Deck 14: Distributions to Shareholders: Dividends and Repurchases

Question 1

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 require that the dividend yield and capital gains yield equal a constant.
B) capital gains are taxed at a higher rate than dividends.
C) investors view dividends as being less risky than potential future capital gains.
D) 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.
E) investors are indifferent between dividends and capital gains.

Answer 1

C

Question 2

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 2

True

Question 3

In the real world,dividends

A) are usually more stable 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, and these changes are randomly higher or lower, depending on whether earnings increased or decreased.
E) are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS will equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the actual dividend depends strictly on earnings.

Answer 3

A

Question 4

MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value,it can affect the cost of capital.

Question 5

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

Question 6

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 7

If a firm adopts a residual distribution policy,distributions are determined as a residual after funding the capital budget.Therefore,the better the firm's investment opportunities,the lower its payout ratio should be.

Question 8

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

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

Question 9

Stock dividends and stock splits should,at least conceptually,have the same effect on shareholders' wealth.

Question 10

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",it will be easier for the firm to maintain a steady dividend in the face of varying investment opportunities or earnings from year to year.

Question 11

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 12

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.

Question 13

Which of the following statements about dividend policies is correct?

A) One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on 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) One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy.
D) The clientele effect suggests that companies should follow a stable dividend policy.
E) Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.

Question 14

A reverse split reduces the number of shares outstanding.

Question 15

Poff Industries' stock currently sells for $120 a share.You own 100 shares of the stock.The company is contemplating a 2-for-1 stock split.Which of the following best describes what your position will be after such a split takes place?

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

Question 16

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

Question 17

Which of the following should not influence a firm's dividend policy decision?

A) A strong preference by most shareholders for current cash income versus capital gains.
B) Constraints imposed by the firm's bond indenture.
C) The fact that much of the firm's equipment has been leased rather than bought and owned.
D) The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains.
E) The firm's ability to accelerate or delay investment projects.

Question 18

Even if a stock split has no information content,and even if the dividend per share adjusted for the split is not increased,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.

Question 19

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 distribution policy.

Question 20

If the information content,or signaling,hypothesis is correct,then changes in dividend policy can have an important effect on the firm's value and capital costs.

Question 21

Sanchez Company has planned capital expenditures that total $2,000,000.The company wants to maintain a target capital structure that is 35% debt and 65% equity.The company forecasts that its net income this year will be $1,800,000.If the company follows a residual dividend policy,what will be its total dividend payment?

A) $100,000
B) $200,000
C) $300,000
D) $400,000
E) $500,000

Question 22

Which of the following statements is correct?

A) Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases.
B) Very 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.
C) Stock repurchases increase the number of outstanding shares.
D) The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter.
E) If a company has a 2-for-1 stock split, its stock price should roughly double.

Question 23

Which of the following statements is correct?

A) One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account.
B) Stock repurchases can be used by a firm that wants to increase its debt ratio.
C) 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.
D) One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.
E) One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.

Question 24

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

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

Question 25

Which of the following statements is NOT correct?

A) After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will rise.
B) Investors can interpret a stock repurchase program as a signal that the firm's managers believe the stock is undervalued.
C) Companies can repurchase shares to distribute large inflows of cash, say from the sale of a division, to stockholders without paying cash dividends.
D) Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend reinvestment plan.
E) Stock repurchases can be used by a firm as part of a plan to change its capital structure.

Question 26

Reynolds Paper Products Corporation 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 company increases the percentage of equity in its target capital structure.
B) The number of profitable potential projects increases.
C) Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed.
D) Earnings are unchanged, but the firm issues new shares of common stock.
E) The firm's net income increases.

Question 27

If a firm adheres strictly to the residual dividend policy,then 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) no dividends to common stockholders.
B) dividends only out of funds raised by the sale of new common stock.
C) dividends only out of funds raised by borrowing money (i.e., issue debt).
D) dividends only out of funds raised by selling off fixed assets.
E) no dividends except out of past retained earnings.

Question 28

Which of the following statements is correct?

A) 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.
B) Stock repurchases tend to reduce financial leverage.
C) If a company declares a 2-for-1 stock split, its stock price should roughly double.
D) 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.
E) 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.

Question 29

Consider two very different firms,M and N.Firm M is a mature firm in a mature industry.Its annual net income and net cash flows are both 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 firm 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 higher dividend payout ratio than Firm N.
B) If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
C) The two firms are equally likely to pay high dividends.
D) Firm N is likely to have a clientele of shareholders who want to receive consistent, stable dividend income.
E) Firm M probably has a lower debt ratio than Firm N.

Question 30

Which of the following actions will best enable a company to raise additional equity capital?

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

Question 31

Grandin Inc.is evaluating its dividend policy.It has a capital budget of $625,000,and it wants to maintain a target capital structure of 60% debt and 40% equity.The company forecasts a net income of $475,000.If it follows the residual dividend policy,what is its forecasted dividend payout ratio?

A) 40.61%
B) 42.75%
C) 45.00%
D) 47.37%
E) 49.74%

Question 32

Which of the following statements is correct?

A) If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase.
B) The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model.
C) Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm's financial risk.
D) A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs.
E) The tax code encourages companies to pay dividends rather than retain earnings.

Question 33

The capital budget of Creative Ventures Inc.is $1,000,000.The company wants to maintain a target capital structure that is 30% debt and 70% equity.The company forecasts that its net income this year will be $800,000.If the company follows a residual dividend policy,what will be its total dividend payment?

A) $100,000
B) $200,000
C) $300,000
D) $400,000
E) $500,000

Question 34

Rohter Galeano Inc.is considering how to set its dividend policy.It has a capital budget of $3,000,000.The company wants to maintain a target capital structure that is 15% debt and 85% equity.The company forecasts that its net income this year will be $3,500,000.If the company follows a residual dividend policy,what will be its total dividend payment?

A) $205,000
B) $500,000
C) $950,000
D) $2,550,000
E) $3,050,000

Question 35

Which of the following statements is correct?

A) 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.
B) If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve.
C) 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.
D) 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.
E) One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

Question 36

Which of the following statements is correct?

A) The clientele effect can explain why so many firms change their dividend policies so often.
B) One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele.
C) 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.
D) Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received.
E) If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

Question 37

The projected capital budget of Kandell Corporation is $1,000,000,its target capital structure is 60% debt and 40% equity,and its forecasted net income is $550,000.If the company follows a residual dividend policy,what total dividends,if any,will it pay out?

A) $122,176
B) $128,606
C) $135,375
D) $142,500
E) $150,000

Question 38

Which of the following statements is correct?

A) One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends.
B) 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 has relatively few good investment opportunities.
C) If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.
D) Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities.
E) Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.

Question 39

Which of the following statements is correct?

A) One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like.
B) An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM.
C) 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.
D) Stock repurchases make the most sense at times when a company believes its stock is undervalued.
E) Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.

Question 40

Which of the following statements is CORRECT?

A) 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 it is illegal today.
B) 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.
C) When a company declares a stock split, the price of the stock typically declines-by about 50% after a 2-for-1 split-and this necessarily reduces the total market value of the equity.
D) 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 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low-say $2 per share-then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share.
E) 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.

Question 41

Victor Rumsfeld Inc.'s dividend policy is under review by its board.Its projected capital budget is $2,000,000,its target capital structure is 60% debt and 40% equity,and its forecasted net income is $600,000.If the company follows a residual dividend policy,what total dividends,if any,will it pay out?

A) $240,000
B) $228,000
C) $216,600
D) $205,770
E) $0

Question 42

Downie Foods 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 caused by the split,what was the stock price following the split?

A) $28.43
B) $29.93
C) $31.50
D) $33.08
E) $34.73

Question 43

The capital budget forecast for the Santano Company is $725,000.The CFO wants to maintain a target capital structure of 45% debt and 55% equity,and it also wants to pay dividends 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? Net Income Payout

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

Last week,Weschler Paint Corp.completed a 3-for-1 stock split.Immediately prior to the split,its stock sold for $150 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) $50.00
B) $52.50
C) $55.13
D) $57.88
E) $60.78

Question 45

The following data apply to Elizabeth's Electrical Equipment: Value of operations             $\$ 20,000$
Short-term investments           $\$ 1,000$
Debt                       $\$ 6,000$
Number of shares                 $300$
The company plans on distributing $50 million by repurchasing stock.What will the intrinsic per share stock price be immediately after the repurchase?

A) $47.50
B) $50.00
C) $52.50
D) $55.13
E) $57.88

Question 46

McCann Publishing has a target capital structure of 35% debt and 65% equity.This year's capital budget is $850,000 and it 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 47

In recent years Constable Inc.has suffered losses,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

Question 48

Getler Inc.'s projected capital budget is $2,000,000,its target capital structure is 40% debt and 60% equity,and its forecasted net income is $1,000,000.If the company follows a residual dividend policy,how much dividends will it pay or,alternatively,how much new stock must it issue? Dividends Stock Issued

A) $514,425 $162,901
B) $541,500 $171,475
C) $570,000 $180,500
D) $600,000 $190,000
E) $          0 $200,000

Question 49

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

A) $42,869
B) $45,125
C) $47,500
D) $50,000
E) $52,500

Question 50

United Builders wants to maintain a target capital structure with 30% debt and 70% equity.Its forecasted net income is $550,000,and because of market conditions,the company will not issue any new stock 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 51

The Meltzer Corporation is contemplating a 7-for-3 stock split.The current stock price is $75.00 per share,and the firm believes that its total market value would increase by 5% as a result of the improved liquidity that it thinks would follow the split.What is the stock's expected price following the split?

A) $32.06
B) $33.75
C) $35.44
D) $37.21
E) $39.07

Question 52

Brinkley Resources stock has increased significantly over the last five years,selling now for $175 per share.Management feels this price is too high for the average investor and 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) 6.65
B) 6.98
C) 7.00
D) 7.35
E) 7.72

Question 53

Norton Electrical has quite a few positive NPV projects from which to choose.The problem is that it has more of these projects than it can finance without issuing new stock and the board of directors refuses to issue any new shares in the foreseeable future.Norton's projected net income is $150.0 million,its target capital structure is 25% debt and 75% equity,and its target payout ratio is 65%.The CFO now wants to determine how the maximum capital budget would be affected by changes in capital structure policy and/or the target dividend payout policy.Versus the current policy,how much larger could the capital budget be if (1)the target debt ratio were raised to 75%,other things held constant, (2)the target payout ratio were lowered to 20%,other things held constant,and (3)the debt ratio and payout were both changed by the indicated amounts. Increase in Capital Budget
Increase Lower
Debt to 75% Payout to 20% Do both

A) $114.0 $73.3 $333.9
B) $120.0 $77.2 $351.5
C) $126.4 $81.2 $370.0
D) $133.0 $85.5 $389.5
E) $140.0 $90.0 $410.0

Question 54

The following data apply to Garber Industries,Inc.(GII): Value of operations               $\$ 1,000$
Short-term investments             $\$ 100$
Debt                         $\$ 300$
Number of shares                 $100$
The company plans on distributing $50 million as dividend payments.What will the intrinsic per share stock price be immediately after the distribution?

A) $6.32
B) $6.65
C) $7.00
D) $7.35
E) $7.72

Question 55

Harvey's Industrial Plumbing Supply's target capital structure consists of 40% debt and 60% equity.Its capital budget this year is forecast to be $650,000.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 capital 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 56

Yesterday,Berryman Investments was selling for $90 per share.Today,the company completed a 7-for-2 stock split.If the total market value was unchanged by the split,what is the price of the stock today?

A) $23.21
B) $24.43
C) $25.71
D) $27.00
E) $28.35

Question 57

Warren Supply Inc.is evaluating its capital budget.The company finances with debt and common equity,but because of market conditions,wants to avoid issuing any new common stock during the coming year.It is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock.Its capital budget is forecasted at $800,000,and it is committed to maintaining a $2.00 dividend per share.Given these constraints,what percentage of the capital budget must be financed with debt?

A) 30.54%
B) 32.15%
C) 33.84%
D) 35.63%
E) 37.50%

Question 58

Silvana 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? $\begin{array}{l}\begin{array}{lcl}\text { EBIT } & \$ 2,000,000 & \text { Capital budget } &\$ 850,000 \\\text { Interest rate } & 10 \% & \% \text { Debt } &40 \%\\\text { Debt outstanding } & \$ 5,000,000 & \% \text { Equity } &60 \%\\\text { Shares outstanding } & \$ 5,000,000 & \text { Tax rate }&40 \%\end{array}\\\end{array}$

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