= 10000 + (10000 × 10%)
= 11000 Shares
= Tk. 107250
New Common Stock = 1000 × 100 = 100000


Preferred stock Tk. 500000
Common stock (1000000 + 100000) Tk. 1100000
Additional paid up capital (1200000 + 7250) Tk. 1207250
Total Shareholders' equity Tk. 2930000
P-07: Nazia company has 4 million shares of common stock outstanding and earnings per share is
Tk. 5. Nazia has a dividend payout ratio of 40%. The firm is considering a 2 for 1 stock to lower
the price of common stock from Tk. 150 per share to a more attractive level. What will be the
effect of stock split on: (a) EPS; (b) Price per share after Stock Split
Solution:
Net income
Old EPS =
Old Number of Share Outstandings
5 = Net income/ 4000000 = 20000000
Net income
New EPS = = (20000000/ 8000000) = 2.5
New Number of ShareOutstandings
P-08: Rafi Ltd. has the following stockholders account:

Common stock (Tk. 10 per share) Tk.10,00,000
10%preferred stock Tk. 8,00,000
Retained earnings Tk. 7,00,000
Total shareholder’s equity Tk. 25,00,000
Requirement: What will happen to this account and to the number of shares outstanding with? (a) A
10% stock dividend (b) A 2 for 1 stock-split (c) A 1 for 2 reverse stock split.
Solution: (a)10% Stock dividend effect on Balance Sheet

Old Number of Share outstanding = 1000000 /10 = 100000
= 100000 + (100000 × 10%)
= 110000 Shares
= Tk. 192500
New Common Stock = 10000 × 10 = 100000


10% Preferred stock Tk. 800000
Common stock (1000000 + 100000) Tk. 1100000
Additional paid up capital Tk. 92500
Total Shareholders' equity Tk. 2500000


Common stock (200000 × Tk. 5) Tk.10,00,000
10%prefeered stock Tk. 8,00,000
Market price per share = (100000 × 19.25)/200000 = Tk. 9.625
(C)Old number of shares = 100000


Common stock (50000 × Tk. 20) Tk.10,00,000
10%prefeered stock Tk. 8,00,000
Market price per share = (100000 × 19.25)/50000 = Tk. 38.50
P-09: A company's current stockholder's equity account is as follows:

10% preferred stock capital 4,00,000
Common stock (6,00,000) shares @ tk. 3) 18,00,000
Paid-in capital in excess of per 2,00,000
Total stockholders' Equity 32,00,000
Required:
Requirement: (a) Indicate the change, if any, expected if the firm declares a 2- for 1- stock split.
(b) Indicate the change, if any, expected if the firm declares a 3- for 1- stock split.
Solution: (a) Old number of shares = 600000


10% preferred stock capital Tk. 4,00,000
Common stock (12,00,000 shares × Tk. 1.5) Tk.18,00,000
Paid-in capital in excess of per Tk. 2,00,000
Total stockholders' Equity Tk. 32,00,000
(b)Old number of shares = 600000

10% preferred stock capital Tk. 4,00,000
Common stock (18,00,000 shares × Tk. 1) Tk.18,00,000
Paid-in capital in excess of per Tk. 2,00,000
Total stockholders' Equity Tk. 32,00,000
P-10: ABC Company's shareholder's equity account (book value) as of December 31, 2012, is as
follows:-
Common stock (Tk. 5 per value) Tk. 50,00,000
Additional paid in capital Tk. 50.00.000
Total shareholder's’ equity Tk. 2,50,00,000
At present, ABC is under pressure from shareholders to pay some dividend. Its cash balance is tk.
5,00,000 all of which is needed for transaction purposes. The stock is trading for Tk. 7 a share.
Required:(a) Reformulate the shareholders equity account if the company pays a 15 percent stock
dividend.
(b) Reformulate the shareholders equity account if the company declares a 5 for 4 stock split.
Solution:
(a) Old Number of Share outstanding = (5000000/5)= 1000000
Total New Number of Share outstanding after 15% = 100000 + (100000 × 15%)
= 1150000 Shares
= Tk. 1050000

Common stock [5000000 + (150000 × 5)] Tk. 5750000
(b) Old number of share =1000000

New number of share = (1000000/4 × 5) = 12500000
New Book Value per share = (5/5) × 4 = 4
Common stock (1250000 × Tk. 4) Tk. 5000000
Additional paid in capital Tk. 5000000
Retained earnings Tk. 15000000
7 ×1000000
Market Price after declaring stock dividend = = 5.6
1250000
P-11: ABC Company's shareholder's equity account (book value) of December 31, 2015 is as
follows:-
Common stock capital (Tk. 5 per value) Tk. 50,00,000
Additional paid in capital Tk. 50.00.000
Total shareholder's’ equity Tk. 2,50,00,000
At present, ABC is under pressure from shareholders to pay some dividends. Company cash balance
is Tk. 5,00,000 all of which is needed for transaction purposes. The current market price of
common stock is tk. 7 per share.
Required: (a) Reformulate the company equity account if the company pays a 25% stock dividend.
Show effect on market price.
(b) Reformulate the company equity account if the company declares a 2 for 1 stock split. Show
effect on market price.
Solution: (a)25% stock dividend effect on Balance sheet.
Old Number of Share outstanding = (5000000/5)= 1000000
= 1250000 Shares
= Tk. 1750000

Common Stock (2000000 @ Tk. 2.5) 5000000
Paid up capital in excess of per 5000000
7 ×1000000
1250000
(b) Old number of share =1000000

New number of share = (1000000 × 2) = 2000000
New Book Value per share = (5/2) =2.5

Common Stock (1250000 @ Tk. 5) 62,50,000
Paid up capital in excess of per (5000000 + (1750000-1250000) 55,00,000
Retained earnings (15000000 - 1750000) 1325,00,00
7 ×1000000
Market Price after declaring stock split = = 3.5
2000000
P-12: Bey Roger Co's shares are selling now at Tk. 40 per share, while 1,00,000 shares of common
stock exist the market. It has the following equity capitalization:
Particulars TAKA
Common Stock @ Tk. 10 10,00,000
Paid up capital in excess of per 20,00,000
The company declares a 15% stock dividend. What would happen to the accounts?
Solution:
= 115000 Shares
= Tk. 600000

Common Stock (115000 @ Tk. 10) 10,00,000
Paid up capital in excess of per (2000000 + (600000-1500000) 20,00,000
Retained earnings (20000000 - 600000) 1940,00,00
40 ×100000
115000
Walter Model and Gordon Model

P-13 (NU BBA 2009): From the following information, determine the theoretical market value o
equity shares of a company as per Walters model:
Earning of the company Tk. 5,00,000
Dividend paid Tk. 3,00,000
Number of shares outstanding Tk. 1,00,000
Price earnings ratio Tk. 8
Rate of return on investment Tk. 15%
Are you satisfies with the current policy of the firm? If not, what should be the optimal dividend
pay-out ratio in this case?
Solution:
EPS = (500000/100000) = 5
DPS (D0) = (300000/100000) = 3
Internal rate of investment = 15%
g = Return on Equity × Retention ratio
= (Net income/ Total Common Equity) × [(Net income - dividend)/ Net income
= [500000/(100000 × 100)] × [ (500000 - 300000)/ 500000]
=0.05 × 0.40 = 0.02
Market price per share, P0 = P/ E ratio × EPS = 8 × 5 = 40
Cost of Equity Capital, Ke = [D0 (1 +g)/P0] + g = [3(1 + 0.02)/ 40] + 0.02 = 0.0965
Walter Model
P 0=
DPS + ()
r
k
( EPS−DPS ) 3+
=
0.15
(
0.0965
(5−3 ))= 63.3037
k 0.0965
No. we are not satisfied with the current dividend policy. The optimum dividend payout ratio given
the fact should be zero. in this situation, the market price of the share is falling.
Optimal dividend payout ratio is zero that means dividend payment is zero
P 0=
DPS + ( kr )( EPS−DPS ) = 0+( 0.0965
0.15
) ( 5−0 ) = 80.539
k 0.0965
P-14: United finance currently has an EPS of Tk. 40. The cost of capital of the firm is 10% and
internal rate of return 4%. If the company pays 60% dividend of its earnings, then price of the
share according to Gordon model.
Solution: b = 100% - DPR = 100% - 60% = 40%

g = 0.04 × 0.4 = 0.016
EPS1 = EPS0 (1 + g) = 40 (1 + 0.016) = 40.64
EPS (1−b) 40.64 (1−0.40)

P0= = = 290.28
K s−b× r 0.10−(0.40 ×0.04)
P-15: Zenith Company earns Tk. 6 per share, is capitalized at a rate of 10% and has a rate of
return earning on investment of 22%. According to Walters model what should be the price per
share at 25.5% dividend payout ratio?
Solution: Dividend Payout ratio = 25.5%
Cost of capital = 10%
Rate of Return = 22%
EPS = Tk. 6
DPS = EPS × DPR = Tk. 6 × 25.5% = 1.53
P0 =
( kr )( EPS−DPS ) = 1.53+( 0.10
DPS +
0.22
) (6−1.53 ) = 113.64
k 0.10
P-16: The PQS Company Ltd earning per share is Tk. 10. The cost of capital is 12% and has a rate
of return on investment is 15%. According to Walters model what should be the price of share at
(i) 25% dividend payout ratio and (ii) 50% dividend payout ratio?
Solution: Given EPS = Tk. 10
Cost of Capital = 12%
Dividend Payout Ratio = 50% and 25%
(i) If DPR is 25%
DPS = EPS × DPR = 10 × 0.25 = Tk. 2.5
P0 =
( kr )( EPS−DPS ) = 2.5+( 0.15
DPS +
0.12 )
(10−2.5 )
= 98.9583
k 0.12
(ii) If DPR is 50%

DPS = EPS × DPR = 10 × 0.50 = Tk. 5
P0=
DPS + ( kr )( EPS−DPS ) = 5+( 0.15
0.12 )
(10−5 )
= 93.75
k 0.12
P-17: Following information are available for a company: Market price per share-Tk. 75. EPS-Tk.
12.50; DPS-Tk. 5; Expected price earnings ratio (P/E)-4 times.
Required: (using waiter model ) : (a)Cost of equity (Ke);(b) Dividend payout ratio; (c) Retention
ratio; (d) Internal rate of reinvestment
Solution: (a) Ke = (1/ expected price-earnings ratio) = (1/4) = 0.25 or 25%
(b) Dividend Payout Ratio = [Dividend Per share (DPS)/ Earnings per share (EPS)] = (5/12.5) = 0.40
(c) Retention Ratio = (1 - Dividend Payout Ratio) = (1 - 0.40) =0.60
(d) Walter Model

P0=
DPS + ()
r
k
( EPS−DPS )
75
¿
5+ ( 0 .r25 ) ( 12. 5−5 )
0 .25
r = 0.4583
P-18: The following data relate of Imtiaz company Ltd.

Earnings per share is Tk. 20; Capitalization rate is 11%, Retention ratio is 40%. If the internal rate
of return is: 12%, 11% and 8%. Determine the piece per share under Walter model and Gordon
model.
Solution: Given that
EPS = Tk. 20
Cost of capital = 11%
Retention ratio = 40%
DPR = 100% - RR = 100% -40% = 60%
DPS = EPS × 60% = Tk. 12
Walter Model if the rate of return is 12%
P 0=
DPS + ( kr )( EPS−DPS ) = 12+( 0.12
0.11 )
( 10−12 )
= 188.43
k 0.11
P 0=
DPS + ( kr )( EPS−DPS ) = 12+( 0.11
0.11 )
( 10−12 )
= 181.82
k 0.11
P 0=
DPS + ( kr )( EPS −DPS ) = 12+( 0.08
0.11 )
( 10−12 )
= 161.98
k 0.11
Gordon Model if the rate of return is 12%
EPS (1−b) 20(1−0.40)

P 0= = = 193.55
K s−b× r 0.11−(0.40 ×0.12)

EPS (1−b) 20(1−0.40)
P 0= = = 181.82
K s−b× r 0.11−(0.40 ×0.11)
EPS(1−b) 20(1−0.40)
P0= = = 153.85
K s−b× r 0.11−(0.40 ×0.08)
Solve these Problems of your own
P-19: The following data relate of Rahman Co. Ltd. Earnings per share is Tk. 20, Capitalization rate
is 11%, and Retention ratio is 40%. The internal rate of return is 12%, 11%, and 8%. Determine the
price per share under Walter Model and Gordon Model.
P-20: The following information is available in respect of a firm: Capitalization rate (Ke) = 10%;
Earnings per share (E) = Tk. 10
Rate of return on investment (R) = 12%, 10% and 8%. Show the effect of dividend policy on the
price of the share under Walter Model.
Modigliani and Miller Dividend Policy

P-21 (NU BBA -2018): The Ranges company Ltd. Currently has 1,00,000 outstanding shares
selling for tk. 100 each. The cost of capital rate of the company is 10%. The company is expecting a
profit of tk. 10,00,000 in the next year and also thinking for declaring dividend for tk. 5 per share.
The company has a new investment opportunity of tk. 20,00,000. How much a shareholder will get
at the end of the first year according to MM Hypothesis? (a) What will be the price of the share
in the next year if the dividend is paid? (b) What will be the price of the share in the next year if
the dividend is not paid? (c) How many new shares must be issued to finance the new investment if
dividend is paid?
Solution: a. Value of the firm when dividends are paid
P1=[ P 0 × ( 1+ K e ) ]−D1=[Tk. 100 + (1 + 0.10)] – Tk. 5 = Tk. 105
2. Amount required to be raised from the issue of new shares
∆ n P1=¿I-(E-nD1) =Tk. 500000 – (Tk. 250000 – Tk. 125000) = 375000
I−( E−n D1) 375000

∆ n= = = 3571.43
P1 105
( n+ ∆ n ) P 1−I + E ( 25000+3571.43 ) 105−500000+250000
n P 0= = = 2500000
(1+ K e ) 1.10
P1=[ P 0 × ( 1+ K e ) ]−D1 = [Tk. 100 + (1 + 0.10)] - 0 = Tk. 110
∆ n P1=¿ I-(E-nD1) = Tk. 500000 – (Tk. 250000 – Tk. 25000 × 0) = 250000

I−( E−n D1) 250000

∆ n= = = 2272.73
P1 110
( n+ ∆ n ) P 1−I + E ( 25000+2272.73 ) 110−500000+250000

n P 0= = = 2500000
(1+ K e ) 1.10
P-22: Sumon Limited belong to risk-class for which the equity capitalisation rate (Ke) is 14%. It
currently has outstanding 5 lakhs shares of taka 100 each. The firm is planning to declare dividend
of 8 per share at the end of the year. Using M. M. Model, you are required to determine: (1) Price
of the stock at the end of the year-(a) If dividend is declared: (b) If dividend is not declared.
(2) Assuming that the firm pays dividend, has-net Income of Taka 50 lakh and makes new
investment of Taka 40 lakhs, during the period how many new shares must be issued?
Solution: Given, P0 = Tk. 100, Ke = 14% and D1 = Tk. 8
1. (a) Expected Market price of the share at the end of a period if dividend is declared
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.14)] – Tk. 8 = Tk. 106
(b) Expected Market price of the share at the end of a period if dividend is not declared
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.14)] – Tk. 0 = Tk. 114
2. Amount required to be raised from the issue of new shares if dividend is paid
∆ n P1=¿I-(E-nD1) = Tk. 4000000 – [Tk. 5000000 – (Tk. 500000 × 8)] = Tk. 3000000
Number of additional shares to be issued
I −(E−n D1) Tk . 3000000

∆ n= = = 28301.88679
P1 Tk . 106
P-23:Mahfuz Limited belong to risk-class for which the equity capitalisation rate (Ke) is 14%. It
currently has outstanding 5 lakhs shares of taka 100 each. The firm is planning to declare dividend
of 8 per share at the end of the year. Using M. M. Model, you are required to determine: (1)Price
of the stock at the end of the year-(a) If dividend is declared: (b) If dividend is not declared.
(2) Assuming that the firm pays dividend, has-net Income of Taka 50 lakh and makes new
investment of Taka 40 lakhs, during the period how many new shares must be issued?
1. (a) Expected Market price of the share at the end of a period if dividend is declared
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.14)] – Tk. 8 = Tk. 106
(b) Expected Market price of the share at the end of a period if dividend is not declared
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.14)] – Tk. 0 = Tk. 114
2. Amount required to be raised from the issue of new shares if dividend is paid
∆ n P1=¿I-(E-nD1) = Tk. 4000000 – [Tk. 5000000 – (Tk. 500000 × 8)] = Tk. 3000000
I −(E−n D1) Tk . 3000000

∆ n= = = 28301.88679
P1 Tk . 106
P-24: The capitalization rate of Bajaj Company is 10%. It currently has 1,00,000 shares at Tk. 100
each. The firm is contemplating the declaration of Tk. 10 dividend per share at the end of the
year. Answer the following questions based on the MM Model and the assumption of on taxes: (1)
What will be the price of the share at the end of the period of-(a) Dividend is paid and(b) Dividend
is not paid(2)Assume that the firm pays dividend, has net income of Tk. 10,00,000 and makes new
investment of Tk. 20,00,000. How many new shares must be issued (a) if dividend is paid and (b) if
dividend is not paid?
1. (a) Expected Market price of the share at the end of a period if dividend is paid
P1=[ P 0 × ( 1+ K e ) ]−D1 = [Tk. 100 + (1 + 0.10)] – Tk. 10 = Tk. 100
(b) Expected Market price of the share at the end of a period if dividend is not paid
P1=[ P 0 × ( 1+ K e ) ]−D 1 = [Tk. 100 + (1 + 0.10)] – Tk. 0 = Tk. 110
2. (a) Amount Required to be raised from the issue of new shares if dividend is paid
∆ n P1=¿I-(E-nD1) = Tk. 2000000 – [Tk. 1000000 – (Tk. 100000 × 10)] = Tk. 2000000
I −( E−n D1) Tk . 2000000

∆ n= = = 20000
P1 Tk . 100
(b) Amount required to be raised from the issue of new shares if dividend is not paid
∆ n P1=¿I-(E-nD1) = Tk. 2000000 – [Tk. 1000000 – (Tk. 100000 × 0)] = Tk. 1000000
I −( E−n D1) Tk . 1000000

∆ n= = = 9090.909
P1 Tk . 110
P-25: Maria Ltd has a cost of equity capital of 12%. The current value of the firm is Tk. 20,00,000
(@ Tk. 20 per share). Assume values for new investment Tk. 6,00,000 and earning Tk. 2,00,00 and
total dividends per share Tk. 1. Show that under M. M. Model the payment of dividend does not
affect the value of the firm.
a. Value of the firm when dividends are paid
P1=[ P 0 × ( 1+ K e ) ]−D 1= [Tk. 20+ (1 + 0.12)] – Tk. 1 = Tk. 21.4
∆ n P1=¿I-(E-nD1) = Tk. 600000 – [Tk. 20000 – (Tk. 2000000/20 × 1) = 680000
I −( E−n D1) Tk .68000

∆ n= = = 31775.70093
P1 21.4
( n+ ∆ n ) P 1−I + E ( 100000+ 31775.70093 ) 21.4−600000+20000
n P 0= = = 2000000
(1+ K e ) 1.12
P1=[ P 0 × ( 1+ K e ) ]−D1 = [Tk. 20 + (1 + 0.12)] - 0 = Tk. 22.4
∆ n P1=¿ I-(E-nD1) = Tk. 600000 – [Tk. 20000 – (Tk. 2000000/20 × 0) = 580000

I −( E−n D1) Tk .580000

∆ n= = = 25892.85714
P1 Tk .22 .4
( n+ ∆ n ) P 1−I + E ( 100000+ 25892.85714 ) 2.4−600000+20000

n P 0= = = 2000000
(1+ K e ) 1.12
P-26 (Solve this Problem): Surma Limited has a cost of equity of 12%, the current market value
of the firm (V) is Tk. 25,00,000 @ Tk. 25 per share). Assume values for 1 (new investment), E
(earning) and D (dividends) at the end of year at 1 = Tk. 7,00,000, E = Tk. 3,00,000, and D = Tk. 2
per share. Show that under the MM assumptions, the payment of dividend does not affect the
value of the firm.
P-27: Integrated Math Problem-Solve the following problem

Balance Sheet
Other information
Requirement:
• Show the effect in Balance sheet, EPS, market price after declaring 10% Stock Dividend
• Show effect in balance sheet, market price, EPS after declaring 5:3 stock split, 1:4 reverse
stock split.
• Calculate the EPS and market price after share repurchase if the company has excess cash Tk.
200000.
• Calculate the price of the share in Walter Model
• Calculate the price of share in Gordon Model
• Show that under the MM assumption, the payment of dividend doesn’t affect the value of the
firm.
Problems on Right Issues
1. Rights Offerings The Hadron Corporation currently has 3 million shares outstanding. The
stock sells for $40 per share. To raise $20 million for a new particle accelerator, the firm is
considering a rights offering at $25 per share. What is the value of a right in this case? The ex-
rights price?
Solution: To raise $20 million at $25 per share, $20 million/25 = 800,000 shares will have to be
sold. Before the offering, the firm is worth 3 million /$40 = $120 million. The issue will raise $20
million, and there will be 3.8 million shares outstanding. The value of an ex-rights share will
therefore be $140 million/3.8 million = $36.84. The value of a right is thus $40 - 36.84 = $3.16.
2. Rights Offerings. Big Time, Inc.,is proposing a rights offering. Presently there are 350,000
shares outstanding at $85 each. There will be 70,000 new shares offered at $70 each.
a. What is the new market value of the company?
b. How many rights are associated with one of the new shares?
c. What is the ex-rights price?
d. What is the value of a right?
e. Why might a company have a rights offering rather than a general cash offer?
Solution: (a) What is the market value of the new company?
The new market value will be: new market value = (current shares outstanding the stock price) +
(the rights offered the rights price)
350,000 shares x $85/share + 70,000 new shares x $70/share
$29,750,000 + $4,900,000 = $34,650,000
(b) How many rights are associated with one of the new shares?
The number of rights associated with each old share is equal to the number of shares outstanding
[350,000] divided by the number of new shares [70,000]
350,000/70,000 = 5 rights per new share
(c) What is the ex-rights price?
The new price of the stock will be the new market value of the company divided by the total
number of shares outstanding after the rights offer, which will be:
Px = $34,650,000/[350,000 + 70,000] = $34,650,000/420,000
Px = $82.50
(d) What is the value of a right?
Value of the right = $85 - $82.50 = $2.50
(e) Why might a company have a rights offering rather than a general cash offer?
A rights offering usually costs less, it protects the proportionate interests of existing
shareholders and also protects against underpricing.
3. Rights Offerings. The Clifford Corporation has announced a rights offer to raise $35 million
for a new journal, the Journal of Financial Excess. This journal will review potential articles after
the author pays a non-refundable reviewing fee of $5,000 per page. The stock currently sells for
$53 per share, and there are 3.9 million shares outstanding.
a. What is the maximum possible subscription price? What is the minimum?
b. If the subscription price is set at $47 per share, how many shares must be sold? How many
rights will it take to buy one share?
c. What is the ex-rights price? What is the value of a right?
d. Show how a shareholder with 1,000 shares before the offering and no desire (or money) to buy
additional shares is not harmed by the rights offer.
Solution:
a.) The maximum subscription price is the current stock price, or $53.
The minimum price is anything greater than $0.
b.) number of new shares = the amount raised/by the subscription price
$35,000,000/$47
744,681 shares
Number of rights needed to buy one share = the current shares outstanding/by the number of
new shares offered
3,900,000/744,681
Number of rights needed = 5.24
c.) A shareholder can buy 5.24 rights-on shares for:

5.24($53) = $277.57
The shareholder can exercise these rights for $47, at a total cost of:
$277.57 + 47 = $324.57
The investor will then have:
Ex-rights shares = 1 + 5.24
Ex-rights shares = 6.24
The ex-rights price per share is:
PX = [5.24($53) + $47]/6.24
PX = [277.72 + 47]/6.24
PX = 324.72/6.24
PX = $52.04
So, the value of a right is:

Value of a right = $53 - 52.04
Value of a right = $.96
d.) Before the offer, a shareholder will have the shares owned at the current market price, or:
Portfolio value = (1,000 shares)($53)
Portfolio value = $53,000
After the rights offer, the share price will fall, but the shareholder will also hold the rights, so:
Portfolio value = (1,000 shares)($52.04) + (1,000 rights)($.96)
= 52,040 + 960
Portfolio value = $53,000
4. Rights. Red Shoe Co. has concluded that additional equity financing will be needed to expand
operations and that the needed funds will be best obtained through a rights offering. It has
correctly determined that as a result of the rights offering, the share price will fall from $49 to
$47.60 ($49 is the rights-on price;$47.60 is the ex-rights price, also known as the when-issued
price).The company is seeking $16.5 million in additional funds with a per-share subscription price
equal to $34.How many shares are there currently, before the offering? (Assume that the
increment to the market value of the equity equals the gross proceeds from the offering.)
Solution: Using the equation we derived in Problem 2, part c to calculate the price of the stock
ex-rights, we can find the number of shares a shareholder will have ex-rights, which is:
$47.60 = [N($49) + $34]/(N + 1)

47.60N + 47.60 = 49N + 34
47.60N + 13.6 = 49N
13.6 = 1.4N
9.714 = N
N = 9.714
number of new shares = the amount raised/the per-share subscription price

Number of new shares = $16,500,000/$34
Number of new shares = 485,294
the number of old shares = the number of new shares * the number of rights per share
Number of old shares = 9.714(485,294)

Number of old shares = 4,714,286
5. Rights. Bell Hill Mfg. is considering a rights offer. The company has determined that the ex-
rights price would be $63. The current price is $68 per share, and there are 26 million shares
outstanding. The rights offer would raise a total of $70 million. What is the subscription price?
Solution: The number of new shares is the amount raised divided by the subscription price, so:
Number of new shares = $70,000,000/PS
And the ex-rights number of shares (N) is equal to:
N = Old shares outstanding/New shares outstanding

N = 26,000,000/($70,000,000/PS)
N = .371PS
We know the equation for the ex-rights stock price is:
PX = [NPRO + PS]/(N + 1)
We can substitute in the numbers we are given, and then substitute the two previous results.
Doing so, and solving for the subscription price, we get:
PX = $63 = [N($68) + PS]/(N + 1)

$63 = [$68(.371PS) + PS]/(.371PS + 1)
$63 = $26.26PS/(1 + .371PS)
PS = $22.05
7. Selling Rights. Prahm Corp. wants to raise $4.7 million via a rights offering. The company
currently has 530,000 shares of common stock outstanding that sell for $55 per share. Its
underwriter has set a subscription price of $30 per share and will charge the company a
spread of 6 percent. If you currently own 5,000 shares of stock in the company and decide
not to participate in the rights offering, how much money can you get by selling your rights?
Solution:
The net proceeds to the company on a per share basis is the subscription price times one minus
the underwriter spread, so:
Net proceeds to the company = $30(1 - .06)

Net proceeds to the company = $28.20 per share
So, to raise the required funds, the company must sell:
New shares offered = $4,700,000/$28.20

New shares offered = 166,667
The number of rights needed per share is the current number of shares outstanding divided by
the new shares offered, or:
Number of rights needed = 530,000 old shares/166,667 new shares

Number of rights needed = 3.18 rights per share
We must adjust the ex-rights stock price for the floatation costs, so the ex-rights stock price
will be:
PX = [NPRO + PS(1 - f)] / (N + 1)

PX = [3.18($55) + 30(1 - .06)]/(3.18 + 1)
PX = $48.59
We can also find the ex-rights price using the balance sheet. The company wants to raise $4.7
million but will only net $28.20 per share after the underwriter fee. After issuing the rights, the
value of equity will be:
Total value of equity = $55(530,000) + $4,700,000

Total value of equity = $33,850,000
So, the price per share after issuance will be:
PX = $33,850,000/(530,000 + 166,667)
PX = $48.59
The value of a right is:
Value of a right = $55 - 48.59

Value of a right = $6.41
And your proceeds from selling your rights will be:
Proceeds from selling rights = 5,000($6.41)

Proceeds from selling rights = $32,057.42
7.Valuing a Right. Knight Inventory Systems, Inc., has announced a rights offer. The company has
announced that it will take four rights to buy a new share in the offering at a subscription price
of $35.At the close of business the day before the ex-rights day, the company's stock sells for
$60 per share. The next morning, you notice that the stock sells for $53 per share and the rights
sell for $3 each. Are the stock and the rights correctly priced on the ex-rights day? Describe a
transaction in which you could use these prices to create an immediate profit.
Solution:
Using the equation for valuing a stock ex-rights, we find:
PX = [NPRO + PS]/(N + 1)
PX = [4($60) + $35]/(4 + 1)
PX = $55
The stock is incorrectly priced. Calculating the value of a right using the actual stock price, we
find:
Value of a right = PRO - PX

Value of a right = $60 - 53
Value of a right = $7
So, the rights are underpriced. You can create an immediate profit on the ex-rights day if the
stock is selling for $53 and the rights are selling for $3 by executing the following transactions:
Buy four rights in the market for 4($3) = $12. Use these rights to purchase a new share at the
subscription price of $35. Immediately sell this share in the market for $53, creating an instant
$6 profit.
8. Integrated Math on Right (NU, BBA (Hons.) Ace-2019. Big boss Corporation has announced
a right offer to raised Tk. 3000000 for new journal, the journal of financial express. The journal
will review potential articles after the author pays a non-refundable reviewing fee of Tk.3000 per
page. The stock is selling Tk. 60 per share currently and there are 240000 shares outstanding.
(a) If the subscription price is set Tk. 50 per share, how many shares must be sold?
(b) How many rights will it take to buy one share?
(c) What is the ex-right price?
(d) What is the value of right?
(e) How a shareholder with 1000 shares before the offering and no desire to buy additional
shares is not harmed by the right offer.
Solution:
¿ 3000000
(i) Number of new share issued = Fund ¿ be Raised = = 60000
Subscribtion Price 50
shares
Number of old Shares 240000

(ii) Number of Rights = = = = 4 shares
Number of New shares 60000
( P¿¿ 0 × N )+ SP ( 60× 4 ) +50

(iii) Market price per share at Ex-right (Px) = = ¿= = Tk. 58
N +1 4 +1
P 0−SP 60−50
(iv) Value of Rights (at rights on) (R0) = = = Tk. 2
N +1 4+ 1
(v) Before offer Portfolio (1000 × 60) = Tk. 60000
After right shares (1000 × 58) = Tk. 58000
Right shares (1000 × 2) = Tk. 2000
Total = Tk. 60000
Solve yourself
Rights Offerings: Big Time, Inc., is proposing a rights offering. Presently there are 500,000
shares outstanding at $81 each. There will be 60,000 new shares offered at $70 each.
a. What is the new market value of the company?
b. How many rights are associated with one of the new shares?
c. What is the ex-rights price?
d. What is the value of a right?
e. Why might a company have a rights offering rather than a general cash offer?
2. Rights Offerings: The Clifford Corporation has announced a rights offer to raise $40
million for a new journal, the Journal of Financial Excess. This journal will review potential
articles after the author pays a nonrefundable reviewing fee of $5,000 per page. The stock
currently sells for $53 per share, and there are 4.1 million shares outstanding.
a. What is the maximum possible subscription price? What is the minimum?
b. If the subscription price is set at $48 per share, how many shares must be sold?
How many rights will it take to buy one share?
c. What is the ex-rights price? What is the value of a right?
d. Show how a shareholder with 1,000 shares before the offering and no desire (or money) to
buy additional shares is not harmed by the rights offer.
3. Rights: Red Shoe Co. has concluded that additional equity financing will be needed to expand
operations and that the needed funds will be best obtained through a rights offering. It has
correctly determined that as a result of the rights offering, the share price will fall from $81
to $74.80 ($81 is the rights-on price; $74.80 is the ex-rights price, also known as the when-
issued price). The company is seeking $20 million in additional funds with a per-share
subscription price equal to $40. How many shares are there currently, before the offering?
(Assume that the increment to the market value of the equity equals the gross proceeds from
the offering.)
4. Rights: Keira Mfg. is considering a rights offer. The company has determined that the ex-
rights price would be $71. The current price is $76 per share, and there are 19 million shares
outstanding. The rights offer would raise a total of $60 million. What is the subscription price?
5. Value of a Right: Show that the value of a right just prior to expiration can be written as:
Value of a right =PRO -PX =(PRO -PS)/(N +1)
Where PRO, PS , and PX stand for the rights-on price, the subscription price, and the ex-rights
price, respectively, and N is the number of rights needed to buy one new share at the
subscription price.
6. Selling Rights: Roth Corp. wants to raise $5.6 million via a rights offering. The company
currently has 650,000 shares of common stock outstanding that sell for $50 per share. Its
underwriter has set a subscription price of $23 per share and will charge the company a 6
percent spread. If you currently own 5,000 shares of stock in the company and decide not to
participate in the rights offering, how much money can you get by selling your rights?
Valuing a Right: Knight Inventory Systems, Inc., has announced a rights offer. The company
has announced that it will take four rights to buy a new share in the offering at a subscription
price of $35. At the close of business the day before the ex-rights day, the company’s stock
sells for $60 per share. The next morning, you notice that the stock sells for $53 per share and
the rights sell for $3 each. Are the stock and the rights correctly priced on the ex-rights day?
Describe a transaction in which you could use these prices to create an immediate profit.
Suggested Questions
 Describe the factors influencing dividend policy. (BBA Professional 2007, 2008, 2011)
 Differentiate between stock dividend and stock split. (BBA Professional 2012)
 Modigliani and Miller model (MM thesis) is based on unrealistic assumptions. Evaluate the
reality of the assumptions made by MM. ( BBA Professional 2011)
 Differentiate between the MM hypothesis & the Gordon's bird-in-the -hand theory (BBA
Professional 2007, 2011)
 Show the similarities and distinction between Walter model and Gordon model of dividend
policy and share price. Explain with example. (BBA Professional 2013)
 What is cash dividend? Explain the standard method of cash dividend payment.
 Explain the cash dividend payment procedure or the dividend payment date chronology.
 Describe a constant-payout-ratio dividend policy, a regular dividend policy, and a low-
regular-and-extra dividend policy. What are the effects of these policies?
 Explain the types of dividend policies.
 What constraints affect dividend policy?
 How do the availability and cost of outside capital affect dividend policy?
 What factors do firms consider in establishing dividend policy? Briefly describe each of
them.
 Explain the alternative sources of capital.
 What is stock dividend? What are the reasons for stock dividend?
 What is stock Split? What are the reasons for stock Split?
 What is reverse stock split? What are the reasons for reverse stock split?
 What is stock repurchase or treasury stock? What are the reasons for stock repurchase?
 How does a rights offering work? What are the reasons for right share?
 What questions must financial managers answer in a rights offering?
 How is the value of a right determined?
 When does a rights offering affect the value of a company’s shares?
 Does a rights offering cause share prices to decrease? How are existing shareholders
affected by a rights offering?
 Explain dividend irrelevance theory.
 Explain clientele effect.
 What is residual dividend policy?
 How can an investor create a homemade dividend?
 Are dividends irrelevant?
 What is MM model of dividend? What is the assumption and criticism of MM model of
dividend?
 What is homemade dividend policy?
 Contrast the basic arguments about dividend policy advanced by Miller and Modigliani (M and
M) and by Gordon and Lintner.
 Explain Gordon’s Model with its Assumptions and Criticisms.
 What is Relation of Dividend Decision and Value of a Firm in case of Gordon model? What
are the implications of Gordon’s Model?
 What is Modigliani and Miller View of Gordon Model?
 Explain Walter Model with its Assumptions and Criticisms.
 What are the implications of Walter Model?
 Differentiate between Gordon model and Walter model.
 Explain tax effect theory in detail.
 What is dividend signalling theory?

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Chapter 06: Dividend Decision

................Md. Jobayair Ibna Rafiq..............

The Great Recession of 2007: Will Dividends Ever Be the Same?

Standard Method of Cash Dividend Payment

Types of Dividend Policies

Constant-Payout-Ratio Dividend Policy

Regular Dividend Policy

6.2. Factors Affecting Dividend Decision

Alternative Sources of Capital

3. Control. If management is concerned about maintaining control, it may be reluctant to sell

Effects of Other Issues

6.3. Stock Dividend

Reasons for Stock Dividend

Balance Sheet (Equity Position)

Old Number of Share outstanding = 100000 Shares

Total New Number of Share outstanding = 100000 + (100000 × 10%)

Market Value of New total Share = (100000 × 30)

Balance Sheet (Equity Position)

Effect on Accounting Data

Particulars Before Stock Dividend After Stock Dividend Effect

6.4. Stock Split

Reasons for Stock Split

Balance Sheet (Equity Position)

Effect in Balance Sheet (Equity Position) declaring 5:3 Stock Split

Old Number of Share outstanding = 100000 Shares

Total New Number of Share outstanding = (100000/3) × 5

Book value per share = (10/5) × 3

Balance Sheet (Equity Position)

Particulars Before Stock Dividend After Stock Dividend Effect

6.5. Reverse Stock Split

Reverse Stock Split

Reasons for Reverse Stock Split

Balance Sheet (Equity Position)

Effect in Balance Sheet (Equity Position) declaring 5:3 Stock Split

Old Number of Share outstanding = 100000 Shares

Total New Number of Share outstanding = (100000/4) × 1

Book value per share = (10 × 4)

Balance Sheet (Equity Position)

Effect on Accounting Data

Particulars Before Stock Dividend After Stock Dividend Effect

6.6. Stock Repurchase

Reasons for Stock Repurchase

1. company has Lots of cash but few projects to invest in

Earnings after taxes Tk. 3000000

Current EPS = Tk. 3000000/ 1000000 = Tk. 3 per share

P/E ratio = Tk. 30/ Tk. 3 = 10

Again, the total values for the two alternatives are:

6.7. Right Share

The main reasons to make a Rights issue by a company are as follows:

The Mechanics of a Rights Offering

National Power Company Financial Statements before Rights Offering

Number of Rights Needed to Purchase a Share

Subscription Number of Number of Rights Needed

The Value of a Right

The Value of Rights: The Individual Shareholder

National Power Company Rights Offering

Figure: Ex-Rights Stock Prices

The Underwriting Arrangements

6.8. Dividend Irrelevance Theory