Dividend Policy and Internal Financing: True/False

CHAPTER 17
Dividend Policy and Internal Financing
True/False
1. Dividends per share divided by earnings per share (EPS) equals the dividend retention date.
ANSWER: False
DIFFICULTY: Moderate
KEYWORDS: dividend retention rate
2. The payment of dividends does not increase the monitoring of management’s investment activities.
ANSWER: False
KEYWORDS: agency costs, dividends
3. We typically expect to find rapidly growing firms to have high payout ratios.
ANSWER: False
KEYWORDS: payout ratios
4. A firm’s payout is calculated as the ratio of interest payments to earnings before interest and taxes
(EBIT).
ANSWER: False
KEYWORDS: payout ratio
5. Information asymmetry takes into account the higher stock price that can be achieved due to certainty
from the accessibility of information between management and investors.
ANSWER: False
KEYWORDS: information asymmetry
6. Dividend policy takes on greater importance the more perfect are the market conditions.
ANSWER: False
DIFFICULTY: Easy
KEYWORDS: dividend policy
7. If a firm were to unexpectedly omit payment of its quarterly dividend, that firm’s stock price would
probably drop.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: eliminating a dividend
8. A stock dividend increases a firm’s retained earnings.

ANSWER: False
DIFFICULTY: Easy
KEYWORDS: retained earnings, stock dividend
9. As long as a firm has a positive level of retained earnings, it can pay a dividend.
ANSWER: False
DIFFICULTY: Easy
KEYWORDS: retained earnings
10. Unexpected dividends would cause investors to reassess their perceptions about a firm’s stock.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: unexpected dividends
11. After a stock split of 2–1, each investor will have one-half of the percentage ownership in the firm that
he had before the split.
ANSWER: False
KEYWORDS: stock split
12. If a company in a perfect capital market decreased its dividend per share, an investor would be forced
to sell his common stock at a depressed price.
ANSWER: False
KEYWORDS: perfect capital market
13. Other things equal, individuals in high income tax brackets should have a preference for firms that
retain their earnings rather than pay dividends.
ANSWER: True
KEYWORDS: tax bracket, dividend
14. The ex-dividend date occurs prior to the declaration date.

ANSWER: False
KEYWORDS: ex-dividend date
15. As a firm’s investment opportunities increase, the dividend payout ratio should increase.
ANSWER: False
KEYWORDS: dividend payout policy
16. Security markets are considered to be perfect when firms can issue securities at no cost and the investor
incurs no brokerage commissions.
ANSWER: True
KEYWORDS: perfect security markets
17. By virtue of its nature, dividend policy is inherently a wealth-creating activity for the firm’s owners.
ANSWER: False
18. Ownership control takes a higher priority for large corporations than for small to mid-sized companies.
ANSWER: False
KEYWORDS: ownership control
19. A firm with high profitability will always have the cash flow necessary to pay high dividends.
ANSWER: False
KEYWORDS: dividends, cash flow
20. When a firm makes the decision to pay dividends, it also makes the decision not to reinvest the cash in
the firm.
ANSWER: True
KEYWORDS: dividends, cash flow
21. The residual dividend theory suggests that dividends should be paid to stockholders first, and then,
what is left can be reinvested by the firm.
ANSWER: False
KEYWORDS: residual dividend theory
22. According to the expectations theory, dividend policy should be treated as a short-term residual.
ANSWER: False
KEYWORDS: expectations theory
23. A stable dividend policy generally leads to a lower required rate of return on the part of the investor
when compared to similar stocks with erratic fluctuations in dividends.
ANSWER: True
KEYWORDS: stable dividend policy
24. In a perfect market, investors are concerned only with total returns and are not concerned whether it is
in capital gains or dividend income.
ANSWER: True
KEYWORDS: perfect market
25. Increasing a firm’s dividend reduces the stock’s risk.

ANSWER: False
DIFFICULTY: Easy
KEYWORDS: increase in dividend, stock risk
26. When considering taxes, most investors prefer capital gains over dividend income.
ANSWER: True
KEYWORDS: capital gains versus dividend income
27. Due to the strengthening of the stock market over the past 50 years, stock splits and stock dividends are
more common than cash dividends.
ANSWER: False
DIFFICULTY: Easy
KEYWORDS: stock dividends, stock splits
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28. If we assume that the firm has already made its investment and borrowing decisions and the existence
of perfect capital markets, then it follows that there is no relation between dividend policy and stock
value.
ANSWER: True
KEYWORDS: perfect capital markets
29. The bird-in-the-hand dividend theory indicates that capital gains income has a higher value to the
investor than does dividend income.
ANSWER: False
KEYWORDS: bird-in-the-hand dividend theory
30. Although there is criticism of the bird-in-the-hand dividend theory, there is still a strong perception
among many investors and professional investment advisors that dividends are important.
ANSWER: True
31. The view that dividends might actually hurt the investor is based on the argument that there is a
difference in tax treatment for dividend income and capital gains income.
ANSWER: True
KEYWORDS: tax treatment of dividends
32. The residual dividend theory indicates that a firm would never pay dividends unless the firm’s profits
were larger than its equity financing needs.
ANSWER: True
33. The clientele effect suggests that firms can change their dividend policy frequently with no potential
adverse effect on the firm.
ANSWER: False
KEYWORDS: clientele effect
34. The information effect of dividends suggests that dividends are an important communication tool since
management might have no other credible way to inform investors about future earnings.
ANSWER: True
KEYWORDS: information effect
35. The expectations theory of dividends indicates that management’s dividend decision might not be
important unless it departs from what investors had expected.
ANSWER: True
KEYWORDS: expectations theory
36. Stock dividends and stock splits have generally been associated with companies that have growing
earnings.
ANSWER: True
KEYWORDS: stock dividends and stock splits, growing earnings
37. Company managers strive to gradually increase dividend series over the long-term future.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: dividend series
38. Empirical evidence is conclusive that dividend policy matters.

ANSWER: False
DIFFICULTY: Easy
39. Legal restrictions on dividends might restrict dividends from being paid if the firm’s assets exceed its
liabilities.
ANSWER: False
DIFFICULTY: Easy
KEYWORDS: legal restrictions
40. Dividend payout ratios are generally much lower for small or newly established firms than for large,
publicly owned firms.
ANSWER: True
DIFFICULTY: Easy
KEYWORDS: dividend payout ratios
41. Dividends tend to be higher for firms with stable earnings.

ANSWER: True
DIFFICULTY: Easy
KEYWORDS: dividends, stable earnings
42. High levels of inflation tend not to affect dividend payments.

ANSWER: False
KEYWORDS: inflation, dividend payout
43. The stable dollar dividend policy is the most common.

ANSWER: True
DIFFICULTY: Easy
KEYWORDS: stable dividends
44. The increasing-stream hypothesis of dividend policy indicates that dividend stability is essentially a
smoothing of the dividend stream to minimize the effect of other types of company reversals.
ANSWER: True
KEYWORDS: increasing-stream hypothesis
45. Managers avoid cutting dividends even in response to short-term fluctuations in earnings.
ANSWER: True
KEYWORDS: cutting dividends
46. A reasonable conclusion about dividend policy is that management should avoid surprising investors
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when it comes to the firm’s dividend decision.
ANSWER: True
KEYWORDS: dividends, avoiding surprises
47. German firms tend to pay out more dividends than British firms.
ANSWER: False
KEYWORDS: German versus British firms, dividend payout
48. The dividend declaration date is the date at which the stock transfer books are to be closed for
determining the investor to receive the next dividend payment.
ANSWER: False
KEYWORDS: dividend declaration date
49. There is absolutely no difference on an economic basis between a stock dividend and a stock split.
ANSWER: True
KEYWORDS: stock dividend, stock split
50. Firms can use stock repurchases as a dividend substitute.

ANSWER: True
KEYWORDS: stock repurchases
Multiple Choice
51. Reasons why multinational firms enter international markets during economic prosperity include to:
a. find lower net present value (NPV) of projects.
b. dilute country-related economic risks.
c. achieve a competitive cost advantage.
d. both b and c.
e. all of the above.
ANSWER: d
KEYWORDS: international markets
52. Which of the following countries is MOST favored when corporate cash is available to U.S.
multinational firms?
a. Italy
b. France
c. United Kingdom
d. Germany
ANSWER: c
DIFFICULTY: Easy
KEYWORDS: multinational firms and international funds
53. Flotation costs:

a. include the fees paid to the investment bankers, lawyers, and accountants involved in selling a
new security issue.
b. encourage firms to pay large dividends.
c. are encountered whenever a firm fails to pay a dividend.
d. are incurred when investors fail to cash their dividend check.
ANSWER: a
KEYWORDS: flotation costs
54. According to the perfect markets approach to dividend policy:

a. other things equal, the greater the payout ratio, the greater the share price of the firm.
b. the price of a share of stock is not affected by dividend policy.
c. the firm should retain earnings so stockholders will receive a capital gain.
d. the firm should pay a dividend only after current equity financing needs have been met.
ANSWER: b
KEYWORDS: perfect markets
55. According to the residual theory of dividends, dividends are considered a residual after:
a. investment financing needs have been met.
b. preferred stock is issued.
c. EPS is allocated.
d. retained earnings are financed.
ANSWER: a
KEYWORDS: residual theory
56. The ex-dividend date is _________ the holder of record date.

a. five days before
b. two weeks before
c. four days before
d. three days after
ANSWER: c
DIFFICULTY: Easy
57. Dividends tend to be more stable than:

a. cash flow.
b. earnings.
c. preferred stock.
d. both b and c.
ANSWER: b
DIFFICULTY: Easy
KEYWORDS: dividend stability
58. All of the following might influence a firm’s dividend payment EXCEPT:
a. investment opportunities.
b. investor transaction costs.
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c. common stock par value.
d. flotation costs.
ANSWER: c
KEYWORDS: dividend payment
59. A stock repurchase increases the:

a. retention ratio of earnings.
b. number of shares outstanding.
c. EPS.
d. both b and c.
ANSWER: d
KEYWORDS: stock repurchase
60. Stock splits decrease the:

a. number of shares to stockholders.
b. par value of the stock.
c. paid-in capital of the stock.
d. both b and c.
e. all of the above.
ANSWER: d
KEYWORDS: stock splits
61. Which of the following is not included in perfect capital markets?

a. Transaction costs
b. Personal taxes
c. Bankruptcy costs
d. Both a and c
e. All of the above
ANSWER: e
KEYWORDS: perfect capital markets
62. Which of the following are not subject to income taxes?

a. Commercial banks
b. Manufacturing corporations
c. Pension funds
d. None of the above
ANSWER: c
KEYWORDS: pension funds, tax implications
63. Which of the following dividend policies will cause dividends per share to fluctuate the most?
a. Constant dividend payout ratio
b. Stable dollar dividend
c. Small, low, regular dividend plus a year-end extra
d. Small, low, regular dividend
ANSWER: a
KEYWORDS: dividends per share fluctuation
64. For accounting purposes, a stock split has been defined as a stock dividend exceeding:
a. 25%.
b. 35%.
c. 45%.
d. 55%.
ANSWER: a
65. Which of the following would influence a firm’s decision about dividends for large firms?
a. Ownership control
b. Liquidity position
c. Earnings predictability
d. Both b and c
e. All of the above
ANSWER: d
KEYWORDS: determinants of dividend policy
66. A firm that maintains dollar dividends will generally not increase the dividend unless:
a. a stock split occurs.
b. the firm merges with another profitable firm.
c. the firm is sure that a higher dividend level can be maintained.
d. the price-earnings (P/E) ratio increased steadily over the past five years.
ANSWER: c
KEYWORDS: increasing dividends
67. A justification for stable dividends could be:

a. satisfaction of guaranteed current income.
b. satisfaction for stockholders’ informational needs.
c. existence of legal listing.
d. all of the above.
ANSWER: d
KEYWORDS: stable dividends
68. The final approval of a dividend payment comes from the:

a. controller.
b. president of the company.
c. board of directors.
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d. Chief Financial Officer.
ANSWER: c
KEYWORDS: approval of dividend payment
69. The only definite result from a stock dividend or a stock split is:
a. an increase in the P/E ratio.
b. an increase in the common stock’s market value.
c. an increase in the number of shares outstanding.
d. cannot be determined from the above.
ANSWER: c
70. Dividend policy is influenced by:

a. a company’s investment opportunities.
b. a firm’s capital structure mix.
c. a company’s availability of internally generated funds.
d. all of the above.
e. none of the above.
ANSWER: d
71. The __________ designates the date on which the stock transfer books are closed in regard to a
dividend payment.
a. declaration date
b. ex-dividend date
c. date of record
d. payment date
ANSWER: c
KEYWORDS: date of record
72. Which of the following conclusions on the importance of a dividend policy is FALSE?
a. As a firm’s investment opportunities increase, the dividend payout ratio should decrease.
b. The firm’s expected earning power and the risk of these earnings are more important to the investor
than the dividend policy.
c. Dividends can influence stock price by the investor’s desire to minimize and/or defer taxes and
from the role of dividends in minimizing agency costs.
d. In order to avoid surprising investors, management should anticipate financing needs for the
short-term but not for the long-term.
ANSWER: d
73. Many European companies follow a low mid-year, higher end-of-the-year dividend policy. What type
of U.S. investor would not be attracted to the stock of these European companies? Investor clientele
who want:
a. very predictable dividend cash flow to meet income needs.
b. unpredictable dividends for higher returns.
c. less risk-averse investments than the typical investment.
d. both a & c.
ANSWER: a
KEYWORDS: stock in European companies
74. The problem with the constant dividend payout ratio is:
a. investors might come to expect a specified amount.
b. the dollar amount of the dividend fluctuates from year to year.
c. management is reluctant to cut the dividend even if there are low profits in a year.
d. all of the above are possible problems.
ANSWER: b
KEYWORDS: constant dividend payout ratio
75. Which of the following is not a rationale given for a stock dividend or split?
a. The price will not fall proportionately to the share increase.
b. An optimum price range does not exist.
c. There is positive informational content associated with the announcement.
d. The actual dividend paid is too certain.
ANSWER: b
76. What is the fundamental purpose of a stock split?

a. A split shows the company’s preference for retaining funds.
b. A split immediately brings the stock price to a lower trading range.
c. A split immediately increases the investor’s wealth.
d. A split increases the threat of a hostile takeover.
ANSWER: b
77. All of the following are methods available to a corporation who desires to repurchase stock EXCEPT:
a. offering to employees who own an interest in the firm.
b. open market.
c. tender offer to all existing stockholders.
d. offer to one or more major stockholders on a negotiated basis.
ANSWER: a
KEYWORDS: stock repurchase methods
78. The conclusion that one dividend policy is as good as another is consistent with which of the following
statements?
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a. In the aggregate, investors are concerned only with total returns from investment decisions.
b. Investors are indifferent about whether their returns come from capital gains or from dividend
income.
c. Investors recognize that the dividend decision, given the investment policy, is really a choice of
financing strategy.
d. All of the above.
ANSWER: d
79. Which of the following typically would not affect the dividend policy of the firm?
a. Today’s dividend policy is affected by future dividend expectations among investors.
b. Managers are afraid to decrease their voting control of the company by issuing stock
dividends.
c. The failure of so many high-tech and dot.com companies showed that dividends are important to
long-term investors.
d. The current and future cash flow expectations of the company affect dividend policy.
ANSWER: b
80. Which of the following statements about the residual dividend theory is FALSE?
a. The firm will maintain its optimum debt ratio in financing future investments.
b. Dividend policy by itself has no direct influence on the market price of the firm’s common stock.
c. The firm will issue new common stock to finance investment opportunities in order to ensure
that some dividend will be paid.
d. The firm’s investment opportunities, capital structure, and profitability all influence the firm’s
dividend policy.
ANSWER: c
Use the following information to answer questions 81-83.

Epsilon, Inc. finances 30% of its investments with debt and 70% with common equity. Currently, the firm has
generated $3 million from operations that can be used to finance the common equity portion of new
investments or to pay common dividends. Epsilon uses a residual dividend policy.
81. If Epsilon has $3 million in positive NPV investment opportunities that it can accept without increasing
its marginal cost of capital, then:
a. Epsilon will pay no dividends.
b. Epsilon will pay $900,000 in dividends.
c. Epsilon will accept less than the $3 million in projects so it can pay a dividend.
d. Epsilon will have to issue new common equity to be able to invest in all positive NPV projects.
ANSWER: b
KEYWORDS: net present value, residual dividend policy
82. If Epsilon has $2.1 million in positive NPV investment opportunities that it can accept without
increasing its marginal cost of capital, then:
b. Epsilon will pay $900,000 in dividends.
c. Epsilon will pay $1,470,000 in dividends.
d. Epsilon will pay $1,530,000 in dividends.
ANSWER: d
KEYWORDS: net present value, dividends
83. If Epsilon has $4.3 million in positive NPV investment opportunities that it can accept without
increasing its marginal cost of capital, then:
b. Epsilon will pay $3 million in dividends.
c. Epsilon will accept less than the $4.3 million in projects so it can pay a dividend.
d. Epsilon will pay $1 million in dividends.
ANSWER: a
KEYWORDS: net present value, dividends
84. The agency cost theory of dividends suggests:

a. dividends might make a meaningful contribution to firm value.
b. dividends do not affect the ability to monitor management’s investment activities.
c. dividend policy is irrelevant.
d. none of the above.
ANSWER: a
KEYWORDS: agency cost theory
85. Which of the following conclusions about dividend policy is reasonable?

a. An inverse relation should exist between the amount of acceptable investments a firm has and the
dividends remitted to investors.
b. Management’s actions regarding dividends might carry greater weight than a statement by
management that earnings will be increasing.
c. Management should avoid surprising investors when it comes to the firm’s dividend decision.
d. All of the above are reasonable.
ANSWER: d
86. Which of the following is NOT consistent with the life cycle growth theory of dividend policy?
a. In the growth stage, a company should declare stock dividends.
b. In the development stage, a company should pay some low cash dividends.
c. In the maturity stage, a company should pay moderate to high cash dividends.
d. In the expansion stage, a company should pay low to medium cash dividends.
ANSWER: b
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KEYWORDS: life cycle growth theory
87. Which of the following statements is true?

a. The constant dividend payout ratio keeps the dollar amount of the dividend stable.
b. If the firm maintains a stable dollar dividend policy, then the dividend usually does not
increase unless management is convinced that the higher dividend can be maintained in the
future.
c. The dividend policy which allows for an extra dividend at year-end in prosperous years includes a
fairly large regular dividend payment per share every year.
d. All of the above are true.
ANSWER: b
KEYWORDS: stable dollar dividends
88. When comparing a stock dividend and a stock split, we know that:
a. the stock split is defined as a stock dividend exceeding 25%.
b. the stock dividend affects retained earnings and the capital accounts on the balance sheet.
c. the stock split does not affect the dollar amounts of the balance sheet accounts.
d. all of the above are true.
ANSWER: d
Use the following information to answer questions 89-93.

Your firm is planning to issue a 15% stock dividend. The market price for the stock has been $28. The table
below presents the equity portion of your firm’s balance sheet prior to the distribution.
Common stock
Par value (1 million shares
outstanding; $4 par value) $ 4,000,000
Paid-in capital 16,000,000
Retained earnings 30,000,000
Total equity $50,000,000
89. The 15% stock dividend increases the number of shares outstanding by:
a. 150,000.
b. 1,150,000.
c. 2 million.
d. 1 million.
ANSWER: a
KEYWORDS: stock dividend
90. The new balances, after the stock dividend is paid, in the par value, paid-in capital, and retained
earnings accounts are, respectively:
a. $600,000; $3,600,000; $4,200,000.
b. $4,600,000; $19,600,000; $25,800,000.
c. $4,000,000; $16,000,000; $30,000,000.
d. none of the above.
ANSWER: b
91. Which of the following statements would be true if a 3–2 stock split were declared?
a. The common stock account remains constant, but each share now represents only a 2/3
proportion.
b. The retained earnings account would decrease.
c. The cash account would decrease.
d. The market price of a share of common stock would increase automatically by a 3-to-2 factor.
ANSWER: a
92. If instead of a stock dividend, your firm decided to split the stock 2–1, then the number of shares
outstanding and their par value per share would be:
a. 1 million; $4.
b. 1 million; $8.
c. 2 million; $2.
d. 2 million; $4.
ANSWER: c
93. If instead of a stock dividend, your firm decided to split the stock 2–1, then the new balances, after the
stock split, in the par value, paid-in capital, and retained earnings accounts are, respectively:
a. $600,000; $3,600,000; $4,200,000.
b. $4,600,000; $19,600,000; $25,800,000.
c. $4,000,000; $16,000,000; $30,000,000.
ANSWER: c
94. Which of the following reasons is used to justify stock repurchases?

a. The repurchase is a means for providing an internal investment opportunity.
b. The repurchase modifies the firm’s capital structure.
c. The repurchase reduces the firm’s costs associated with servicing small stockholders.
d. All of the above.
ANSWER: d
95. If a firm’s EPS are $8.33, and the firm is paying a dividend of $1.25 per share, what is the firm’s
dividend payout ratio?
a. 33%
b. 6%
c. 15%
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d. 25%
e. 66%
ANSWER: c
KEYWORDS: dividend payout ratio
96. Franklin Electric is presently generating earnings available to common shareholders of $7.25 per share.
The firm’s income tax rate is 40%. Franklin is paying a dividend to the preferred shareholders of $2.10
per share. The firm’s dividend payout ratio on common stock is 20%. What is the amount per share that
Franklin will pay in dividends to common shareholders?
a. $0.58
b. $1.45
c. $3.12
d. $0.42
e. $2.20
ANSWER: b
KEYWORDS: dividends per share
97. Which of the following statements is true?

a. According to the bird-in-the-hand theory, investors value capital gains greater than they value cash
dividends.
b. According to the residual theory of dividends, a firm should only invest in capital projects after the
payment of dividends to preferred and common stockholders.
c. According to the clientele effect, a firm can make a substantial alteration to its dividend payment
without any effect on the price of its stock.
d. According to the dividend irrelevance theory, there is no relationship between a firm’s
dividend policy and the value of its common stock.
ANSWER: d
KEYWORDS: dividend irrelevance theory
98. According to the residual theory of dividends:

a. dividends are to be paid out only after investment financing needs have been met.
b. earnings remaining after payment of preferred stock dividends should be paid to common
stockholders.
c. dividend payments are a constant percentage of EPS.
d. a dividend is the residual above the payout ratio.
ANSWER: a
99. Assume that as the result of a firm announcing a large unexpected increase in its dividend payment, the
price of the firm’s common stock rises. This event would be consistent with which of the following?
a. The dividend irrelevance theory
b. The tax preference theory
c. The information effect
d. The beta effect
ANSWER: c
KEYWORDS: the information effect
100. Which of the following policies would not lead to potentially significant fluctuations in annual
dividends?
a. The residual dividend approach
b. The constant dividend payout ratio approach
c. The stock dividend approach
d. The constant dividend cash yield approach
ANSWER: c
KEYWORDS: stock dividend approach
101. Which of the following considerations would be expected to influence a firm’s decision regarding the
payment of dividends?
a. Earnings predictability
b. Legal restrictions
c. Liquidity position
d. All of the above
ANSWER: d
KEYWORDS: considerations in paying dividends
102. The date upon which a dividend is formally declared by the board of directors is the ______ date:
a. declaration.
b. record.
c. payment.
d. ex-dividend.
ANSWER: c
KEYWORDS: declaration date
103. Stock splits:

a. increase the number of shares outstanding.
b. decrease the common stock account by the amount of the split.
c. reduce retained earnings.
d. increase the total wealth of stockholders.
e. none of the above.
ANSWER: a
KEYWORDS: stock splits
104. The dividend policy that states smoothing of the dividend stream in order to minimize the effect of
company reversals is called the:
a. increasing-stream hypothesis of dividend policy.
b. stable dollar dividend policy.
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c. clientele effect policy.
d. “bird-in-the-hand” policy.
ANSWER: b
KEYWORDS: dividend policies
105. What might an investor reasonably expect from a company with excess cash and few internal
investment growth opportunities?
a. The company will buy Treasury bills with all the excess cash.
b. The company will split its stock 3–2.
c. The company will declare a stock dividend.
d. The company will repurchase some of its own shares.
ANSWER: d
KEYWORDS: excess cash, stock repurchase
106. Which of the following is a description of the residual theory of dividend policy?
a. A high enough dividend is paid to maintain a stable total dividend payment.
b. A high enough dividend is paid to maintain a stable dividend payout ratio.
c. The dividend level is adjusted to maintain a stable dividend in relation to cash flow.
d. The dividend level is set to the full amount of profits that remain after the company commits
to internal investment funding.
ANSWER: d
107. Which of the following describes the clientele effect concept of dividend policy?
a. The clientele effect looks at investor preferences for dividends compared to share repurchase
programs.
b. The clientele effect defines the relationship between the shareholder and a stockbroker.
c. The clientele effect focuses entirely on the stability of dividends.
d. Modern corporations do not consider shareholders to be "clients."
ANSWER: a
KEYWORDS: clientele effect
108. The bird-in-the-hand theory of dividends suggests that investors will value cash dividends more highly
than potential capital gains. This argument is based on the assumption that:
a. investors are indifferent between dividends and capital gains.
b. investors require that the dividend yield and capital gains yield equal a constant.
c. capital gains are taxed at a higher rate than dividends.
d. investors view dividends as being less risky than potential future capital gains.
ANSWER: d
109. Which of the following statements is correct?

a. The effect of new information about a company on the firm’s stock price depends more on
how the new information compares to expectations than on the actual announcement itself.
b. If an increase in the cost of equity capital occurs when a company announces an increase in its
dividend per share, this would be consistent with the bird-in-the-hand theory.
c. An increase in the stock price when a company decreases its dividend is consistent with the
signaling theory.
d. A dividend policy that involves paying a consistent percentage of net income is the best policy if
the clientele effect is correct.
ANSWER: a
KEYWORDS: effect of new information
110. Super Growth Corp. has decided to increase its dividend to $5 per share beginning next year. The firm’s
growth rate is expected to be 12.5% for the foreseeable future. Investors require a rate of return on the
firm’s stock of 18%. Utilize the Gordon Model to calculate the expected price of the firm’s stock.
a. $64
b. $75
c. $83
d. $91
e. $98
ANSWER: d
KEYWORDS: expected price of stock
111. Assume that on January 1 a firm announces that on June 30 they will pay a dividend of $2.50 per share
to holders of record on March 30. When does the stock sell ex-dividend?
a. January 5
b. April 5
c. March 26
d. July 5
e. June 25
ANSWER: c
112. Which of the following is the most widely accepted reason that motivates corporations to pay stock
dividends?
a. To keep the firm’s beta within its optimal range
b. To conserve cash
c. To reallocate capital to shareholders
d. All of the above
e. None of the above
ANSWER: b
KEYWORDS: stock dividends
113. Which of the following motivates corporations to split their common stock?
458
a. To keep the price of the firm’s common stock within an optimum price range
b. To increase retained earnings
d. To reallocate capital to shareholders
e. To increase their paid-in capital
ANSWER: a
114. Which of the following describes the effect of a stock dividend?

a. A stock dividend immediately increases the market price of a share of stock.
b. A stock dividend immediately decreases the paid-in capital account.
c. A stock dividend immediately increases the number of shares outstanding.
d. A stock dividend indicates that the company must be short on cash.
ANSWER: c
115. Which of the following motivates corporations to enter into stock repurchase programs?
a. Favorable impact on EPS
b. Expected favorable impact on stock price
c. To modify the firm’s capital structure
d. All of the above
ANSWER: d
116. Which of the following is a reason that a company would repurchase its own shares of stock in the
market?
a. To award employees
b. To increase outstanding equity shares
c. To have shares available to offer a merger target
d. Both a & b
e. All of the above
ANSWER: a
117. Which of the following is the most probable way in which a shareholder will benefit from a stock split?
a. The immediately lower share price will attract enough increased interest in the stock to cause
the market price to increase on a more consistent basis.
b. The immediately higher number of shares that an investor owns immediately increases the
investor’s wealth.
c. The shareholder can use the immediately increased wealth to borrow more money to buy even
more shares at the immediately lower market price.
d. A shareholder can lose money after a stock split if the market believes that the split was an artificial
way of attracting attention to a company that is not well managed.
ANSWER: a
118. A stock split will cause changes in the dollar value of which of the below capital accounts?
a. Common stock
b. Additional paid-in capital
c. Retained earnings
d. All of the above
ANSWER: e
119. Select Corp. recently declared a 15% stock dividend. As of the date of the announcement, Select Corp.
had 16 million shares outstanding which were selling on the NYSE for $46 per share. An accounting
entry is required on the balance sheet in order to transfer an amount from retained earnings to the
common stock and additional paid-in capital accounts. What is the dollar amount of retained earnings
that will be transferred from retained earnings as the result of the stock dividend? Assume that the par
value of Select Corp. is $2 per share.
a. $80.4 million
b. $110.4 million
c. $140.4 million
d. $2170.4 million
ANSWER: b
120. ZZZ Corporation has declared a stock dividend that pays one share of stock for every 10 shares owned.
What will happen to EPS immediately upon the distribution of the stock dividend?
a. There is not enough information to know.
b. EPS will increase by 10%.
c. EPS will not be affected by the stock dividend.
d. EPS will decrease by 10%.
ANSWER: d
121. ZZZ Company, Inc. has 100,000 shares outstanding with a $0.10 par value. The shares were issued for
$20. The stock is currently selling for $40. ZZZ now has $10 million in retained earnings and has
declared a cash dividend of $2 per share. What will happen to the retained earnings account when the
dividend obligation is recorded?
a. It will increase by $2 million.
b. It will not be affected because the dividend only lowers the cash account.
c. It will decrease by $200,000.
d. It will not be affected because the dividend only affects the dividends payable account.
ANSWER: c
460
KEYWORDS: retained earnings, dividend
122. ZZZ Corporation had net income of $100 million last year and 50 million common shares outstanding.
They declared an 8% stock dividend. Calculate EPS before and after the stock dividend.
a. EPS before would be $2; after the dividend, EPS would be $1.85.
b. There is not enough information to make this calculation.
c. EPS before would be $0.50; after the dividend, EPS would be $0.46.
d. Since they made $100 million in net income, the EPS cannot change.
ANSWER: a
KEYWORDS: earnings per share, stock dividend
123. Trendy Corp. recently declared a 10% stock dividend. As of the date of the announcement, Trendy had
10 million shares outstanding which were selling on the NYSE for $50 per share. An accounting entry
is required on the balance sheet in order to transfer an amount from retained earnings to the common
stock and additional paid-in capital accounts. What is the dollar amount of retained earnings that will
be transferred from retained earnings to the common stock account as the result of the stock dividend?
Assume that the par value of Trendy is $2 per share.
a. $6 million
b. $5 million
c. $4 million
d. $3 million
e. $2 million
ANSWER: e
KEYWORDS: retained earnings, stock dividend
124. A stock dividend will cause changes in the dollar value of which of the below capital accounts?
a. Common stock
b. Additional paid-in capital
c. Retained earnings
d. All of the above
ANSWER: d
Short Answer
125. Define perfect capital markets and discuss its assumptions.
ANSWER: A perfect capital market is a market where investors can buy and sell stock without
incurring any transaction costs, such as brokerage costs. In addition, companies can issue stock
without incurring any cost in doing so. It assumes that there are no personal or corporate taxes.
Complete information about the firm is readily available, and there are no conflicts of interest
between management and stockholders. Lastly, financial distress and bankruptcy costs are
nonexistent.
KEYWORDS: perfect competition
126. List the benefits of a firm repurchasing its own stock.
ANSWER: Stock repurchases can be very advantageous to a firm. First, repurchases are a means
for providing an internal investment opportunity as well as an approach for modifying a firm’s
capital structure. In general, repurchases create a favorable impact on EPS. Elimination of a
minority ownership group of stockholders can be achieved as well. The firm can minimize the
dilution in EPS associated with mergers and can reduce the costs associated with servicing small
stockholders.
KEYWORDS: stability and dividends
127. Pettry, Inc. expects EPS this year to be $5.25. If EPS grow at an average annual rate of 10%, and if
Pettry pays 60% of its earnings as dividends, what will the expected dividend per share be in 10 years?
10
ANSWER: $5.25 (1 + 0.10) = 13.62 = EPS in 10 years
$13.62 × 0.6 = $8.17 = Expected dividends per share
DIFFICULTY: Easy
KEYWORDS: expected dividends per share
128. Klone Enterprises maintains a capital structure of 40% debt and 60% equity. If additions to retained
earnings for the coming year are expected to be $36 million, how large can the capital budget be?
Assume the existing capital structure is to be maintained.
ANSWER: $36,000,000/0.6 = $60,000,000

DIFFICULTY: Easy
KEYWORDS: capital budget and capital structure
129. You are considering the stock of two firms to add to your portfolio. The companies differ only with
respect to their dividend policies. For both firms, investors expect EPS for each of the next two years to
be $7 and dividends and ending price for each of the next two periods to be:
D1 D2 P2
Firm A $2 $2 $60.70
Firm B 4 4 56.42
The required rate of return for the stock of Firm A is 14%. Assuming perfect capital markets:
a. How much would investors pay for the stock of Firm A?
b. How much would investors pay for the stock of Firm B?
c. For a less-than-perfect world, provide an argument for each of the
following:
(1) Investors prefer the dividend policy of Firm A.
(2) Investors prefer the dividend policy of Firm B.
(3) Firms prefer the dividend policy of Firm A.
ANSWER:
2
a. Po = ($2.00/1.14) + [($2.00 + $60.72)/(1.14) ]
Po = $50
b. Exactly the same in the perfect capital market environment.
2
Po = ($4.00/1.14) + (($4.00 + $56.42)/(1.14) )
Po = $50
c. (1) Tax structure
462
(2) Investors’ need for current income
(3) Firms need additional equity to finance growth.
KEYWORDS: stock price, dividends
130. The Clysdale Corporation has an optimal capital structure consisting of 40% debt and 60% equity. The
marginal cost of capital is calculated to be 14%. Total earnings available to common stockholders for
the coming year total $1.2 million.
Investment opportunities are:
Project Investment IRR(%)
A $1,200,000 21
B 100,000 19
C 600,000 15
D 200,000 13
a. According to the residual dividend theory, what should the firm’s total dividend payment be?
b. If the firm paid a total dividend of $480,000 and restricted equity financing to internally
generated funds, which projects should be selected? Assume the marginal cost of capital is
constant.
ANSWER:
a. Select Projects A, B, C for an investment of $1,900,000
$1,900,000 × .4 = $760,000 debt
$1,900,000 × .6 = $1,140,000 common equity
Dividend payment $1,200,000 - $1,140,000 = $60,000
b. $1,200,000 - $480,000 = $720,000 for investment. Choose Project A only.
KEYWORDS: residual dividend theory, project selection
131. XYZ Corporation has 400,000 shares of common stock outstanding, a P/E ratio of 8, and $500,000
available for common stockholders. The board of directors has just voted a 3–2 stock split.
a. If you had 100 shares of stock before the split, how many shares will you have after the split?
b. What was the total value of your investment in XYZ stock before the split?
c. What should be the total value of your investment in XYZ stock after the split?
d. In view of your answers to (b) and (c) above, why would a firm’s management want to have a stock
split?
ANSWER:
a. Number of shares after split = 3/2 × 100 = 150
b. EPS before split = ($500,000/400,000) = $1.25
Price per share before split = 8 × $1.25 = $10
Total value of investment = $10 × 100 = $1,000
c. Total number of shares after split = 3(400,000/2) = 600,000
EPS after split = ($500,000/600,000) = $.8333
Price per share after split = 8 × $.833 = $6.67
Total value of investment after split = $6.67 × 150 = $1,000
d. (1) Stock splits are believed to have favorable information content. Splits are often associated
with growth companies.
(2) Splits can conserve corporate cash if the firm has cash flow problems or needs additional
funds for attractive investment opportunities.
132. Coppell Timber Company had total earnings last year of $5 million but expects total earnings to drop to
$4,750,000 this year because of a slump in the housing industry. There are currently 1 million shares of
common stock outstanding. The company has $4 million worth of investments to undertake this year.
The company finances 40% of its investments with debt and 60% with equity capital. The company
paid $3 per share in dividends last year.
a. If the company follows a pure residual dividend policy, how large a dividend will each
shareholder receive this year?
b. If the company maintains a constant dividend payout ratio each year, how large a dividend will
each shareholder receive this year?
c. If the company follows a constant dollar dividend policy, how large a dividend will each
shareholder receive this year?
ANSWER:
a. Equity financing for new investments = $4,000,000(.60) = $2,400,000
Residual dividends = $4,750,000 - $2,400,000 = $2,350,000
Dividends per share = ($2,350,000/1,000,000) = $2.35
b. Dividends = ($3.00)(1,000,000) = $3,000,000
Dividend payout ratio = ($3,000,000/$5,000,000) = .60
Dividends this year = (.60)($4,750,000) = $2,850,000
Dividends per share = ($2,850,000/1,000,000) = $2.85
c. Dividends per share = $3.00
KEYWORDS: residual dividend theory, constant dollar dividend policy
133. Noblesville Auto Supply Company’s stock is trading ex-dividend at $5 per share. The company just
paid a 10% stock dividend. The P/E ratio for the stock is 10. What was the price of the stock prior to
trading ex-dividend?
ANSWER:
EPS after stock dividend = ($5.00/10.00) = $.50
EPS after stock dividend = (EPS before stock dividend)/(1.10)
($.50)(1.10) = $.55 = EPS before stock dividend
Stock price prior to stock dividend = (10)($.55) = $5.50
KEYWORDS: stock price, stock dividend
134. The equity section of the TMW Corporation balance sheet is shown below. The company’s common
stock is currently trading at $20 per share. Reconstruct the equity section of the balance sheet
assuming:
a. a 2–1 stock split.
b. a 5% stock dividend.
TMW Corporation
Balance Sheet
Common Stock:
Par value (4 million shares; $2 par value) $ 8,000,000
ANSWER:
a.
Common Stock:
464
Par value (8 million shares; $1 par value) $ 8,000,000
b.
Common Stock:
Par value (4.2 million shares; $2 par value) $ 8,400,000b
Paid-in capital 25,600,000c
Retained earnings 36,000,000 a
aMarket value of stock dividend = ($20)(4,000,000)(.05) = $4,000,000
Retained earnings = $40,000,000 - $4,000,000 =$36,000,000
bPar value = $8,000,000 + ($2.00)(200,000) =$8,400,000
cPaid-in capital = $22,000,000 + $4,000,000 -$400,000 = $25,600,000
KEYWORDS: stock split, stock dividend
135. Ernest T. Bass Frozen Frog Legs, Inc. has found three acceptable investment opportunities. The three
projects require a total of $3 million in financing. It is the company’s policy to finance its investments
by using 35% debt and 65% common equity. The firm has generated $2.2 million dollars from its
operations that could be used to finance the common equity portion of its investments.
a. What portion of the new investments will be financed by common equity and what portion by debt?
b. According to the residual dividend theory, how much would be paid out in dividends?
ANSWER:
a. Common equity = .65 × $3 million = $1,950,000
Debt = .35 × $3 million = $1,050,000
b. Dividends = $2,200,000 - $1,950,000 = $250,000
136. Ted Tech, Inc. is offering a 10% stock dividend. The firm currently has 200,000 shares outstanding and
after-tax profits of $800,000. The current price of the stock is $48.
a. Calculate the new EPS.
b. What is the original price/earnings multiple?
c. Providing that the price/earnings multiple stays the same, what will the new stock price be after the
stock dividend?
ANSWER:
a. EPS = ($800,000/200,000 (1.10)) = $3.636
b. price/earnings multiple = $48/$4 = 12
c. 12 × $3.636 = $43.63
KEYWORDS: earnings per share, price/earnings multiple, stock dividend
137. If flotation costs for a common stock issue are 18%, how large will a stock issue have to be so that the
firm will net $8 million? If the market price of the common stock is $132, how many shares must be
issued?
ANSWER:
a. $8,000,000 = x - .18x = x(1 - .18)
x = $8,000,000/.82 = $9,756,097
b. x = $9,756,097/$132 = 73,910
KEYWORDS: market price common stock
138. Outpost has 2 million shares of common stock outstanding, net income is $300,000, the P/E ratio is 9,
and management is considering an 18% stock dividend. What will be the expected effect on the price of
the common stock? If an investor owns 300 shares in the company, how does this change his total
value? Explain.
ANSWER:
a. Before dividend
Shares outstanding 2,000,000
Net income $300,000
EPS $0.15
P/E 9
Current price $ 1.35 = $0.15 × 9
Investor’s shares 300
Value before dividend $ 405.00 = $1.35 × 300 shares
After dividend
Shares outstanding 2,360,000 = 2,000,000 × (1 + 0.18)
New EPS $0.127
New price $1.144 = $0.127 × 9
Investor’s shares 354 = 300 × 1.18
Value after dividend $ 405.00 = 354 × $1.144
Change $ 0.00 = $405 (before)
$405 (after)
The total value of the investor’s holdings does not change because the price of the stock reacted
fully to the increase in the shares outstanding.
DIFFICULTY: Hard
KEYWORDS: effect on common stock price, stock dividend
139. Kelly owns 10,000 shares in McCormick Spices, which currently has 500,000 shares outstanding. The
stock sells for $86 on the open market. McCormick’s management has decided on a 2–1 split.
a. Will Kelly’s financial position alter after the split, assuming that the stocks will fall
proportionately?
b. Assuming only a 35% fall on each stock, what will be Kelly’s value after the split?
ANSWER:
McCormick Spices Corporation - Stock Split
Market price $86.00
Split multiple 2
Shares outstanding 500,000
a.
Investor’s shares = 10,000
Position before split $860,000 = 10,000 shares × $86 per share
Price after split $43.00 = $86/2
Kelly’s shares after split 20,000 = 10,000 × 2
Position after split $860,000 = 20,000 shares × $43 per share
Net gain $0
b.
Price fall 0.35
Price after split $55.90 = $86.00(1 - .35)
466
Position after split $1,118,000 = 20,000 shares × $55.90 per share
Net gain $258,000 = $1,118,000 - $860,000
DIFFICULTY: Hard
140. Trevor Co.’s future earnings for the next four years are predicted below. Assuming there are 500,000
shares outstanding, what will the yearly dividend per share be if the dividend policy is as follows?
a. A constant payout ratio of 40%
b. Stable dollar dividend targeted at 40% of the average earnings over the four-year period
c. Small, regular dividend of $0.75 plus a year-end extra of 40% of profits exceeding $1 million
Trevor Co.
Year 1 $ 900,000
Year 2 1,200,000
Year 3 850,000
Year 4 1,350,000
ANSWER:
a. .40($900,000)/500,000 = $0.72
.40($1,200,000)/500,000 = $0.96
.40($850,000)/500,000 = $0.68
.40($1,350,000)/500,000 = $1.08
b. .40($1,075,000) = $430,000/500,000 = $0.86
c. Year 1 $0.75 = $0.75
Year 2 $0.75 + $0.16 = $0.91
Year 3 $0.75 = $0.75
Year 4 $0.75 + $0.28 = $1.03
KEYWORDS: dividends per share

Dividend Policy and Internal Financing: True/False

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Dividend Policy and Internal Financing: True/False

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CHAPTER 17

Dividend Policy and Internal Financing

8. A stock dividend increases a firm’s retained earnings.

14. The ex-dividend date occurs prior to the declaration date.

25. Increasing a firm’s dividend reduces the stock’s risk.

38. Empirical evidence is conclusive that dividend policy matters.

41. Dividends tend to be higher for firms with stable earnings.

42. High levels of inflation tend not to affect dividend payments.

43. The stable dollar dividend policy is the most common.

50. Firms can use stock repurchases as a dividend substitute.

53. Flotation costs:

54. According to the perfect markets approach to dividend policy:

56. The ex-dividend date is _________ the holder of record date.

57. Dividends tend to be more stable than:

59. A stock repurchase increases the:

60. Stock splits decrease the:

61. Which of the following is not included in perfect capital markets?

62. Which of the following are not subject to income taxes?

67. A justification for stable dividends could be:

68. The final approval of a dividend payment comes from the:

70. Dividend policy is influenced by:

76. What is the fundamental purpose of a stock split?

Use the following information to answer questions 81-83.

84. The agency cost theory of dividends suggests:

85. Which of the following conclusions about dividend policy is reasonable?

87. Which of the following statements is true?

Use the following information to answer questions 89-93.

94. Which of the following reasons is used to justify stock repurchases?

97. Which of the following statements is true?

98. According to the residual theory of dividends:

103. Stock splits:

109. Which of the following statements is correct?

114. Which of the following describes the effect of a stock dividend?

125. Define perfect capital markets and discuss its assumptions.

ANSWER: $36,000,000/0.6 = $60,000,000

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