Principles of Managerial Finance, Brief, 7e (Gitman)
Chapter 13 Payout Policy
13.1 Understand cash payout procedures, their tax treatment, and the role of dividend
reinvestment plans.
1) Payout policy refers to the decisions that firms make about whether to distribute cash to
shareholders, how much cash to distribute, and by what means the cash should be distributed.
2) Rapidly growing firms pay high dividends to shareholders.
3) Dividends are the only means by which firms can distribute cash to shareholders.
4) Because retained earnings are a form of internal financing, the dividend decision can
significantly affect a firm’s external financing requirements.
5) Dividends provide information about a firm’s current performance.
6) Holders of record are stockholders whose names are recorded on the date of record receive the
declared dividend.
7) Purchasers of a stock selling ex dividend receive the current dividend.
8) The date of record (dividends) is the actual date on which a company will mail the dividend
payment to the holders of record.
9) The dividend payment date is set by a firm’s board of directors and represents the actual date
on which the firm mails the dividend payment to the holders of record.
10) The payment date is five days after the date of record, on which the company will mail the
dividend payment to the holders of record.
11) The ex dividend period begins four business days prior to the payment date.
12) The payment of cash dividends to corporate stockholders is decided based on the
recommendation of the auditors.
13) The repurchase of common stock results in a type of reverse dilution, since the earnings per
share and the market price of stock are increased by reducing the number of shares outstanding.
14) The repurchase of shares reduces the number of outstanding shares.
15) In a tender offer share repurchase, a firm announces the price it is willing to pay to buy back
shares and the quantity of shares it wishes to repurchase.
16) The Jobs and Growth Tax Relief Reconciliation Act of 2003 significantly changed the tax
treatment of corporate dividends for most taxpayers by dropping the tax rate to the rate
applicable on capital gains, which is a maximum rate of 15%.
17) The Jobs and Growth Tax Relief Reconciliation Act of 2009 significantly changed the tax
treatment of corporate dividends for most taxpayers by dropping the tax rate to the rate
applicable on capital gains, which is a maximum rate of 25%.
18) By purchasing shares through a firm’s dividend reinvestment plan (or DRIP), shareholders
typically can acquire shares at a value that is below the prevailing market price.
19) By purchasing shares through a firm’s dividend reinvestment plan (or DRIP), shareholders
typically can acquire shares at a value that is above the prevailing market price.
20) Dividend reinvestment plans (DRIPs) enable stockholders to use dividends received on a
firm’s stock to acquire additional shares–even fractional shares–at little or no transaction
(brokerage) cost.
21) Ignoring general market fluctuations, the stock’s price would be expected to drop by the
amount of the declared dividend on the ex dividend date.
22) When common stock is repurchased and retired, the underlying motive is to ________.
A) delay taxes
B) boost the stock’s dividends
C) distribute the excess cash to the owners
D) reduce the retained earnings balance
23) Which of the following type of firms are most likely to payout cash dividends?
A) rapidly growing firms
B) firms encouraging innovation
C) large mature firms
D) firms expanding their operations
24) At a firm’s quarterly dividend meeting held April 9, the directors declared a $0.50 per share
cash dividend for the holders of record on Monday, May 1. The firm’s stock will sell ex
dividends on ________.
A) April 28
B) May 5
C) April 29
D) April 27
25) Ex dividend is ________.
A) a period beginning 2 business days prior to the date of record, during which a stock is sold
without the right to receive the current dividend
B) the date on which all investors whose names are recorded as stockholders receive a declared
dividend at a specified future time
C) a period beginning 7 business days prior to the date of record, during which a stock is sold
without the right to receive the current dividend
D) the actual date on which a firm mails the dividend payment to the holders of record
26) The payment of cash dividends to corporate stockholders is decided by the ________.
A) creditors
B) stockholders
C) SEC
D) board of directors
27) In a(n) ________, a firm specifies a range of prices that it is willing to repurchase shares and
the quantity of shares that it desires.
A) Dutch auction
B) tender offer
C) American option
D) self-tender offer
28) In a(n) ________, a firm announces the price it is willing to pay to buy back shares and the
quantity of shares it wishes to repurchase.
A) Dutch auction
B) tender offer
C) American option
D) European auction
29) Tender offer repurchase is a repurchase program in which a firm ________.
A) offers to repurchase a fixed number of shares, usually at a discount relative to the market
value
B) offers to repurchase a fixed number of shares, usually at a premium relative to the market
value
C) offers to repurchase a fixed number of shares, usually at par relative to the market value
D) has a right to repurchase a fixed number of shares at a premium relative to the market value
30) Which of the following is a reason for a firm for repurchasing its shares?
A) to diminish the shareholder value by increasing the number of shares outstanding and thereby
raising earnings per share
B) to help encourage a friendly takeover by increasing the number of publicly traded shares
C) to make shares available for stock option plans
D) to make shares available for cash dividends
31) The net effect of a stock repurchase is ________.
A) similar to an interest payment
B) similar to a cash dividend
C) similar to a stock split
D) similar to a reverse stock split
32) Which of the following is true of a dividend payout?
A) When a firm announces that it will increase its dividend, the share price usually decreases on
that news.
B) Dividend payments send a positive signal to investors in the marketplace that management
believes that the stock is overvalued.
C) When a firm pays out dividends the share price will fall.
D) Dividend payouts have no impact on the share price of a stock in an efficient market.
33) Which of the following methods can be utilized by a firm when it wants to purchase
outstanding shares of common stock?
A) a purchase of stock through private placement
B) a tender offer at varying prices
C) a tender offer at a specified price
D) an European auction plan
34) Repurchase of stock ________ the earnings per share and ________ the market price of
stock.
A) increases; increases
B) decreases; decreases
C) increases; decreases
D) decreases; increases
35) In a Dutch auction, ________.
A) a firm offers to repurchase a fixed number of shares, at a discount
B) a firm offers to repurchase a fixed number of shares, at a premium
C) a firm specifies a range of prices at which it is willing to repurchase shares and the quantity of
shares that it desires
D) a firm enables stockholders to use dividends received on the firm’s stock to acquire additional
shares
36) Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, the maximum rate of
taxation on dividends received by shareholders was set at ________.
A) 18%
B) 20%
C) 25%
D) 15%
37) A dividend reinvestment plan enables stockholders to ________.
A) reinvest the dividends in money market instruments which are risk free
B) reinvest all dividends in the firm with no accompanying increase in equity
C) acquire additional dividends through redemption of stock
D) acquire shares at little or no transaction costs
38) At the quarterly meeting of Tangshan Mining Corporation, held on September 10th, the
directors declared a $1.00 per share dividend for the firm’s 100,000 shares of common stock
outstanding. The net effect of declaring and paying this dividend would be to ________.
A) decrease total assets by $100,000 and increase stockholders equity by $100,000
B) decrease total assets by $100,000 and decrease stockholders equity by $100,000
C) increase total assets by $100,000 and increase stockholders equity by $100,000
D) increase total assets by $100,000 and decrease stockholders equity by $100,000
13.2 Describe the residual theory of dividends and the key arguments with regard to dividend
irrelevance and relevance.
1) The residual theory of dividends suggests that the dividend paid by a firm should be viewed as
a residual, the amount left over after all acceptable investment opportunities have been
undertaken.
2) The residual theory of dividends implies that if a firm’s available retained earnings are in
excess of its financing needs, it should distribute the earnings by paying dividends to
stockholders.
3) The residual theory of dividends, as espoused by Modigliani and Miller, suggests that
dividends represent an earnings residual rather than an active decision variable that affects firm
value; this means that a firm’s decision to pay dividends or not will not have any impact on a
firm’s share price.
4) The representative theory of dividends, as espoused by Modigliani and Miller, suggests that
dividends represent a significant active decision variable that affects firm value.
5) Clientele effect is the argument that a firm attracts shareholders whose preferences with
respect to the payment and stability of dividends corresponds to the payment pattern and stability
of the firm itself.
6) According to Modigliani and Miller, a firm’s value is determined solely by the earning power
and risk of its assets and that the manner in which it splits its earnings stream between dividends
and internally retained funds does not affect this value.
7) Due to clientele effect, Modigliani and Miller argue that the shareholders get what they expect
and, thus, the value of a firm’s stock is unaffected by dividend policy.
8) According to the bird-in-the-hand argument, current dividend payments reduce investor
uncertainty and result in a higher value for a firm’s stock.
9) As per dividend relevance theory, current dividend payments are believed to reduce investor’s
uncertainty, thereby—all else being equal—placing a lower value on a firm’s stock after its
payment.
10) The bird-in-the-hand argument espousing the importance of dividends or dividend relevance
suggests that investors view current dividends as less risky than future dividends or capital gains.
11) Informational content of dividends throws light with respect to future earnings. In other
words, investors view a change in dividends, up or down, as a signal that management expects
future earnings to change in the same direction.
12) Dividend payment policy is a form of ________.
A) capital budgeting policy
B) financing policy
C) working capital policy
D) dividend reinvestment policy
13) The residual theory of dividends suggests that ________.
A) different payout policies attract different types of investors but still do not change the value of
a firm
B) dividends are irrelevant in determining the value of a firm
C) as long as a firm’s equity need exceeds the amount of retained earnings, no cash dividend is
paid
D) the payout policies of different firms have no impact on the taxes that investors have to pay
14) According to the residual theory of dividends, if a firm’s equity need is less than the amount
of retained earnings, the firm would ________.
A) borrow to pay the cash dividend
B) declare a dividend equal to the remaining balance
C) pay no cash dividends
D) pay dividends higher than the remaining balance to gain credibility
15) According to the residual theory of dividends, if a firm’s equity need exceeds the amount of
retained earnings, the firm would ________.
A) borrow to pay the cash dividend
B) sell additional stock to pay the cash dividend
C) pay no cash dividends
D) pay less dividends
16) The clientele effect refers to ________.
A) the relevance of dividend policy on a firm’s share value
B) a firm’s ability to attract stockholders whose dividend preferences are similar to the firm’s
dividend policy
C) the informational content of dividends that helps in predicting the future earnings and growth
of a firm
D) the “bird-in-the-hand” argument
17) Modigliani and Miller argue that when a firm has no acceptable investment opportunities, it
should ________.
A) preserve the funds and not declare dividends
B) distribute the surplus funds to the owners
C) lower its cost of capital
D) retain the funds until an acceptable project arises
18) Modigliani and Miller suggest that the value of a firm is not affected by the firm’s dividend
policy, due to ________.
A) the relevance of dividends
B) the clientele effect
C) the informational content
D) the optimal capital structure
19) Gordon and Lintner, recognizing that dividends affect stock prices, suggest that positive
effects of dividend increases are attributable ________.
A) directly to the dividend policy
B) directly to the optimal capital structure
C) not to the informational content but to the consistency in the payment of dividends
D) to the informational content of the dividends with respect to future earnings
20) Gordon’s “bird-in-the-hand” argument suggests that ________.
A) dividends are irrelevant
B) firms should have a 100 percent payout policy
C) shareholders are risk averse and attach less risk to current dividends
D) the market value of a firm is unaffected by dividend policy
21) The information content of dividends refers to ________.
A) the nonpayment of dividends by corporations
B) dividend changes as indicators of a firm’s future
C) a stable and continuous dividend
D) a study of firm’s history of dividend payments
22) Which of the following is true of arguments for dividend relevance?
A) A firm’s value is determined solely by the earning power and risk of its assets.
B) Investors are generally risk averse and attach less risk to current dividends than future
dividends or capital gains.
C) The value of a firm is unaffected as it functions in a perfect market.
D) A clientele effect exists which causes a firm’s shareholders to receive the dividends that they
expect.
13.3 Discuss the key factors involved in establishing a dividend policy.
1) While an earnings requirement limiting the amount of dividends paid is sometimes imposed, a
firm is not prohibited from paying more in dividends than its current earnings.
2) Since lenders are generally reluctant to grant loans to a firm to pay dividends, the firm’s ability
to pay cash dividends is generally constrained by the amount of excess cash available.
3) In most states, legal capital is measured not only by the par value and paid-in capital in excess
of par, but also by any accumulated retained earnings.
4) In most states, legal capital is measured either by the par value of common stock; other states,
however, define legal capital to include not only the par value of the stock, but also any paid-in
capital in excess of par.
5) If a firm has overdue liabilities or is legally insolvent or bankrupt, most states prohibit its
payment of cash dividends.
6) Legal constraints prohibit the payment of cash dividends until a certain level of earnings has
been achieved or limit the amount of dividends paid to a certain dollar amount or percentage of
earnings.
7) The level of dividends a firm expects to pay is often directly related to how rapidly it expects
to grow and expand its operations.
8) The level of dividends a firm expects to pay is generally unrelated to how rapidly it expects to
grow as well as the level of asset investments required.
9) Because dividends are taxed at the same rate as capital gains under the 2003 Tax Act, a firm’s
strategy of paying low or no dividends primarily offers tax advantages to wealthy stockholders
through tax deferral.
10) In establishing a dividend policy, a firm should retain funds for investment in projects
yielding higher returns than the owners could obtain from external investments of equal risk.
11) If a firm pays out a higher percentage of earnings, new equity capital will have to be raised
with common stock, which will result in higher control and earnings for the existing owners.