Professional Documents
Culture Documents
1.The optimal distribution policy strikes that balance between current dividends and
capital gains that maximizes the firm's stock price.
ANS: True PTS: 1
2.Other things held constant, the higher a firm's target payout ratio, the higher its
expected growth rate should be.
ANS: False PTS: 1
3.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.
ANS: True PTS: 1
4. 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.
ANS: False PTS: 1
5.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.
ANS: True PTS: 1
6.A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the
same effect on the firm's stock price.
ANS: True PTS: 1
7. A “reverse split” reduces the number of shares outstanding.
ANS: True PTS: 1
8. 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.
ANS: False PTS: 1
9. 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.
ANS: False PTS: 1
10. 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.
ANS: False PTS: 1
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.
ANS: True PTS: 1
12.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.
ANS: True PTS: 1
15.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.
ANS: True PTS: 1
16. Suppose a firm that has been earning P2 and paying a dividend of P1.00, or a 50%
dividend payout, announces that it is increasing the dividend to P1.50. The stock price
then jumps from P20 to P30. Some people would argue that this is proof that investors
prefer dividends to retained earnings. Miller and Modigliani would agree with this
argument.
ANS: False PTS: 1
18.Ifa 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.
ANS: True PTS: 1
19.Ifa 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.
ANS: False PTS: 1
20.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.
ANS: False PTS: 1
21.If
on January 3, 2012, a company declares a dividend of P1.50 per share, payable on
January 31, 2012, then the price of the stock should drop by approximate P1.50 on
January 31.
ANS: False PTS: 1
22.If
on January 3, 2012, a company declares a dividend of $1.50 per share, payable on
January 31, 2012, to holders of record on January 19, then the price of the stock should
drop by approximately $1.50 on January 17, which is the ex-dividend date.
ANS: True PTS: 1
23. One advantage of dividend reinvestment plans is that they allow shareholders to
delay paying taxes on the dividends that they choose to reinvest.
ANS: False PTS: 1
a. True
b. False
a. True
b. False
a. True
b. False
a. True
b. False
a. True
b. False
Multiple Choice: Conceptual
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.
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.
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 the residual dividend model 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.
(Comp.) Repurchases and DRIPS C R Answer: c MEDIUM
39. Which of the following statements is CORRECT?
a. Under the tax laws as they existed in 2011, 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. As a result, share
prices fall when dividend increases are announced because 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.
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.
(Comp.) Dividend concepts C R Answer: c MEDIUM
42. 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. 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.
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.
a. Firms with a lot of good investment opportunities and a relatively small amount of
cash tend to have above-average dividend payout ratios.
b. One advantage of the residual dividend model 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 its stock
price.
e. Stock repurchases make the most sense at times when a company believes its
stock is undervalued.
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 model is that this makes it
easier for corporations to meet the requirements of Modigliani and Miller's dividend
clientele theory.
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.
a. If a firm follows the residual dividend model, 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 model 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.
a. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a
50% dividend 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 dividend 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 dividend payout ratio.
Multiple Choice: Problems
These problems can be changed algorithmically, and the computer can, at times,
produce combinations of variables where the residual policy results in zero dividends
and a zero payout ratio. We sometimes constrain the input variables to prevent this
from occurring, but we sometimes permit it. When this possibility exists, we so indicate.
a. 25.36%
b. 28.17%
c. 31.30%
d. 34.78%
e. 38.26%
a. $36.10
b. $38.00
c. $40.00
d. $42.00
e. $44.10
a. $30.00
b. $31.50
c. $33.08
d. $34.73
e. $36.47
a. $20.63
b. $21.71
c. $22.86
d. $24.00
e. $25.20
(15-3) Residual dividend model C R Answer: b EASY/MEDIUM
55. 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 model, 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
a. $ 904,875
b. $ 952,500
c. $1,000,125
d. $1,050,131
e. $1,102,638
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%
a. $673,652
b. $709,107
c. $746,429
d. $785,714
e. $825,000
(15-3) Residual dividend model C R Answer: d MEDIUM
59. Dentaltech Inc. projects the following data for the coming year. If the firm follows
the residual dividend model and also maintains its target capital structure, what will its
dividend payout ratio be?
a. 37.2%
b. 39.1%
c. 41.2%
d. 43.3%
e. 45.5%
a. $45,125
b. $47,500
c. $50,000
d. $52,500
e. $55,125
a. $183,264
b. $192,909
c. $203,063
d. $213,750
e. $225,000
a. $20,363
b. $21,434
c. $22,563
d. $23,750
e. $25,000
(15-3) Residual dividend model C R Answer: a MEDIUM
63. 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%
a. 60.71%
b. 63.75%
c. 70.13%
d. 77.14%
e. 84.85%
a. 18.23%
b. 20.25%
c. 22.50%
d. 25.00%
e. 27.50%
a. 47.50
b. 49.88
c. 50.00
d. 52.50
e. 55.13
(15-6) Stock split C R Answer: b MEDIUM
67. 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
a. $29.93
b. $31.50
c. $33.08
d. $34.73
e. $36.47
a. $1,093,500
b. $1,215,000
c. $1,350,000
d. $1,485,000
e. $1,633,500
(15-3) Residual dividend model C R Answer: a MEDIUM/HARD
70. Purcell Farms Inc. has the following data, and it follows the residual dividend
model. Currently, it finances with 15% debt. Some Purcell family members would like
for the dividend payout ratio to be increased. If Purcell increased its debt ratio, which
the firm's treasurer thinks is feasible, by how much could the dividend payout ratio be
increased, holding other things constant?
a. 38.6%
b. 40.5%
c. 42.5%
d. 44.7%
e. 46.9%
a. $486,000
b. $540,000
c. $600,000
d. $660,000
e. $726,000
a. $462,983; $244,352
b. $487,350; $257,213
c. $513,000; $270,750
d. $540,000; $285,000
e. $ 0; $300,000
(15-6) Stock split C R Answer: b MEDIUM/HARD
73. Grullon Co. is considering 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 should 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
% Debt 35%
% Equity = 1.0 – % Debt 65%
Capital budget under the residual dividend model $5,000,000
Net income; it will not change this year even if
dividends increase $3,500,000
Equity to support the capital budget
= % Equity × Capital budget $3,250,000
Dividends paid = NI − Equity needed $250,000
Currently projected dividend payout ratio7.1%
Target dividend payout ratio 70.0%
a. -$2,741,538
b. -$3,046,154
c. -$3,384,615
d. -$3,723,077
e. -$4,095,385
a. 30.54%
b. 32.15%
c. 33.84%
d. 35.63%
e. 37.50%
(15-3) Residual dividend model C R Answer: e HARD
76. Del Grasso Fruit Company has more positive NPV projects than it can finance
under its current policies without issuing new stock, but its board of directors had
decreed that it cannot issue any new shares in the foreseeable future. Your boss, the
CFO, wants to know how the capital budget would be affected by changes in capital
structure policy and/or the target dividend payout policy. You obtained the following
data, which shows the firm's projected net income (NI), its current capital structure and
dividend payout policies, and three possible new policies. Projected net income for the
coming year will not be affected by a policy change. How much larger could the capital
budget be if (1) the target debt ratio were raised to the indicated amount, other things
held constant, (2) the target payout ratio were lowered to the indicated amount, other
things held constant, or (3) the debt ratio and dividend payout were both changed by the
indicated amounts?
The higher the payout ratio, the less of its earnings the firm reinvests in the business, and the lower the
reinvestment rate, the lower the firm’s growth rate.
MM would disagree. They would say that investors took the dividend increase as a signal that the firm's
management expected higher future earnings. MM say dividends have information content regarding future
earnings.
The higher the debt ratio, the more dollars of debt will be used to fund a given capital budget. So, the higher
the debt ratio, the less equity will be needed, and this results in a higher dividend payout ratio according to
the residual dividend model.
This is false. The stock price will drop on the ex-dividend date, which is two days prior to the holder of
record date, which is well before the actual January 31 payment date. Also, because the dividend is taxable,
the price decline is generally somewhat less than the full amount of the dividend.
22. (15-3) Dividend payment procedures F R Answer: a MEDIUM
This is true. The stock price will drop on the ex-dividend date, which is two days prior to the holder of
record date, which is well before the actual January 31 payment date. Note, though, that because the dividend
is taxable, the price decline may be somewhat less than the full amount of the dividend.
This is true, because if the company retains its earnings rather than paying them out, investors should receive
capital gains rather than dividend income, and the taxes on those gains will be deferred until the stock is sold.
Note that the money will be reinvested by the company in either case, so the risk to stockholders under
dividend reinvestment and retained earnings should be the same.
(1) The firm's WACC would increase, (2) this would cause fewer projects to be accepted, (3) this would lead
to a smaller capital budget, (4) thus less money would be needed to fund the capital budget, (5) thus less
equity would be needed, so (6) the dividend payout ratio would increase.
Firm U could fund its capital budget with varying amounts of debt without causing large changes in its
WACC and thus in its value and stock price. Firm V could not vary its debt ratio without increasing its
WACC. Thus, Firm V would have to raise and lower its dividend payout in order to obtain the equity it
needed to support its capital budget. Firm U, on the other hand, could maintain a stable, steady dividend, and
let the debt ratio vary without causing much harm to its stock price.
c is correct, but perhaps the easiest way to answer this question is to eliminate the other choices, which are
obviously wrong.
% Debt 30%
% Equity 70%
Net income $550,000
Max. capital budget = NI/% Equity $785,714
Check: Is calculated Max. capital budget × % Equity = NI? $550,000 = Net income
EBIT $2,000,000
− Interest expense = Interest rate × Debt 500,000
Taxable income $1,500,000
− Taxes = Tax rate × Income 600,000
Net income (NI) $ 900,000
− Equity needed for capital budget = % Equity(Capital budget) 510,000
Dividends = NI − Equity needed $ 390,000
% Debt 30%
% Equity 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Capital budget × % Equity $350,000
Old shares surrendered per 1 new share = Target price/Old price = 50.00
No. of new shares per 1 old share = Current price/Target price = 7.00
Post-split stock price = (P0/[New shares per old shares) × (1 + % Value increase)] = $31.50
Old New
% Debt 15% 60%
% Equity = 1.0 – % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000
Old New
% Debt 15% 60%
% Equity = 1.0 – % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000
Dividend payout ratio 27.1% 65.7%
Old New
% Debt 40% 40%
% Equity = 1.0 – % Debt 60% 60%
Capital budget $3,000,000 $2,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $1,800,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $1,700,000 $2,300,000
Old New
Net income (NI) $3,500,000 $3,500,000
% Debt 35% 35%
% Equity = 1.0 – % Debt 65% 65%
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS × Shares outstanding $1,500,000
Dividends paid = DPS × Shares outstanding $1,000,000
Retained earnings available $500,000
Capital budget − Retained earnings = Debt needed $300,000
New Maximums:
Current If Increase If Lower If Do
Found as: Maximum Debt Payout Both
NI Given $175.0 $175.0 $175.0 $175.0
% Debt “ 25.0% 75.0% 25.0% 75.0%
% Equity “ 75.0% 25.0% 75.0% 25.0%
% Payout “ 65.0% 65.0% 20.0% 20.0%
Dividends Payout % × NI $113.8 $113.8 $35.0 $35.0
Ret. earnings, RE NI – Dividends $61.3 $61.3 $140.0 $140.0
Max. cap. budget RE/% Equity $81.7 $245.0 $186.7 $560.0