Deck 19: Dividend Policy

Question 1

Which three of the following could result if the cost of capital as a discount rate is too high?

A) Shareholders will miss out on value- enhancing opportunities.
B) Firms will not grow as they should.
C) Investment will be constrained.
D) Bank lending is likely to fall as a proportion of investment levels.

Answer 1

A, B, C

Question 2

What does the X represent in the formula X= d1 p
, if d1 is the annual preference dividend and kp
Is the investors' required rate of return?

A) Price- productivity ratio
B) Rate of return on preference shares
C) Preference share ratio
D) Price of (perpetual) preference shares

Answer 2

D

Question 3

Which three of the following factors have the greatest impact on the cost of debt?

A) The benefit derived from interest being tax deductible
B) The risk of default
C) The prevailing interest rates
D) The level to which equity is classed as tradable

Answer 3

A, B, C

Question 4

Which three of the following are among the difficulties encountered when computing required rates of return?

A) Obtaining the riskfree rate
B) Estimating the equity risk premium
C) Creating a maximised gearing level
D) The unreliability of the CAPM's beta

Question 5

What is meant by the term 'cost of capital'?

A) The rate of return that a company has to offer finance providers to induce them to buy and hold a financial security
B) The rate of return that a company has to offer shareholders as dividends
C) The rate of return that a company has to offer purchasers of bonds to induce them to buy and hold a financial security
D) The rate of return that a company has to pay for its capital investments

Question 6

What is RP in the formula kD = rf + RP ?

A) Risk- free rate
B) Market rate
C) Risk premium
D) Cost of debt capital

Question 7

Which statement describes the rate of return expected when lending funds to a firm as compared with the rate when lending to a reputable state?

A) It must be lower because a lender to a firm cannot expect to not to be exposed to any risk.
B) It must be higher because a lender to a state cannot expect not to be exposed to any risk.
C) It must be lower because the term lengths will generally be shorter.
D) It must be higher because a lender to a firm cannot expect not to be exposed to any risk.

Question 8

On what basis do most UK firms identify their risk free rate?

A) Rate of inflation
B) Medium- term UK government bonds
C) Real rate of interest (including inflation)
D) Short- term UK government bonds

Question 9

What does the symbol kD represent in the formula WACC = kDWE + kEWD ?

A) The market value of debt
B) The market/debt equivalent
C) The weighting applied to debt
D) The cost of debt

Question 10

Which of the following would you expect to have the lowest level of risk- return?

A) A Treasury Bill
B) An internet start- up share
C) A Marks and Spencer share
D) A high- yield bond

Question 11

When should short- term debt be included when calculating WACC?

A) Always
B) Only for a public, listed company
C) Only for a private company
D) Never

Question 12

What is the effect of financial distress and taxation on gearing?

A) Both push for increased gearing.
B) Both constrain gearing.
C) The tax constrains gearing; financial distress pushes for increased gearing.
D) The tax pushes for increased gearing; financial distress constrains gearing.

Question 13

The average market return is 6 per cent and the risk- free return is 4 per cent. If beta for a particular share is 1.5, what is the required rate of return on the shares?

A) 7%
B) 6%
C) 21%
D) 12%

Question 14

Modigliani and Miller concluded that there is no point in adjusting the debt or equity proportions in choosing the capital structure of the firm, but which two important factors did they ignore?

A) Taxation
B) Financial distress
C) Inflation
D) Interest

Question 15

Yven has capital of £2m, three- quarters from shareholders who require a rate of return of 10 per cent and one- quarter from lenders, who require an 8 per cent return. If, as a result of considering tax, kDAT = 6%, what is the WACC?

A) 8.5%
B) 6.75%
C) 4%
D) 9%

Question 16

Which two of the following are implicit assumptions when estimating the equity risk premium?

A) There has been no systematic change in the risk aversion of investors over time.
B) Historical returns are so unreliable that they should be ignored.
C) The index being used as a benchmark has had an average riskiness that has not changed in a systematic way over time.
D) The risk premium is now so small that it can be ignored.

Question 17

What is the fundamental formula of the Gordon growth model?

A) kE = P1 - g
B) kE = d1 - g
C) kE = d1 + g
D) kE = P1 + g
D P P d

Question 18

Which three of the following are thought to be the factors that most affect fundamental beta?

A) Operating gearing
B) The type of business
C) The number of SBUs
D) Financial gearing

Question 19

The cost of equity capital, kE, is calculated using the formula kE = rf + RP. What does rf represent?

A) Cost of debt capital
B) Risk premium
C) Risk- free rate
D) Market rate

Question 20

Which of the following are the main forms of capital available to firms?

A) Equity and foreign currency
B) Convertible bonds and equity
C) Equity and debt
D) Non- convertible bonds and debt

Question 21

How is the rate of interest of a floating- rate debt normally expressed?

A) At a level determined by a gradually- increasing formula stated at initial sale
B) At a margin over a benchmark such as the bank base rate
C) At a margin below a benchmark such as the bank base rate
D) At a fixed rate stated at initial sale

Question 22

Which three of the following are difficulties encountered in implementing WACC?

A) The unreliability of the CAPM's beta
B) Obtaining the risk- free rate
C) Estimating the equity risk premium
D) Calculating the existing rate of gearing

Question 23

In the formula kE = rf + fi(rm - rf), what is beta based on?

A) The minimum share price in the past year
B) The covariance of the share with similar shares
C) The maximum share price in the past year
D) The covariance of the share with the market

Question 24

What does the term d1 represent in the formula kE = d1 + g ?

A) The discount rate
B) The discount rate in year 1
C) The dividend to be received next year
D) The dividend to be received in each year

Question 25

A particular (perpetual) preference share has an annual preference dividend of 50p, and the investors' required rate of return is 8 per cent. What is the cost of the preference share?

A) 625p
B) 400p
C) 160p
D) 500p

Question 26

Which of the following best shows how market capitalisation is calculated?

A) Multiply the gearing ratio by the level of debt
B) Multiply the current share price by the number of shares issued to investors
C) Multiply the current equity by the number of shares issued to investors
D) Calculate the net value of debt, equity, and hybrid securities

Question 27

Which three of the following correctly relate to the formula P = di ? kE - g

A) P = the company's share price.
B) kE = rate of return required for this risk class.
C) g = br, where b is the fraction of earnings retained each year, and r is the rate of return on reinvestment.
D) d1 = the dividend in the previous year of operations.

Question 28

Which three of the following statements correctly describe the situation regarding retained earnings?

A) They should be seen as belonging to shareholders.
B) They are 'costless'.
C) They are the most important source of long- term finance for most corporations.
D) They are part of the equity of the firm.

Question 29

What is meant by the term 'the cost of retained earnings'?

A) The current market rate of return for a risk class of debt
B) The expected returns required by investors buying corporation bonds in competing companies
C) The expected returns required by shareholders buying new shares in the firm
D) The cost to the firm of income less taxable profits

Question 30

Which two of the following describe the two stages of estimating the relevant risk premium on a firm's equity?

A) Adjust the risk premium for a typical share to suit the risk level of the particular company's shares.
B) Compare the expected return from equities with the return provided by bonds.
C) Assess the capital asset price.
D) Estimate the average return demanded by investors above the risk- free return to induce them to buy average- risk shares.

Question 31

Which two of the following statements best apply to views on the cost of capital?

A) The shareholder wants to ensure that dividends exceed the return on other shares.
B) The shareholder wants an expected return appropriate for the risk, when compared with other investments.
C) The firm wants to know the cost, in terms of expected return, needed to induce purchase and retention of shares.
D) The firm wants to ensure that the cost of return is sufficient to overcome variation in future costs.

Question 32

Which formula would you use if you needed to find the value of WACC for three types of finance?

A) WACC = kDATWD - kpWp + kEWE
B) WACC = kEWE - kDATWD - kpWp
C) WACC = kEWE + kDATWD - kpWp
D) WACC = kEWE + kDATWD + kpWp

Question 33

Which two of the following types of information would most usefully help you to quickly estimate an approximate required rate of return for a bond?

A) The debt capital
B) The risk class of the bond you are considering
C) The annual nominal interest
D) Rates payable for bonds of different credit ratings

Question 34

Which of the following is the most obvious problem with using the fundamental beta approach?

A) The difficulty of deriving the exact extent to which beta should be adjusted
B) The historical variations of beta
C) The difficulty of calculating regression values for the firm's returns
D) The unpredictability of interest rates

Question 35

For a particular share the dividend to be paid in the first year is 50p, the current price is 400p, and the rate at which the dividend stream is expected to grow is 2 per cent. What is the expected rate of return on the shares?

A) 16%
B) 8.2%
C) 12.2%
D) 14.5%

Question 36

Which three of the following factors have the greatest effects on the cost of debt?

A) The benefit derived from interest being tax deductible
B) The prevailing interest rates
C) The proportion of earnings that are retained
D) The risk of default (and expected rate of recovery of money lent in the event of default)

Question 37

What name is given to the ratio of a company's level of long- term debt to its equity capital?

A) Investment ratio
B) Gearing
C) Cost of capital
D) Equity- capital ratio

Question 38

What is X in the formula X = di ? Pp

A) The company's predicted rate of return for ordinary shares
B) Investors' required rate of return for (perpetual) preference shares
C) The company's preferred rate of return for preference shares
D) Investors' required rate of return for ordinary shares

Question 39

What of the following best describe the approaches analysts typically take when calculating the cost of capital?

A) Personal judgement aided by a theoretical framework
B) Scientific, theoretically- based, calculations
C) Personal judgement
D) A theoretical framework with a small element of personal judgement

Question 40

The introduction of tax benefit pushes the bias towards very high gearing levels to obtain lower WACC and higher value. What is the main reason why we do not observe such high gearing in real- world companies?

A) The higher risk to the firm of financial distress
B) The increasing risk of financial distress borne by finance providers
C) The lower risk to the finance providers of liquidation
D) The lower risk to the firm of financial distress

Question 41

Which of the following options best explains how the cost of capital is determined?

A) It is the average return offered on alternative securities.
B) It is based on predictions of future profits to the firm.
C) It is equal to the Bank of England base rate.
D) It is the return offered on alternative securities with the same risk.

Question 42

Which of the following best describes what determines the cost of debt capital?

A) The current market rate of return for a risk class of debt
B) The cost to the firm of income less taxable profits
C) The expected returns required by shareholders buying new shares in a firm
D) The expected returns required by investors buying corporation bonds in competing companies

Question 43

When selecting the weights to be used in WACC calculations which values should be used?

A) Risk free values
B) Capitalised values
C) Market values
D) Balance sheet values

Question 44

What term is used for the weighted cost of equity and debt in proportion to their contribution to the total capital of the firm?

A) Weighted and capitalised costs
B) Weighted amalgamated costs of capital
C) Weighted average cost of capital
D) Weighted costs of average capital

Question 45

Which assumption is necessary for the formula WACC = kEWE + kDATWD to apply?

A) The tax shield is ignored.
B) Financial distress is not ignored.
C) Taxation is ignored.
D) There must be a 50:50 capital structure.

Question 46

Xtra has capital of £2m, three- quarters from shareholders who require a rate of return of 10 per cent and one- quarter from lenders, who require an 8 per cent return. What is the WACC?

A) 9%
B) 18%
C) 9.5%
D) 8.5%

Question 47

For complete certainty in relation to the risk free rate, which two of the following conditions are needed?

A) The risk of default must be zero.
B) Investors shall become gradually less risk averse over time.
C) When intermediate cash flows are earned on a multi- year investment there is no uncertainty about reinvestment rates.
D) Future required rates of interest must be covariant with the bank rate.

Question 48

Which ratio is used to calculate gearing?

A) Debt to overall investment
B) Equity to debt
C) Debt to equity
D) Equity to overall investment

Question 49

The market risk premium is 4 per cent and, for a particular share, beta is 1.2. If the rates on government securities are 6 per cent, what is the required rate of return for the shares?

A) 11.2%
B) 8.4%
C) 6.4%
D) 10.8%