Deck 15: Distributions to Shareholders: Dividends and

Question 1

Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument.

Answer 1

False

Question 2

Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on either its cost of capital or its stock price.

Answer 2

True

Question 3

If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio.

Answer 3

True

Question 4

If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the better the firm's investment opportunities, the lower its payout ratio will be, other things held constant.

Question 5

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price.

Question 6

Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be.

Question 7

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.

Question 8

A "reverse split" reduces the number of shares outstanding.

Question 9

If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout company because that would save him or her taxes and brokerage costs.

Question 10

Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends has no effect on its cost of capital, but it does affect its stock price.

Question 11

It has been argued that investors prefer high-payout companies because dividends are more certain (less risky) than the capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that this argument is incorrect, and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most dividends are reinvested in stocks, hence are exposed to the same risks as reinvested earnings.

Question 12

The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in dividend payout ratios.

Question 13

One implication of the bird-in-the-hand theory of dividends is that a given 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 14

If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then it must adhere to the residual dividend policy.

Question 15

A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's stock price.

Question 16

If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after providing for the equity required to fund the capital budget. Under this model, the higher the firm's debt ratio, the lower its payout ratio will be, other things held constant.

Question 17

If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can have an important effect on its stock price and cost of equity.

Question 18

The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock, other things held constant.

Question 19

The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, if the tax rate on dividends is high relative to that on capital gains, then individuals with low taxable incomes should favor stocks with low payouts and high-income individuals should favor high-payout companies.

Question 20

Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy.

Question 21

If a firm pays out all of its earnings as dividends and its stockholders then elect to have all of their dividends reinvested, the company should reconsider its dividend policy and possibly move to a lower payout ratio.

Question 22

Which of the following does NOT normally influence a firm's dividend policy decision?

A) The firm's ability to accelerate or delay investment projects without adverse consequences.
B) A strong preference by most of its shareholders for current cash income versus potential future capital gains.
C) Constraints imposed by the firm's bond indenture.
D) The fact that much of the firm's equipment is leased rather than bought and owned.
E) The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains.

Question 23

One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.

Question 24

Which of the following statements is CORRECT?

A) When firms are deciding on the size of stock splits--say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.
B) Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and reverse splits are illegal today.
C) Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits.
D) When a company declares a stock split, the price of the stock typically declines--for example, by about 50% after a 2-for-1 split--and this necessarily reduces the total market value of the firm's equity.
E) If a firm's stock price is quite high relative to most stocks--say $500 per share--then it can declare a stock split of say 20-for-1 so as to bring the price down to something close to $25. Moreover, if the price is relatively low--say $2 per share--then it can declare a "reverse split" of say 1-for-10 so as to bring the price up to somewhere around $20 per share.

Question 25

Which of the following statements is CORRECT?

A) If a company has a 2-for-1 stock split, its stock price should roughly double.
B) Capital gains earned on shares repurchased are taxed less favorably than dividends, which is why companies typically pay dividends and avoid share repurchases.
C) often, a company's stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen.
D) Stock repurchases increase the number of outstanding shares.
E) The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter. Answer: c is correct, but perhaps the easiest way to answer this question is to eliminate the other choices, which are obviously wrong.

Question 26

Which of the following statements about dividend policies is CORRECT?

A) Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the-hand" effect.
B) One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing stock is that dividends are normally taxed at a lower rate than gains on repurchased stock.
C) One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends that they choose to reinvest.
D) One key advantage of a residual dividend policy 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 27

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

A) investors are indifferent between dividends and capital gains.
B) investors require that the dividend yield plus the 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 prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower tax rate on capital gains.

Question 28

Which of the following statements is CORRECT?

A) Historically, the tax code has encouraged companies to pay dividends rather than retain earnings.
B) If a company uses the residual dividend model to determine its dividend payments, dividend payout will tend to increase whenever its profitable investment opportunities increase relatively rapidly.
C) The more a firm's management believes in the clientele effect, the more likely the firm is to adhere strictly to the residual dividend model.
D) Large stock repurchases financed by debt tend to increase expected earnings per share, but they also tend to increase the firm's financial risk.
E) A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out in dividends. Thus, both companies and investors should be indifferent between distributing cash through dividends and stock repurchase programs.

Question 29

Which of the following statements is CORRECT?

A) Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.
B) One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like.
C) An increase in the stock price when a company cuts its dividend is consistent with signaling theory as postulated by MM.
D) If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price.
E) Stock repurchases make the most sense at times when a company believes its stock is undervalued.

Question 30

Your firm follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share?

A) The firm's net income increases.
B) The company increases the percentage of equity in its target capital structure.
C) The number of profitable potential projects increases.
D) Congress lowers the tax rate on capital gains, leaving the rest of the tax code unchanged.
E) Earnings are unchanged, but the firm issues new shares of common stock.

Question 31

Which of the following statements is CORRECT?

A) Under the tax laws as they existed in 2007, a dollar received by an individual taxpayer as interest income is taxed at the same rate as a dollar received as dividends.
B) One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends.
C) Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and, as a result, share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm expects fewer good investment opportunities in the future.
D) If a company needs to raise new equity capital, a new stock dividend reinvestment plan would make sense. However, if the firm does not need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.
E) Dividend reinvestment plans have not caught on in most industries, and today over 99% of all DRIPs are offered by utilities.

Question 32

You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The company is about to declare a 2-for-1 stock split. Which of the following best describes your likely position after the split?

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 $600 a share.

Question 33

Which of the following statements is CORRECT?

A) One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their investment in the company.
B) One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.
C) Stock repurchases can be used by a firm that wants to increase its debt ratio.
D) Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities.
E) One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

Question 34

There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would have been paid as dividends to buy stock on the open market. Under the other type, the company issues new stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who choose to reinvest their dividends.

Question 35

If on January 2, 2008, a company declares a dividend of $1.50 per share, payable on January 31, 2008, then the price of the stock should drop by approximate $1.50 on January 31.

Question 36

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

A) the same dividend as it paid the prior year.
B) no dividends to common stockholders.
C) dividends only out of funds raised by the sale of new common stock.
D) dividends only out of funds raised by borrowing money (i.e., issuing debt).
E) dividends only out of funds raised by selling off fixed assets.

Question 37

If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be $25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to signaling effects--investors believe that management split the stock because they think the firm is going to do better in the future. The higher price could also be because investors like lower-priced shares.

Question 38

If on January 2, 2008, a company declares a dividend of $1.50 per share, payable on January 31, 2008, to holders of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is the ex-dividend date.

Question 39

If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that

A) the dividend payout ratio has remained constant.
B) the dividend payout ratio is increasing.
C) no dividends will be paid during the year.
D) the dividend payout ratio is decreasing.
E) the dollar amount of capital investments had decreased.

Question 40

Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?

A) Its earnings become more stable.
B) Its access to the capital markets increases.
C) Its R&D efforts pay off, and it now has more high-return investment opportunities.
D) Its accounts receivable decrease due to a change in its credit policy.
E) Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

Question 41

NY Fashions has the following data. If it follows the residual dividend model, how much total dividends, if any, will it pay out?

A) $20,363
B) $21,434
C) $22,563
D) $23,750
E) $25,000

Question 42

Which of the following statements is CORRECT?

A) If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.
B) An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers.
C) Stock repurchases tend to reduce financial leverage.
D) If a company declares a 2-for-1 stock split, its stock price should roughly double.
E) One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory.

Question 43

Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of $500,000. If the company follows the residual dividend policy, how much income must it earn, and what will its dividend payout ratio be?

A) $898,750; 55.63%
B) $943,688; 58.41%
C) $990,872; 61.34%
D) $1,040,415; 64.40%
E) $1,092,436; 67.62%

Question 44

Which of the following actions will best enable a company to raise additional equity capital, other things held constant?

A) Refund long-term debt with lower cost short-term debt.
B) Declare a stock split.
C) Begin an open-market purchase dividend reinvestment plan.
D) Initiate a stock repurchase program.
E) Begin a new-stock dividend reinvestment plan.

Question 45

Fauver Industries plans to have a capital budget of $650,000. It wants to maintain a target capital structure of 40% debt and 60% equity, and it also wants to pay a dividend of $225,000. If the company follows the residual dividend policy, how much net income must it earn to meet its investment requirements, pay the dividend, and keep the capital structure in balance?

A) $584,250
B) $615,000
C) $645,750
D) $678,038
E) $711,939

Question 46

Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock sold for $80 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split?

A) $20.63
B) $21.71
C) $22.86
D) $24.00
E) $25.20

Question 47

Chicago Brewing has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?

A) 48.11%
B) 50.52%
C) 55.57%
D) 61.13%
E) 67.24%

Question 48

(Comp.) Dividend concepts C R Answer: d MEDIUM/

A) Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% payout, announces that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument.
B) Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be.
C) Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings that a firm pays out in dividends has no effect on its cost of capital, but it does affect its stock price.
D) The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to a decrease in dividend payout ratios.
E) If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a high payout ratio.

Question 49

Dentaltech Inc. projects the following data for the coming year. If the firm follows the residual dividend policy and also maintains its target capital structure, what will its payout ratio be?

A) 37.2%
B) 39.1%
C) 41.2%
D) 43.3%
E) 45.5%

Question 50

Torrence Inc. has the following data. If it uses the residual dividend model, how much total dividends, if any, will it pay out?

A) $183,264
B) $192,909
C) $203,063
D) $213,750
E) $225,000

Question 51

Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $90 per share. The firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's post-split price?

A) $30.00
B) $31.50
C) $33.08
D) $34.73
E) $36.47

Question 52

Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock sold for $80 per share. If the firm's total market value is unchanged by the split, what will the stock price be following the split?

A) $36.10
B) $38.00
C) $40.00
D) $42.00
E) $44.10

Question 53

Portland Plastics Inc. has the following data. If it follows the residual dividend policy, what is its forecasted dividend payout ratio?

A) 25.36%
B) 28.17%
C) 31.30%
D) 34.78%
E) 38.26%

Question 54

Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a target capital structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the company follows the residual dividend policy, how much in dividends, if any, will it pay?

A) $45,125
B) $47,500
C) $50,000
D) $52,500
E) $55,125

Question 55

(Comp.) Dividend concepts C R Answer: a MEDIUM/

A) If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects would be likely to lead to a reduction of the firm's dividend payout ratio.
B) The clientele effect explains why so many firms change their dividend policies so often.
C) One advantage of adopting the residual dividend policy is that this policy makes it easier for a corporation to attract a specific and well-identified dividend clientele.
D) New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the firm's total amount of book equity.
E) Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received.

Question 56

Ring Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and 65% equity, and it also wants to pay a dividend of $400,000. If the company follows a residual dividend policy, how much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital structure in balance?

A) $904,875
B) $952,500
C) $1,000,125
D) $1,050,131
E) $1,102,638

Question 57

Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is $550,000, and its board of directors has decreed that no new stock can be issued during the coming year. If the firm follows the residual dividend policy, what is the maximum capital budget that is consistent with maintaining the target capital structure?

A) $673,652
B) $709,107
C) $746,429
D) $785,714
E) $825,000

Question 58

Which of the following statements is CORRECT?

A) One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.
B) If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy.
C) If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever its investment opportunities improve.
D) If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios.
E) Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees.

Question 59

Which of the following statements is NOT CORRECT?

A) Stock repurchases can be used by a firm as part of a plan to change its capital structure.
B) After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will rise.
C) Investors may interpret a stock repurchase program as a signal that the firm's managers believe the stock is undervalued, or, alternatively, as a signal that the firm does not have many good investment opportunities.
D) A company can repurchase stock to distribute a large one-time cash inflow, say from the sale of a division, to stockholders without having to increase its regular dividend.
E) Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan.

Question 60

Firm M is a mature company in a mature industry. Its annual net income and net cash flows are consistently high and stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is a relatively new company in a new and growing industry. Its markets and products have not stabilized, so its annual operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is expected to be large relative to its net income for the foreseeable future. Which of the following statements is CORRECT?

A) Firm M probably has a lower target debt ratio than Firm N.
B) Firm M probably has a higher target dividend payout ratio than Firm N.
C) If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
D) The two firms are equally likely to pay high dividends.
E) Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.

Question 61

Keys Financial has done extremely well in recent years, and its stock now sells for $175 per share. Management wants to get the price down to a more typical level, which it thinks is $25 per share. What stock split would be required to get to this price, assuming the transaction has no effect on the total market value? Put another way, how many new shares should be given per one old share?

A) 6.98
B) 7.00
C) 7.35
D) 7.72
E) 8.10

Question 62

Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If the firm's total market value increased by 5% as a result of increased liquidity and favorable signaling effects, what was the stock price following the split?

A) $29.93
B) $31.50
C) $33.08
D) $34.73
E) $36.47

Question 63

LA Moving Company has the following data, dollars in thousands. If it follows the residual dividend model, what will its dividend payout ratio be?

A) 60.71%
B) 63.75%
C) 70.13%
D) 77.14%
E) 84.85%

Question 64

New Orleans Builders Inc. has the following data. If it follows the residual dividend policy, what is its forecasted dividend payout ratio?

A) 18.23%
B) 20.25%
C) 22.50%
D) 25.00%
E) 27.50%

Question 65

Ross-Jordan Financial has suffered losses in recent years, and its stock currently sells for only $0.50 per share. Management wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $25 per share. How many of the old shares must be given up for one new share to achieve the $25 price, assuming this transaction has no effect on total market value?

A) 47.50
B) 49.88
C) 50.00
D) 52.50
E) 55.13