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Chapter 8 Dividend Policy and Retained Earnings Discussion Questions 8.

1 How does the marginal principle of retained earnings relate to the returns that a stockholder may make in other investments? The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the stockholders can earn the most on funds associated with retained earnings. Thus, we must consider what the stockholders can earn on other investments. 8.2 Discuss the difference between a passive and an active dividend policy. A passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at alternate investment opportunities than at preferences for dividends. If dividends are considered as an active decision variable, stockholder preference for cash dividends is considered very early in the decision process. 8.3 How does the stockholder, in general, feel about the relevance of dividends? The stockholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some stockholders may say that the dividends are relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the immediate income tax. 8.4 Explain the relationship between a companys growth possibilities and its dividend policy. Explain the relationship between a companys growth possibilities and its dividend policy. The greater a companys growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show four-year growth rates for selected U.S. corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm. 8.5 Since initial contributed capital theoretically belongs to the stockholders, why are there legal restrictions on paying out the funds to the stockholders? Creditors have extended credit on the assumption that a given capital base would remain intact throughout the life of a loan. While they may not object to the payment of dividends from past and current earnings, they must have the protection of keeping contributed capital in place. 8.6 Discuss how desire for control may influence a firms willingness to pay dividends. Managements desire for control could imply that a closely held firm should avoid dividends to minimize the need for outside financing. For a larger firm, management may have to pay dividends in order to maintain their current position through keeping stockholders happy. 8.7 If you buy stock on the ex-dividend date, will you receive the upcoming quarterly dividend? No, the old stockholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 8.8 How is a stock split (versus a stock dividend) treated on the financialstatements of a corporation? For a stock split, there is no transfer of funds, but merely a reduction inpar value and a proportionate increase in the number of shares outstanding.

Impact of a Stock Split Before Common stock (1,000,000 shares at $10 par) After (2,000,000 shares at $5 par)

8.9 Why might a stock dividend or a stock split be of limited value to an investor? The asset base remains the same and the stockholders proportionate interest is unchanged (everyone got the same new share). Earnings per share will go down by the exact proportion that the number of shares increases. If the P/E ratio remains constant, the total value of each shareholders portfolio will not increase. The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value is when dividends per share remain constant and total dividends go up, or where substantial information is provided about the growth of the company. A stock split may have some functionality in placing the Company into a lower stock price trading range. 8.10 Does it make sense for a corporation to repurchase its own stock? Explain. A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up as the shares decline and if the price-earnings ratio remains the same, the stockholder will receive the same dollar benefit as if a cash dividend was paid. Because the benefits are in the format of capital gains the tax may be deferred until the stock is sold. A corporation also may justify the repurchase of its own stock because it is at a very low price, or to maintain constant demand for the shares. Reacquired shares may be used for employee options or as a part of a tender offer in a merger or acquisition. Firms may also reacquire part of their stock as protection against a hostile takeover. 8.11 What advantages to the corporation and the stockholder do dividend reinvestment plans offer? Dividend reinvestment plans allow corporations to raise funds continually from present stockholders. This reduces the need for some external funds. These plans allow stockholders to reinvest dividends at low costs and to buy fractional shares, neither of which can be easily accomplished in the market by an individual. The strategy of dividend reinvestment plans allows for the compounding of dividendsand the accumulation of common stock over time. Chapter 6 Long-Term Debt and Lease Financing Discussion Questions 16-1.Corporate debt has been expanding very dramatically in the last three decades. What has been the impact on interest coverage, particularly since 1977? In 1977, the average U.S. manufacturing corporation had its interest covered almost eight times. By the 2000s, the ratio had been cut to less than half. 16-2. What are some specific features of bond agreements? The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 16-3.What is the difference between a bond agreement and a bond indenture? The bond agreement covers a limited number of items, whereas the bond indenture is a supplement that often contains over 100 pages of complicated legal wording and specifies every minute detail concerning the bond issue. The bond indenture covers such topics as pledged collateral, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation.

16-4.Discuss the relationship between the coupon rate (original interest rate at time of issue) on a bond and its security provisions. The greater the security provisions afforded to a given class of bondholders, the lower the coupon rate. 16-5.Take the following list of securities and arrange them in order of their priority of claims: Preferred stock Senior debenture Subordinated debenture Senior secured debt Common stock Junior secured debt The priority of claims can be determined from Figure 16-2: senior secured debt, junior secured debt, senior debenture, subordinated debenture, preferred stock, common stock. 16-6.What method of "bond repayment" reduces debt and increases the amount of common stock outstanding? Conversion of bonds to common stock through either a convertible bond or an exchange offer. 16-8.Under what circumstances would a call on a bond be exercised by a corporation? What is the purpose of a deferred call? A call provision may be exercised when interest rates on new securities are considerably lower than those on previously issued debt. The purpose of a deferred call is to insure that the bondholder will not have to surrender the security due to a call for at least the first five or ten years.

16-9. Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds? Bond prices on outstanding issues and market interest rates move in opposite directions. If interest rates go up, bond prices will go down and vice versa. Long-term bonds are particularly sensitive to interest rate Changes because the bondholder is locked into the interest rate for an extended period of time. 16-10.What is the difference between the following yields: coupon rate, current yield, yield to maturity? The different bond yield terms may be defined as follows: Coupon rate -stated interest rate divided by par value. Current yield-stated interest rate divided by the current price of the bond. Yield to maturity -the interest rate that will equate future interest payments and payment at maturity to a current market price. 16-15. Explain how the zero-coupon rate bond provides return to the investor. What are the advantages to the corporation? The zero-coupon-rate bond is initially sold at a deep discount from par value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. The advantages to the corporation are that there is immediate cash inflow to the corporation, without any outflow until the bond matures. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes over the life of the bond by the corporation.

16-16. Explain how floating rate bonds can save the investor from potential embarrassments in portfolio valuations. Interest payments change with changing interest rates rather than with the market value of the bond. This means that the market value of a floating rate bond is almost fixed. The one exception is when interest rates dictated by the floating rate formula approach (or exceed) broadly defined limits. 16-17. Discuss the advantages and disadvantages of debt. The primary advantages of debt are: a. Interest payments are tax deductible. b. The financial obligation is clearly specified and of a fixed nature. c. In an inflationary economy, debt may be paid back with cheaper dollars (the dollars have less purchasing power than when received). d. The use of debt, up to a prudent point, may lower the cost of capital to the firm. The disadvantages are: a. Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances. b. Bond indenture agreements may place burdensome restrictions on the firm. c. Debt, utilized beyond a given point, may serve as a depressant on outstanding common stock. 16-19. What do we mean by capitalizing lease payments? Capitalizing lease payments means computing the present value of future lease payments and showing them as an asset and liability on the balance sheet. Chapter 17 Common and Preferred Stock Financing Discussion Questions 17-1.Why has corporate management become increasingly sensitive to the desires of large institutional investors? Corporate management has become increasingly sensitive to the desires of large institutional investors because they fear these shareholders may side with corporate raiders in voting their shares in mergers or takeovers attempt. 17-2.Why might a corporation use a special category such as founders stock in issuing common stock? Founders stock may carry special voting rights that allow the original founders to maintain voting privileges in excess of their proportionate ownership. 17-3.What is the purpose of cumulative voting? Are there any disadvantages to management? The purpose of cumulative voting is to allow some minority representation on the board of directors. A possible disadvantage to management is that minority stockholders can challenge their actions. 17-6.During a rights offering, the underlying stock is said to sell rights-on and ex-rights. Explain the meaning of these terms and their significance to current stockholders and potential stockholders. When a rights offering is announced, a stock initially trades rights-on, that is, if you buy the stock you will also acquire a right toward future purchase of stock. After a certain period of time (say four weeks), the stock goes ex-rights; thus when you buy the stock you no longer get a right toward future purchase of stock.

The significance to current and future stockholders is that they must decide if they wish to use or sell the right when the stock is trading rights-on. The stock will go down by the appropriate value of the right when the stock moves to an ex-rights designation. 17-8.Preferred stock is often referred to as a hybrid security. What is meant by this term as applied to preferred stock? Preferred stock is a hybrid or intermediate form of security possessing some of the characteristics of debt and common stock. The fixed amount provision is similar to debt, but the no contractual obligation is similar to common stock. Though the preferred stockholder does not have an ownership interest in the firm, the priority of claim is higher than that of the common stockholder. 17-9.What is the most likely explanation for the use of preferred stock from a corporate viewpoint? Most corporations that issue preferred stock do so to achieve a balance in their capital structure. It is a means of expanding the capital base of the firm without diluting the common stock ownership position or incurring contractual debt obligations. 17-10.Why is the cumulative feature of preferred stock particularly important to preferred stockholders? With the cumulative feature, if preferred stock dividends are not paid in any one year, they accumulate and must be paid in total before common stockholders can receive dividends. Even though preferred stock dividends are not a contractual obligation as is true of interest on debt, the cumulative feature tends to make corporations very aware of obligations to preferred stockholders. Preferred stockholders may even receive new securities for forgiveness of missed dividend payments. 17-11.A small amount of preferred stock is participating. What would your reaction be if someone said common stock is also participating? The participation privileges of a few preferred stock issues mean that preferred stockholders may receive a payout over and above the quoted rate when the corporation enjoys a particularly good year. This is very similar to the situation with common stock and one can certainly say that common stock is a participationtype security.