Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 1
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
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
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
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 4
a. True
b. False
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
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
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 6
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
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
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 10
b. False
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
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
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 14
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.
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.
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.
e. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital
gains.
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 18
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.
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.
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.
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 19
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.
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.
45. Firm M is a mature company in a mature industry. Its annual net income and cash flows are consistently high and
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.
Chapter 14: Distributions to Shareholders: Dividends and Share Repurchases
Copyright Cengage Learning. Powered by Cognero.
Page 20
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.
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.
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.