978-0134083285 Chapter 13 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 13 Dividend Policy and Internal Financing

Learning Objective 13.1

1) Dividends per share divided by earnings per share equal the dividend payout ratio.

Keywords: Dividends Per Share, Earnings Per Share, Dividend Payout Ratio

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

2) A firm‘s dividend policy includes two basic components: the dividend payout ratio and dividend

stability.

Keywords: Dividend Policy, Dividend Payout Ratio, Dividend Stability

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

3) Corporations distribute cash back to their owners (stockholders) either as cash dividends or by

repurchasing shares of stock in the open market.

Keywords: Cash Dividends, Share Repurchases

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

4) Expected dividends and share repurchases are the cash flow that underlies stock valuation.

Keywords: Dividends, Share Repurchases

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

5) Share repurchases are not part of the stock valuation process because by definition the cash flow from a

share repurchase ends the investment as the stock is no longer owned by the shareholder.

Keywords: Share Repurchase, Stock Valuation

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

6) A firm‘s dividend policy includes two basic components: the dividend payout ratio and the profit

retention ratio.

Keywords: Dividend Payout Ratio, Profit Retention Ratio

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

7) When Firm X makes the decision to pay dividends, they also make the decision not to reinvest the cash

in the firm.

Keywords: Dividend Policy, Retained Earnings

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

8) Analysis of dividend policy begins with the basic assumption that shareholder wealth maximization is

the primary goal, and therefore dividends should be of primary concern even if their payment results in

capital rationing.

Keywords: Dividends, Capital Rationing

Learning Obj.: L.O. 13.1

AACSB: Analytical Thinking

9) QRW, Inc. has a retained earnings balance of $2,000,000. The company reported net income of $600,000,

sales of $4,000,000, and has 200,000 shares of common stock outstanding. The company announced a

dividend of $2.00 per share. Therefore the company‘s dividend payout ratio is

A) 66.7%.

B) 50%.

C) 20%.

D) 10%.

Keywords: Dividend Payout Ratio

Learning Obj.: L.O. 13.1

AACSB: Analytical Thinking

10) A firm‘s dividend payout ratio is

A) the ratio of dividends to sales.

B) the ratio of dividends to market equity.

C) the ratio of dividends to earnings.

D) the ratio of dividends to book equity.

Keywords: Dividend Payout Ratio

Learning Obj.: L.O. 13.1

AACSB: Reflective Thinking

11) Memory, Inc. expects earnings per share this year to be $8. If earnings per share grow at an average

annual rate of 6 percent and if Baker pays 60 percent of its earnings as dividends, what will the expected

dividend per share be in 7 years?

Keywords: Dividend Payout Ratio, Earnings Per Share

Learning Obj.: L.O. 13.1

AACSB: Analytical Thinking

Learning Objective 13.2

1) An investor who pays no tax would be more likely to accept the view that high dividends increase

stock values rather than the view that low dividends increase stock values.

Keywords: Dividend Policy, Time Value of Money, Taxes

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

2) According to the clientele effect, dividend policy matters even if capital markets are perfect because

investors self-select into dividend preference groups.

Keywords: Clientele Effect, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

3) The information effect suggests dividend policy matters because dividends act as a persuasive

communications tool, signaling investors about the financial condition of the firm.

Keywords: Information Effect, Dividend Policy, Signal

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

4) A closely-held company whose owners are trying to maintain control would be less likely to pay

dividends so that all earnings may be retained to finance future growth.

Keywords: Closely-held Company, Dividends, Retained Earnings

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

5) One potential rationale for paying dividends is that the payment of dividends indirectly results in a

closer monitoring of management’s investment activities, hence lowering agency costs.

Keywords: Agency Costs, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

6) According to the expectations theory, the actual dividend must equal the expected dividend, or else the

stock price will decrease after the dividend amount is announced.

Keywords: Expectations Theory, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

7) In order to maximize shareholder value, a corporation must earn a higher rate of return on a dollar that

is retained in the corporation than the shareholders can earn by investing the dollar elsewhere.

Keywords: Shareholder Wealth Maximization, Retained Earnings, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

8) A fast-growing company with many high net present value projects may maximize shareholder wealth

by NOT paying a dividend.

Keywords: Maximizing Shareholder Wealth, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

9) Because of the overriding importance of cash flows to valuation, one basic tenet of finance is that

dividends increase the value of a company‘s common stock.

Keywords: Dividend Policy, Common Stock Valuation

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

10) According to the “bird-in–the-hand” dividend theory, the required return for a stock that pays its

entire return from dividends is higher than the required return for a high-growth stock that pays no

dividend.

Keywords: “Bird–in-the-hand” Dividend Theory, Required Return

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

11) Low dividends may increase stock value due to the advantage of tax deferral that comes with capital

gains.

Keywords: Capital Gains, Dividend Income, Taxation

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

12) The residual dividend theory is based on the observation that flotation costs make the cost of new

common stock significantly higher than the cost of retained earnings.

Keywords: Residual Dividend Theory, Flotation Costs

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

13) As a corporation’s investment opportunities increase, the dividend payout ratio should decrease so

that the corporation can avoid flotation costs.

Keywords: Investment Opportunities, Dividend Payout Ratio, Flotation Costs

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

14) Since stock dividends do not require payment in cash, their impact on a corporation‘s share price can

be only positive (if there is an information effect) or neutral, but not negative.

Keywords: Stock Dividend, Information Effect

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

15) The residual theory of dividends connects a firm’s dividend policy and its level of capital investments.

Keywords: Residual Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

16) We typically expect to find rapidly growing firms to have high payout ratios.

Keywords: Dividend Payout Ratio

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

17) Under the ideal conditions of perfect capital markets, dividend policy has no effect upon share price.

Keywords: Perfect Capital Markets, Dividend Irrelevance

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

18) If a firm were to unexpectedly omit payment of its quarterly dividend, that firm’s stock price would

probably drop.

Keywords: Dividend Policy, Information Effects

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

19) 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.

Keywords: Perfect Capital Markets, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

20) A firm‘s dividend policy provides information pertaining to the firm’s payout ratio and its stability.

Keywords: Dividend Policy, Payout Ratio, Stability

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

21) Security markets are considered to be perfect when firms can issue securities at no cost and the

investor incurs no brokerage commissions.

Keywords: Perfect Markets, Transactions Costs

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

22) The existence of taxes can directly affect a common shareholder’s preference for capital gains or

dividend income.

Keywords: Capital Gains Taxes, Clientele Effect

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

23) When an unexpected change in dividend policy develops, investors may attach informational content

to the events.

Keywords: Information Effect, Dividend Changes

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

24) The residual dividend theory suggests that dividends should be paid to stockholders first, and then

what is left can be reinvested by the firm.

Keywords: Residual Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

25) In a perfect market, investors are only concerned with total returns and are not concerned whether it

is in capital gains or dividend income.

Keywords: Perfect Markets, Capital Gains, Dividend Income

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

26) When considering taxes, most investors prefer capital gains over dividend income.

Keywords: Capital Gains Taxation, Dividend Income Taxation

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

27) According to the bird-in-the-hand dividend theory, investors value a dollar of expected capital gain

more highly than a dollar of expected dividends because capital gains are more unpredictable than

dividends.

Keywords: “Bird–in-the-hand” Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

28) An investor who requires an 18% percent return for a stock that pays no dividends and requires a 12%

return for a stock that pays its entire return from dividends may be following the bird–in-the-hand

dividend theory.

Keywords: “Bird–in-the–hand” Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

29) Federal tax law is irrelevant to corporate dividend policy because dividends are not tax deductible.

Keywords: Dividend Policy, After-tax Returns

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

30) The residual dividend theory implies that internally generated funds (i.e., retained earnings) should

be used to fund all new investment projects before the company uses any additional debt.

Keywords: Residual Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

31) If the tax rate on dividends and the tax rate on capital gains are the same, then investors are

indifferent to dividend policy.

Keywords: After-tax Return, Capital Gains, Tax Deferral

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

32) The clientele effect does not imply that either high or low dividends are optimal, rather that firms

should not make significant and arbitrary changes in their existing dividend policy.

Keywords: Clientele Effect

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

33) In order to reduce agency costs, managers may decrease dividends, thus shifting the focus of

investors to future capital gains that can only be attained by a well-run corporation.

Keywords: Agency Costs, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

34) The information effect hypothesis implies that increasing dividends provides a more credible signal of

higher future earnings than does management’s assertion that future earnings will be higher.

Keywords: Information Effect, Dividend Policy

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

35) Other things equal, individuals in high-income tax brackets should have a preference for firms that

retain their earnings rather than pay dividends.

Keywords: Clientele Effect, Capital Gains Taxation, Ordinary Income, Retained Earnings, Dividends

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

36) Dew Drop In, Inc. announces is quarterly dividend will increase from $3.80 to $4.00. After the

announcement, the price of Dew Drop In, Inc.’s stock drops. The most likely explanation is that

A) the stock market is a perfect market.

B) investors are irrational.

C) investors were expecting a larger increase.

D) Dew Drop In, Inc.‘s debt ratio decreased.

Keywords: Expectations Theory

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking

37) A corporation announces a large increase in its annual dividend, but its stock price declines. This

could result from

A) residual dividend theory.

B) bird-in-the-hand theory.

C) perfect capital markets.

D) MM’s indifference theorem.

Keywords: Residual Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

38) A corporation announces a significant increase in its annual dividend and its stock price increases on

the news. This could be explained most directly by

A) residual dividend theory.

B) bird-in–the-hand theory.

C) perfect capital markets.

D) MM”s indifference theorem.

Keywords: “Bird–in-the-hand” Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

39) An investor who requires a 12% percent return for a stock that pays no dividends and requires a 9%

return for a stock that pays its entire return from dividends is most likely a proponent of

A) the bird-in-the-hand dividend theory.

B) the residual dividend theory.

C) the clientele effect.

D) the information effect.

Keywords: “Bird–in-the-hand” Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

40) The dividend irrelevance hypothesis is based on all of the following assumptions EXCEPT

A) investment decisions will not be altered by the amount of dividend payments.

B) investors do not need cash dividends to supplement their current income.

C) perfect capital markets.

D) borrowing decisions will not be altered by the amount of dividend payments.

Keywords: Dividend Irrelevance Hypothesis

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

41) Grainery Distillers, Inc. is experiencing high demand for its products and high growth rates. The

company just reported earnings per share of $5 for the most recent year and has many positive NPV

projects to fund. One vice president wants to pay a dividend of $5 per share, arguing that this will

maximize shareholder value. You argue that a much smaller dividend will maximize value. Your

argument may be based on

A) the bird-in-the-hand theory.

B) the residual dividend theory.

C) the information effect.

D) the very high agency costs of the corporation.

Keywords: Residual Dividend Theory

Learning Obj.: L.O. 13.2

AACSB: Reflective Thinking

42) A corporation with very high growth prospects and many positive NPV projects to fund may want to

increase its dividend based on

A) the tax bias against capital gains.

B) the residual dividend theory.

C) the information effect.

D) the very low agency costs of the corporation.

Keywords: Information Effect

Learning Obj.: L.O. 13.2

AACSB: Analytical Thinking