Question

Crawford Inc. uses a residual dividend policy. A debt/equity of 1.0 is considered optimal. Earnings for the period just ended were $1,400, and a total dividend of $420 was declared.

(a) How much new debt was taken? What was the total capital expenditure for investment?

(b) Suppose the company has 5,000 shares outstanding. The average tax rate on dividend is 15% and the tax rate on capital gain is 30%. What do you expect the company’s share price will drop after the dividend is paid.

Answer 1

(a) Earnings for the period = $ 1400

Dividends declared = $420

Retained Earnings = $1400 - $420 = $980

Optimal debt/equity ratio is 1. Equity increased by $980 this year. This means new debt taken for the capital investment was equal to the increase in equity, as debt/equity ratio should be 1.

Therefore, New debt taken = $980

Total Capital Expenditure for investment = new debt taken + Retained earnings used = $980 + $980 = $1,960

(b)Shares Outstanding = 5000

Average Tax Rate on Dividend = 15%

Tax Rate on Capital gain = 30%

Other factors remaining same, the stock prices usually decrease by the ex-dividends date by an amount equal to dividend per share, as the stock market offsets the payout by selling the stocks immediately, thereby taking the dividend equivalent amount today. As the rate of Capital gains at 30% is more than tax rate on dividends at 15%, it is more logical to receive dividends and pay 15%, rather than selling the stock and pay the capital gains @30%. In that sense, the Company's share price should not drop.

But in real life, the investors may have investments in various stocks or in the same stock bought at different point of time. So, they may be able to book capital losses by selling the stock, or they may be incomes below the tax threshold, and may not be liable to taxes, and hence they may prefer to sell, or simply some investors may want to shift their investments and as they expect reduction in price, they may sell the stocks now.

So, we can expect the share prices to drop from the day on which the dividends are declared to the extent of amount of dividend per share, which is equal to $420 / 5000 shares = $ 0.084 per share

But the drop is just after the declaration. Thus, we don't expect the share prices to drop after the dividend is paid.

I hope there is clarity on how the market acts on the dividend declaration news.