Deck 17: Distributions to Shareholders

Question 1

Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.

Answer 1

True

Question 2

Even if a stock split has no information content, and even if the dividend per share adjusted for the split does not increase, there can still be a real benefit (i.e., a higher value for shareholders) from such a split, but any such benefit is probably small.

Answer 2

True

Question 3

A decrease in a firm's willingness to pay dividends is likely to result from an increase in its

A) Earnings stability.
B) Access to capital markets.
C) Profitable investment opportunities.
D) Collection of accounts receivable.
E) Stock price.

Answer 3

C

Question 4

In the real world, we find that dividends

A) Usually exhibit greater stability than earnings.
B) Fluctuate more widely than earnings.
C) Tend to be a lower percentage of earnings for mature firms.
D) Are usually changed every year to reflect earnings changes.
E) Are usually set as a fixed percentage of earnings.

Question 5

Which of the following statements best describes the theories of investors' preferences for dividends?

A) Modigliani and Miller argue that investors prefer dividends to capital gains.
B) The bird-in-hand theory suggests that a company can reduce its cost of equity capital by reducing its dividend payout ratio.
C) The tax preference theory suggests that a company can increase its stock price by increasing its dividend payout ratio.
D) One key advantage of a residual distribution policy (with all distributions as dividends) is that it enables a company to follow a stable dividend policy.
E) The clientele effect suggests that companies should follow a stable dividend policy.

Question 6

If investors do, in fact, prefer that firms retain most of their earnings, then firms that want to maximize stock price should hold dividend payments to low levels.
a. True
b. False

Question 7

If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as opposed to a shallow "U", the easier it will be for the firm to maintain a steady dividend in the face of varying investment opportunities from year to year.

Question 8

Which of the following would not have an influence on the optimal distribution policy?

A) The possibility of accelerating or delaying investment projects.
B) A strong shareholders' preference for current income versus capital gains.
C) Bond indenture constraints.
D) The costs associated with selling new common stock.
E) All of the statements above can have an effect on dividend policy.

Question 9

If a firm adopts a residual distribution policy, distributions are determined as a residual item. Therefore, the better the firm's investment opportunities, the lower its distributions should be.

Question 10

Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that

A) Investors are indifferent between dividends and capital gains.
B) Investors require that the dividend yield and capital gains yield equal a constant.
C) Capital gains are taxed at a higher rate than dividends.
D) Investors view dividends as being less risky than potential future capital gains.
E) Investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.

Question 11

The announcement of an increase in the cash dividend always causes an increase in the price of the firm's common stock.

Question 12

The dividend irrelevance theory, proposed by Miller and Modigliani, says that as long as a firm pays a dividend, how much it pays does not affect either its cost of capital or its stock price.

Question 13

Which of the following statements is most correct?

A) The bird-in-the-hand theory implies that a company can reduce its WACC by reducing its dividend payout.
B) The bird-in-the-hand theory implies that a company can increase its stock price by reducing its dividend payout.
C) One problem with following a residual distribution policy (with all distributions in the form of dividends) is that it can lead to erratic dividend payouts that may prevent the firm from establishing a reliable clientele of investors who prefer a particular dividend policy.
D) Statements a and c are correct.
E) All of the statements above are correct.

Question 14

One implication of the bird-in-the-hand theory of dividends is that a reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant.

Question 15

MM's dividend irrelevance theory says that dividend policy does not affect a firm's value but can affect its cost of capital.
a. True
b. False

Question 16

A stock dividend and a stock split should, at least conceptually, have the same effect on shareholders' wealth.

Question 17

A reverse split reduces the number of shares outstanding.

Question 18

A firm that follows a residual distribution policy must believe that the dividend irrelevance theory is correct.

Question 19

If the information content, or signaling, hypothesis is correct, then changes in dividend policy can be important with respect to firm value and capital costs.

Question 20

The optimal distribution policy for a firm strikes a balance between current dividends and capital gains, and results in the maximization of stock price.

Question 21

Which of the following statements is most correct?

A) If a firm repurchases its stock in the open market, the shareholders that tender are subject to capital gains taxes.
B) If you own 100 shares in a company's stock, and the company does a 2- for-1 stock split, you will own 200 shares in the company following the split.
C) Some dividend reinvestment plans increase the amount of equity capital available to the firm.
D) All of the statements above are correct.
E) Answers a and b are correct.

Question 22

Which of the following statements is most correct?

A) One advantage of stock repurchases is that they are generally taxed more favorably than dividend payments.
B) One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.
C) Stock repurchases make sense if a company is interested in increasing its equity ratio.
D) Stock repurchases make sense if a company believes that its stock is overvalued and that it has a lot of profitable projects to fund over the next year.
E) One advantage of an open market dividend reinvestment plan is that it increases the number of shares the company has outstanding.

Question 23

Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests on the contention that

A) rs = D1/P0 + g is constant for any dividend policy.
B) Because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.
C) Investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of dividends.
D) Most investors will reinvest rather than spend dividends, so it would save investors money (taxes) if corporations simply reinvested earnings rather than paid them out as dividends.
E) None of the answers above.

Question 24

Which of the following statements is most correct?

A) "New-stock" dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the total equity of a firm.
B) Investors receiving stock dividends must pay taxes on the new shares at the time the stock dividends are received.
C) Stockholders pay no income tax on dividends reinvested in a dividend reinvestment plan.
D) Both statements a and b are correct.
E) None of the statements above is correct.

Question 25

Which of the following statements is most correct?

A) One reason that companies tend to avoid stock repurchases is that dividend payments are taxed more favorably than stock repurchases.
B) One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.
C) If a company announces a 2-for-1 stock split and the overall value of the firm remains unchanged, the company's stock price must have doubled.
D) All of the statements above are correct.
E) None of the statements above is correct.

Question 26

Which of the following statements is most correct?

A) In general, stock repurchases are taxed the same way as dividends.
B) One nice feature of dividend reinvestment plans is that they enable investors to reduce the taxes paid on their dividends.
C) On average, companies send a negative signal to the marketplace when they announce an increase in their dividend.
D) If a company is interested in issuing new equity capital, a new stock dividend reinvestment plan probably makes more sense than an open market dividend reinvestment plan.
E) Statements b and d are correct.

Question 27

If a firm adheres strictly to the residual distribution policy with all distributions in the form of dividends), then if its optimal capital budget requires the use of all earnings for that year (along with new debt according to the optimal debt/total assets ratio), the firm should pay

A) No dividends except out of past retained earnings.
B) No dividends to common stockholders.
C) Dividends, in effect, out of a new issue of common stock.
D) Dividends by borrowing the money (debt).
E) Either c or d above could be used.

Question 28

Which of the following statements is most correct?

A) The tax preference theory states that, all else equal, investors prefer stocks that pay low dividends because retained earnings can lead to capital gains that are taxed preferentially.
B) An increase in the cost of equity capital (rs) when a company announces an increase in its dividend per share would be consistent with the bird-in-the-hand theory.
C) An increase in the stock price when a company decreases its dividend is consistent with the signaling theory.
D) A dividend policy that involves paying a consistent percentage of net income is the best policy if the "clientele effect" is correct.
E) Both statements a and d are correct.

Question 29

A stock split will cause a change in the total dollar amounts shown in which of the following balance sheet accounts?

A) Cash.
B) Common stock.
C) Paid-in capital.
D) Retained earnings.
E) None of the above.

Question 30

If a firm adheres strictly to the residual distribution policy (with all distributions in the form of dividends), a sale of new common stock by the company would suggest that

A) The dividend payout ratio has remained constant.
B) The dividend payout ratio is increasing.
C) No dividends were paid for the year.
D) The dividend payout ratio is decreasing.
E) The dollar amount of investments has decreased.

Question 31

Which of the following statements is most correct?

A) An open-market dividend reinvestment plan is likely to be attractive to companies that are looking to issue additional shares of common stock.
B) Stock repurchases have the effect of reducing financial leverage.
C) If a company does a 2-for-1 stock split, its stock price will roughly double.
D) All of the answers above are correct.
E) None of the answers above is correct.

Question 32

If the MM hypothesis about dividends is correct, and if one found a group of companies that differed only with respect to dividend policy, which of the following statements would be most correct?

A) The residual distribution model should not be used, because it is inconsistent with the MM dividend hypothesis.
B) The total expected return, which in equilibrium is also equal to the required return, would be higher for those companies with lower payout ratios because of the greater risk associated with capital gains versus dividends.
C) If the expected total return of each of the sample companies were divided into a dividend yield and a growth rate, and then a scatter diagram (or regression) analysis were undertaken, then the slope of the regression line (or b in the equation D1/P0 = a + b(g)) would be equal to +1.0.
D) None of the statements above is true.
E) All of the statements above are true.

Question 33

Which of the following statements is most correct?

A) The tax preference hypothesis suggests that companies can reduce their costs of capital by increasing their dividend payout ratios.
B) One advantage of the residual distribution policy (with all distributions as dividends) is that it leads to a stable dividend payout, which is desired by investors.
C) Firms with a large number of investment opportunities and a relatively small amount of cash tend to have above average dividend payouts.
D) Answers a and b are correct.
E) None of the answers above is correct.

Question 34

Which of the following statements is most correct?

A) The bird-in-the-hand theory would predict that companies could decrease their cost of equity financing by raising their dividend payout.
B) The clientele effect can explain why firms often change their dividend policies.
C) One advantage of adopting a residual distribution policy (with all distributions in the form of dividends) is that it makes it easier for corporations to maintain dividend clienteles.
D) Answers a and c are correct.
E) None of the answers above is correct.

Question 35

Which of the following statements is most correct?

A) The tax code encourages companies to pay large dividends to their shareholders.
B) If your company has established a clientele of investors who prefer large dividends, the company is unlikely to adopt a residual dividend policy.
C) If a firm follows a residual distribution policy (with all distributions in the form of dividends), holding all else constant, its dividend payout will tend to rise whenever the firm's investment opportunities improve.
D) All of the statements above are correct.
E) Answers b and c are correct.

Question 36

You currently own 100 shares of stock in Beverly Brothers Inc. The stock currently trades at $120 a share. The company is contemplating a 2-for-1 stock split. Which of the following best describes your position after the proposed stock split takes place?

A) You will have 200 shares of stock, and the stock will trade at or near $120 a share.
B) You will have 200 shares of stock, and the stock will trade at or near $60 a share.
C) You will have 100 shares of stock, and the stock will trade at or near $60 a share.
D) You will have 50 shares of stock, and the stock will trade at or near $120 a share.
E) You will have 50 shares of stock, and the stock will trade at or near $60 a share.

Question 37

Which of the following statements is most correct?

A) If a company puts in place a 2-for-1 stock split, its stock price should roughly double.
B) Share repurchases are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases.
C) On average, a company's stock price tends to rise when it announces that it is initiating a share repurchase program.
D) Statements a and b are correct.
E) All of the statements above are correct.

Question 38

Which of the following statements is most correct?

A) Companies can repurchase shares either (1) to change their capital structures or (2) to distribute cash to stockholders without paying cash dividends. In the second situation, tax considerations will probably play a key role in the decision to repurchase stock versus to pay more cash dividends.
B) Stock dividends provide investors with additional shares of stock, not cash, yet many investors must pay cash in the form of taxes on the value of the stock dividends. For this reason, stock dividends are rarely used today.
C) The bird-in-the-hand theory of dividend policy could be rejected immediately if personal income taxes were abolished.
D) If the curve relating the WACC and the debt ratio looks like a sharp 'V', this would make it more feasible for a firm to follow the residual dividend policy than if the curve looks like a shallow bowl (or a shallow 'U').
E) The open market type of dividend reinvestment plan is the best type for firms that need to bring in new equity capital.

Question 39

Which of the following statements is most correct?

A) If a company wants to issue new shares of common stock and also wants to implement a dividend reinvestment plan, then it should implement a new-stock dividend reinvestment plan, rather than an open-market purchase plan.
B) If a company undertakes a 3-for-1 stock split, then the number of shares outstanding should fall, and the stock price should rise.
C) If a company wants to reduce its debt ratio, then it should repurchase some of its common stock.
D) Answers a and c are correct.
E) Answers b and c are correct.

Question 40

Which of the following statements is most correct?

A) If the dividend irrelevance theory (which is associated with the names Modigliani and Miller) were exactly correct, and if this theory could be tested with "clean" data, then we would find, in a regression of dividend yield and capital gains, a line with a slope of -1.0.
B) The tax preference and bird-in-the-hand theories lead to identical conclusions as to the optimal dividend policy.
C) If a company raises its dividend by an unexpectedly large amount, the announcement of this new and higher dividend is generally accompanied by an increase in the stock price. This is consistent with the bird-in-the-hand theory, and Modigliani and Miller used these findings to support their position on dividend theory.
D) If it could be demonstrated that a clientele effect exists, this would suggest that firms could alter their dividend payment policies from year to year to take advantage of investment opportunities without having to worry about the effects of changing dividends on capital costs.
E) Each of the statements above is false.

Question 41

Your company has decided that its capital budget during the coming year will be $20 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) are projected to be $34.667 million for the year. The company has $200 million of assets; its average interest rate on outstanding debt is 10 percent; and its tax rate is 40 percent. If the company follows the residual distribution policy (with all distributions in the form of dividends) and maintains the same capital structure, what will its dividend payout ratio be?

A) 15%
B) 20%
C) 25%
D) 30%
E) 35%

Question 42

Strategic Systems Inc. expects to have net income of $800,000 during the next year. Its target, and current, capital structure is 40 percent debt and 60 percent common equity. The Director of Capital Budgeting has determined that the optimal capital budget for next year is $1.2 million. If Strategic uses the residual distribution model (with all distributions in the form of dividends) to determine next year's dividend payout, what is the expected dividend payout ratio?

A) 0%
B) 10%
C) 28%
D) 42%
E) 56%

Question 43

Flavortech Inc. expects EBIT of $2,000,000 for the current year. The firm's capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. For the next year, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual distribution policy (with all distributions in the form of dividends) and has no other projects, what is its expected dividend payout ratio?

A) 100%
B) 60%
C) 40%
D) 20%
E) 0%

Question 44

Chandler Communications' CFO has provided the following information: • The company's capital budget is expected to be $5,000,000.
• The company's target capital structure is 70 percent debt and 30 percent equity.
• The company's net income is $4,500,000.
If the company follows a residual distribution policy (with all distributions in the form of dividends), what portion of its net income should it pay out as dividends this year?

A) 33.33%
B) 40.00%
C) 50.00%
D) 60.00%
E) 66.67%

Question 45

Powell Products anticipates that its capital budget next year will be $3 million. The company expects to report net income of $5 million this year. The company's target capital structure is 65 percent common equity and 35 percent long-term debt. Assume the company follows a strict residual distribution policy (with all distributions in the form of dividends). What is the expected dividend payout ratio this year?

A) 65%
B) 39%
C) 61%
D) 56%
E) 100%

Question 46

Driver Corporation has plans calling for a capital budget of $60 million. Its optimal capital structure is 60 percent equity and 40 percent debt. Its earnings before interest and taxes (EBIT) were $98 million for the year. The firm has $200 million in assets, pays an average of 10 percent on all its debt, and faces a marginal tax rate of 35 percent. If the firm maintains a residual distribution policy (with all distributions in the form of dividends) and will keep its optimal capital structure intact, what will be the amount of the dividends it pays out after financing its capital budget?

A) $22.5 million
B) $59.4 million
C) $60.0 million
D) $30.0 million
E) $ 0

Question 47

Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target capital structure that is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual distribution policy (with all distributions in the form of dividends), what will be its payout ratio?

A) 0%
B) 20%
C) 40%
D) 60%
E) 80%

Question 48

Loiselle Graphics recently announced a 3-for-1 stock split. Prior to the split, the company's stock was trading at $90 per share. The split had no effect on the wealth of the company's investors. What will be the new stock price?

A) $270
B) $ 45
C) $180
D) $ 60
E) $ 30

Question 49

Tarheel Computing's stock was trading at $150 per share before its recent 3-for-1 stock split. The 3-for-1 split led to a 5 percent increase in Tarheel's market capitalization. (Market capitalization equals the stock price times the number of shares.) What was Tarheel's price after the stock split?

A) $472.50
B) $ 50.00
C) $ 47.62
D) $428.57
E) $ 52.50

Question 50

Albany Motors recently completed a 3-for-1 stock split. Prior to the split, the company had 10 million shares outstanding and its stock price was $150 per share. After the split, the total market value of the company's stock equaled $1.5 billion. What was the price of the company's stock following the stock split?

A) $ 15
B) $ 45
C) $ 50
D) $150
E) $450

Question 51

Brock Brothers wants to maintain its capital structure that is 30 percent debt, and 70 percent equity. The company forecasts that its net income this year will be $1,000,000. The company follows a residual distribution policy (with all distributions in the form of dividends), and anticipates a dividend payout ratio of 40 percent. What is the size of the company's capital budget?

A) $ 600,000
B) $ 857,143
C) $1,000,000
D) $1,428,571
E) $2,000,000

Question 52

Wolfpack Multimedia follows a strict residual distribution policy (with all distributions in the form of dividends). Wolfpack forecasts that its net income will be $12 million this year. The company has no depreciation expense so its net cash flow is $12 million, and its target capital structure consists of 70 percent equity and 30 percent debt. Wolfpack's capital budget is $10 million. What is the company's dividend payout ratio?

A) 16.67%
B) 41.67%
C) 11.67%
D) 0.00%
E) 58.30%

Question 53

Which of the following actions will enable a company to raise additional equity capital (that is, which of the following will raise the total book value of equity)?

A) The establishment of a new-stock dividend reinvestment plan.
B) A stock split.
C) The establishment of an open-market purchase dividend reinvestment plan.
D) A stock repurchase.
E) Answers a and d are correct.

Question 54

Which of the following statements is most correct?

A) Stock repurchases can be used by firms to defend against hostile takeovers since they increase the proportion of debt in a firm's capital structure.
B) After a 3-for-1 stock split, a company's price per share will fall and its number of shares outstanding will rise.
C) Investors can interpret a stock repurchase by a firm as a signal that the firm's managers believe the stock is underpriced.
D) Both statements a and b are correct.
E) All of the statements above are correct.

Question 55

Redwood Systems follows a strict residual distribution policy (with all distributions in the form of dividends). The company estimates that its capital expenditures this year will be $40 million, its net income will be $30 million, and its target capital structure is 60 percent equity and 40 percent debt. What will be the company's dividend payout ratio?

A) 80%
B) 60%
C) 40%
D) 20%
E) 15%

Question 56

The following facts apply to your company: Target capital structure: 50% debt; 50% equity.
EBIT: $200 million.
Assets: $500 million.
Tax rate: 40%.
Cost of new and old debt: 8%.
Based on the residual distribution policy (with all distributions in the form of dividends), the payout ratio is 60 percent. How large (in millions of dollars) will the capital budget be?

A) $ 43.2
B) $ 50.0
C) $ 64.8
D) $ 86.4
E) $108.0

Question 57

Firm M is a mature firm in a mature industry. Its annual net income and net cash flow are both consistently high and very stable. The company's growth prospects are quite limited; therefore, the company's capital budget is small relative to its net income. Firm N is a relatively new firm in a new industry. Its annual operating income fluctuates considerably, but the company has substantial growth opportunities. Its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is most correct?

A) Firm M probably has a lower debt ratio than Firm N.
B) Firm M probably has a higher distribution ratio (the total of dividend payout ratio and stock repurchase ratio) than Firm N.
C) If the corporate tax rate increases, the debt ratio of both firms is likely to fall.
D) Statements a and b are correct.
E) Statements b and c are correct.

Question 58

Arden Manufacturing follows a strict residual distribution policy (with all distributions in the form of dividends). The company is forecasting that its net income will be $500 million this year. The company anticipates that its capital budget will be $250 million. The company has a target capital structure that consists of 50 percent equity and 50 percent long-term debt. What is the company's anticipated dividend payout ratio?

A) 75%
B) 55%
C) 50%
D) 25%
E) 47%

Question 59

Which of the following statements is most correct?

A) If you were testing dividend theories and found that a dividend increase resulted in higher stock prices, then you could rule out all other theories and conclude that the bird-in-the-hand theory was most consistent with the evidence you found.
B) The clientele effect suggests that investors choose their investments based on firms' past dividend policies and changes to established dividend policies may be costly to investors.
C) Dividends paid under a residual dividend policy might send conflicting signals to investors.
D) Both statements b and c are correct.
E) All of the statements above are correct.

Question 60

Plato Inc. expects to have net income of $5,000,000 during the next year. Plato's target capital structure is 35 percent debt and 65 percent equity. The company's director of capital budgeting has determined that the optimal capital budget for the coming year is $6,000,000. If Plato follows a residual distribution policy (with all distributions in the form of dividends) to determine the coming year's dividend, then what is Plato's payout ratio?

A) 38%
B) 42%
C) 58%
D) 33%
E) None of the answers above is correct.