Chapter 14

Payout Policy

 Suggested Answer to Opener-in-Review Question

The chapter opener described Whirlpool’s decision to dramatically increase its dividend in early 2017 to $1.10 per
share. In the previous quarter, Whirlpool paid a dividend of $1 on March 15 to shareholders of record on March
3. When do you think the stock began trading ex dividend? The market price of Whirlpool stock just before the ex
dividend date was $178.59. Immediately after the stock went ex dividend, the market price was $178.14. Is that
price change surprising? Calculate the return that an investor might have earned if she had purchased the stock
before the ex dividend date, sold the stock immediately afterward, and received the dividend a few weeks later.

If the record date was March 3, then the stock would have started trading ex dividend two business days before on March
1. On that day, Whirlpool stock dropped $0.45, which is less than we would expect given that the dividend was $1.10. A
shareholder who purchased the stock at $178.59, sold it at $178.14, and received the $1.10 dividend would have netted a
$0.65 profit on that trade, or in percentage terms a return of 0.36%. That’s not much, but keep in mind that the investor
held the stock for a single day. For perspective, that daily return is on the order of 100 times greater than the average one-
day return on the overall stock market.

 Answers to Review Questions

1. The two primary ways in which a firm can distribute cash to shareholders is through a dividend payment and share
repurchases. Many companies use both techniques to return money to investors. In recent years, firms have paid
similar amounts of money to shareholders through each method in the aggregate. Whereas companies attempt to
provide smooth growth in dividends over time, firms adjust their short-term payout primarily by adjusting share
repurchases.

2. Rapidly growing firms may not have sufficient funds available to support all acceptable projects. Such firms depend
heavily on internal sources of capital such as retained earnings and, therefore, generally do not pay dividends.

3. Dividends are divided by earnings in computation of the dividend payout ratio. Because dividends are more stable
than earnings, the dividend payout ratio increases in a recession. During economic expansions, earnings growth will
exceed dividend growth, and the dividend payout ratio will drop.

4. All holders of a firm’s stock in the firm’s stock ledger on the date of record, which is set by the directors, will receive
a declared dividend. These stockholders are referred to as holders of record. Due to the time needed to make
bookkeeping entries when a stock is traded, the stock will sell ex dividend, which means without dividends,
beginning two business days prior to the date of record. The firm’s directors set both the date of record and the
dividend payment date.

© 2019 Pearson Education, Ltd.

316  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

5. The Jobs and Growth Tax Reconciliation Act of 2003 substantially reduced the marginal tax rate on dividends
received by taxpayers. Prior to the 2003 act, dividends were taxed at the ordinary income tax rate, which could reach
as high as 35%. The act reduced the marginal rate to the same 15% rate as capital gains are taxed. The impact of this
act has resulted in firms increasing their dividend payouts. More recently, the Tax Cuts and Jobs Act created new tax
brackets for dividend income which do not align exactly with the brackets for ordinary income. The top dividend tax
rate under the new rate schedule is 20%, not counting the investment income tax that is part of the Affordable Care
Act.

6. Dividend reinvestment plans enable stockholders to use dividends to acquire full or fractional shares at little or no
transaction cost. These plans can be handled in either of two ways. In one approach, a third-party trustee is paid a fee
to buy the firm’s outstanding shares on the open market on behalf of the shareholders. This plan benefits the
participants by reducing their transaction cost. The second approach involves buying newly issued shares directly
from the firm with no transaction cost.

7. The residual theory of dividends suggests that a firm’s dividend payment should be the amount left over (the
residual) after all acceptable investment opportunities have been undertaken. Because investment opportunities would
tend to vary year to year, this approach would not lead to a stable dividend. This theory considers dividends
irrelevant, representing an earnings residual rather than an active policy component affecting the firm’s value.

8. The dividend irrelevance theory proposed by Miller and Modigliani (M & M) states that in a perfect world the value
of a firm is not affected by dividends but is determined solely by the earnings power and risk of the company’s
assets. The proportion of retained earnings used for dividends versus reinvestment also has no impact on value. M &
M argues that changes in share price following increases or decreases in dividends are the result of the informational
content of dividends, which sends a signal to investors that management expects future earnings to change in the
same direction as the change in dividends. Another aspect of M & M’s theory is the clientele effect, which means
that investors choose firms with dividend policies corresponding to their own preferences. Because shareholders get
what they expect, stock value is unaffected by dividend policy.
Conversely, Gordon and Lintner’s dividend relevance theory states that there is a direct relationship between a firm’s
dividend policy and its market value. According to their bird-in-the-hand argument, investors are generally risk
averse, and current dividends (bird-in-the-hand) reduce investor uncertainty by lowering the discount rate applied to
earnings, thereby increasing stock value.
Although empirical studies of the dividend relevance theory have not provided conclusive evidence supporting this
argument, it intuitively makes sense. In practice, it appears that actions of managers and investors support dividend
relevance.

9. a. Legal constraints prohibit the corporation from paying out cash dividends that are considered part of a firm’s
“legal capital,” measured either by the par value of common stock or the par value plus paid-in capital in excess
of par.
b. Contractual constraints limit a firm’s ability to pay dividends according to the restrictive covenants in a loan
agreement.
c. Growth prospects limit the amount of cash dividends because a firm needs to direct all available funds to finance
capital expenditures.

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  317

d. Owner considerations take into account factors that lead to a dividend policy favorably affecting the majority of
owners. Examples are the tax status of the stockholder, his or her other investment opportunities, and ownership
dilution, each of which can direct a firm toward a high or low dividend payout policy.
e. Market considerations are the perceptions of the stockholders and their response to the dividend policy, which
may indirectly affect the stock price.

10. With a constant-payout-ratio dividend policy, a firm pays out a certain percentage of earnings each period. A regular
dividend policy is a fixed dollar dividend payment each period. The amount of this payment may be increased over
the long run in response to proven increases in earnings. Low-regular- and-extra dividend policy pays a constant dollar
or regular dividend in each period; in periods with especially high earnings, an “extra” dividend is paid.
The constant-payout-ratio policy results in dividends that fluctuate in sync with earnings, whereas the other policies
tend to lead to more stable dividends over time.

11. A stock dividend is a dividend paid in the form of stock made to existing owners. Although stock dividends are more
costly to issue than cash dividends, stock dividends are a means of giving the owners something without needing to
use cash.
The stockholder’s assumption that he or she will break even in five years with a 20% stock dividend is incorrect. A
stock dividend does not mean an increase in value of holdings; the per-share value decreases in proportion to the
dividend and the investor’s holdings remain the same in terms of both value and percentage ownership.

12. A stock split is a method of increasing the number of shares belonging to each shareholder. A stock split reduces the
par value of stock outstanding and increases the number of shares outstanding. A stock split also reduces the price
per share roughly in the same proportion as the split, so the total value of shares remains more or less the same. For
example, in a 2-for-1 split, the price of the stock should fall by half. A reverse stock split is exactly the opposite of a
stock split. The par value is increased and the number of shares outstanding is reduced. Neither type of split has any
effect on a firm’s financial structure but can be viewed as a change in accounting values. Normally, (reverse) stock
splits are made when the firm believes its stock price is too (low) high to be actively traded. A stock dividend works
the same as a stock split except that the ratio of new shares to old shares is lower. For example, a common stock split
is 2 for 1. A stock dividend may be a 10% dividend, having the same effect as a 1.1 for 1 split.

 Suggested Answer to Focus on Ethics Box: Buyback Mountain

Given the market generally punishes firms that miss their EPS forecast, do you believe it is ethical to use stock
repurchases just to hit the target?

It is probably naïve for managers to think that if they hit an EPS target simply by repurchasing shares that participants in the
stock market will not realize this. The number of outstanding shares is public knowledge (reported with a lag of course), so
analysts can easily ascertain what EPS would have been in the absence of share repurchases. As long as managers do not
attempt to hide their repurchase activities, it is probably too strong to say that repurchasing shares to reach an EPS target is
unethical, though it might be a sign of poor management if a firm consistently meets EPS targets only by reducing the
denominator of that calculation.

© 2019 Pearson Education, Ltd.

318  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

 Suggested Answer to Focus on Practice Box: Capital Gains and Dividend

Tax Treatment Extended to 2012
How might the expected future reappearance of higher tax rates on individuals receiving dividends affect
corporate dividend payout?

Just as the lowering of the individual tax rates on corporate dividends has stimulated corporate dividend payouts, an
increase in the tax on dividends could reverse the recent increase in dividend payouts.

 Answers to Warm-Up Exercises

E14-1. Relevant dividend dates
Answer: The firm will need £77,000 of cash to pay the dividend. The stock will begin selling ex dividend on December
6, which is one day before the date of record.

E14-2. Residual theory of dividend payout

Answer: 1. Capital budget $1,730,000
2. Equity needed (60% ×1) 1,038,480
3. Dividends [retained earnings – (2)] 261,520
4. Dividend payout ratio [(3)  retained earnings] 20.12%

E14-3. Legal constraints on dividend payout

Answer: If legal capital is defined solely as the par value of common stock, Ashkenazi will be able to pay out paid-in
capital in excess of par plus all retained earnings.
Paid-in capital in excess of par 4,000,000
Retained earnings 550,000
Total available for dividends £4,550,000

Potential dividend per share (divide total available by 5,871,000 shares)  £0.77
If legal capital is defined as both the par value of common stock and paid-in capital in excess of par, Legal &
General will only be able to pay out the retained earnings.
Total available for dividends  £550,000
Potential dividend per share (divide total available by 5,871,000 shares)  £0.09

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  319

E14-4. Constant dividend payout ratio

Answer: The first step in analyzing the Kopi scenario is to determine the historical payout ratio.

Year EPS Dividend/Share Dividend Payout Ratio

2016 $1.75 $0.95 54.29%

2017 1.95 1.20 61.54

2018 2.05 1.25 60.98

2019 2.25 1.30 57.78

Discussion: Kopi Companies’ historical dividend payout ratio has been fairly consistent and near the 60%
constant payout ratio that the board is considering. So in terms of dollar amounts, the new policy would not
significantly change the dividend payout to the shareholders in the future. Once the dividend is tied to a
constant percentage, the dividends will be tied to Kopi’s future earnings and could fluctuate from year to year.
However, the evidence from the past four years shows that Kopi’s earnings have increased from 5% to 11% per
year with no down years.

E14-5. Stock dividend

Answer: After the 1% stock dividend, Legal & General’s stockholder’s equity account is as follows:
Common stock (5,929,710 shares at £1 par) £5,929,710
Paid-in capital in excess of par 4,099,220
Retained earnings 392,070
Total stockholders’ equity £10,421,000

 Solutions to Problems
P14-1. Dividend payment procedures
LG 1; Basic
a. Ex dividend date is Thursday, July 6.

b. Ex dividend date is Thursday, July 6.

c. Cash $150,000 Dividends payable $0

Retained earnings $1,500,000

d. The dividend payment (of $2) will result in a decrease in total assets equal to the amount of the payment.
e. The net effect of declaring and paying dividends is the reduction of total assets by the amount paid in
dividends that is with $500,000.

© 2019 Pearson Education, Ltd.

320  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P14-2. Personal finance: Dividend payment

LG 1; Intermediate
a. Dividend = 800 × $1.05 = $840
b. She would receive $840, as she is not entitled to the dividends payable on the 100 shares—the previous
owner (seller) will receive the dividend
c. The price will decrease with the amount of the dividend, that is, $1.05.
d. She would receive $840, as she is entitled to the dividends payable on the 200 shares—the new owner
(buyer) will not receive the dividend.

P14-3. Residual dividend policy

LG 2; Intermediate
a. Residual dividend policy means that the firm will consider its investment opportunities first. If after meeting
these requirements there are funds left, the firm will pay the residual out in the form of dividends. Thus, if the
firm has excellent investment opportunities, the dividend will be smaller than if investment opportunities are
limited.

b. Capital budget = $1.5 million

Equity required = Equity % × Capital budget = 0.4 × $1,500,000 = $600,000
Residual dividend = Retained earnings ‒ Equity required
= $2,200,000 ‒ $600,000 = $1,600,000; Thus, a dividend amount of $1,600,000 can be paid.

Capital budget = $2.5 million

Equity required = Equity % × Capital budget = 0.4 × $2,500,000 = $1,000,000
Residual dividend = Retained earnings ‒ Equity required
= $2,200,000 ‒ $1,000,000 = $1,200,000

Capital budget = $3,500,000

Equity required = Equity %  Capital budget = 0.4 × $3,500,000 = $1,400,000
Residual dividend = Retained earnings ‒ Equity required
= $2,200,000 ‒ $1,400,000 = $800,000

c. The amounts payable as dividends are dependent on the capital budget and the financing of the capital
budget. If more debt is allowed, then more funds will be available to be distribution to the stockholders.

P14-4. Dividend constraints

LG 3; Intermediate
$ 1,200,000
a. Maximum dividend (includes all paid-in capital): =$ 4.29 per share
280,000
$ 980,000
b. Maximum dividend (includes only common stock): =$ 3.50 per share
280,000
c. Dividend = $1,200,000  $25,000 = $1,225,000

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  321

Dividend per share = $4.38.

d. It is established to provide a sufficient equity base to protect creditors’ claims.

P14-5. Dividend constraints

LG 3; Intermediate

a. Maximum dividend:
b. A $20,000 decrease in cash and retained earnings is the result of a $0.80 per share dividend.
c. Cash is the key constraint because a firm cannot pay out more in dividends than it has in cash, unless it borrows.
P14-6. Low-regular-and-extra dividend policy
LG 4; Intermediate

a. Year Payout % Year Payout %

2020 21.43 2017 31.25

2019 24.19 2016 31.91

2018 26.79 2015 38.46

b.

60% Actual 60% Actual

Year Payout Payout $ Diff. Year Payout Payout $ Diff.

2020 $2.10 0.75 1.35 2017 $1.44 0.75 

2019 1.86 0.75 1.11 2016 1.41 0.75 

2018 1.68 0.75 0.93 2015 1.17 0.75 

c.

© 2019 Pearson Education, Ltd.

322  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Year Dividend $ Difference

2020 $0.75 $0.50

2019 $0.75 $0.50

2018 $0.75 $0.50

2017 $0.75 none

2016 $0.75 none

2015 $0.75 none

d. The board should consider legal constraints, contractual constraints, growth prospects, owner considerations,
and market considerations.

P14-7. Alternative dividend policies

LG 4; Intermediate

Year Dividend Year Dividend

a. 2010 $0.10 2015 $1.28

2011 0.00 2016 1.12

2012 0.72 2017 1.28

2013 0.48 2018 1.52

2014 0.96 2019 1.60

b. 2010 $1.00 2015 $1.10

2011 1.00 2016 1.20

2012 1.00 2017 1.30

2013 1.00 2018 1.40

2014 1.00 2019 1.50

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  323

Year Dividend Year Dividend

c. 2010 $0.50 2015 $0.66

2011 0.50 2016 0.50

2012 0.50 2017 0.66

2013 0.50 2018 1.14

2014 0.50 2019 1.30

d. With a constant-payout policy, if the firm’s earnings drop or a loss occurs, the dividends will be low or nonexistent. A
regular dividend or a low-regular-and-extra dividend policy reduces owner uncertainty by paying relatively fixed and
continuous dividends.

P14-8. Alternative dividend policies

LG 4; Challenge

Year Dividend Extra Year Dividend Extra

Dividend Dividend
a. 2020 $0.96 -- 2016 $0.66 --

2019 0.80 -- 2015 0.51 --

2018 0.72 -- 2014 0.40 --

2017 0.00 -- 2013 0.34 --

b. 2020 $0.85 -- 2016 $0.85 --

2019 0.85 -- 2015 0.75 --

2018 0.85 -- 2014 0.75 --

2017 0.00 -- 2013 0.75 --

c. 2020 $0.75 $0.50 2016 $0.75 $0.50

2019 0.75 0.50 2015 0.75 --

2018 0.75 0.50 2014 0.75 --

2017 0.00 -- 2013 0.75 --

© 2019 Pearson Education, Ltd.

324  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Year Dividend Extra Year Dividend Extra

Dividend Dividend

d. 2020 $0.75 $0.45 2016 $0.75 $0.70

2019 0.75 0.25 2015 0.75 --

2018 0.75 0.15 2014 0.75 --

2017 0.00 -- 2013 0.75 --

e. Low- regular- and extra dividend policies. Steel Enterprises provides the investors with a stable income
necessary to build investors’ confidence in the firm and the extra dividend permits the investors to share in
the earnings from an especially good period.

P14-9. Stock dividend—firm

LG 5; Intermediate
(a) 5% (b) (1) 10% (b) (2) 15%
Stock Dividend Stock Dividend Stock Dividend
Preferred stock $100,000 $100,000 $100,000

Common stock (at $4.00 par) 504,0001 528,0002 552,0003

Paid-in capital in excess of par 2,016,000 2,112,000 2,208,000
Retained earnings 240,000 120,000 ……….0
Stockholders’ equity $2,860,000 $2,860,000 $2,860,000

1
126,000 shares
2
132,000 shares
3
138,000 shares

c. The total stockholders’ equity will not change, but the retained earnings will reduce with the par value of the new
stock issued. The paid-in capital in excess of par will also change as it reflects the total difference between the market
value and the par value of the stock outstanding.

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  325

P14-10. Cash versus stock dividend

LG 5; Intermediate
a.
Cash Dividend
€0.1 €0.5 €1.0 €2.0
Preferred stock €1,000,00 €100,000 €100,000 €100,000
0

Common stock
 (100,000 shares
 @€20 par) 2,000,000 2,000,000 2,000,000 2,000,000
Paid-in capital in
 excess of par 5,000,000 5,000,000 5,000,000 5,000,000
Retained earnings 840,000 800,000 750,000 650,000
Stockholders’ equity €8,440,000 €8,400,000 €8, 350,000 €8,250,000

b.
Stock Dividend
1% 5% 10% 20%
Preferred stock €1,000,000 €1,000,000 €1,000,000 €1,000,000

Common stock
 (xx shares
 @€20 par) 2,020,000 2,100,000 2,200,000 2,400,000
Paid-in capital in
 excess of par 5,020,000 5,100,000 5,200,000 5,400,000
Retained earnings 810,000 650,000 450,000 50,000
Stockholders’ equity $8,850,000 $8,850,000 $8,850,000 $8,850,000

c. Stock dividends do not affect stockholders’ equity; they only redistribute retained earnings into common
stock and additional paid-in capital accounts. Cash dividends cause a decrease in retained earnings, and hence
in overall stockholders’ equity.

P14-11. Personal finance: Stock dividend—investor

LG 5; Intermediate
$ 220,000
a. EPS= =$ 4.40
50,000
500
b. Percent ownership ¿ =1%
50,000

© 2019 Pearson Education, Ltd.

326  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

c. Percent ownership after stock dividend: 550 ÷ 55,000 = 1%; stock dividends maintain the same ownership
percentage. They do not have a real value.
d. Market price drop: ($25 × 100 ÷ 110) = $22.73 per share
e. The retained earnings will reduce with the amount of new stock issued, which is $125,000. Therefore,
retained earnings will decrease from $220,000 to $95,000. After stock dividend, EPS = 220,000 ÷ 55,000 =
$4.00.

P14-12. Personal finance: Stock dividend—investor

LG 5; Challenge

a.

c.

The market price of the stock will drop to maintain the same proportion because more shares are being used.

d.

e. Value of holdings: $20,000 under each plan.

As long as the firm’s earnings remain unchanged, his total share of earnings will be the same.
f. The investor should have no preference because the only value is of a psychological nature. After a stock
split or dividend, however, the stock price tends to go up faster than before.

P14-13. Stock split—firm

LG 6; Intermediate
a. Preferred stock $ 300,000
Common stock (400,000 shares at $2.50 par) 1,000,000
Paid-in capital in excess of par 500,000
Retained earnings 820,000
Total stockholders’ equity $2,620,000

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  327

b. Preferred stock $ 300,000

Common stock (100,000 shares at $10 par) 1,000,000
Paid-in capital in excess of par 500,000
Retained earnings 820,000
Total stockholders’ equity $2,620,000
c. Preferred stock $ 300,000
Common stock (600,000 shares at $1.66667 par) 1,000,000
Paid-in capital in excess of par 500,000
Retained earnings 820,000
Total stockholders’ equity $2,620,000
d. Preferred stock $ 300,000
Common stock (50,000 shares at $20 par) 1,000,000
Paid-in capital in excess of par 500,000
Retained earnings 820,000
Total stockholders’ equity $2,620,000
e. The total stockholders’ equity remains unchanged. Only the number of outstanding stock and the par value of
stock change, but the actual dollar amount also remain unchanged.

P14-14. Stock splits

LG 6; Easy
a. 100 × 5  500 shares will be owned by Brambilla after the split.
b. €64  5  €12.8 per share of Brembo after the 5:1 split.
c. Value of Brembo in Brambilla’s portfolio = shares owned  price per share.
100 × €64 = €6,400 value; before the split
500 × €12.8 = €6,400; value after the split
d. Brambilla does not experience a gain or a loss, and hence his financial condition does not change. Brambilla
still owns the same percentage of all Brembo shares.
e. Even if there was a gain or loss attributable to the split, Brambilla would not have any tax liability unless he
actually sold the stock and realized that change for tax purposes.

P14-15. Stock split versus stock dividend—firm

LG 5, 6; Challenge
a. Preferred stock $ 500,000
Common stock (225,000 shares at $4 par) 900,000
Paid-in capital in excess of par 2,850,000
Retained earnings 760,000
Total stockholders’ equity $5,010,000
b. The market price of stocks will drop immediately after a split to $16.67 or [$25 × (2 ÷ 3)].
c. Before stock split = 760,000 ÷ 150,000 = $5.07
After the stock split = 760,000 ÷ 225,000 = $3.3
d. Maximum cash dividend before split = 200 × $5.07 = $1,014

© 2019 Pearson Education, Ltd.

328  Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Maximum cash dividend after split = 300 × $3.38 = $1,014

Based on the maximum cash dividend, the stockholder should be indifferent. For future dividends, the stock
split should yield larger dividend payments.
e. Stock splits cause an increase in the number of shares outstanding and a decrease in the par value of the stock
with no alteration of the firm’s equity structure. However, stock dividends cause an increase in the number of
shares outstanding without any decrease in par value. Stock dividends cause a transfer of funds from the
retained earnings account into the common stock account and paid-in capital in excess of the par account.

P14-16. Stock dividend versus stock split—firm

LG 5, 6; Challenge
a. A 30% stock dividend would increase the number of shares to 65,000 but would not entail a decrease in par
value. There would be a transfer of €30,000 into the common stock account and €390,000 [(€15 – €2) =
30,000] in the paid-in capital in excess of the par account from the retained earnings account. The per-share
earnings would decrease because the net income remains the same, but the number of shares outstanding
would increase by 30,000. EPS stock dividend = 2.5 × 50,000 ÷ 65,000 = €1.92
b. There would be a decrease in the par value of the stock from €2 to €1 per share. The shares outstanding would
increase to 100,000. The common stock account would still be €100,000 (100,000 shares at €1.00 par). The
per-share earnings would decrease because the net income remains the same, but the number of shares
outstanding would increase by 50,000. EPS stock dividend = 2.5 × 50,000 ÷ 100,000 = €1.25.
c. The option in part (b) is better as the stock split will accomplish the goal of reducing the stock price while
maintaining a stable level of retained earnings. A stock split does not cause any change in retained earnings
but reduces the price of the shares in the same proportion as the split ratio.
d. The firm may be restricted in the amount of retained earnings available for dividend payments, whether cash or
stock dividends. Stock splits do not have any impact on the firm’s retained earnings.

P14-17. Stock repurchase:

LG 6; Intermediate

© 2019 Pearson Education, Ltd.

 Chapter 14 Payout Policy  329

a. Shares to be repurchased = €295,000,000 ÷ €170.2 = 1,733,255 shares

b. EPS = €3,631,450,000 ÷ (295,000,000 – 1,733,255) = €12.38 per share

If 1,733,255 shares are repurchased, the number of common shares outstanding will decrease and the
earnings per share will increase.

c. Market price: €12.38 × 13.82 = €171.13 per share.

d. The stock repurchase results in an increase in earnings per share from €170.19 to €171.13.

e. The pre-repurchase market price is different from the post-repurchase market price by the amount of the
cash dividend paid. The post-repurchase price is higher because fewer shares are outstanding.

In Germany, stockholders are taxed on cash dividends at a rate of 26.375% including the solidarity
change. If the firm repurchases stock, taxes on the increased value resulting from the purchase are also
due at the time of the repurchase. The additional €1 gain might be taxed progressively up to 47.475%,
including the solidarity surcharge, depending on the overall taxable income of the individual. Taxes
would not have to be paid on the repurchase gains until the shares are sold.

P14-18. Stock repurchase:

LG 6; Challenge
a. a. Shares outstanding needed = (€900,000,000 × 0.30) ÷ €2.5 = 108,000,000
b. b. 198,420,000 – 108,000,000  90,420,000.00 shares to be repurchased.

P14-19. Ethics problem

LG 6; Intermediate
Students should argue that all of the methods being contemplated by the chief financial officer (CFO) are legal
and therefore not unethical. Others may argue that even if legal, the actions are unethical and should not be
pursued. The final question tries to address how firm the students’ convictions are. It is one thing to demonstrate
a course of action and make a recommendation. Acting in the face of an opposing view by a superior is a bit more
difficult but should not discourage the student from maintaining their viewpoint.

© 2019 Pearson Education, Ltd.