13) Which of the following equations is INCORRECT?
A) Pcum – Pex = Div ×
B) Pcum – Pex = Div ×
C) =
D) (Pcum – Pex)(1 – τd) = Div(1 – τg)
Use the information for the question(s) below.
Consider the following tax rates:
Year
Capital
Gains Rate
Ordinary
Income Rate
Dividend
Rate
1997-2000
20%
40%
40%
2001-2002
20%
39%
39%
2003-
15%
35%
15%
*The current tax rates are set to expire in 2008 unless Congress extends them. The tax rates
shown are for financial assets held for one year. For assets held less than one year, capital gains
are taxed at the ordinary income tax rate (currently 35% for the highest bracket); the same is true
for dividends if the assets are held for less than 61 days.
14) The effective dividend tax rate for a buy and hold individual investor in 2006 is closest to:
A) 0%
B) 35%
C) 15%
D) 20%
15) The effective dividend tax rate for a one-year individual investor in 2006 is closest to:
A) 20%
B) 15%
C) 35%
D) 0%
16) The effective dividend tax rate for a pension fund in 2006 is closest to:
A) 20%
B) 0%
C) 25%
D) 15%
17) The effective dividend tax rate for a buy and hold individual investor in 1999 is closest to:
A) 25%
B) 0%
C) 20%
D) 40%
18) The effective dividend tax rate for a one-year individual investor in 1999 is closest to:
A) 0%
B) 20%
C) 25%
D) 40%
19) The effective dividend tax rate for a pension fund in 1999 is closest to:
A) 40%
B) 20%
C) 0%
D) 25%
20) Using the available tax information for 2002, calculate the effective dividend tax rate for a:
(1) one-year individual investor
(2) buy and hold individual investor
(3) pension fund
17.5 Payout Versus Retention of Cash
Use the following information to answer the question(s) below.
d’Anconia Copper has $200 million in cash that it can use for a share repurchase. Suppose
instead that d’Anconia Copper invests the funds in an account paying 5% interest for one year.
Assume that the corporate tax rate is 35%, the individual capital gains rate is 15% and the
individual rate on ordinary income is 30%.
1) The amount of additional cash that d’Anconia Copper will have at the end of the year net of
corporate taxes is closest to:
A) $2.0 million
B) $5.5 million
C) $6.5 million
D) $7.0 million
2) Net of capital gains taxes, the amount the total value of d’Anconia Copper shares increase is
closest to:
A) $5.5 million
B) $6.5 million
C) $7.0 million
D) $10.0 million
3) Net of ordinary income taxes, the amount that investors would have if they invested the $200
million on their own is closest to:
A) $5.5 million
B) $6.5 million
C) $7.0 million
D) $10.0 million
4) Suppose that d’Anconia Copper retained the $200 million in cash so that it would not need to
raise new funds from outside investors for an expansion it has planned for next year. If it did
raise new funds, it would have to pay issuance fees. Assuming that these fees can be expensed
for corporate tax purposed, the amount that d’Anconia Copper needs to save in issuance fees to
make retaining the cash beneficial for its investors is closest to:
A) $2.0 million
B) $5.5 million
C) $6.5 million
D) $7.0 million
5) Which of the following statements is FALSE?
A) In perfect capital markets, buying and selling securities is a zero-NPV transaction, so it
should not affect firm value.
B) Making positive-NPV investments will create value for the firm’s investors, whereas saving
the cash or paying it out will not.
C) In perfect capital markets, if a firm invests excess cash flows in financial securities, the firm’s
choice of payout versus retention is irrelevant and does not affect the initial share price.
D) After adjusting for investor taxes, there remains a substantial tax advantage for the firm to
retain excess cash.
6) Which of the following statements is FALSE?
A) A firm must balance the tax costs of holding cash with the potential benefits of having to raise
external funds in the future.
B) Paying out excess cash through dividends or share repurchases can boost the stock price by
reducing managers’ ability and temptation to waste resources.
C) If there is a reasonable likelihood that future earnings will be insufficient to fund future
positive-NPV investment opportunities, a firm may start accumulating cash to make up the
difference.
D) According to the managerial entrenchment theory of payout policy, managers pay out cash
only when pressured to do so by the firm’s investors.
7) Which of the following formulas is INCORRECT?
A) τ*retain =
B) Pretain =
C) Pretain = Pcum ×
D) Pretain = Pcum × (1 – τ*retain)
8) Consider the following equation:
Pretain = Pcum ×
The term τi in this equation represents:
A) the corporation’s tax rate on interest income.
B) the investor’s tax rate on capital gains.
C) the investor’s tax rate on interest income.
D) the investor’s tax rate on cumulative dividends.
9) Consider the following equation:
Pretain = Pcum ×
The term Pretain in this equation represents:
A) the price of the stock if it retains and invests the cash.
B) the percentage of net income retained or reinvested back into the firm.
C) the percentage of net income paid out as a cash dividend.
D) the price of the stock if it retains cash to use in a share repurchase.
10) Consider the following equation:
Pretain = Pcum ×
The term τc in this equation represents:
A) the corporation’s tax rate on interest income.
B) the investor’s tax rate on interest income.
C) the investor’s tax rate on cumulative dividends.
D) the investor’s tax rate on capital gains.
Use the information for the question(s) below.
Luther Industries has $5 million in excess cash and 1 million shares outstanding. Luther is
considering investing the cash in one-year treasury bills that are currently paying 5% interest,
and then using the cash to pay a dividend next year. Alternatively, Luther can pay the cash out
as a dividend immediately and the shareholders can invest in the treasury bills themselves.
Assume that capital markets are perfect.
11) If Luther invests the excess cash in treasury bills, then the dividend per share next year will
be closest to:
A) $5.00
B) $5.25
C) $4.75
D) $1.05
12) If Luther decides to pay the dividend immediately the dividend per share will be closest to:
A) $1.05
B) $5.25
C) $5.00
D) $4.75
13) In 2006, Luther Incorporated paid a special dividend of $5 per share for the 100 million
shares outstanding. If Luther has instead retained that cash permanently and invested it into
treasury bills earning 5%, then the present value of the additional taxes paid by Luther would be
closest to:
A) $35 million
B) $290 million
C) $175 million
D) $585 million
Use the information for the question(s) below.
Consider the following tax rates:
Year
Corporate
Tax Rate
Capital
Gains Rate
Ordinary
Income Rate
Dividend
Rate
1997-2000
35%
20%
40%
40%
2001-2002
35%
20%
39%
39%
2003-
35%
15%
35%
15%
14) The effective tax disadvantage for retaining cash in 2006 is closest to:
A) 14.75%
B) 12.50%
C) 35.00%
D) 15.00%
15) The effective tax disadvantage for retaining cash in 2002 is closest to:
A) 15.00%
B) 14.75%
C) 30.00%
D) 35.00%
16) The effective tax disadvantage for retaining cash in 2000 is closest to:
A) 15.00%
B) 13.35%
C) 14.75%
D) 35.00%
Use the information for the question(s) below.
Iota Industries is an all-equity firm with 50 million shares outstanding. Iota has $200 million in
cash and expects future free cash flows of $75 million per year. Management plans to use the
cash to expand the firm’s operations, which in turn will increase future free cash flows by 12%.
Iota’s cost of capital is 10% and assume that capital markets are perfect.
17) The value of Iota if they use the $200 million to expand is closest to:
A) $825 million
B) $688 million
C) $840 million
D) $950 million
18) The value of Iota if they do not to use the $200 million to expand and hold the cash instead is
closest to:
A) $840 million
B) $825 million
C) $950 million
D) $688 million
19) The price per share of Iota if they use the $200 million to expand is closest to:
A) $13.75
B) $16.50
C) $19.00
D) $16.80
20) The price per share of Iota if they not to use the $200 million to expand and hold the cash
instead is closest to:
A) $16.50
B) $16.80
C) $19.00
D) $13.75
21) The NPV of Iota’s expansion project is closest to:
A) -$110 million
B) -$137.5 million
C) $0
D) $75 million
22) A member of Iota’s board of directors suggests that Iota’s stock price would be higher if they
used the $200 million to repurchase shares instead of funding the expansion. If you were
advising the board, what course of action would you recommend, expansion or repurchase?
Which provides the higher stock price?
23) Suppose that Iota is able to invest the $200 million in excess cash into a project that will
increase future free cash flows by 30%. If you were advising the board, what course of action
would you recommend, investing the $200 million in an expansion project that will raise future
free cash flows by 30% or use the $200 million to repurchase shares? Which provides the higher
stock price?
Use the information for the question(s) below.
Consider the following tax rates:
Year
Corporate
Tax Rate
Capital
Gains Rate
Ordinary
Income Rate
Dividend
Rate
1997-2000
35%
20%
40%
40%
2001-2002
35%
20%
39%
39%
2003-
35%
15%
35%
15%
24) Calculate the effective tax disadvantage for retaining cash in 1999, 2001, and 2005.
17.6 Signaling with Payout Policy
1) Which of the following statements is FALSE?
A) Firms adjust dividends relatively infrequently, and dividends are much less volatile than
earnings. This practice of maintaining relatively constant dividends is called dividend signaling.
B) When a firm increases its dividend, it sends a positive signal to investors that management
expects to be able to afford the higher dividend for the foreseeable future.
C) The average size of the stock price reaction increases with the magnitude of the dividend
change, and is larger for dividend cuts.
D) When managers cut the dividend, it may signal that they have given up hope that earnings
will rebound in the near term and so need to reduce the dividend to save cash.
2) Which of the following statements is FALSE?
A) If firms smooth dividends, the firm’s dividend choice will contain information regarding
management’s expectations of future earnings.
B) Because of the increasing popularity of repurchases, firms cut dividends much more
frequently than they increase them.
C) Announcing a share repurchase today does not necessarily represent a long-term commitment
to repurchase shares.
D) While cutting the dividend is costly for managers in terms of their reputation and the reaction
of investors, it is by no means as costly as failing to make debt payments.
3) Which of the following statements is FALSE?
A) Managers are much less committed to dividend payments than to share repurchases.
B) Share repurchases are a credible signal that the shares are under-priced, because if they are
over-priced a share repurchase is costly for current shareholders.
C) While an increase of a firm’s dividend may signal management’s optimism regarding its
future cash flows, it might also signal a lack of investment opportunities.
D) Managers will clearly be more likely to repurchase shares if they believe the stock to be
under-valued.
Use the information for the question(s) below.
Rockwood Industries has 100 million shares outstanding, a current share price of $25, and no
debt. Rockwood’s management believes that the shares are under-priced, and that the true value
is $30 per share. Rockwood plans to pay $250 million in cash to its shareholders by
repurchasing shares. Management expects that very soon new information will come out that
will cause investors to revise their opinion of the firm and agree with Rockwood’s assessment of
the firm’s true value.
4) If Rockwood is able to repurchase shares prior to the market becoming aware of the new
information regarding Rockwood’s true value, then the number of shares outstanding following
the repurchase is closest to:
A) 92 million
B) 10 million
C) 75 million
D) 90 million
5) Assume that Rockwood is not able to repurchase shares prior to the market becoming aware of
the new information regarding Rockwood’s true value. If Rockwood repurchases the shares
following the release of the new information, then the number of shares outstanding following
the repurchase is closest to:
A) 92 million
B) 90 million
C) 75 million
D) 10 million
6) Assume that Rockwood is able to repurchase shares prior to the market becoming aware of the
new information regarding Rockwood’s true value. After the repurchase, and following the
release of the new information regarding the true value of Rockwood, the firm’s share price is
closest to:
A) $30.00
B) $31.50
C) $28.75
D) $30.60
7) Assume that Rockwood is not able to repurchase shares prior to the market becoming aware of
the new information regarding Rockwood’s true value. After the release of the new information
regarding the true value of Rockwood, and following the repurchase, the firm’s share price is
closest to:
A) $30.00
B) $30.60
C) $28.75
D) $31.50
8) Calculate Rockwood’s stock price following the market becoming aware of the new
information regarding Rockwood’s true value, if (1) Rockwood completed the repurchase prior to
the market becoming aware of the information and (2) Rockwood completed the repurchase
following the market becoming aware of the new information.
17.7 Stock Dividends, Splits, and Spin-offs
1) Taggart Transcontinental shares are currently trading at $200 per share. The split ratio need to
brink the stock price down to $80 is:
A) 2:1
B) 3:1
C) 2:5
D) 5:2
2) Which of the following statements is FALSE?
A) Stocks generally trade in lots of 1000 shares, and in any case do not trade in units less than
one share.
B) Non-cash special dividends are commonly used to spin off assets or a subsidiary as a separate
company.
C) The typical motivation for a stock split is to keep the share price in a range thought to be
attractive to small investors.
D) If a company declares a 10% stock dividend, each shareholder will receive one new share of
stock for every 10 shares already owned.
3) Which of the following statements is FALSE?
A) With a stock dividend, a firm does not pay out any cash to shareholders. As a result, the total
market value of the firm’s assets and liabilities, and therefore of its equity, is unchanged.
B) If the price of the stock falls too low, a company can engage in a reverse split and reduce the
number of shares outstanding.
C) Stock dividends of 50% or higher are generally referred to as stock splits.
D) Rather than pay a dividend using cash or shares of its own stock, a firm can also distribute
shares of a subsidiary in a transaction referred to as a off-shoot.
Use the information for the question(s) below.
Luther Industries currently has 5 million shares outstanding and it stock is currently trading at
$40 per share.
4) Assuming Luther issues a 25% stock dividend, then Luther’s new share price is closest to:
A) $24.00
B) $30.00
C) $16.00
D) $32.00
5) Assuming Luther issues a 5:2 stock split, then Luther’s new share price is closest to:
A) $32.00
B) $16.00
C) $24.00
D) $30.00
6) Assuming Luther issues a 5:2 stock split, then the number of shares Luther will have
outstanding following the split is closest to:
A) 25.0 million
B) 12.5 million
C) 2.0 million
D) 16.0 million
7) Delta Products has decided to spin-off one of its subsidiaries, Gamma Technologies. Each
Delta shareholder will receive 0.125 shares of Gamma for each share of Delta they own. Delta’s
price is $35.00 cum-dividend and immediately after the spin-off Gamma Technologies was
trading for $24.00 per share. In a perfect capital market, what would Delta Product’s ex-dividend
share price be after this transaction?