27) Fred Handel owns 2000 shares of Haydn Inc. stock which is currently selling for $18 per
share. If the company repurchases 10% of its outstanding shares at $18 per share and Fred
chooses not to sell any shares back to the company,
A) the value of his shares will stay the same and his percentage ownership of the company will
increase by 10%.
B) his investment in the company and his percentage of ownership will stay the same.
C) his investment in the company will decrease by $3,600 and his percentage of ownership will
stay the same.
D) the value of his remaining shares will stay the same and his percentage of ownership will
increase by 11.11%.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
28) 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.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
29) 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.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: information effect
Principles: Principle 4: Market Prices Reflect Information
30) According to the Modigliani & Miller dividend indifference theorem, if a company decreased
its dividend per share, an investor would be forced to sell his common stock at a depressed price.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
21
31) Dividend policy takes on greater importance when transaction fees and taxes are lower.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
32) As a firm’s investment opportunities increase, the dividend payout ratio should increase.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
33) The timing of dividend payments will not matter if the firm’s rate of return on equity and the
investor’s required rate of return are the same.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
34) When considering taxes, most investors prefer capital gains over dividend income.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
35) Empirical evidence is conclusive that dividend policy matters.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
36) 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.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: information effect
Principles: Principle 3: Cash Flows Are the Source of Value
22
37) The clientele effect suggests that a firm’s dividend policy will be affected by the needs of the
shareholders.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
38) The clientele effect suggests that firms can change their dividend policy frequently with no
potential adverse effect on the firm.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
39) A firm with high profitability will always have the cash flow necessary to pay high
dividends.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
40) When a firm makes the decision to pay dividends, it also makes the decision not to reinvest
the cash in the firm.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
41) Dividends per share divided by earnings per share (EPS) equals the dividend retention date.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
23
42) Under what conditions would the Modigliani and Miller dividend indifference theorem be
literally true.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
43) List the benefits of a firm repurchasing its own stock.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
44) Georges Bizet owns 10,000 shares of Pearl Co. purchased at an average price of $15 per
share. The tax rate on both dividends and capital gains is 15%. Would Bizet prefer a $2.00 per
share dividend or to sell 1,000 shares back to the company at $20 per share? Compute his after–
tax income from each option.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock repurchase
Principles: Principle 3: Cash Flows Are the Source of Value
24
45) Because money has a time value investors should prefer that dividends be paid sooner rather
than later. Agree or disagree. Explain your answer with a numerical example.
10% rate of return and the company decides to defer a $100 dividend for a year, the company
will reinvest the $100 at its ROE and it will grow to $110. Reinvesting the money will allow the
firm to pay a later dividend that is large enough to provide the investor with her required rate of
return. In other words, if an investor requires 10%, she should be indifferent between a $100
dividend now and a $110 dividend a year from now. Note that the 10% includes compensation
for the risk of the future cash flow, the same risk the investor was willing to take when she
bought the stock.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Topic: 16.2 Does Dividend Policy Matter?
Keywords: clientele
Principles: Principle 3: Cash Flows Are the Source of Value
47) Pettry, Inc. expects EPS this year to be $5.25. If EPS grows 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?
Topic: 16.2 Does Dividend Policy Matter?
Keywords: cash dividend
Principles: Principle 3: Cash Flows Are the Source of Value
25
48) 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%. Ignore taxes or transaction fees.
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.
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend indifference
Principles: Principle 3: Cash Flows Are the Source of Value
49) 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?
Topic: 16.2 Does Dividend Policy Matter?
Keywords: stock dividend/split
Principles: Principle 3: Cash Flows Are the Source of Value
26
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
Topic: 16.2 Does Dividend Policy Matter?
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
1) According to the residual dividend payout policy, 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.
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: residual dividend
Principles: Principle 3: Cash Flows Are the Source of Value
2) Dividends tend to be more stable than:
A) cash flow.
B) earnings.
C) preferred stock.
D) both B and C.
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
27
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
4) All of the following might influence a firm’s dividend payment EXCEPT:
A) investment opportunities.
B) investor transaction costs.
C) common stock par value.
D) flotation costs.
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
5) 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
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: dividend policy
Principles: Principle 3: Cash Flows Are the Source of Value
6) A firm that maintains stable cash 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.
Topic: 16.3 Cash Distribution Policies in Practice
Keywords: stable dividend
Principles: Principle 3: Cash Flows Are the Source of Value
28