Financial Management II..............................................................

Addis Ababa University

Addis Ababa University

College of Business and Economics
Department of Accounting and Finance
Chapter 2: Dividend and Dividend Policy
Submission Date: 13/05/2022
Part 1: Short Answer Questions

Instruction: Answer the following questions.

1. The dividend payout ratio equals dividends paid divided by earnings. How would you
expect this ratio to behave during this Covid-19 crisis?
2. Describe the dividend policy decision process. Be sure to discuss all the factors that
influence the decision.
3. How do stock dividends and splits affect stock prices?
4. In what situations should managers consider the use of stock dividends and in what
situations should they consider the use of stock splits?
5. What are some advantages and disadvantages of stock repurchasing?
6. How can stock repurchases help a company operate in accordance with the residual
dividend model?
7. Dividend policy involves three issues: would you mention them please?

8. The optimal dividend policy strikes a balance between current dividends and future
growth so as to maximize the firm’s stock price. Discuss.

9. Why do you think, the bird-in-the-hand theory holds that the firm’s value will be
maximized by a high dividend payout ratio?

10. Dividend policy should take account of the information content of dividends
(signaling) and the clientele effect. Do these factors considered by firms
considering stable dividend policy or a change in dividend policy? Why?

11. What is the difference between a stock dividend and a stock split? As a stockholder,
would you prefer to see your company declare a 100 percent stock dividend or a two-for-
one split? Assume that either action is feasible.

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Financial Management II..............................................................Addis Ababa University

12. Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.

13. One position expressed in the financial literature is that firms set their dividends as a
residual after using income to support new investment. Explain what a residual dividend
policy implies.

14. The tax preference theory states that because long-term dividends are subject to more
onerous taxes than capital gains, investors prefer to have companies pay out them as
dividends rather than they retain earnings. Do you agree? Why?
15. Miller and Modigliani developed the dividend irrelevance theory, which holds that a
firm’s dividend policy has an effect on both the value of its stock and its cost of capital. Is
this statement correct? Why/Why not?
16. What is optimal dividend policy?
17. Contrast the basic arguments about dividend policy advanced by Miller and Modigliani
(M and M) and by Gordon and Lintner.
18. The similarities between a stock dividend and a stock split are:
a. Cash is not paid. b. Shares outstanding increase.
c. Stockholders’ equity remains the same. d. All of the above.
19. The differences between a stock dividend and a stock split are,
a. With a stock dividend, retained earnings are reduced and there is a pro rata
distribution of shares to stockholders whereas, a stock split increases the shares
outstanding but does not lower retained earnings.
b. The par value of stock remains the same with a stock dividend but is proportionally
reduced in a stock split.
c. The par value of stock remains the same with a stock splits but is proportionally
reduced in stock dividends.
d. With a stock splits, retained earnings are reduced whereas, a stock dividend increases
the shares outstanding but does not lower retained earnings.
e. A and B

20. To the company, the advantages from a stock repurchase include the following except,

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Financial Management II..............................................................Addis Ababa University

a. If there is excess cash flow that is deemed temporary, management may prefer to
repurchase stock than to pay a higher dividend that they feel cannot be maintained.
b. Treasury stock can be used for future acquisitions or used as a basis for stock options.
c. If management is holding stock, they would favor a stock repurchase rather than a
dividend because of the favorable tax treatment.
d. Treasury stock can be resold in the market if additional funds are needed.
e. None of the above.

21. Mr. Ujulu owned 100 shares of $10 par value stock. He then received in exchange 200
shares of $5 par value stock. This is referred to as a(n) ______________________.

22. ___________________________________ refers to shares reacquired by the company.

Part 2: Workout Questions.

Instruction: Solve each of the following workout questions on separate sheet of paper. Show all
the necessary steps.
1. ABC company has a target capital structure that consists of 70 percent debt and 30
percent equity. The company anticipates that its capital budget for the upcoming year will
be $3,000,000. If ABC reports net income of $2,000,000 and it follows a residual
dividend payout policy, what will be its dividend payout ratio?

2. After a 5-for-1 stock split, Corona Company paid a dividend of $ 0.75 per new share,
which represents a 9 percent increase over last year’s pre-split dividend. What was last
year’s dividend per share?

3. XYZ Steel Company has earnings available for common stockholders of $2 million and
has 500,000 shares of common stock outstanding at $60 per share. The firm is currently
contemplating the payment of $2 per share in cash dividends.
a. Calculate the firm’s current earnings per share (EPS) and price/earnings (P/E) ratio.
b. If the firm can repurchase stock at $62 per share, how many shares can be
purchased in lieu of making the proposed cash dividend payment?
c. How much will the EPS be after the proposed repurchase? Why?

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Financial Management II..............................................................Addis Ababa University

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