CHAPTER 16—DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND SHARE

REPURCHASES
1. The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the
firm's stock price.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Optimal distribution policy
KEYWORDS: Bloom’s: Knowledge

2. Other things held constant, the higher a firm's target payout ratio, the higher its expected growth rate should be.
a. True
b. False
ANSWER: False
RATIONALE: The higher the payout ratio, the less of its earnings the firm reinvests in the business, and the lower the
reinvestment rate, the lower the firm's growth rate.
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Target payout ratio
KEYWORDS: Bloom's: Comprehension

3. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends
has no effect on either its cost of capital or its stock price.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividend irrelevance
KEYWORDS: Bloom’s: Knowledge

4. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings a firm pays out in dividends
has no effect on its cost of capital, but it does affect its stock price.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividend irrelevance
KEYWORDS: Bloom’s: Knowledge
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5. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a
low payout ratio.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Investors' div. preferences
KEYWORDS: Bloom's: Comprehension

6. A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm's stock price.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock dividends and splits
KEYWORDS: Bloom's: Comprehension

7. A "reverse split" reduces the number of shares outstanding.

a. True
b. False split down
ANSWER: True
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Reverse split
KEYWORDS: Bloom’s: Knowledge

8. The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the
firm's stock, other things held constant.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividends and stock prices
KEYWORDS: Bloom's: Comprehension

9. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, an
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increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in dividend payout
ratios.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividends and stock prices
KEYWORDS: Bloom's: Comprehension

10. The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant, if
the tax rate on dividends is high relative to that on capital gains, then individuals with low taxable incomes should favor
stocks with low payouts and high-income individuals should favor high-payout companies.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividends and stock prices
KEYWORDS: Bloom's: Comprehension

11. It has been argued that investors prefer high-payout companies because dividends are more certain (less risky) than the
capital gains that are supposed to come from retained earnings. However, Miller and Modigliani say that this argument is
incorrect, and they call it the "bird-in-the-hand fallacy." MM base their argument on the belief that most dividends are
reinvested in stocks, hence are exposed to the same risks as reinvested earnings.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
TOPICS: Dividends and stock prices
KEYWORDS: Bloom’s: Knowledge

12. Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the
firm is determined only by its basic earning power and its business risk.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividend irrelevance

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KEYWORDS: Bloom’s: Knowledge

13. One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset
by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held
constant.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Dividend-growth tradeoff
KEYWORDS: Bloom’s: Knowledge

14. If a retired individual lives on his or her investment income, then it would make sense for this person to prefer stocks
with high payouts so he or she could receive cash without going to the trouble and expense of selling stocks. On the other
hand, it would make sense for an individual who would just reinvest any dividends received to prefer a low-payout
company because that would save him or her taxes and brokerage costs.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-2 Other Dividend Policy Issues
TOPICS: Dividends and stock prices
KEYWORDS: Bloom's: Comprehension

15. Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others
prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend
policy and stick to it, and then it will attract a clientele of investors who like that policy.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-2 Other Dividend Policy Issues
TOPICS: Dividends and stock prices
KEYWORDS: Bloom’s: Knowledge

16. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces that it
is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would argue that this is
proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree with this argument.
a. True
b. False
ANSWER: False
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RATIONALE: MM would disagree. They would say that investors took the dividend increase as a signal that the firm's
management expected higher future earnings. MM say dividends have information content regarding
future earnings.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-2 Other Dividend Policy Issues
TOPICS: Dividends and stock prices
KEYWORDS: Bloom's: Comprehension

17. If the information content, or signaling, hypothesis is correct, then a change in a firm's dividend policy can have an
important effect on its stock price and cost of equity.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-2 Other Dividend Policy Issues
TOPICS: Signaling hypothesis
KEYWORDS: Bloom's: Comprehension

18. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after
providing for the equity required to fund the capital budget. Under this model, the better the firm's investment
opportunities, the lower its payout ratio will be, other things held constant.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Comprehension

19. If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual after
providing for the equity required to fund the capital budget. Under this model, the higher the firm's debt ratio, the lower its
payout ratio will be, other things held constant.
a. True
b. False
ANSWER: False
RATIONALE: The higher the debt ratio, the more dollars of debt will be used to fund a given capital budget. So, the
higher the debt ratio, the less equity will be needed, and this results in a higher dividend payout ratio
according to the residual dividend model.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
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KEYWORDS: Bloom's: Comprehension

20. If management wants to maximize its stock price, and if it believes that the dividend irrelevance theory is correct, then
it must adhere to the residual dividend policy.
a. True
b. False
ANSWER: False
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom’s: Knowledge

21. If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, then the price
of the stock should drop by approximately $1.50 on January 31.
a. True
b. False
ANSWER: False
RATIONALE: This is false. The stock price will drop on the ex-dividend date, which is two days prior to the holder of
record date, which is well before the actual January 31 payment date. Also, because the dividend is
taxable, the price decline is generally somewhat less than the full amount of the dividend.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Dividend payment procedures
KEYWORDS: Bloom's: Comprehension

22. If on January 3, 2015, a company declares a dividend of $1.50 per share, payable on January 31, 2015, to holders of
record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is the ex-
dividend date.
a. True
b. False
ANSWER: True
RATIONALE: This is true. The stock price will drop on the ex-dividend date, which is two days prior to the holder of
record date, which is well before the actual January 31 payment date. Note, though, that because the
dividend is taxable, the price decline may be somewhat less than the full amount of the dividend.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Dividend payment procedures
KEYWORDS: Bloom's: Comprehension

23. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the dividends
that they choose to reinvest.
a. True

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b. False
ANSWER: False
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-4 Dividend Reinvestment Plans
TOPICS: Dividend reinvestment plans
KEYWORDS: Bloom’s: Knowledge

24. There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would have
been paid as dividends to buy stock on the open market. Under the other type, the company issues new stock, keeps the
cash that would have been paid out, and in effect sells new stock to those investors who choose to reinvest their dividends.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-4 Dividend Reinvestment Plans
TOPICS: Dividend reinvestment plans
KEYWORDS: Bloom’s: Knowledge

25. If a firm pays out all of its earnings as dividends and its stockholders then elect to have all of their dividends
reinvested, the company should reconsider its dividend policy and possibly move to a lower dividend payout ratio.
a. True
b. False
ANSWER: True
RATIONALE: This is true, because if the company retains its earnings rather than paying them out, investors should
receive capital gains rather than dividend income, and the taxes on those gains will be deferred until the
stock is sold. Note that the money will be reinvested by the company in either case, so the risk to
stockholders under dividend reinvestment and retained earnings should be the same.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-4 Dividend Reinvestment Plans
TOPICS: Dividend reinvestment plans
KEYWORDS: Bloom's: Comprehension

26. If a firm declares a 20:1 stock split, and the pre-split price was $500, then we might expect the post-split price to be
$25. However, it often turns out that the post-split price will be higher than $25. This higher price could be due to
signaling effects investors believe that management split the stock because they think the firm is going to do better in the
future. The higher price could also be because investors like lower-priced shares.
a. True
b. False
ANSWER: True
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-6 Stock Dividends and Stock Splits
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REPURCHASES
TOPICS: Stock split
KEYWORDS: Bloom's: Comprehension

27. Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock prices
decline. Your firm's earnings, investment opportunities, and capital structure do not change. If the firm follows the
residual dividend model, then its dividend payout ratio would increase.
a. True
b. False
ANSWER: True
RATIONALE: (1) The firm's WACC would increase, (2) this would cause fewer projects to be accepted, (3) this would
lead to a smaller capital budget, (4) thus less money would be needed to fund the capital budget, (5)
thus less equity would be needed, so (6) the dividend payout ratio would increase.
POINTS: 1
DIFFICULTY: CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Comprehension

28. Suppose you plotted a curve which showed a Firm U's WACC on the vertical axis and its debt ratio on the horizontal
axis. Then you plotted a similar curve for Firm V. The curve for firm U resembled a shallow "U," while that for Firm V
resembled a sharp "V." Both firms have debt ratios that cause their WACCs to be minimized. Other things held constant,
it would be easier for Firm V than for Firm U to maintain a steady dividend in the face of varying investment
opportunities and earnings from year to year.
a. True
b. False
ANSWER: False
RATIONALE: Firm U could fund its capital budget with varying amounts of debt without causing large changes in its
WACC and thus in its value and stock price. Firm V could not vary its debt ratio without increasing its
WACC. Thus, Firm V would have to raise and lower its dividend payout in order to obtain the equity it
needed to support its capital budget. Firm U, on the other hand, could maintain a stable, steady
dividend, and let the debt ratio vary without causing much harm to its stock price.
POINTS: 1
DIFFICULTY: CHALLENGING
REFERENCES: 16-5 Summary of Factors Influencing Dividend Policy
TOPICS: WACC and dividend policy
KEYWORDS: Bloom's: Comprehension

29. In the real world, dividends

a. are usually more stable than earnings.
b. fluctuate more widely than earnings.
c. tend to be a lower percentage of earnings for mature firms.
d. are usually changed every year to reflect earnings changes, and these changes are randomly higher to lower,
depending on whether earnings increased or decreased.
e. are usually set as a fixed percentage of earnings, e.g., at 40% of earnings, so if EPS = $2.00, then DPS would
equal $0.80. Once the percentage is set, then dividend policy is on "automatic pilot" and the dividend actually
paid depends strictly on earnings.

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ANSWER: a
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Dividend payout
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

30. You own 100 shares of Troll Brothers' stock, which currently sells for $120 a share. The company is about to declare a
2-for-1 stock split. Which of the following best describes your likely position after the split?
a. You will have 200 shares of stock, and the stock will trade at or near $120 a share.
b. You will have 200 shares of stock, and the stock will trade at or near $60 a share. pag price divide
pag share multiply
c. You will have 100 shares of stock, and the stock will trade at or near $60 a share.
d. You will have 50 shares of stock, and the stock will trade at or near $120 a share.
e. You will have 50 shares of stock, and the stock will trade at or near $600 a share.
ANSWER: b
POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Conceptual

31. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is
lowered. Their argument is based on the assumption that
a. investors are indifferent between dividends and capital gains.
b. investors require that the dividend yield plus the 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.
e. investors prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower tax
rate on capital gains.
ANSWER: d
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-1 Dividends Versus Capital Gains: What Do Investors Prefer?
TOPICS: Investors' div. preferences
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

32. Your firm adheres strictly to the residual dividend model. All else equal, which of the following factors would be most
likely to lead to an increase in the firm's dividend per share?
a. The firm's net income increases.
b. The company increases the percentage of equity in its target capital structure.
c. The number of profitable potential projects increases.
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d. Congress lowers the tax rate on capital gains, leaving the rest of the tax code unchanged.
e. Earnings are unchanged, but the firm issues new shares of common stock.
ANSWER: a
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application

33. If a firm adheres strictly to the residual dividend policy, and if its optimal capital budget requires the use of all
earnings for a given year (along with new debt according to the optimal debt/assets ratio), then the firm should pay
a. the same dividend as it paid the prior year.
b. no dividends to common stockholders.
c. dividends only out of funds raised by the sale of new common stock.
d. dividends only out of funds raised by borrowing money (i.e., issuing debt).
e. dividends only out of funds raised by selling off fixed assets.
ANSWER: b
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Conceptual

34. If a firm adheres strictly to the residual dividend model, the issuance of new common stock would suggest that
a. the dividend payout ratio has remained constant.
b. the dividend payout ratio is increasing.
c. no dividends will be paid during the year.
d. the dividend payout ratio is decreasing.
e. the dollar amount of capital investments had decreased.
ANSWER: c
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Conceptual

35. Which of the following does NOT normally influence a firm's dividend policy decision?
a. The firm's ability to accelerate or delay investment projects without adverse consequences.
b. A strong preference by most of its shareholders for current cash income versus potential future capital gains.
c. Constraints imposed by the firm's bond indenture.
d. The fact that much of the firm's equipment is leased rather than bought and owned.
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e. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital
gains.
ANSWER: d
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-5 Summary of Factors Influencing Dividend Policy
TOPICS: Factors in div. policy
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

36. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?
a. Its earnings become more stable.
b. Its access to the capital markets increases.
c. Its research and development efforts pay off, and it now has more high-return investment opportunities.
d. Its accounts receivable decrease due to a change in its credit policy.
e. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock
market averages.
ANSWER: c
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-5 Summary of Factors Influencing Dividend Policy
TOPICS: Factors in div. policy
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

37. Which of the following statements is CORRECT?

a. When firms are deciding on the size of stock splits--say whether to declare a 2-for-1 split or a 3-for-1 split, it is
best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher
than if the 3-for-1 split had been used.
b. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their
stock prices. However, this was determined to be a deceptive practice, and reverse splits are illegal today.
c. Stock splits create more administrative problems for investors than stock dividends, especially determining the
tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than
stock splits.
d. When a company declares a stock split, the price of the stock typically declines--for example, by about 50%
after a 2-for-1 split--and this necessarily reduces the total market value of the firm's equity.
e. If a firm's stock price is quite high relative to most stocks--say $500 per share--then it can declare a stock split
of say 20-for-1 so as to bring the price down to something close to $25. Moreover, if the price is relatively
low--say $2 per share--then it can declare a "reverse split" of say 1-for-10 so as to bring the price up to
somewhere around $20 per share.
ANSWER: e
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock dividends and splits
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KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

38. Which of the following statements about dividend policies is CORRECT?

a. Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more
certain than capital gains. They call this the "bird-in-the-hand" effect.
b. One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing
stock is that dividends are normally taxed at a lower rate than gains on repurchased stock.
c. One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the
dividends that they choose to reinvest.
d. One key advantage of the residual dividend model is that it enables a company to follow a stable dividend
policy.
e. The clientele effect suggests that companies should follow a stable dividend policy.
ANSWER: e
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend theories
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

39. Which of the following statements is CORRECT?

a. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who
want to increase their investment in the company.
b. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the
dividends credited to their account.
c. Stock repurchases can be used by a firm that wants to increase its debt ratio.
d. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the
next few years, provided investors are aware of these investment opportunities.
e. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and
increases the shares outstanding.
ANSWER: c
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Repurchases and DRIPS
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

40. Which of the following statements is CORRECT?

a. Under the tax laws as they existed in 2014, a dollar received by an individual taxpayer as interest income
is taxed at the same rate as a dollar received as dividends.
b. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would
have to pay if they received cash dividends.
c. Empirical research indicates that, in general, companies send a negative signal to the marketplace when
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they announce an increase in the dividend. As a result, share prices fall when dividend increases are
announced because investors interpret the increase as a signal that the firm expects fewer good investment
opportunities in the future.
d. If a company needs to raise new equity capital, a new-stock dividend reinvestment plan would make
sense. However, if the firm does not need new equity, then an open market purchase dividend
reinvestment plan would probably make more sense.
e. Dividend reinvestment plans have not caught on in most industries, and today over 99% of all DRIPs are
offered by utilities.
ANSWER: d
POINTS: 1
DIFFICULTY: MODERATE
TOPICS: Divs., DRIPs, and repurch.
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

41. Which of the following statements is CORRECT?

a. Historically, the tax code has encouraged companies to pay dividends rather than retain earnings.
b. If a company uses the residual dividend model to determine its dividend payments, dividend payout will tend
to increase whenever its profitable investment opportunities increase relatively rapidly.
c. The more a firm's management believes in the clientele effect, the more likely the firm is to adhere strictly to
the residual dividend model.
d. Large stock repurchases financed by debt tend to increase expected earnings per share, but they also tend to
increase the firm's financial risk.
e. A dollar paid out to repurchase stock has the same tax benefit as a dollar paid out in dividends. Thus, both
companies and investors should be indifferent between distributing cash through dividends and stock
repurchase programs.
ANSWER: d
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Div. policy and repurchases
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

42. Which of the following statements is CORRECT?

a. If a company has a 2-for-1 stock split, its stock price should roughly double.
b. Capital gains earned on shares repurchased are taxed less favorably than dividends, which is why companies
typically pay dividends and avoid share repurchases.
c. Very often, a company's stock price will rise when it announces that it plans to commence a share repurchase
program. Such an announcement could lead to a stock price decline, but this does not normally happen.
d. Stock repurchases increase the number of outstanding shares.
e. The clientele effect is the best explanation for why companies tend to vary their dividend payments from
quarter to quarter.
ANSWER: c
RATIONALE: c is correct, but perhaps the easiest way to answer this question is to eliminate the other choices, which
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are obviously wrong.
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

43. Which of the following statements is CORRECT?

a. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above-
average dividend payout ratios.
b. One advantage of the residual dividend model is that it leads to a stable dividend payout, which investors like.
c. An increase in the stock price when a company cuts its dividend is consistent with signaling theory as
postulated by MM.
d. If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant
percentage of net income will probably maximize its stock price.
e. Stock repurchases make the most sense at times when a company believes its stock is undervalued.
ANSWER: e
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

44. Which of the following statements is CORRECT?

a. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the
dividends they receive.
b. If a company has an established clientele of investors who prefer a high dividend payout, and if management
wants to keep stockholders happy, it should not adhere strictly to the residual dividend model.
c. If a firm adheres strictly to the residual dividend model, then, holding all else constant, its dividend payout
ratio will tend to rise whenever its investment opportunities improve.
d. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this
would motivate companies to increase their dividend payout ratios.
e. Despite its drawbacks, following the residual dividend model will tend to stabilize actual cash dividends, and
this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees.
ANSWER: b
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

45. Firm M is a mature company in a mature industry. Its annual net income and cash flows are consistently high and
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stable. However, M's growth prospects are quite limited, so its capital budget is small relative to its net income. Firm N is
a relatively new company in a new and growing industry. Its markets and products have not stabilized, so its annual
operating income fluctuates considerably. However, N has substantial growth opportunities, and its capital budget is
expected to be large relative to its net income for the foreseeable future. Which of the following statements is CORRECT?
a. Firm M probably has a lower target debt ratio than Firm N.
b. Firm M probably has a higher target dividend payout ratio than Firm N.
c. If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
d. The two firms are equally likely to pay high dividends.
e. Firm N is likely to have a clientele of shareholders who want a consistent, stable dividend income.
ANSWER: b
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Conceptual

46. Which of the following statements is CORRECT?

a. If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than
they paid for it will be subject to capital gains taxes.
b. An open-market dividend reinvestment plan will be most attractive to companies that need new equity and
would otherwise have to issue additional shares of common stock through investment bankers.
c. Stock repurchases tend to reduce financial leverage.
d. If a company declares a 2-for-1 stock split, its stock price should roughly double.
e. One advantage of adopting the residual dividend model is that this makes it easier for corporations to meet the
requirements of Modigliani and Miller's dividend clientele theory.
ANSWER: a
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

47. Which of the following actions will best enable a company to raise additional equity capital, other things held
constant?
a. Refund long-term debt with lower cost short-term debt.
b. Declare a stock split.
c. Begin an open-market purchase dividend reinvestment plan.
d. Initiate a stock repurchase program.
e. Begin a new-stock dividend reinvestment plan.
ANSWER: e
POINTS: 1
DIFFICULTY: MODERATE
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REPURCHASES
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

48. Which of the following statements is NOT CORRECT?

a. Stock repurchases can be used by a firm as part of a plan to change its capital structure.
b. After a 3-for-1 stock split, a company's price per share should fall, but the number of shares outstanding will
rise.
c. Investors may interpret a stock repurchase program as a signal that the firm's managers believe the stock is
undervalued, or, alternatively, as a signal that the firm does not have many good investment opportunities.
d. A company can repurchase stock to distribute a large one-time cash inflow, say from the sale of a division, to
stockholders without having to increase its regular dividend.
e. Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend
reinvestment plan.
ANSWER: e
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: Comprehensive
TOPICS: Repurchases and splits
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

49. Which of the following statements is CORRECT?

a. If a firm follows the residual dividend model, then a sudden increase in the number of profitable projects
would be likely to lead to a reduction of the firm's dividend payout ratio.
b. The clientele effect explains why so many firms change their dividend policies so often.
c. One advantage of adopting the residual dividend model is that this policy makes it easier for a corporation to
attract a specific and well-identified dividend clientele.
d. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number
of shares outstanding but don't change the firm's total amount of book equity.
e. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock
dividends are received.
ANSWER: a
POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

50. Which of the following statements is CORRECT?

a. Suppose a firm that has been earning $2 and paying a dividend of $1.00, or a 50% dividend payout, announces
that it is increasing the dividend to $1.50. The stock price then jumps from $20 to $30. Some people would
argue that this is proof that investors prefer dividends to retained earnings. Miller and Modigliani would agree
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with this argument.
b. Other things held constant, the higher a firm's target dividend payout ratio, the higher its expected growth rate
should be.
c. Miller and Modigliani's dividend irrelevance theory says that the percentage of its earnings that a firm pays out
in dividends has no effect on its cost of capital, but it does affect its stock price.
d. The federal government sometimes taxes dividends and capital gains at different rates. Other things held
constant, an increase in the tax rate on dividends relative to that on capital gains would logically lead to a
decrease in dividend payout ratios.
e. If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price
should set a high dividend payout ratio.
ANSWER: d
POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: Comprehensive
TOPICS: Dividend concepts
KEYWORDS: Bloom's: Comprehension
OTHER: Multiple Choice: Conceptual

51. Portland Plastics Inc. has the following data. If it follows the residual dividend model, what is its forecasted dividend
payout ratio?
Capital budget $12,500
% Debt 40%
Net income (NI) $11,500

a. 25.36%
b. 28.17%
c. 31.30%
d. 34.78%
e. 38.26%
ANSWER: d
RATIONALE:
Capital budget $12,500
Net income (NI) $11,500
% Debt 40%
% Equity = 1.0 − % Debt = 60%
Equity needed to support the capital budget = % Equity × Capital budget $7,500
Dividends paid = NI − Equity needed if positive, otherwise $0.0. $4,000

Payout ratio = Dividends paid/NI = 34.78%

POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem
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52. Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock sold for $80 per share. If the firm's
total market value is unchanged by the split, what will the stock price be following the split?
a. $36.10
b. $38.00
c. $40.00
d. $42.00
e. $44.10
ANSWER: c
RATIONALE:
Number of new shares 2
Number of old shares 1
Old (pre-split) price $80

New price = Old price × (Old shares/New shares) = $40.00

POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

53. Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $90 per share. The
firm's total market value was unchanged by the split. Other things held constant, what is the best estimate of the stock's
post-split price?
a. $30.00
b. $31.50
c. $33.08
d. $34.73
e. $36.47
ANSWER: a
RATIONALE:
Number of new shares 3
Number of old shares 1
Pre-split stock price $90.00
Post-split stock price: P0/New per old = $30.00

POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

54. Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock sold for $80 per share. If the
firm's total market value is unchanged by the split, what will the stock price be following the split?
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a. $20.63
b. $21.71
c. $22.86
d. $24.00
e. $25.20
ANSWER: c
RATIONALE:
Number of new shares 7
Number of old shares 2
Old (pre-split) price $80.00

New price = Old price × (Old shares/New shares) = $22.86

POINTS: 1
DIFFICULTY: EASY
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

55. Fauver Industries plans to have a capital budget of $650,000. It wants to maintain a target capital structure of 40%
debt and 60% equity, and it also wants to pay a dividend of $225,000. If the company follows the residual dividend
model, how much net income must it earn to meet its investment requirements, pay the dividend, and keep the capital
structure in balance?
a. $584,250
b. $615,000
c. $645,750
d. $678,038
e. $711,939
ANSWER: b
RATIONALE:
Capital budget $650,000
% Equity 60%
Dividends to be paid $225,000

Required net income = Dividends + (Capital budget × % Equity) = $615,000

POINTS: 1
DIFFICULTY: EASY/MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

56. Ring Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and 65%
equity, and it also wants to pay a dividend of $400,000. If the company follows the residual dividend model, how much
net income must it earn to meet its capital budgeting requirements and pay the dividend, all while keeping its capital
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structure in balance?
a. $ 904,875
b. $ 952,500
c. $1,000,125
d. $1,050,131
e. $1,102,638
ANSWER: b
RATIONALE:
Capital budget $850,000
Equity ratio 65%
Dividends to be paid $400,000

Required net income = Dividends + (Capital budget × % Equity) = $952,500

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

57. D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45% debt
and 55% equity, and she also wants to pay a dividend of $500,000. If the company follows the residual dividend model,
how much income must it earn, and what will its dividend payout ratio be?
a. $ 898,750; 55.63%
b. $ 943,688; 58.41%
c. $ 990,872; 61.34%
d. $1,040,415; 64.40%
e. $1,092,436; 67.62%
ANSWER: a
RATIONALE:
Capital budget $725,000
Equity ratio 55%
Dividends paid $500,000

NI = Dividends + (Equity % × Capital budget) = $898,750

Payout = Dividends/NI = 55.63%

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

58. Banerjee Inc. wants to maintain a target capital structure with 30% debt and 70% equity. Its forecasted net income is
$550,000, and its board of directors has decreed that no new stock can be issued during the coming year. If the firm
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follows the residual dividend model, what is the maximum capital budget that is consistent with maintaining the target
capital structure?
a. $673,652
b. $709,107
c. $746,429
d. $785,714
e. $825,000
ANSWER: d
RATIONALE:
% Debt 30%
% Equity 70%
Net income $550,000
Max. capital budget = NI/% Equity $785,714

Check: Is calculated Max. capital budget × % Equity = NI? $550,000 = Net income

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

59. Dentaltech Inc. projects the following data for the coming year. If the firm follows the residual dividend model and
also maintains its target capital structure, what will its dividend payout ratio be?
EBIT $2,000,000 Capital budget $850,000
Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares outstanding 5,000,000 Tax rate 40%

a. 37.2%
b. 39.1%
c. 41.2%
d. 43.3%
e. 45.5%
ANSWER: d
RATIONALE:
EBIT $2,000,000 Capital budget $850,000
Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares outstanding 5,000,000 Tax rate 40%

EBIT $2,000,000
− Interest expense = Interest rate × Debt 500,000
Taxable income $1,500,000
− Taxes = Tax rate × Income 600,000
Net income (NI) $900,000
− Equity needed for capital budget = % Equity(Capital budget) $10,000

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Dividends = NI − Equity needed $390,000

Payout ratio = Dividends/NI = 43.33%

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

60. Mortal Inc. expects to have a capital budget of $500,000 next year. The company wants to maintain a target capital
structure with 30% debt and 70% equity, and its forecasted net income is $400,000. If the company follows the residual
dividend model, how much in dividends, if any, will it pay?
a. $45,125
b. $47,500
c. $50,000
d. $52,500
e. $55,125
ANSWER: c
RATIONALE:
% Debt 30%
% Equity 70%
Capital budget $500,000
Net income $400,000
Equity requirement = Capital budget × % Equity $350,000

Dividends = NI − Equity requirement = $50,000

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

61. Torrence Inc. has the following data. If it uses the residual dividend model, how much total dividends, if any, will it
pay out?

Capital budget $1,000,000

% Debt 60%
Net income (NI) $625,000

a. $183,264
b. $192,909
c. $203,063
d. $213,750
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e. $225,000
ANSWER: e
RATIONALE:
Capital budget $1,000,000
Net income (NI) $625,000
% Debt 60%
% Equity = 1.0 − % Debt 40%
Equity needed to support the capital budget = % Equity × Capital budget $400,000

Dividends paid = NI − Equity needed if positive (otherwise, $0.0) = $225,000

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

62. NY Fashions has the following data. If it follows the residual dividend model, how much total dividends, if any, will it
pay out?

Capital budget $1,500,000

% Debt 65%
Net income (NI) $550,000

a. $20,363
b. $21,434
c. $22,563
d. $23,750
e. $25,000
ANSWER: e
RATIONALE:
Capital budget $1,500,000
Net income (NI) $550,000
% Debt 65%
% Equity = 1.0 − % Debt 35%
Equity needed to support the capital budget = % Equity × Capital budget $525,000

Dividends paid = NI − Equity needed if positive (otherwise, $0.0) = $25,000

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

63. Chicago Brewing has the following data, dollars in thousands. If it follows the residual dividend model, what will its
dividend payout ratio be?

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Capital budget $5,000
% Debt 45%
Net income (NI) $5,300

a. 48.11%
b. 50.52%
c. 55.57%
d. 61.13%
e. 67.24%
ANSWER: a
RATIONALE:
Capital budget $5,000
Net income (NI) $5,300
% Debt 45%
% Equity = 1.0 − % Debt 55%
Equity needed to support the capital budget = % Equity × Capital budget $2,750
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $2,550

Payout ratio = Dividends paid/NI = 48.11%

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

64. LA Moving Company has the following data, dollars in thousands. If it follows the residual dividend model, what will
its dividend payout ratio be?

Capital budget $5,000

% Debt 45%
Net income (NI) $7,000

a. 60.71%
b. 63.75%
c. 70.13%
d. 77.14%
e. 84.85%
ANSWER: a
RATIONALE:
Capital budget $5,000
Net income (NI) $7,000
% Debt 45%
% Equity = 1.0 − % Debt 55%
Equity needed to support the capital budget = % Equity × Capital budget $2,750
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $4,250

Payout ratio = Dividends paid/NI = 60.71%

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POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

65. New Orleans Builders Inc. has the following data. If it follows the residual dividend model, what is its forecasted
dividend payout ratio?

Capital budget $7,500

% Debt 35%
Net income (NI) $6,500

a. 18.23%
b. 20.25%
c. 22.50%
d. 25.00%
e. 27.50%
ANSWER: d
RATIONALE:
Capital budget $7,500
Net income (NI) $6,500
% Debt 35%
% Equity = 1.0 − % Debt 65%
Equity needed to support the capital budget = % Equity × Capital budget $4,875
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $1,625

Payout ratio = Dividends paid/NI = 25.00%

POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

66. Ross-Jordan Financial has suffered losses in recent years, and its stock currently sells for only $0.50 per share.
Management wants to use a reverse split to get the price up to a more "reasonable" level, which it thinks is $25 per share.
How many of the old shares must be given up for one new share to achieve the $25 price, assuming this transaction has no
effect on total market value?
a. 47.50
b. 49.88
c. 50.00
d. 52.50
e. 55.13
ANSWER: c
RATIONALE:
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Current price $0.50
Target price $25.00

Old shares surrendered per 1 new share = Target price/Old price = 50.00
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

67. Keys Financial has done extremely well in recent years, and its stock now sells for $175 per share. Management wants
to get the price down to a more typical level, which it thinks is $25 per share. What stock split would be required to get to
this price, assuming the transaction has no effect on the total market value? Put another way, how many new shares
should be given per one old share?
a. 6.98
b. 7.00
c. 7.35
d. 7.72
e. 8.10
ANSWER: b
RATIONALE:
Current price $175.00
Target price $25.00

No. of new shares per 1 old share = Current price/Target price = 7.00
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

68. Whited Products recently completed a 4-for-1 stock split. Prior to the split, its stock sold for $120 per share. If the
firm's total market value increased by 5% as a result of increased liquidity and favorable signaling effects, what was the
stock price following the split?
a. $29.93
b. $31.50
c. $33.08
d. $34.73
e. $36.47
ANSWER: b
RATIONALE:
New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%

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Post-split stock price = (P0/[(New shares per old shares) × (1 + % Value increase)] = $31.50
POINTS: 1
DIFFICULTY: MODERATE
REFERENCES: 16-5 Summary of Factors Influencing Dividend Policy
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

69. Clark Farms Inc. has the following data, and it follows the residual dividend model. Currently, it finances with 15%
debt. Some Clark family members would like for the dividends to be increased. If Clark increased its debt ratio, which the
firm's treasurer thinks is feasible, by how much could the dividend be increased, holding other things constant?
Capital budget $3,000,000
Net income (NI) $3,500,000
% Debt now 15%
% Debt after change 60%

a. $1,093,500
b. $1,215,000
c. $1,350,000
d. $1,485,000
e. $1,633,500
ANSWER: c
RATIONALE:
Old New
% Debt 15% 60%
% Equity = 1.0 − % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000

Increase in dividends paid = $1,350,000

POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

70. Purcell Farms Inc. has the following data, and it follows the residual dividend model. Currently, it finances with 15%
debt. Some Purcell family members would like for the dividend payout ratio to be increased. If Purcell increased its debt
ratio, which the firm's treasurer thinks is feasible, by how much could the dividend payout ratio be increased, holding
other things constant?

Capital budget $3,000,000

Net income (NI) $3,500,000
% Debt now 15%

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% Debt after change 60%

a. 38.6%
b. 40.5%
c. 42.5%
d. 44.7%
e. 46.9%
ANSWER: a
RATIONALE:
Old New
% Debt 15% 60%
% Equity = 1.0 − % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget
= % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000
Dividend payout ratio 27.1% 65.7%

Increase in dividend payout ratio = 38.6%

POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

71. Whitman Antique Cars Inc. has the following data, and it follows the residual dividend model. Some Whitman family
members would like more dividends, and they also think that the firm's capital budget includes too many projects whose
NPVs are close to zero. If Whitman reduced its capital budget to the indicated level, by how much could dividends be
increased, holding other things constant?
Original capital budget $3,000,000
New capital budget $2,000,000
Net income $3,500,000
% Debt 40%

a. $486,000
b. $540,000
c. $600,000
d. $660,000
e. $726,000
ANSWER: c
RATIONALE:
Old New
% Debt 40% 40%
% Equity = 1.0 − % Debt 60% 60%
Capital budget $3,000,000 $2,000,000
Net income (NI) $3,500,000 $3,500,000

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Equity needed to support the capital budget
= % Equity × Capital budget $1,800,000 $1,200,000
Dividends paid = NI − Equity needed if positive (otherwise, $0.0) $1,700,000 $2,300,000

Increase in dividends paid = $600,000

POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

72. Pavlin Corp.'s projected capital budget is $2,000,000, its target capital structure is 40% debt and 60% equity, and its
forecasted net income is $900,000. If the company follows the residual dividend model, how much dividends will it pay
or, alternatively, how much new stock must it issue?
a. $462,983; $244,352
b. $487,350; $257,213
c. $513,000; $270,750
d. $540,000; $285,000
e. $ 0; $300,000
ANSWER: e
RATIONALE:
Capital budget $2,000,000
% Equity 60%
Net income (NI) $900,000
Equity required for capital budget = % Equity × Capital budget $1,200,000
Dividends = NI − Equity required if > 0 (otherwise, 0) = $0
Required new stock = NI − Equity required if < 0 (otherwise, 0) = $300,000

Dividends paid = NI − [% Equity(Cap. bud.)], Dividends: or new stock:

stock issued if dividends zero or neg. $0 $300,000

POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Application
OTHER: Multiple Choice: Problem

73. Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75.00 per share, and the firm believes that
its total market value would increase by 5% as a result of the improved liquidity that should follow the split. What is the
stock's expected price following the split?
a. $32.06
b. $33.75
c. $35.44
d. $37.21
e. $39.07

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ANSWER: b
RATIONALE:
Number of new shares 7
Number of old shares 3
Old (pre-split) price $75.00
% Increase in value 5%
New price before value increase = Old price/(New shares/Old shares) $32.14

New price after value increase = Prior × (1 + % Value increase) = $33.75

POINTS: 1
DIFFICULTY: MODERATE/CHALLENGING
REFERENCES: 16-6 Stock Dividends and Stock Splits
TOPICS: Stock split
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

74. Walter Industries is a family owned concern. It has been using the residual dividend model, but family members who
hold a majority of the stock want more cash dividends, even if that means a slower future growth rate. Neither the net
income nor the capital structure will change during the coming year as a result of a dividend policy change to the
indicated target payout ratio. By how much would the capital budget have to be cut to enable the firm to achieve the new
target dividend payout ratio?

% Debt 35%
% Equity = 1.0 − % Debt 65%
Capital budget under the residual dividend model $5,000,000
Net income; it will not change this year even if dividends increase $3,500,000
Equity to support the capital budget = % Equity × Capital budget $3,250,000
Dividends paid = NI − Equity needed $250,000
Currently projected dividend payout ratio 7.1%
Target dividend payout ratio 70.0%

a. −$2,741,538
b. −$3,046,154
c. −$3,384,615
d. −$3,723,077
e. −$4,095,385
ANSWER: c
RATIONALE:
Old New
Net income (NI) $3,500,000 $3,500,000
% Debt 35% 35%
% Equity = 1.0 − % Debt 65% 65%

New target dividend payout ratio 70%

Target dividend = Target dividend payout × NI $2,450,000
Target retained earnings (RE) = NI − Dividends $1,050,000
Max. capital budget = RE/% Equity $1,615,385
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Check: % Equity × Capital budget consistent = Calculated RE? Yes $1,050,000

New capital budget − Old capital budget = $1,615,385 − $5,000,000 = −$3,384,615

POINTS: 1
DIFFICULTY: CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

75. Sheehan Corp. is forecasting an EPS of $3.00 for the coming year on its 500,000 outstanding shares of stock. Its
capital budget is forecasted at $800,000, and it is committed to maintaining a $2.00 dividend per share. It finances with
debt and common equity, but it wants to avoid issuing any new common stock during the coming year. Given these
constraints, what percentage of the capital budget must be financed with debt?
a. 30.54%
b. 32.15%
c. 33.84%
d. 35.63%
e. 37.50%
ANSWER: e
RATIONALE:
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS × Shares outstanding $1,500,000
Dividends paid = DPS × Shares outstanding $1,000,000
Retained earnings available $500,000
Capital budget − Retained earnings = Debt needed $300,000

Debt needed/Capital budget = % Debt financing = 37.5%

POINTS: 1
DIFFICULTY: CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Analysis
OTHER: Multiple Choice: Problem

76. Del Grasso Fruit Company has more positive NPV projects than it can finance under its current policies without
issuing new stock, but its board of directors had decreed that it cannot issue any new shares in the foreseeable future. Your
boss, the CFO, wants to know how the capital budget would be affected by changes in capital structure policy and/or the
target dividend payout policy. You obtained the following data, which shows the firm's projected net income (NI), its
current capital structure and dividend payout policies, and three possible new policies. Projected net income for the
coming year will not be affected by a policy change. How much larger could the capital budget be if (1) the target debt
ratio were raised to the indicated amount, other things held constant, (2) the target payout ratio were lowered to the
indicated amount, other things held constant, or (3) the debt ratio and dividend payout were both changed by the indicated
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amounts?

Current ______________ Policy Changes ___________

Policy Increase Debt Lower Payout Do Both
Projected NI $175.0 $175.0 $175.0 $175.0
% Debt 25.0% 75.0% 25.0% 75.0%
% Equity 75.0% 25.0% 75.0% 25.0%
% Payout 65.0% 65.0% 20.0% 20.0%

a. $133.0; $ 85.5; $389.6

b. $140.0; $ 90.0; $410.1
c. $147.4; $ 94.8; $431.7
d. $155.2; $ 99.8; $454.4
e. $163.3; $105.0; $478.3
ANSWER: e
RATIONALE:
New Maximum New Maximum New Maximum If
Current
Found as: If If Do
Maximum
Increase Debt Lower Payout Both
NI Given $175.0 $175.0 $175.0
$175.0
% Debt " 25.0% 75.0% 25.0% 75.0%
% Equity " 75.0% 25.0% 75.0% 25.0%
% Payout " 65.0% 65.0% 20.0% 20.0%
Dividends Payout % × NI $113.8 $35.0 $35.0
$113.8
Ret. earnings,
NI − Dividends $61.3 $61.3 $140.0 $140.0
RE
Max. cap.
RE/% Equity $81.7 $245.0 $186.7 $560.0
budget

Increase: New max. − Current

$163.3 $105.0 $478.3
max. =
Percentage increase:
New max./Current max. − 1.0 = 200.0% 128.6% 585.7%

POINTS: 1
DIFFICULTY: CHALLENGING
REFERENCES: 16-3 Establishing the Dividend Policy in Practice
TOPICS: Residual dividend model
KEYWORDS: Bloom's: Evaluation
OTHER: Multiple Choice: Problem

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