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CHAPTER 14—DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND
REPURCHASES
TRUE/FALSE
1. The optimal distribution policy strikes that balance between current dividends and capital gains that
maximizes the firm's stock price.
2. The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at
least some dividends, how much it pays does not affect either its cost of capital or its stock price.
3. MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can
affect the cost of capital.
4. 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.
5. 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.
6. If a firm adopts a residual distribution policy, distributions are determined as a residual after funding
the capital budget. Therefore, the better the firm's investment opportunities, the lower its payout ratio
should be.
7. Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders'
wealth.
8. A reverse split reduces the number of shares outstanding.
9. 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.
10. 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.
11. If the information content, or signaling, hypothesis is correct, then changes in dividend policy can have
an important effect on the firm's value and capital costs.
12. 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 distribution policy.
13. If the shape of the curve depicting a firm's WACC versus its debt ratio is more like a sharp "V", as
opposed to a shallow "U", it will be easier for the firm to maintain a steady dividend in the face of
varying investment opportunities or earnings from year to year.
14. Even if a stock split has no information content, and even if the dividend per share adjusted for the
split is not increased, there can still be a real benefit (i.e., a higher value for shareholders) from such a
split, but any such benefit is probably small.
MULTIPLE CHOICE
15. 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 or 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 will equal $0.80. Once the percentage is set, then dividend policy is on
"automatic pilot" and the actual dividend depends strictly on earnings.
16. Poff Industries' stock currently sells for $120 a share. You own 100 shares of the stock. The company
is contemplating a 2-for-1 stock split. Which of the following best describes what your position will be
after such a split takes place?
a.
You will have 200 shares of stock, and the stock will trade at or near $60 a share.
b.
You will have 100 shares of stock, and the stock will trade at or near $60 a share.
c.
You will have 50 shares of stock, and the stock will trade at or near $120 a share.
d.
You will have 50 shares of stock, and the stock will trade at or near $60 a share.
e.
You will have 200 shares of stock, and the stock will trade at or near $120 a share.
17. Myron Gordon and John Lintner believe that the required return on equity increases as the dividend
payout ratio is decreased. Their argument is based on the assumption that
a.
investors require that the dividend yield and capital gains yield equal a constant.
b.
capital gains are taxed at a higher rate than dividends.
c.
investors view dividends as being less risky than potential future capital gains.
d.
investors value a dollar of expected capital gains more highly than a dollar of expected
dividends because of the lower tax rate on capital gains.
e.
investors are indifferent between dividends and capital gains.
18. Which of the following should not influence a firm's dividend policy decision?
a.
A strong preference by most shareholders for current cash income versus capital gains.
b.
Constraints imposed by the firm's bond indenture.
c.
The fact that much of the firm's equipment has been leased rather than bought and owned.
d.
The fact that Congress is considering changes in the tax law regarding the taxation of
dividends versus capital gains.
e.
The firm's ability to accelerate or delay investment projects.
19. Which of the following statements about dividend policies is correct?
a.
One reason that companies tend to avoid stock repurchases is that dividend payments are
taxed at a lower rate than gains on stock repurchases.
b.
One advantage of dividend reinvestment plans is that they allow shareholders to avoid
paying taxes on the dividends that they choose to reinvest.
c.
One key advantage of a residual dividend policy is that it enables a company to follow a
stable dividend policy.
d.
The clientele effect suggests that companies should follow a stable dividend policy.
e.
Modigliani and Miller argue that investors prefer dividends to capital gains because
dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.
20. Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio?
a.
Its access to the capital markets increases.
b.
Its R&D efforts pay off, and it now has more high-return investment opportunities.
c.
Its accounts receivable decrease due to a change in its credit policy.
d.
Its stock price has increased over the last year by a greater percentage than the increase in
the broad stock market averages.
e.
Its earnings become more stable.
21. Reynolds Paper Products Corporation follows a strict residual dividend policy. 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 company increases the percentage of equity in its target capital structure.
b.
The number of profitable potential projects increases.
c.
Congress lowers the tax rate on capital gains. The remainder of the tax code is not
changed.
d.
Earnings are unchanged, but the firm issues new shares of common stock.
e.
The firm's net income increases.
22. If a firm adheres strictly to the residual dividend policy, then if its optimal capital budget requires the
use of all earnings for a given year (along with new debt according to the optimal debt/total assets
ratio), then the firm should pay
a.
no dividends to common stockholders.
b.
dividends only out of funds raised by the sale of new common stock.
c.
dividends only out of funds raised by borrowing money (i.e., issue debt).
d.
dividends only out of funds raised by selling off fixed assets.
e.
no dividends except out of past retained earnings.
23. If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would
suggest that
a.
the dividend payout ratio is increasing.
b.
no dividends were paid during the year.
c.
the dividend payout ratio is decreasing.
d.
the dollar amount of investments has decreased.
e.
the dividend payout ratio has remained constant.
24. Which of the following statements is correct?
a.
One advantage of dividend reinvestment plans is that they enable investors to postpone
paying taxes on the dividends credited to their account.
b.
Stock repurchases can be used by a firm that wants to increase its debt ratio.
c.
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.
d.
One advantage of an open market dividend reinvestment plan is that it provides new
equity capital and increases the shares outstanding.
e.
One disadvantage of dividend reinvestment plans is that they increase transactions costs
for investors who want to increase their ownership in the company.
25. Which of the following statements is correct?
a.
One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes
investors would have to pay if they received cash dividends.
b.
Empirical research indicates that, in general, companies send a negative signal to the
marketplace when they announce an increase in the dividend, and as a result share prices
fall when dividend increases are announced. The reason is that investors interpret the
increase as a signal that the firm has relatively few good investment opportunities.
c.
If a company wants to raise new equity capital rather steadily over time, a new stock
dividend reinvestment plan would make sense. However, if the firm does not want or need
new equity, then an open market purchase dividend reinvestment plan would probably
make more sense.
d.
Dividend reinvestment plans have not caught on in most industries, and today about 99%
of all companies with DRIPs are utilities.
e.
Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be
taxed at the same rate as a dollar received as dividends.
26. Which of the following statements is correct?
a.
If a company uses the residual dividend model to determine its dividend payments,
dividends payout will tend to increase whenever its profitable investment opportunities
increase.
b.
The stronger management thinks the clientele effect is, the more likely the firm is to adopt
a strict version of the residual dividend model.
c.
Large stock repurchases financed by debt tend to increase earnings per share, but they also
increase the firm's financial risk.
d.
A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in
dividends. Thus, both companies and investors are indifferent between distributing cash
through dividends and stock repurchase programs.
e.
The tax code encourages companies to pay dividends rather than retain earnings.
27. Which of the following statements is correct?
a.
Capital gains earned in a share repurchase are taxed less favorably than dividends; this
explains why companies typically pay dividends and avoid share repurchases.
b.
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.
c.
Stock repurchases increase the number of outstanding shares.
d.
The clientele effect is the best explanation for why companies tend to vary their dividend
payments from quarter to quarter.
e.
If a company has a 2-for-1 stock split, its stock price should roughly double.
28. Which of the following statements is correct?
a.
One advantage of the residual dividend policy is that it leads to a stable dividend payout,
which investors like.
b.
An increase in the stock price when a company decreases its dividend is consistent with
signaling theory as postulated by MM.
c.
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 the stock price.
d.
Stock repurchases make the most sense at times when a company believes its stock is
undervalued.
e.
Firms with a lot of good investment opportunities and a relatively small amount of cash
tend to have above average payout ratios.
29. Which of the following statements is correct?
a.
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 follow the strict
residual dividend policy.
b.
If a firm follows a strict residual dividend policy, then, holding all else constant, its
dividend payout ratio will tend to rise whenever the firm's investment opportunities
improve.
c.
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.
d.
Despite its drawbacks, following the residual dividend policy 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.
e.
One advantage of dividend reinvestment plans is that they enable investors to avoid paying
taxes on the dividends they receive.
30. Consider two very different firms, M and N. Firm M is a mature firm in a mature industry. Its annual
net income and net cash flows are both 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
firm 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 higher dividend payout ratio than Firm N.
b.
If the corporate tax rate increases, the debt ratio of both firms is likely to decline.
c.
The two firms are equally likely to pay high dividends.
d.
Firm N is likely to have a clientele of shareholders who want to receive consistent, stable
dividend income.
e.
Firm M probably has a lower debt ratio than Firm N.
31. Which of the following statements is CORRECT?
a.
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 it is illegal today.
b.
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.
c.
When a company declares a stock split, the price of the stock typically declines⎯by about
50% after a 2-for-1 split⎯and this necessarily reduces the total market value of the equity.
d.
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 10-for-1 so as to bring the price down to something close to
$50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can declare a
"reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per
share.
e.
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.
32. Which of the following statements is correct?
a.
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.
b.
Stock repurchases tend to reduce financial leverage.
c.
If a company declares a 2-for-1 stock split, its stock price should roughly double.
d.
One advantage of adopting the residual dividend policy is that this makes it easier for
corporations to meet the requirements of Modigliani and Miller's dividend clientele theory.
e.
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.
33. Which of the following actions will best enable a company to raise additional equity capital?
a.
Declare a stock split.
b.
Begin an open-market purchase dividend reinvestment plan.
c.
Initiate a stock repurchase program.
d.
Begin a new-stock dividend reinvestment plan.
e.
Refund long-term debt with lower cost short-term debt.
34. Which of the following statements is NOT correct?
a.
After a 3-for-1 stock split, a company's price per share should fall, but the number of
shares outstanding will rise.
b.
Investors can interpret a stock repurchase program as a signal that the firm's managers
believe the stock is undervalued.
c.
Companies can repurchase shares to distribute large inflows of cash, say from the sale of a
division, to stockholders without paying cash dividends.
d.
Stockholders pay no income tax on dividends if the dividends are used to purchase stock
through a dividend reinvestment plan.
e.
Stock repurchases can be used by a firm as part of a plan to change its capital structure.
35. Which of the following statements is correct?
a.
The clientele effect can explain why so many firms change their dividend policies so
often.
b.
One advantage of adopting the residual dividend policy is that this policy makes it easier
for corporations to develop a specific and well-identified dividend clientele.
c.
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.
d.
Investors who receive stock dividends must pay taxes on the value of the new shares in the
year the stock dividends are received.
e.
If a firm follows the residual dividend policy, then a sudden increase in the number of
profitable projects is likely to reduce the firm's dividend payout.
36. The projected capital budget of Kandell Corporation is $1,000,000, its target capital structure is 60%
debt and 40% equity, and its forecasted net income is $550,000. If the company follows a residual
dividend policy, what total dividends, if any, will it pay out?
a.
$122,176
b.
$128,606
c.
$135,375
d.
$142,500
e.
$150,000
37. Grandin Inc. is evaluating its dividend policy. It has a capital budget of $625,000, and it wants to
maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of
$475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio?
a.
40.61%
b.
42.75%
c.
45.00%
d.
47.37%
e.
49.74%
38. The capital budget of Creative Ventures Inc. is $1,000,000. The company wants to maintain a target
capital structure that is 30% debt and 70% equity. The company forecasts that its net income this year
will be $800,000. If the company follows a residual dividend policy, what will be its total dividend
payment?
a.
$100,000
b.
$200,000
c.
$300,000
d.
$400,000
e.
$500,000
39. Rohter Galeano Inc. is considering how to set its dividend policy. It has a capital budget of
$3,000,000. The company wants to maintain a target capital structure that is 15% debt and 85% equity.
The company forecasts that its net income this year will be $3,500,000. If the company follows a
residual dividend policy, what will be its total dividend payment?
a.
$205,000
b.
$500,000
c.
$950,000
d.
$2,550,000
e.
$3,050,000
40. Sanchez Company has planned capital expenditures that total $2,000,000. The company wants to
maintain a target capital structure that is 35% debt and 65% equity. The company forecasts that its net
income this year will be $1,800,000. If the company follows a residual dividend policy, what will be
its total dividend payment?
a.
$100,000
b.
$200,000
c.
$300,000
d.
$400,000
e.
$500,000
41. Yesterday, Berryman Investments was selling for $90 per share. Today, the company completed a 7-
for-2 stock split. If the total market value was unchanged by the split, what is the price of the stock
today?
a.
$23.21
