Solution 18.

1
The earnings reinvestment and dividend payout over time for firms A and B are:
Firm A
$1000
$1000

$100
$100

$100
$100

Year
NI
$1000.0
$1040.0

3
$1000
.
.
.
.
and so on forever.

$100
.
.

$100
.
.

$1081.6
.
.

1
2

Firm B
NI

Assets
Div
$100.00
$104.00

$60.00
$62.40

$108.16
.
.

$64.896
.
.

Div

Assets

The growth rate for Firm A is 0% and the growth rate for Firm B is 4% (g = ROE x Plowback Ratio). The
market value of Firm A is $100/.10 = $1000. The market value of Firm B is $60/(.1 - .04) = $1000. The fact
that both companies have the same value is consistent with the Modigliani-Miller dividend irrelevance
proposition.
Problem 18.2
Firms C and D have time zero EBIT of $1000. The required return on equity for both of these unlevered
firms is 10%. The marginal corporate tax rate is 34%. Firm C has a dividend payout ratio of 20% and a
dividend growth rate of 8%. Firm D has a dividend payout ratio of 80% and a dividend growth rate of 4%.
a. What is each firm's expected dividend at the end of the next year?
b. Which firm has the higher market value?
c. Given a fixed dividend payout ratio, EBIT must grow at the same rate as dividends. Calculate the
after-tax rate of return on each firm's reinvestment of earnings (EBIT(l-Tc)/RE).
Solution 18.2
a. DIV = NI (DIV/NI) (1 + g) = (EBT(1-Tc))(DIVIDEND PAYOUT)(1 + g)
DIVC = $1000 (1 - .34) (0.2) (1.08) = $142.56
DIVD = $1000 (1 - .34) (0.8) (1.04) = $549.12
b. MVC = $142.56 / (0.1 - 0.08) = $7128
MVD = $549.12 / (0.1 - 0.04) = $9152
c. Time 0 NIC = $1000 (1 - .34) = $660
Time 0 DIVC = $660 (0.2) = $132
Time 0 REC = NIC - DIVC = $660 - $132 = $528
Time 1 dollar growth in EBIT = EBITC = $1000 (0.08) = $80
After-tax return REC = EBITC (l - T)/REC = $80(1-.34)/$528 = 10%
Similarly, EBITD (1-T) / RED = $40 (1 - .34) / $132 = 20%

Although firm D has a lower dividend growth rate, it has a higher market value because it has a higher
return on reinvested earning

Case
Case 28
Lancaster Colony
Purpose: The purpose of this case is to discuss the different dividend payment policy
alternatives and how they might affect stockholders.
1. The Residual Theory of Dividends states that all available cash flow should be
invested in projects with a positive net present value. Then any money left over should
be paid out to stockholders in the form of a dividend so that no free cash flow (FCF) is
left. Since we are not given an investment opportunity set in the case, it is not possible to
say with 100% certainty that Lancaster is not following this policy. However, given the
stable and steady increase in dividend payments, it is certainly unlikely to be the policy
chosen by Lancaster.
2. A Constant Payout Ratio means the company will keep the ratio "DPS divided by
EPS" at the exact same level each year. Table 1 shows that although the number has
been consistent and stable over the last 5 years, it certainly is not the same. Moreover,
there are several drawbacks associated with the Constant Payout Ratio policy and it is
therefore not often used by firms.
3. The Fixed-Dollar or "Regular" dividend payment policy maintains that the firm would
pay the exact same dollar amount every dividend payment period and would only
increase the dividend payment when it was very certain that the new, higher dividend
could be sustained in the long-run as subsequent dividend cuts send a severely negative
signal to the market. In the case of Lancaster Colony, the dividend payment amount is
clearly different each year so this policy is not being followed.
4. The Low-Regular-and-Extra Dividend policy holds that the firm will pay the same
dollar dividend over the first three quarters (dividends in the US are typically paid every
quarter, not just at year's end), then pay a fourth quarter dividend that is at least the same
as, but likely higher than that paid for each of the first three quarters. The amount of the
year end dividend is a function of how well the company has done during the year and
also a function of their investment opportunity set in the near future.
Although the data given in the case does not breakdown dividend payments by
quarter, it is very likely that Lancaster follows this policy coupled with the very
conscience decision to ensure that the annual amount of dividends continues to increase
each year. We can also safely assume that both the firm's investment opportunity set and
how well they performed have also been taken into consideration given that their
dividends do not always increase at the same rate or by the same dollar amount.
5-6. If Lancaster cut its dividend for the first time in 39 years, it would certainly send a

negative signal to the market causing the stock price to drop. However, Lancaster could
mitigate this reaction by coupling their dividend cut announcement with an explanation
that the reason for the cut is to allow the company to earn an even greater rate of return
57
by investing in internal projects that are highly profitable. Even still, the investor base or
investor composition might change from income seeking conservatives to more
aggressive growth-oriented investors. This will cause extra volatility in Lancaster's stock
as investors buy and sell their shares to transfer ownership.
58