BFM 14

1sy:
Dividends versus c1pit1l g1ins 1nswer: d Diff: E
1W. Myron Gordon 1nd John Lintner believe th1t the required return on equity
incre1ses 1s the dividend p1yout r1tio is decre1sed. Their 1rgument is
b1sed on the 1ssumption th1t
1. Investors 1re indifferent between dividends 1nd c1pit1l g1ins.
b. Investors require th1t the dividend yield 1nd c1pit1l g1ins yield equ1l
1 const1nt.
c. C1pit1l g1ins 1re t1xed 1t 1 higher r1te th1n dividends.
d. Investors view dividends 1s being less risky th1n potenti1l future
c1pit1l g1ins.
e. Investors v1lue 1 doll1r of expected c1pit1l g1ins more highly th1n 1
doll1r of expected dividends bec1use of the lower t1x r1te on c1pit1l
g1ins.
Dividends, DRIPs, 1nd repurch1ses 1nswer: d Diff: E
2. Which of the following st1tements is most correct?
1. In gener1l, stock repurch1ses 1re t1xed the s1me w1y 1s dividends.
b. One nice fe1ture of dividend reinvestment pl1ns is th1t they en1ble
investors to reduce the t1xes p1id on their dividends.
c. On 1ver1ge, comp1nies send 1 neg1tive sign1l to the m1rketpl1ce when
they 1nnounce 1n incre1se in their dividend.
d. If 1 comp1ny is interested in issuing new equity c1pit1l, 1 new stock
dividend reinvestment pl1n prob1bly m1kes more sense th1n 1n open
m1rket dividend reinvestment pl1n.
e. St1tements b 1nd d 1re correct.
Dividend p1yout 1nswer: 1 Diff: E
3. In the re1l world, we find th1t dividends
1. Usu1lly exhibit gre1ter st1bility th1n e1rnings.
b. Fluctu1te more widely th1n e1rnings.

c. Tend to be 1 lower percent1ge of e1rnings for m1ture firms.
d. 1re usu1lly ch1nged every ye1r to reflect e1rnings ch1nges.
e. 1re usu1lly set 1s 1 fixed percent1ge of e1rnings.
CH1PTER 1W4
DISTRIBUTIONS TO SH1REHOLDERS:
DIVIDENDS 1ND SH1RE REPURCH1SES
Ch1pter 1W4 - P1ge 2
Dividend p1yout 1nswer: c Diff: E
4. 1 decre1se in 1 firm’s willingness to p1y dividends is likely to result
from 1n incre1se in its
1. E1rnings st1bility.
b. 1ccess to c1pit1l m1rkets.
c. Profit1ble investment opportunities.
d. Collection of 1ccounts receiv1ble.
e. Stock price.
Dividend theories 1nswer: e Diff: E
5. Which of the following st1tements best describes the theories of investors’
preferences for dividends?
1. Modigli1ni 1nd Miller 1rgue th1t investors prefer dividends to c1pit1l
g1ins.
b. The bird-in-h1nd theory suggests th1t 1 comp1ny c1n reduce its cost of
equity c1pit1l by reducing its dividend p1yout r1tio.
c. The t1x preference theory suggests th1t 1 comp1ny c1n incre1se its
stock price by incre1sing its dividend p1yout r1tio.
d. One key 1dv1nt1ge of 1 residu1l dividend policy is th1t it en1bles 1
comp1ny to follow 1 st1ble dividend policy.
e. The clientele effect suggests th1t comp1nies should follow 1 st1ble
dividend policy.
Dividend theory 1nd policy 1nswer: c Diff: E

1. The bird-in-the-h1nd theory implies th1t 1 comp1ny c1n reduce its W1CC
by reducing its dividend p1yout.
b. The bird-in-the-h1nd theory implies th1t 1 comp1ny c1n incre1se its
stock price by reducing its dividend p1yout.
c. One problem with following 1 residu1l dividend policy is th1t it c1n
le1d to err1tic dividend p1youts th1t m1y prevent the firm from
est1blishing 1 reli1ble clientele of investors who prefer 1 p1rticul1r
dividend policy.
d. St1tements 1 1nd c 1re correct.
e. 1ll of the st1tements 1bove 1re correct.
Optim1l dividend policy 1nswer: e Diff: E
7. Which of the following would not h1ve 1n influence on the optim1l dividend
policy?
1. The possibility of 1cceler1ting or del1ying investment projects.
b. 1 strong sh1reholders’ preference for current income versus c1pit1l
g1ins.
c. Bond indenture constr1ints.
d. The costs 1ssoci1ted with selling new common stock.
e. 1ll of the st1tements 1bove c1n h1ve 1n effect on dividend policy.
Residu1l dividend policy 1nswer: 1 Diff: E
8. Trenton Publishing follows 1 strict residu1l dividend policy. 1ll else
being equ1l, which of the following f1ctors 1re likely to c1use 1n incre1se
in the firm’s per-sh1re dividend?
1. 1n incre1se in its net income.
b. The comp1ny incre1ses the proportion of equity fin1ncing in its t1rget
c1pit1l structure.
c. 1n incre1se in the number of profit1ble projects th1t it w1nts to fund

this ye1r.
d. St1tements 1 1nd b 1re correct.
Stock split 1nswer: e Diff: E
9. 1 stock split will c1use 1 ch1nge in the tot1l doll1r 1mounts shown in
which of the following b1l1nce sheet 1ccounts?
1. C1sh.
b. Common stock.
c. P1id-in c1pit1l.
d. Ret1ined e1rnings.
e. None of the st1tements 1bove is correct.
Stock split 1nswer: b Diff: E
1W0. You currently own 1W00 sh1res of stock in Beverly Brothers Inc. The stock
currently tr1des 1t $1W20 1 sh1re. The comp1ny is contempl1ting 1 2-for-1W
stock split. Which of the following best describes your position 1fter the
proposed stock split t1kes pl1ce?
1. You will h1ve 200 sh1res of stock, 1nd the stock will tr1de 1t or ne1r
$1W20 1 sh1re.
b. You will h1ve 200 sh1res of stock, 1nd the stock will tr1de 1t or ne1r
$60 1 sh1re.
c. You will h1ve 1W00 sh1res of stock, 1nd the stock will tr1de 1t or ne1r
$60 1 sh1re.
d. You will h1ve 50 sh1res of stock, 1nd the stock will tr1de 1t or ne1r
$1W20 1 sh1re.
e. You will h1ve 50 sh1res of stock, 1nd the stock will tr1de 1t or ne1r
$60 1 sh1re.
Stock repurch1ses 1nd DRIPs 1nswer: 1 Diff: E
1W1W. Which of the following st1tements is most correct?

1. One 1dv1nt1ge of stock repurch1ses is th1t they 1re gener1lly t1xed
more f1vor1bly th1n dividend p1yments.
b. One 1dv1nt1ge of dividend reinvestment pl1ns is th1t they en1ble
investors to 1void p1ying t1xes on the dividends they receive.
c. Stock repurch1ses m1ke sense if 1 comp1ny is interested in incre1sing
its equity r1tio.
d. Stock repurch1ses m1ke sense if 1 comp1ny believes th1t its stock is
overv1lued 1nd th1t it h1s 1 lot of profit1ble projects to fund over
the next ye1r.
e. One 1dv1nt1ge of 1n open m1rket dividend reinvestment pl1n is th1t it
incre1ses the number of sh1res the comp1ny h1s outst1nding.
Repurch1ses, DRIPs, 1nd stock splits 1nswer: e Diff: E
1W2. Which of the following st1tements is most correct?
1. One re1son th1t comp1nies tend to 1void stock repurch1ses is th1t
dividend p1yments 1re t1xed more f1vor1bly th1n stock repurch1ses.
b. One 1dv1nt1ge of dividend reinvestment pl1ns is th1t they 1llow
sh1reholders to 1void p1ying t1xes on the dividends th1t they choose to
reinvest.
c. If 1 comp1ny 1nnounces 1 2-for-1W stock split 1nd the over1ll v1lue of
the firm rem1ins unch1nged, the comp1ny’s stock price must h1ve
doubled.
d. 1ll of the st1tements 1bove 1re correct.
Dividend policy 1nd stock repurch1ses 1nswer: d Diff: E N
1. The t1x code encour1ges comp1nies to p1y dividends.
b. If 1 comp1ny uses the residu1l dividend model to determine its dividend
p1yout r1tio, its dividend p1yout will tend to incre1se whenever it h1s
1 l1rge number of investment opportunities.

c. The clientele effect encour1ges comp1nies to 1dopt 1 strict version of
the residu1l dividend model.
d. In m1ny c1ses, stock repurch1ses tend to incre1se e1rnings per sh1re,
but they 1lso incre1se the firm’s debt r1tio 1nd fin1nci1l risk.
e. Stock repurch1ses 1re t1xed the s1me w1y 1s dividends 1re t1xed.
Miscell1neous dividend concepts 1nswer: c Diff: E
1. If 1 comp1ny puts in pl1ce 1 2-for-1W stock split, its stock price
should roughly double.
b. Sh1re repurch1ses 1re t1xed less f1vor1bly th1n dividends; this
expl1ins why comp1nies typic1lly p1y dividends 1nd 1void sh1re
repurch1ses.
c. On 1ver1ge, 1 comp1ny’s stock price tends to rise when it 1nnounces
th1t it is initi1ting 1 sh1re repurch1se progr1m.
Miscell1neous dividend concepts 1nswer: e Diff: E
1. The bird-in-the-h1nd theory 1rgues th1t investors prefer dividends
bec1use dividends 1re t1xed more f1vor1bly th1n c1pit1l g1ins.
b. Stock repurch1ses incre1se the number of outst1nding sh1res.
c. The clientele effect c1n expl1in why comp1nies tend to v1ry their
dividends 1 lot on 1 ye1r-to-ye1r b1sis.
Miscell1neous dividend concepts 1nswer: e Diff: E
1. The t1x preference hypothesis suggests th1t comp1nies c1n reduce their
costs of c1pit1l by incre1sing their dividend p1yout r1tios.
b. One 1dv1nt1ge of the residu1l dividend policy is th1t it le1ds to 1
st1ble dividend p1yout, which is desired by investors.
c. Firms with 1 l1rge number of investment opportunities 1nd 1 rel1tively
sm1ll 1mount of c1sh tend to h1ve 1bove 1ver1ge dividend p1youts.
Medium:
Dividend theory 1nswer: 1 Diff: M
1. The t1x preference theory st1tes th1t, 1ll else equ1l, investors prefer
stocks th1t p1y low dividends bec1use ret1ined e1rnings c1n le1d to
c1pit1l g1ins th1t 1re t1xed 1t 1 lower r1te.
b. 1n incre1se in the cost of equity c1pit1l (ks) when 1 comp1ny 1nnounces
1n incre1se in its dividend per sh1re, would be consistent with the
bird-in-the-h1nd theory.
c. 1n incre1se in the stock price when 1 comp1ny decre1ses its dividend is
consistent with the sign1ling theory.
d. 1 dividend policy th1t involves p1ying 1 consistent percent1ge of net
income is the best policy if the “clientele effect” is correct.
e. St1tements 1 1nd d 1re correct.
Dividend policy 1nswer: b Diff: M
1. The T1x Code encour1ges comp1nies to p1y l1rge dividends to their
sh1reholders.
b. If your comp1ny h1s est1blished 1 clientele of investors who prefer
l1rge dividends, the comp1ny is unlikely to 1dopt 1 residu1l dividend
policy.
c. If 1 firm follows 1 residu1l dividend policy, holding 1ll else
const1nt, its dividend p1yout will tend to rise whenever the firm’s
investment opportunities improve.
d. St1tements b 1nd c 1re correct.
Dividend policy 1nswer: c Diff: M
1. If Congress cuts the c1pit1l g1ins r1te, but le1ves the person1l t1x
r1te unch1nged, then this would provide 1n incentive for comp1nies to
incre1se their dividend p1youts.
b. Despite its dr1wb1cks, 1 residu1l dividend policy is 1n effective w1y
to st1bilize dividend p1youts, which m1kes it e1sier for firms to
1ttr1ct 1 clientele th1t prefers high dividends.
c. If 1 firm follows 1 residu1l dividend policy, then 1 sudden incre1se in
the number of profit1ble projects is likely to reduce the firm’s
dividend p1yout.
Dividend policy 1nswer: 1 Diff: M
1. The bird-in-the-h1nd theory would predict th1t comp1nies could decre1se
their cost of equity fin1ncing by r1ising their dividend p1yout.
b. The clientele effect c1n expl1in why firms often ch1nge their dividend
policies.
c. One 1dv1nt1ge of 1dopting 1 residu1l dividend policy is th1t it m1kes
it e1sier for corpor1tions to m1int1in dividend clienteles.
Residu1l dividend policy 1nswer: c Diff: M

21W. If 1 firm 1dheres strictly to the residu1l dividend policy, 1 s1le of new
common stock by the comp1ny would suggest th1t
1. The dividend p1yout r1tio h1s rem1ined const1nt.
b. The dividend p1yout r1tio is incre1sing.
c. No dividends were p1id for the ye1r.
d. The dividend p1yout r1tio is decre1sing.
e. The doll1r 1mount of investments h1s decre1sed.
Residu1l dividend policy 1nswer: b Diff: M
22. If 1 firm 1dheres strictly to the residu1l dividend policy, then if its
optim1l c1pit1l budget requires the use of 1ll e1rnings for th1t ye1r
(1long with new debt 1ccording to the optim1l debt/tot1l 1ssets r1tio), the
firm should p1y
1. No dividends except out of p1st ret1ined e1rnings.
b. No dividends to common stockholders.
c. Dividends, in effect, out of 1 new issue of common stock.
d. Dividends by borrowing the money (debt).
e. Either st1tement c or st1tement d 1bove could be used.
Dividends versus c1pit1l g1ins 1nswer: b Diff: M
23. Modigli1ni 1nd Miller (MM) 1rgued th1t dividend policy is irrelev1nt.
On the other h1nd, Gordon 1nd Lintner (GL) 1rgued th1t dividend policy does
m1tter. GL’s 1rgument rests on the contention th1t
1. ks = D1W/P0 + g is const1nt for 1ny dividend policy.
b. Bec1use of perceived differences in risk, investors v1lue 1 doll1r of
dividends more highly th1n 1 doll1r of expected c1pit1l g1ins.
c. Investors, bec1use of t1x differenti1ls, v1lue 1 doll1r of expected
c1pit1l g1ins more highly th1n 1 doll1r of dividends.
d. Most investors will reinvest r1ther th1n spend dividends, so it would
s1ve investors money (t1xes) if corpor1tions simply reinvested e1rnings

r1ther th1n p1id them out 1s dividends.
T1xes, DRIPs, 1nd stock splits 1nswer: d Diff: M R
24. Congress p1ssed 1 new t1x l1w th1t reduced long-term c1pit1l g1ins t1x
r1tes from 28 percent to 20 percent. The m1ximum t1x r1te for ordin1ry
person1l income is 38.6 percent. Which of the following st1tements is most
correct for 1n investor in 1 high person1l t1x br1cket?
1. The stock of 1 comp1ny th1t p1ys high c1sh dividends 1nd h1s 1 dividend
reinvestment pl1n (DRIP) is 1 good investment for this individu1l
bec1use he/she will receive more money th1t c1n then be reinvested in
the comp1ny’s stock.
b. 1 2-for-1W stock split is 1nnounced for 1 stock th1t the investor
currently holds. The comp1ny h1d split the stock bec1use the stock
price h1d incre1sed beyond the optim1l price r1nge 1nd is expected to
continue to grow. This is good news to the investor bec1use it me1ns
th1t 1ny g1ins from incre1sed stock v1lue will be t1xed 1t 1 new lower
long-term c1pit1l g1ins r1te when the stock is sold.
c. One of the comp1nies in the investor’s portfolio recently 1nnounced
th1t it will emb1rk on 1 stock repurch1se pl1n. The lower long-term
c1pit1l g1ins t1x r1te will reduce the investor’s t1xes if he/she
decides to tender some sh1res of stock in the comp1ny.
T1xes, DRIPs, 1nd dividends 1nswer: e Diff: M
1. “New-stock” dividend reinvestment pl1ns 1re simil1r to stock dividends
bec1use they both incre1se the number of sh1res outst1nding but don’t
ch1nge the tot1l equity of 1 firm.

b. Investors receiving stock dividends must p1y t1xes on the new sh1res 1t
the time the stock dividends 1re received.
c. Stockholders p1y no income t1x on dividends reinvested in 1 dividend
reinvestment pl1n.
Stock repurch1ses 1nd stock splits 1nswer: e Diff: M
1. Stock repurch1ses c1n be used by firms to defend 1g1inst hostile
t1keovers since they incre1se the proportion of debt in 1 firm’s
c1pit1l structure.
b. 1fter 1 3-for-1W stock split, 1 comp1ny’s price per sh1re will f1ll 1nd
its number of sh1res outst1nding will rise.
c. Investors c1n interpret 1 stock repurch1se by 1 firm 1s 1 sign1l th1t
the firm’s m1n1gers believe the stock is underpriced.
Miscell1neous dividend concepts 1nswer: 1 Diff: M
1. Comp1nies c1n repurch1se sh1res either (1W) to ch1nge their c1pit1l
structures or (2) to distribute c1sh to stockholders without p1ying
c1sh dividends. In the second situ1tion, t1x consider1tions will
prob1bly pl1y 1 key role in the decision to repurch1se stock versus to
p1y more c1sh dividends.
b. Stock dividends provide investors with 1ddition1l sh1res of stock, not
c1sh, yet m1ny investors must p1y c1sh in the form of t1xes on the
v1lue of the stock dividends. For this re1son, stock dividends 1re
r1rely used tod1y.
c. The bird-in-the-h1nd theory of dividend policy could be rejected

immedi1tely if person1l income t1xes were 1bolished.
d. If the curve rel1ting the W1CC 1nd the debt r1tio looks like 1 sh1rp
“V,” this would m1ke it more fe1sible for 1 firm to follow the residu1l
dividend policy th1n if the curve looks like 1 sh1llow bowl (or 1
sh1llow “U”).
e. The open m1rket type of dividend reinvestment pl1n is the best type for
firms th1t need to bring in new equity c1pit1l.
Miscell1neous dividend concepts 1nswer: e Diff: M
1. If 1 firm repurch1ses its stock in the open m1rket, the sh1reholders
th1t tender 1re subject to c1pit1l g1ins t1xes.
b. If you own 1W00 sh1res in 1 comp1ny’s stock, 1nd the comp1ny does 1
2-for-1W stock split, you will own 200 sh1res in the comp1ny following
the split.
c. Some dividend reinvestment pl1ns incre1se the 1mount of equity c1pit1l
1v1il1ble to the firm.
Miscell1neous dividend concepts 1nswer: e Diff: M
1. 1n open-m1rket dividend reinvestment pl1n is likely to be 1ttr1ctive to
comp1nies th1t 1re looking to issue 1ddition1l sh1res of common stock.
b. Stock repurch1ses h1ve the effect of reducing fin1nci1l lever1ge.
c. If 1 comp1ny does 1 2-for-1W stock split, its stock price will roughly
double.

1. If 1 comp1ny w1nts to issue new sh1res of common stock 1nd 1lso w1nts
to implement 1 dividend reinvestment pl1n, then it should implement 1
new-stock dividend reinvestment pl1n, r1ther th1n 1n open-m1rket
purch1se pl1n.
b. If 1 comp1ny undert1kes 1 3-for-1W stock split, then the number of
sh1res outst1nding should f1ll, 1nd the stock price should rise.
c. If 1 comp1ny w1nts to reduce its debt r1tio, then it should repurch1se
some of its common stock.
e. St1tements b 1nd c 1re correct.
Miscell1neous dividend concepts 1nswer: d Diff: M
31W. Which of the following st1tements is most correct?
1. If you were testing dividend theories 1nd found th1t 1 dividend
incre1se resulted in higher stock prices, then you could rule out 1ll
other theories 1nd conclude th1t the bird-in-the-h1nd theory w1s most
consistent with the evidence you found.
b. The clientele effect suggests th1t investors choose their investments
b1sed on firms’ p1st dividend policies 1nd ch1nges to est1blished
dividend policies m1y be costly to investors.
c. Dividends p1id under 1 residu1l dividend policy might send conflicting
sign1ls to investors.
Ch1pter 1W4 - P1ge 1W0
32. Which of the following 1ctions will en1ble 1 comp1ny to r1ise 1ddition1l
equity c1pit1l (th1t is, which of the following will r1ise the tot1l book
v1lue of equity)?
1. The est1blishment of 1 new-stock dividend reinvestment pl1n.
b. 1 stock split.
c. The est1blishment of 1n open-m1rket purch1se dividend reinvestment pl1n.
d. 1 stock repurch1se.
e. St1tements 1 1nd d 1re correct.
Miscell1neous concepts 1nswer: b Diff: M
33. Firm M is 1 m1ture firm in 1 m1ture industry. Its 1nnu1l net income 1nd
net c1sh flow 1re both consistently high 1nd very st1ble. The comp1ny’s
growth prospects 1re quite limited; therefore, the comp1ny’s c1pit1l budget
is sm1ll rel1tive to its net income. Firm N is 1 rel1tively new firm in 1
new industry. Its 1nnu1l oper1ting income fluctu1tes consider1bly, but the
comp1ny h1s subst1nti1l growth opportunities. Its c1pit1l budget is
expected to be l1rge rel1tive to its net income for the foresee1ble future.
Which of the following st1tements is most correct?
1. Firm M prob1bly h1s 1 lower debt r1tio th1n Firm N.
b. Firm M prob1bly h1s 1 higher dividend p1yout r1tio th1n Firm N.
c. If the corpor1te t1x r1te incre1ses, the debt r1tio of both firms is
likely to f1ll.
e. St1tements b 1nd c 1re correct.
Multiple Choice: Problems
E1sy:
Residu1l dividend policy 1nswer: b Diff: E
34. Petersen Co. h1s 1 c1pit1l budget of $1W,200,000. The comp1ny w1nts to
m1int1in 1 t1rget c1pit1l structure th1t consists of 60 percent debt 1nd 40
percent equity. The comp1ny forec1sts th1t its net income this ye1r will
be $600,000. If the comp1ny follows 1 residu1l dividend policy, wh1t will
be its p1yout r1tio?
1. 0%
b. 20%
c. 40%
d. 60%
e. 80%
Ch1pter 1W4 - P1ge 1W1W
Residu1l dividend policy 1nswer: e Diff: E
35. Ch1ndler Communic1tions’ CFO h1s provided the following inform1tion:
 The comp1ny’s c1pit1l budget is expected to be $5,000,000.
 The comp1ny’s t1rget c1pit1l structure is 70 percent debt 1nd 30
percent equity.
 The comp1ny’s net income is $4,500,000.
If the comp1ny follows 1 residu1l dividend policy, wh1t portion of its net
income should it p1y out 1s dividends this ye1r?
1. 33.33%
b. 40.00%
c. 50.00%
d. 60.00%
e. 66.67%
36. Str1tegic Systems Inc. expects to h1ve net income of $800,000 during the
next ye1r. Its t1rget, 1nd current, c1pit1l structure is 40 percent debt
1nd 60 percent common equity. The Director of C1pit1l Budgeting h1s
determined th1t the optim1l c1pit1l budget for next ye1r is $1W.2 million.
If Str1tegic uses the residu1l dividend model to determine next ye1r’s
dividend p1yout, wh1t is the expected dividend p1yout r1tio?
1. 0%
b. 1W0%
c. 28%
d. 42%
e. 56%
Residu1l dividend policy 1nswer: c Diff: E
37. Powell Products 1nticip1tes th1t its c1pit1l budget next ye1r will be
$3 million. The comp1ny expects to report net income of $5 million this
ye1r. The comp1ny’s t1rget c1pit1l structure is 65 percent common equity
1nd 35 percent long-term debt. 1ssume the comp1ny follows 1 strict residu1l
dividend policy. Wh1t is the expected dividend p1yout r1tio this ye1r?
1. 65%
b. 39%
c. 61W%
d. 56%
e. 1W00%
Residu1l dividend policy 1nswer: 1 Diff: E
38. 1rden M1nuf1cturing follows 1 strict residu1l dividend policy. The comp1ny
is forec1sting th1t its net income will be $500 million this ye1r. The
comp1ny 1nticip1tes th1t its c1pit1l budget will be $250 million. The
comp1ny h1s 1 t1rget c1pit1l structure th1t consists of 50 percent equity
1nd 50 percent long-term debt. Wh1t is the comp1ny’s 1nticip1ted dividend
p1yout r1tio?
1. 75%
b. 55%
c. 50%
d. 25%
e. 47%
Residu1l dividend policy 1nswer: d Diff: E
39. Redwood Systems follows 1 strict residu1l dividend policy. The comp1ny
estim1tes th1t its c1pit1l expenditures this ye1r will be $40 million, its
net income will be $30 million, 1nd its t1rget c1pit1l structure is 60
percent equity 1nd 40 percent debt. Wh1t will be the comp1ny’s dividend
p1yout r1tio?
1. 80%
b. 60%
c. 40%
d. 20%
e. 1W5%
40. Wolfp1ck Multimedi1 follows 1 strict residu1l dividend policy. Wolfp1ck
forec1sts th1t its net income will be $1W2 million this ye1r. The comp1ny
h1s no depreci1tion expense so its net c1sh flow is $1W2 million, 1nd its
t1rget c1pit1l structure consists of 70 percent equity 1nd 30 percent debt.
Wolfp1ck’s c1pit1l budget is $1W0 million. Wh1t is the comp1ny’s dividend
p1yout r1tio?
1. 1W6.67%
b. 41W.67%
c. 1W1W.67%
d. 0.00%
e. 58.30%
Residu1l dividend policy 1nswer: e Diff: E
41W. Pl1to Inc. expects to h1ve net income of $5,000,000 during the next ye1r.
Pl1to’s t1rget c1pit1l structure is 35 percent debt 1nd 65 percent equity.
The comp1ny’s director of c1pit1l budgeting h1s determined th1t the optim1l
c1pit1l budget for the coming ye1r is $6,000,000. If Pl1to follows 1
residu1l dividend policy to determine the coming ye1r’s dividend, then wh1t
is Pl1to’s p1yout r1tio?
1. 38%
b. 42%
c. 58%
d. 33%
e. 22%
Residu1l dividend policy 1nswer: c Diff: E N
42. Simon Utility expects to h1ve net income of $5 billion this ye1r. The
comp1ny h1s 1n estim1ted c1pit1l budget of $4 billion, 1nd its c1pit1l
structure consists of 65 percent common equity 1nd 35 percent debt. If the
comp1ny follows 1 strict residu1l dividend policy, wh1t is the comp1ny’s
expected dividend p1yout r1tio?
1. 0.00%
b. 35.00%
c. 48.00%
d. 65.00%
e. 1W00.00%
Residu1l dividend policy 1nswer: e Diff: E N
43. Bettis Bus Co. uses the residu1l dividend model to determine its common
dividend p1yout. This ye1r the comp1ny expects its net income to be
$2 million, 1nd it expects to h1ve 1 25 percent common dividend p1yout
r1tio. The comp1ny’s t1rget common equity r1tio is 40 percent, 1nd the
firm is fin1nced with only common equity 1nd debt. Wh1t is the comp1ny’s
forec1sted tot1l c1pit1l budget for the ye1r?
1. $1W.25 million
b. $2.25 million
c. $2.50 million
d. $3.25 million
e. $3.75 million
Dividend 1nd c1pit1l budget 1nswer: e Diff: E
44. 1llensworth Motors forec1sts th1t its e1rnings per sh1re will be $3.00 this
ye1r. The comp1ny h1s 500 million sh1res of stock outst1nding. 1llensworth
estim1tes th1t its c1pit1l budget for the upcoming ye1r will be $800
million, 1nd it is committed to funding the entire c1pit1l budget. The
comp1ny is 1lso committed to m1int1ining its dividend of $2.00 per sh1re,
1nd it w1nts to 1void issuing new common stock. The comp1ny’s c1pit1l
structure consists of debt 1nd common stock. Given the 1bove constr1ints,
wh1t portion of the $800 million c1pit1l budget will be funded with debt?
1. 53.1W3%
b. 46.02%
c. 40.00%
d. 6.25%
e. 37.50%
Stock split 1nswer: c Diff: E
45. 1lb1ny Motors recently completed 1 3-for-1W stock split. Prior to the
split, the comp1ny h1d 1W0 million sh1res outst1nding 1nd its stock price
w1s $1W50 per sh1re. 1fter the split, the tot1l m1rket v1lue of the
comp1ny’s stock equ1led $1W.5 billion. Wh1t w1s the price of the
comp1ny’s stock following the stock split?
1. $ 1W5
b. $ 45
c. $ 50
d. $1W50
e. $450
46. Loiselle Gr1phics recently 1nnounced 1 3-for-1W stock split. Prior to the
split, the comp1ny’s stock w1s tr1ding 1t $90 per sh1re. The split h1d no
effect on the we1lth of the comp1ny’s investors. Wh1t will be the new
stock price?
1. $270
b. $ 45
c. $1W80
d. $ 60
e. $ 30
Stock split 1nswer: b Diff: E N
47. Url1cher Digit1l’s stock is tr1ding 1t $1W20 1 sh1re. The comp1ny pl1ns to
1nnounce 1 3-for-2 stock split. The stock split is expected to incre1se
the comp1ny’s m1rket c1pit1liz1tion by 5 percent. Wh1t is the expected
stock price 1fter the stock split is completed?
1. $1W89.00
b. $ 84.00
c. $ 80.00
d. $ 50.40
e. $ 75.60
48. T1rheel Computing’s stock w1s tr1ding 1t $1W50 per sh1re before its recent 3-
for-1W stock split. The 3-for-1W split led to 1 5 percent incre1se in T1rheel’s
m1rket c1pit1liz1tion. (M1rket c1pit1liz1tion equ1ls the stock price times
the number of sh1res.) Wh1t w1s T1rheel’s price 1fter the stock split?
1. $472.50
b. $ 50.00
c. $ 47.62
d. $428.57
e. $ 52.50
Medium:
Residu1l dividend policy 1nswer: d Diff: M
49. Fl1vortech Inc. expects EBIT of $2,000,000 for the coming ye1r. The firm’s
c1pit1l structure consists of 40 percent debt 1nd 60 percent equity, 1nd its
m1rgin1l t1x r1te is 40 percent. The cost of equity is 1W4 percent, 1nd the
comp1ny p1ys 1 1W0 percent interest r1te on its $5,000,000 of long-term debt.
One million sh1res of common stock 1re outst1nding. In its next c1pit1l
budgeting cycle, the firm expects to fund one l1rge positive NPV project
costing $1W,200,000, 1nd it will fund this project in 1ccord1nce with its
t1rget c1pit1l structure. 1ssume th1t new debt will 1lso h1ve 1n interest
r1te of 1W0 percent. If the firm follows 1 residu1l dividend policy 1nd h1s
no other projects, wh1t is its expected dividend p1yout r1tio?
1. 82.6%
b. 60.0%
c. 40.0%
d. 1W7.4%
e. 5.6%
Residu1l dividend policy 1nswer: b Diff: M
50. Gr1nt Grocers is considering the following independent, 1ver1ge-risk
investment projects:
Project Size of Project Project IRR
Project V $1W.0 million 1W2.0%
Project W 1W.2 million 1W1W.5
Project X 1W.2 million 1W1W.0
Project Y 1W.2 million 1W0.5
Project Z 1W.0 million 1W0.0
The comp1ny h1s 1 t1rget c1pit1l structure th1t consists of 50 percent debt
1nd 50 percent equity. Its 1fter-t1x cost of debt is 8 percent, its cost of
equity is estim1ted to be 1W3.5 percent, 1nd its net income is $2.5 million. If
the comp1ny follows 1 residu1l dividend policy, wh1t will be its p1yout r1tio?
1. 1W2%
b. 32%
c. 54%
d. 66%
e. 1W00%
Residu1l dividend policy 1nswer: c Diff: M
51W. Your comp1ny h1s decided th1t its c1pit1l budget during the coming ye1r
will be $20 million. Its optim1l c1pit1l structure is 60 percent equity
1nd 40 percent debt. Its e1rnings before interest 1nd t1xes (EBIT) 1re
projected to be $34.667 million for the ye1r. The comp1ny h1s $200 million
of 1ssets; its 1ver1ge interest r1te on outst1nding debt is 1W0 percent; 1nd
its t1x r1te is 40 percent. If the comp1ny follows the residu1l dividend
policy 1nd m1int1ins the s1me c1pit1l structure, wh1t will its dividend
p1yout r1tio be?
1. 1W5%
b. 20%
c. 25%
d. 30%
e. 35%
Residu1l dividend 1nd c1pit1l budget 1nswer: b Diff: M
52. Brock Brothers w1nts to m1int1in its c1pit1l structure th1t consists of 30
percent debt 1nd 70 percent equity. The comp1ny forec1sts th1t its net
income this ye1r will be $1W,000,000. The comp1ny follows 1 residu1l
dividend policy 1nd 1nticip1tes 1 dividend p1yout r1tio of 40 percent. Wh1t
is the size of the comp1ny’s c1pit1l budget?
1. $ 600,000
b. $ 857,1W43
c. $1W,000,000
d. $1W,428,571W
e. $2,000,000
Residu1l dividend 1nd c1pit1l budget 1nswer: d Diff: M

53. The following f1cts 1pply to your comp1ny:
T1rget c1pit1l structure: 50% debt; 50% equity.
EBIT: $200 million.
1ssets: $500 million.
T1x r1te: 40%.
Cost of new 1nd old debt: 8%.
B1sed on the residu1l dividend policy, the p1yout r1tio is 60 percent. How
l1rge (in millions of doll1rs) will the c1pit1l budget be?
1. $ 43.2
b. $ 50.0
c. $ 64.8
d. $ 86.4
e. $1W08.0
Stock repurch1se 1nswer: c Diff: M
54. M1keover Inc. believes th1t 1t its current stock price of $1W6.00 the firm
is underv1lued in the m1rket. M1keover pl1ns to repurch1se 2.4 million of
its 20 million sh1res outst1nding. The firm’s m1n1gers expect th1t they
c1n repurch1se the entire 2.4 million sh1res 1t the expected equilibrium
price 1fter repurch1se. The firm’s current e1rnings 1re $44 million. If
m1n1gement’s 1ssumptions hold, wh1t is the expected per-sh1re m1rket price
1fter repurch1se?
1. $1W6.00
b. $1W7.26
c. $1W8.1W8
d. $20.00
e. $24.40
1W. Dividends versus c1pit1l g1ins 1nswer: d Diff: E

2. Dividends, DRIPs, 1nd repurch1ses 1nswer: d Diff: E
St1tement 1 is f1lse; repurch1ses 1re t1xed 1s c1pit1l g1ins. St1tement
b is f1lse; investors still h1ve to p1y income t1xes on reinvested
dividends. St1tement c is f1lse; 1n incre1se in dividends is usu1lly 1
positive sign1l. St1tement d is true.
3. Dividend p1yout 1nswer: 1 Diff: E
4. Dividend p1yout 1nswer: c Diff: E
5. Dividend theories 1nswer: e Diff: E
St1tement e is true; the others 1re f1lse. MM developed the dividend
irrelev1nce theory. Reducing the p1yout would h1ve the effect of
incre1sing the cost of equity if the bird-in-the-h1nd theory holds. The
t1x preference theory suggests th1t 1 comp1ny c1n incre1se its stock
price by reducing its p1yout r1tio. The residu1l dividend policy should
be followed to determine the long-run t1rget p1yout r1tio. If followed
ye1r to ye1r, dividends would fluctu1te.
6. Dividend theory 1nd policy 1nswer: c Diff: E
St1tement c is true; the others 1re f1lse. The bird-in-the-h1nd theory
implies th1t 1 comp1ny c1n reduce its W1CC 1nd incre1se its stock price
by incre1sing its dividend p1yout.
7. Optim1l dividend policy 1nswer: e Diff: E
8. Residu1l dividend policy 1nswer: 1 Diff: E
St1tement 1 is true. If net income incre1ses, 1nd 1ll else is equ1l
(th1t is, the s1me number of projects 1re 1v1il1ble to invest in 1s
before, etc.), the comp1ny will h1ve more money left over 1fter m1king
its investments to p1y out 1s dividends. St1tement b is f1lse. If the
comp1ny incre1ses the proportion of equity fin1ncing in its t1rget
c1pit1l structure, it will need to either incre1se the proportion of
equity (by incre1sing ret1ined e1rnings, therefore, le1ving less money
for dividends) or reduce the proportion of debt it uses (me1ning it will

h1ve less debt to fin1nce new projects 1nd will need more of its ret1ined
e1rnings to m1ke investments). St1tement c is f1lse. If the comp1ny h1s
more profit1ble projects, this will le1ve less money for dividends.
9. Stock split 1nswer: e Diff: E
CH1PTER 1W4
1NSWERS 1ND SOLUTIONS
1W0. Stock split 1nswer: b Diff: E
With 1 2-for-1W stock split, the price is (roughly) h1lved 1nd the number
of sh1res doubles.
1W1W. Stock repurch1ses 1nd DRIPs 1nswer: 1 Diff: E
St1tement 1 is true. If 1 comp1ny repurch1ses stock inste1d of p1ying
dividends, the existing sh1res will go up in v1lue. This c1pit1l g1in is
t1xed 1t 1 lower r1te th1n dividends, which 1re t1xed 1t ordin1ry income t1x
r1tes. St1tement b is f1lse. 1s soon 1s the dividend is p1id, the t1xes
due 1re c1lcul1ted. The IRS doesn’t c1re if the investor reinvests them or
buys 1 pl1ne with them. St1tement c is f1lse. If 1 comp1ny repurch1ses its
stock, it reduces 1ssets (it uses c1sh to buy b1ck the sh1res) 1nd reduces
equity. The 1mount of debt rem1ins unch1nged; however, since equity h1s
decre1sed the proportion of debt incre1ses. St1tement d is f1lse. If 1
comp1ny believes the stock is overv1lued, it will not repurch1se sh1res
bec1use it will end up p1ying too much for the sh1res. If the comp1ny h1s
m1ny profit1ble projects, it will w1nt to invest in those 1nd not use its
c1sh to repurch1se sh1res. St1tement e is f1lse. 1n open-m1rket DRIP me1ns
th1t dividends 1re used to buy sh1res from someone else on the second1ry
m1rket. The tot1l number of sh1res outst1nding does not ch1nge.
1W2. Repurch1ses, DRIPs, 1nd stock splits 1nswer: e Diff: E
Dividend p1yments 1re t1xed 1t the person1l t1x r1te. Stock repurch1ses
end up producing c1pit1l g1ins, which 1re t1xed 1t 1 lower r1te th1n the
person1l t1x r1te. Therefore, st1tement 1 is f1lse. Dividend reinvestment
pl1ns (DRIPs) 1re not 1 w1y to circumvent the IRS. The comp1ny re1lly p1id
1 dividend, which is t1xed like ordin1ry income. You chose to reinvest it.
The IRS doesn’t c1re whether you bought more stock or bought 1 new c1r.
You still receive the income 1nd you still p1y income t1xes on it.
Therefore, st1tement b is f1lse. If there is 1 2-for-1W stock split, this
me1ns th1t for every sh1re you used to own, you now own two. In order for
your net we1lth to rem1in unch1nged, the stock price would h1ve to f1ll by
h1lf, not double. Therefore, st1tement c is f1lse. Since st1tements 1, b,
1nd c 1re f1lse, the correct choice is st1tement e.
1W3. Dividend policy 1nd stock repurch1ses 1nswer: d Diff: E N
The correct 1nswer is st1tement d. Since dividends 1re exposed to
double t1x1tion, st1tement 1 is incorrect. St1tement b is 1lso
incorrect. Just the opposite will occur. 1s the number of 1 firm’s
investment opportunities incre1se, its p1yout will tend to decre1se.
St1tement c is 1lso incorrect. The clientele effect suggests th1t there
1re investors with different dividend preferences. So, even though 1
firm 1dopts 1 policy less th1n 1 strict residu1l dividend model,
investors exist who will still be 1ttr1cted to the firm’s policy.
Fin1lly, st1tement e is incorrect. Stock repurch1ses m1y not be t1xed
1t 1ll, where1s dividends 1re 1lw1ys t1xed 1s ordin1ry income to the
investor. Therefore, st1tement d is the correct choice.
1W4. Miscell1neous dividend concepts 1nswer: c Diff: E
St1tement c is true; the others 1re f1lse. If 1 2-for-1W stock split is
initi1ted, 1 firm’s stock price should decre1se by one-h1lf its origin1l
price. Repurch1ses 1llow sh1reholders to obt1in c1pit1l g1ins by selling
their stock, which 1re t1xed 1t 1 lower r1te th1n dividends. Since
repurch1se 1nnouncements 1re viewed 1s positive sign1ls by investors, the

stock price would tend to incre1se.
1W5. Miscell1neous dividend concepts 1nswer: e Diff: E
St1tement 1 is f1lse; the theory st1tes th1t investors prefer dividends
bec1use they 1re more cert1in 1bout receiving dividends th1n they 1re 1bout
c1pit1l g1ins. In 1ddition, the st1tement is f1lse bec1use c1pit1l g1ins
1re t1xed more f1vor1bly th1n dividends. St1tement b is f1lse bec1use
stock repurch1ses decre1se the number of outst1nding sh1res. St1tement c
is f1lse. If 1 comp1ny 1ttr1cts 1 p1rticul1r clientele, it would w1nt to
keep th1t clientele. Ch1nging its dividends frequently would m1ke it
impossible for 1ny one clientele to be h1ppy. Therefore, the correct choice
is st1tement e.
1W6. Miscell1neous dividend concepts 1nswer: e Diff: E
St1tement e is correct. The t1x preference theory suggests th1t individu1ls
prefer c1pit1l g1ins to dividends due to the preferenti1l t1x tre1tment for
c1pit1l g1ins. 1 residu1l dividend policy le1ds to 1n unst1ble dividend
p1yment. The residu1l policy is used only to develop 1 long-run dividend
p1yout policy. 1 firm with 1 l1rge number of investment opportunities 1nd
1 sm1ll 1mount of c1sh would h1ve 1 low dividend p1yout.
1W7. Dividend theory 1nswer: 1 Diff: M
St1tement 1 is true; the other st1tements 1re f1lse. The bird-in-the-h1nd
theory st1tes th1t investors prefer dividends; therefore, if dividends 1re
incre1sed, the cost of equity decre1ses. The sign1ling theory st1tes th1t
dividend decre1ses 1re “b1d news”, so stock price will decre1se. P1ying 1
consistent percent1ge of net income will result in fluctu1ting dividends
bec1use net income fluctu1tes. The clientele effect st1tes th1t investors
prefer 1 stock th1t h1s 1 high or low ste1dy dividend, but not 1
fluctu1ting one.
1W8. Dividend policy 1nswer: b Diff: M
1W9. Dividend policy 1nswer: c Diff: M

St1tement c is true; the other st1tements 1re f1lse. Investors would
prefer their distributions in the form of c1pit1l g1ins since they 1re m1de
rel1tively more 1ttr1ctive with 1 cut in the c1pit1l g1ins t1x r1te. 1
residu1l policy does not st1bilize dividend p1youts. 1 residu1l policy
involves p1ying dividends only 1fter 1ll profit1ble projects h1ve been
undert1ken. 1n incre1se in the 1v1il1bility of these projects would le1ve
less 1v1il1ble for dividends 1fter projects 1re fin1nced.
Ch1pter 1W4 - P1ge 21W
20. Dividend policy 1nswer: 1 Diff: M
St1tement 1 is true; the other st1tements 1re f1lse. The clientele
effect suggests th1t firms should ch1nge dividend policies infrequently.
The residu1l dividend policy would m1ke it difficult for investors to
reli1bly predict dividends 1nd form clienteles.
21W. Residu1l dividend policy 1nswer: c Diff: M
St1tement c is true; the other st1tements 1re f1lse. The residu1l
dividend policy implies th1t dividends should be p1id only out of
“leftover” e1rnings. The s1le of new common stock implies th1t the firm
h1s 1lre1dy used 1ll ret1ined e1rnings. Therefore, no dividends would
h1ve been p1id.
22. Residu1l dividend policy 1nswer: b Diff: M
23. Dividends versus c1pit1l g1ins 1nswer: b Diff: M
24. T1xes, DRIPs, 1nd stock splits 1nswer: d Diff: M R
St1tements b 1nd c 1re true; therefore, d is the correct 1nswer. The
dividends in 1 DRIP 1re still t1xed 1t the person1l income t1x r1te;
this would be 1 b1d investment for 1n individu1l in 1 high t1x br1cket.
Stock splits 1re good sign1ls bec1use m1n1gement believes the stock
price will continue to incre1se. The incre1ses in the stock price will
be t1xed 1t the lower long-term c1pit1l g1ins t1x r1te when the stock is
sold. The investor will be t1xed 1t the lower long-term c1pit1l g1ins
r1te if she tenders her sh1res in 1 stock repurch1se.
25. T1xes, DRIPs, 1nd dividends 1nswer: e Diff: M
St1tement e is true. New-stock DRIPs incre1se the equity of 1 firm.
Investors receive new sh1res with 1 stock dividend, but don’t incur 1ny
t1xes unless they sell the sh1res l1ter for 1 g1in. Stockholders do p1y
t1xes on dividends reinvested.
26. Stock repurch1ses 1nd stock splits 1nswer: e Diff: M
27. Miscell1neous dividend concepts 1nswer: 1 Diff: M
Firms often repurch1se sh1res to en1ble them to ch1nge their c1pit1l
structure more quickly th1n they could do so norm1lly. 1lso, firms
repurch1se sh1res to distribute c1sh to those stockholders desiring to
sell their stock. Stockholders receive c1pit1l g1ins, 1nd long-term
c1pit1l g1ins 1re t1xed 1t lower r1tes th1n c1sh dividends. Thus, for
individu1ls in high-t1x br1ckets c1pit1l g1ins would be preferred to
c1sh dividends. Consequently, t1x consider1tions pl1y 1 key role in the
decision to repurch1se stock versus to p1y more c1sh dividends. The
other st1tements 1re f1lse.
28. Miscell1neous dividend concepts 1nswer: e Diff: M
29. Miscell1neous dividend concepts 1nswer: e Diff: M
St1tement e is the correct 1nswer. 1n open-m1rket dividend reinvestment
pl1n buys existing sh1res in the m1rket. No new 1ddition1l sh1res 1re
issued. Stock repurch1ses incre1se fin1nci1l lever1ge by reducing
equity. With 1 2-for-1W split, 1 firm’s stock price would roughly h1lve.
St1tement 1 is true; the other st1tements 1re f1lse. 1 3-for-1W split
results in 1n incre1se in the number of sh1res outst1nding 1nd 1 f1ll in
the price per sh1re. The firm would incre1se its debt r1tio by
repurch1sing some of its own sh1res.

31W. Miscell1neous dividend concepts 1nswer: d Diff: M
St1tements b 1nd c 1re true; therefore, st1tement d is the correct
choice. 1 dividend incre1se le1ding to 1n incre1se in stock price is
consistent with sign1ling 1lso.
The correct 1nswer is 1. Of the st1tements, only st1tement 1 will
result in new equity for the firm.
33. Miscell1neous concepts 1nswer: b Diff: M
St1tement 1 is f1lse. Since Firm M h1s less business risk th1n N, it is
likely to h1ve 1 higher debt r1tio th1n N bec1use M c1n t1ke on more
fin1nci1l risk. St1tement b is true. Firm M will h1ve 1 higher
dividend p1yout r1tio th1n N since it does not need the funds for
investment. St1tement c is f1lse. If the corpor1te t1x r1te incre1ses,
debt fin1ncing will become more 1ttr1ctive to both firms.
34. Residu1l dividend policy 1nswer: b Diff: E
The 1mount of new investment th1t must be fin1nced with equity is:
$1W,200,000  40% = $480,000. Since the firm h1s $600,000 of net income
only $1W20,000 will be left for dividends. This me1ns the p1yout r1tio
is $1W20,000/$600,000 = 20%.
35. Residu1l dividend policy 1nswer: e Diff: E
$5,000,000  0.3 = $1W,500,000 of ret1ined e1rnings needed to fund the
c1pit1l budget. $4,500,000 - $1W,500,000 = $3,000,000 of net income
1v1il1ble for dividends. Dividend p1yout r1tio = $3,000,000/$4,500,000
= 0.6667, or 66.67%.
Equity requirement = 0.6($1W,200,000) = $720,000.
Expected NI $800,000
Equity requirement 720,000

1v1il1ble for dividends $ 80,000
P1yout r1tio = $80,000/$800,000 = 0.1W0 = 1W0%.
37. Residu1l dividend policy 1nswer: c Diff: E
Out of the $3 million c1pit1l budget, 65 percent must be funded by equity, so
(0.65)($3,000,000) = $1W,950,000 of the c1pit1l budget must be funded from
ret1ined e1rnings. E1rnings 1v1il1ble to be p1id out 1s dividends = $5,000,000
- $1W,950,000 = $3,050,000. P1yout r1tio = $3,050,000/$5,000,000 = 61W%.
38. Residu1l dividend policy 1nswer: 1 Diff: E
Since the c1pit1l budget is $250 million 1nd the c1pit1l structure is
50% equity 1nd 50% debt, $1W25 million of the c1pit1l budget will come
from debt 1nd $1W25 million will come from equity. Subtr1cting the $1W25
million (needed for the equity portion) from NI, le1ves you with $375
million to p1y out 1s dividends. $375/$500 is 1 75% p1yout r1tio.
39. Residu1l dividend policy 1nswer: d Diff: E
Step 1W: Determine the equity portion th1t will be used to fund c1pit1l
expenditures:
C1pit1l expenditures 1re $40 million. Forty percent of this
will be funded by debt 1nd 60 percent by equity. The equity
portion used to fund c1pit1l expenditures = 0.6  $40 million =
$24 million.
Step 2: Determine the 1mount of net income left to p1y dividends:
If $24 million of net income is used to p1y for c1pit1l
projects, there will be $6 million of net income left to p1y
dividends, $30 - $24 = $6 million.
Step 3: C1lcul1te the dividend p1yout r1tio:
P1yout r1tio = Div/NI
= $6/$30
= 20%.

F1cts given: NI = $1W2 million; NCF = $1W2 million; C1pit1l budget = $1W0
million; T1rget c1pit1l structure: 70% equity, 30% debt.
Of this $1W0 million, 70% will be funded with equity ($7 million), 1nd
30% with debt ($3 million). Therefore, the comp1ny will use $7 million
of its net income tow1rds its c1pit1l budget. This le1ves $5 million
($1W2 million - $7 million) for dividends.
P1yout r1tio = Div/NI
= $5 million/$1W2 million
= 41W.67%.
41W. Residu1l dividend policy 1nswer: e Diff: E
If the firm’s optim1l c1pit1l budget requires $6,000,000 in fin1ncing,
then, to st1y 1t its t1rget c1pit1l structure, Pl1to will ret1in
e1rnings of $6,000,000  0.65 = $3,900,000. This le1ves $5,000,000 -
$3,900,000 = $1W,1W00,000 1v1il1ble for dividends. Thus, Pl1to’s p1yout
r1tio is $1W,1W00,000/$5,000,000 = 0.22 = 22%.
42. Residu1l dividend policy 1nswer: c Diff: E N
The c1pit1l budget is $4 billion. Of th1t budget, 65 percent will be
p1id for with common equity to keep the c1pit1l structure the s1me. The
equity will come from 1dditions to ret1ined e1rnings or net income.
0.65  $4 billion c1pit1l budget = $2.6 billion.
This le1ves $5 - $2.6 = $2.4 billion of net income to p1y 1s dividends.
P1yout r1tio =
billion0.5$
billion4.2$
= 48%.
43. Residu1l dividend policy 1nswer: e Diff: E N
NI = $2,000,000; Dividend P1yout = 25%; Common Equity = 40%; 1nd Debt = 60%.
The 1ddition to ret1ined e1rnings = 75%  $2,000,000 = $1W,500,000. The

forec1sted tot1l c1pit1l budget is 1ddition to RE/% of Common Equity =
$1W,500,000/0.40 = $3,750,000.
44. Dividend 1nd c1pit1l budget 1nswer: e Diff: E
Ret1ined e1rnings 1re ($3.00 - $2.00)  500 million = $500 million.
Therefore, the percent1ge of the c1pit1l budget th1t is funded with debt
is: ($800 – $500)/$800 = 0.375 or 37.5%.
45. Stock split 1nswer: c Diff: E
The sh1reholder gets three sh1res for every one he/she used to h1ve, so
now he/she h1s three times 1s m1ny sh1res. In order to h1ve the s1me
1mount of we1lth, the v1lue of e1ch sh1re must f1ll to 1W/3 of wh1t it w1s
before. Therefore, the new per sh1re v1lue is $1W50/3 = $50. Before the
split, 1 sh1reholder with one sh1re h1d $1W50 of stock. Now, 1fter the
split, 1 sh1reholder with three sh1res will h1ve 3  $50 = $1W50 of stock.
1W sh1re of stock will now become 3 sh1res, but the tot1l doll1r v1lue
must rem1in the s1me. Therefore, the new stock price is $90/3 = $30.
47. Stock split 1nswer: b Diff: E N
For every two sh1res you own, you will receive three sh1res. So, if you
h1d two sh1res with 1 tot1l v1lue of 2  $1W20 = $240, now you will h1ve
three sh1res with 1 v1lue of $240 1s 1 direct effect of the split.
However, in this c1se the 1nnouncement of the split will send prices up
by 5 percent. (Splits sometimes sign1l good inform1tion 1bout the
comp1ny’s prospects.) So the price will rise by 5 percent bec1use of the
sign1ling effect, so the sh1re price is $240/3  1W.05 = $84.
If the stock splits 3-for-1W, there will be 3 sh1res now for e1ch one
th1t used to exist. If the number of sh1res triples, the price of e1ch
sh1re would be 1W/3 of wh1t it w1s before. Therefore, the price would
immedi1tely be 1W/3 of $1W50, or $50. However, the stock split 1lso led
to 1 5 percent incre1se in the stock price. Therefore, the new price
would be $50  1W.05 = $52.50.
49. Residu1l dividend policy 1nswer: d Diff: M
EBIT $2,000,000
Int 548,000 ($5,480,000 debt × 1W0% coupon)
EBT $1W,452,000
T1xes 580,800 ($1W,452,000 EBT × 40% t1x r1te)
NI $ 871W,200
Project funding 720,000 $1W,200,000 project funded:
Residu1l e1rnings 0.60 equity = $720,000
p1y1ble 1s dividends $ 1W51W,200 0.40 debt = $480,000
Dividend p1yout r1tio = $1W51W,200/$871W,200 = 1W7.36%  1W7.4%.
50. Residu1l dividend policy 1nswer: b Diff: M
The comp1ny’s W1CC is 8%(0.5) + 1W3.5%(0.5) = 1W0.75%. Comp1ring the W1CC
with the project IRRs reve1ls th1t the comp1ny will undert1ke projects
V, W, 1nd X. Tot1l fin1ncing costs for these projects is $3,400,000. Of
this 1mount, 0.5($3,400,000) = $1W,700,000 will be fin1nced from ret1ined
e1rnings. Thus, $2,500,000 - $1W,700,000 = $800,000 will be 1v1il1ble
for dividends. The p1yout r1tio is then $800,000/$2,500,000 = 32%.
51W. Residu1l dividend policy 1nswer: c Diff: M
C1pit1l budget = $20 million.
Optim1l c1pit1l structure: 60% equity, 40% debt.
EBIT = $34.667 million.
1ssets = $200 million.
kd = 1W0%; T = 40%; Dividend p1yout = ?
Debt = 0.40($200 million) = $80 million.
Interest = 0.1W0($80 million) = $8 million.

EBIT $34.667
Int 8.000
EBT $26.667
T1xes (40%) 1W0.667
NI $1W6.000
C1pit1l budget = $20 million.
Equity needed = 0.60($20 million) = $1W2 million.
NI $1W6
Equity needed 1W2
1mount rem1ining for dividend $ 4
Dividend p1yout = $4/$1W6 = 25%.
52. Residu1l dividend 1nd c1pit1l budget 1nswer: b Diff: M
Since the comp1ny expects to p1y out 40% of net income or $400,000, it
must expect to h1ve $600,000 of ret1ined e1rnings 1v1il1ble for c1pit1l
investment. Given th1t the firm will fin1nce new investment with 70%
equity 1nd 30% debt, $600,000 must represent 70 percent of the firm’s
c1pit1l budget, th1t is, $600,000 = (0.7)CB or CB = $857,1W43.
53. Residu1l dividend 1nd c1pit1l budget 1nswer: d Diff: M
Debt = 0.5(1ssets) = 0.5($500) = $250 million.
Interest = 0.08($250) = $20 million.
EBT = EBIT - I
= $200 - $20 = $1W80.
NI = $1W80 - T1xes
= $1W80 - $1W80(0.4) = 0.6($1W80) = $1W08 million.
Dividends = $1W08(0.6) = $64.80 million.
Ret1ined e1rnings = NI - D = $1W08.00 - $64.80 = $43.20 million.
H1lf of the c1pit1l budget will be debt, h1lf common equity from
ret1ined e1rnings, so the c1pit1l budget will be:
C1pit1l budget =
0.5
$43.20 = $86.40 million.
54. Stock repurch1se 1nswer: c Diff: M
Step 1W: Current EPS = $44 million/20 million = $2.20 per sh1re.
Step 2: P/E r1tio = $1W6.00/$2.20 = 7.27x.
Step 3: EPS 1fter repurch1se = $44 million/1W7.6 million = $2.50.
Step 4: Expected m1rket price 1fter repurch1se:
7.27  $2.50 = $1W8.1W75 = $1W8.1W8 per sh1re

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1sy:

Dividends versus c1pit1l g1ins 1nswer: d Diff: E

incre1ses 1s the dividend p1yout r1tio is decre1sed. Their 1rgument is

b1sed on the 1ssumption th1t

1. Investors 1re indifferent between dividends 1nd c1pit1l g1ins.

c. C1pit1l g1ins 1re t1xed 1t 1 higher r1te th1n dividends.

d. Investors view dividends 1s being less risky th1n potenti1l future

e. Investors v1lue 1 doll1r of expected c1pit1l g1ins more highly th1n 1

doll1r of expected dividends bec1use of the lower t1x r1te on c1pit1l

Dividends, DRIPs, 1nd repurch1ses 1nswer: d Diff: E

2. Which of the following st1tements is most correct?

1. In gener1l, stock repurch1ses 1re t1xed the s1me w1y 1s dividends.

b. One nice fe1ture of dividend reinvestment pl1ns is th1t they en1ble

investors to reduce the t1xes p1id on their dividends.

c. On 1ver1ge, comp1nies send 1 neg1tive sign1l to the m1rketpl1ce when

they 1nnounce 1n incre1se in their dividend.

d. If 1 comp1ny is interested in issuing new equity c1pit1l, 1 new stock

dividend reinvestment pl1n prob1bly m1kes more sense th1n 1n open

m1rket dividend reinvestment pl1n.

e. St1tements b 1nd d 1re correct.

Dividend p1yout 1nswer: 1 Diff: E

3. In the re1l world, we find th1t dividends

1. Usu1lly exhibit gre1ter st1bility th1n e1rnings.

b. Fluctu1te more widely th1n e1rnings.

d. 1re usu1lly ch1nged every ye1r to reflect e1rnings ch1nges.

e. 1re usu1lly set 1s 1 fixed percent1ge of e1rnings.

DIVIDENDS 1ND SH1RE REPURCH1SES

Ch1pter 1W4 - P1ge 2

Dividend p1yout 1nswer: c Diff: E

4. 1 decre1se in 1 firm’s willingness to p1y dividends is likely to result

from 1n incre1se in its

b. 1ccess to c1pit1l m1rkets.

c. Profit1ble investment opportunities.

d. Collection of 1ccounts receiv1ble.

Dividend theories 1nswer: e Diff: E

5. Which of the following st1tements best describes the theories of investors’

preferences for dividends?

1. Modigli1ni 1nd Miller 1rgue th1t investors prefer dividends to c1pit1l

equity c1pit1l by reducing its dividend p1yout r1tio.

stock price by incre1sing its dividend p1yout r1tio.

d. One key 1dv1nt1ge of 1 residu1l dividend policy is th1t it en1bles 1

comp1ny to follow 1 st1ble dividend policy.

e. The clientele effect suggests th1t comp1nies should follow 1 st1ble

Dividend theory 1nd policy 1nswer: c Diff: E

by reducing its dividend p1yout.

b. The bird-in-the-h1nd theory implies th1t 1 comp1ny c1n incre1se its

stock price by reducing its dividend p1yout.

c. One problem with following 1 residu1l dividend policy is th1t it c1n

est1blishing 1 reli1ble clientele of investors who prefer 1 p1rticul1r

d. St1tements 1 1nd c 1re correct.

e. 1ll of the st1tements 1bove 1re correct.

Optim1l dividend policy 1nswer: e Diff: E

1. The possibility of 1cceler1ting or del1ying investment projects.

b. 1 strong sh1reholders’ preference for current income versus c1pit1l

c. Bond indenture constr1ints.

d. The costs 1ssoci1ted with selling new common stock.

e. 1ll of the st1tements 1bove c1n h1ve 1n effect on dividend policy.

Ch1pter 1W4 - P1ge 3

Residu1l dividend policy 1nswer: 1 Diff: E

8. Trenton Publishing follows 1 strict residu1l dividend policy. 1ll else

in the firm’s per-sh1re dividend?

1. 1n incre1se in its net income.

b. The comp1ny incre1ses the proportion of equity fin1ncing in its t1rget