CHAPTER 14: DISTRIBUTIONS TO SHAREHOLDERS: DIVIDENDS AND
SHARE REPURCHASES
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
4.
Miller and Modigliani’s dividend irrelevance theory says that the percentage of its earnings a firm pays out
in dividends has no effect on its cost of capital, but it does affect its stock price.
a.
True
b.
False
5.
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.
a.
True
b.
False
6.
A 100% stock dividend and a 2:1 stock split should, at least conceptually, have the same effect on the firm’s
stock price.
a.
True
b.
False
7.
A “reverse split” reduces the number of shares outstanding.
a.
True
b.
False
8.
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, other things held constant.
a.
True
b.
False
9.
The federal government sometimes taxes dividends and capital gains at different rates. Other things held constant,
an increase in the tax rate on dividends relative to that on capital gains would logically lead to an increase in
dividend payout ratios.
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
12.
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.
a.
True
b.
False
13.
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.
a.
True
b.
False
14.
If a retired individual lives on his or her investment income, then it would make sense for this person to prefer
stocks with high payouts so he or she could receive cash without going to the trouble and expense of selling
stocks. On the other hand, it would make sense for an individual who would just reinvest any dividends received
to prefer a low-payout company because that would save him or her taxes and brokerage costs.
a.
True
b.
False
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
17.
If the information content, or signaling, hypothesis is correct, then a change in a firm’s dividend policy can
have an important effect on its stock price and cost of equity.
a.
True
b.
False
18.
If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual
after providing for the equity required to fund the capital budget. Under this model, the better the firm’s
investment opportunities, the lower its payout ratio will be, other things held constant.
a.
True
b.
False
19.
If a firm uses the residual dividend model to set dividend policy, then dividends are determined as a residual
after providing for the equity required to fund the capital budget. Under this model, the higher the firm’s debt
ratio, the lower its payout ratio will be, other things held constant.
a.
True
b.
False
20.
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 dividend policy.
a.
True
b.
False
21.
If on January 3, 2014, a company declares a dividend of $1.50 per share, payable on January 31, 2014, then the
price of the stock should drop by approximately $1.50 on January 31.
a.
True
b.
False
22.
If on January 3, 2014, a company declares a dividend of $1.50 per share, payable on January 31, 2014, to holders
of record on January 17, then the price of the stock should drop by approximately $1.50 on January 15, which is
the ex- dividend date.
a.
True
b.
False
23.
One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the
dividends that they choose to reinvest.
a.
True
b.
False
24.
There are two types of dividend reinvestment plans. Under one type of plan, the firm uses the cash that would
have been paid as dividends to buy stock on the open market. Under the other type, the company issues new
stock, keeps the cash that would have been paid out, and in effect sells new stock to those investors who choose
to reinvest their dividends.
a.
True
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
27.
Your firm uses the residual dividend model to set dividend policy. Market interest rates suddenly rise, and stock
prices decline. Your firm’s earnings, investment opportunities, and capital structure do not change. If the firm
follows the residual dividend model, then its dividend payout ratio would increase.
a.
True
b.
False
28.
Suppose you plotted a curve which showed a Firm U’s WACC on the vertical axis and its debt ratio on the
horizontal
axis. Then you plotted a similar curve for Firm V. The curve for firm U resembled a shallow “U,”
while that for Firm
V resembled a sharp “V.” Both firms have debt ratios that cause their WACCs to be
minimized. Other things held
constant, it would be easier for Firm V than for Firm U to maintain a steady
dividend in the face of varying
investment opportunities and earnings from year to year.
a.
True
b.
False
29.
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 to
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
would
equal $0.80. Once the percentage is set, then dividend policy is on “automatic pilot” and the
dividend actually
paid depends strictly on earnings.
30.
You own 100 shares of Troll Brothers’ stock, which currently sells for $120 a share. The company is about
to
declare a 2-for-1 stock split. Which of the following best describes your likely position after the split?
a.
You will have 200 shares of stock, and the stock will trade at or near $120 a share.
b.
You will have 200 shares of stock, and the stock will trade at or near $60 a share.
c.
You will have 100 shares of stock, and the stock will trade at or near $60 a share.
d.
You will have 50 shares of stock, and the stock will trade at or near $120 a share.
e.
You will have 50 shares of stock, and the stock will trade at or near $600 a share.
31.
Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout
ratio is
lowered. Their argument is based on the assumption that
a.
investors are indifferent between dividends and capital gains.
b.
investors require that the dividend yield plus the capital gains yield equal a constant.
c.
capital gains are taxed at a higher rate than dividends.
d.
investors view dividends as being less risky than potential future capital gains.
e.
investors prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower
tax
rate on capital gains.
32.
Your firm adheres strictly to the residual dividend model. 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 firm’s net income increases.
b.
The company increases the percentage of equity in its target capital structure.
c.
The number of profitable potential projects increases.
d.
Congress lowers the tax rate on capital gains, leaving the rest of the tax code unchanged.
e.
Earnings are unchanged, but the firm issues new shares of common stock.
33.
If a firm adheres strictly to the residual dividend policy, and if its optimal capital budget requires the use of all
earnings for a given year (along with new debt according to the optimal debt/assets ratio), then the firm should
pay
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.
36.
Which of the following would be most likely to lead to a decrease in a firm’s dividend payout ratio?
a.
Its earnings become more stable.
b.
Its access to the capital markets increases.
c.
Its research and development efforts pay off, and it now has more high-return investment opportunities.
d.
Its accounts receivable decrease due to a change in its credit policy.
e.
Its stock price has increased over the last year by a greater percentage than the increase in the broad stock
market averages.
37.
Which of the following statements is CORRECT?
a.
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.
b.
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 reverse splits are illegal today.
c.
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.
d.
When a company declares a stock split, the price of the stock typically declines—for example, by about 50%
after a 2-for-1 split—and this necessarily reduces the total market value of the firm’s equity.
e.
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 20-for-1 so as to bring the price down to something close to $25. Moreover, if the price is
relatively low—say $2 per share—then it can declare a “reverse split” of say 1-for-10 so as to bring the price
up to somewhere around $20 per share.
38.
Which of the following statements about dividend policies is CORRECT?
a.
Miller and Modigliani argued that investors prefer dividends to capital gains because dividends are more
certain than capital gains. They call this the “bird-in-the-hand” effect.
b.
One reason that companies tend to favor distributing excess cash as dividends rather than by repurchasing
stock is that dividends are normally taxed at a lower rate than gains on repurchased stock.
c.
One advantage of dividend reinvestment plans is that they allow shareholders to delay paying taxes on the
dividends that they choose to reinvest.
d.
One key advantage of the residual dividend model is that it enables a company to follow a stable dividend
policy.
e.
The clientele effect suggests that companies should follow a stable dividend policy.
39.
Which of the following statements is CORRECT?
a.
One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who
want to increase their investment in the company.
b.
One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the
dividends credited to their account.
c.
Stock repurchases can be used by a firm that wants to increase its debt ratio.
d.
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.
e.
One advantage of an open market dividend reinvestment plan is that it provides new equity capital and
increases the shares outstanding.
40.
Which of the following statements is CORRECT?
a.
Under the tax laws as they existed in 2011, a dollar received by an individual taxpayer as interest income is
taxed at the same rate as a dollar received as dividends.
b.
One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have
to
pay if they received cash dividends.
c.
Empirical research indicates that, in general, companies send a negative signal to the marketplace when they
announce an increase in the dividend. As a result, share prices fall when dividend increases are announced
because investors interpret the increase as a signal that the firm expects fewer good investment opportunities
in the future.
d.
If a company needs to raise new equity capital, a new-stock dividend reinvestment plan would make sense.
However, if the firm does not need new equity, then an open market purchase dividend reinvestment plan
would probably make more sense.
e.
Dividend reinvestment plans have not caught on in most industries, and today over 99% of all DRIPs are
offered by utilities.
41.
Which of the following statements is CORRECT?
a.
Historically, the tax code has encouraged companies to pay dividends rather than retain earnings.
b.
If a company uses the residual dividend model to determine its dividend payments, dividend payout will tend
to
increase whenever its profitable investment opportunities increase relatively rapidly.
c.
The more a firm’s management believes in the clientele effect, the more likely the firm is to adhere strictly to
the residual dividend model.
d.
Large stock repurchases financed by debt tend to increase expected earnings per share, but they also tend to
increase the firm’s financial risk.
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.
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.
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.
48.
Which of the following statements is NOT CORRECT?
a.
Stock repurchases can be used by a firm as part of a plan to change its capital structure.
b.
After a 3-for-1 stock split, a company’s price per share should fall, but the number of shares outstanding will
rise.
c.
Investors may interpret a stock repurchase program as a signal that the firm’s managers believe the stock is
undervalued, or, alternatively, as a signal that the firm does not have many good investment opportunities.
d.
A company can repurchase stock to distribute a large one-time cash inflow, say from the sale of a division, to
stockholders without having to increase its regular dividend.
e.
Stockholders pay no income tax on dividends if the dividends are used to purchase stock through a dividend
reinvestment plan.
49.
Which of the following statements is CORRECT?
a.
If a firm follows the residual dividend model, then a sudden increase in the number of profitable projects
would be likely to lead to a reduction of the firm’s dividend payout ratio.
b.
The clientele effect explains why so many firms change their dividend policies so often.
c.
One advantage of adopting the residual dividend model is that this policy makes it easier for a corporation to
attract a specific and well-identified dividend clientele.
d.
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.
e.
Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock
dividends are received.
50.
Which of the following statements is CORRECT?
a.
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.
b.
Other things held constant, the higher a firm’s target dividend payout ratio, the higher its expected growth
rate should be.
c.
Miller and Modigliani’s dividend irrelevance theory says that the percentage of its earnings that a firm pays
out in dividends has no effect on its cost of capital, but it does affect its stock price.
d.
The federal government sometimes taxes dividends and capital gains at different rates. Other things
held constant, an increase in the tax rate on dividends relative to that on capital gains would logically
lead to a decrease in dividend payout ratios.
e.
If investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock
price should set a high dividend payout ratio.
51.
Portland Plastics Inc. has the following data. If it follows the residual dividend model, what is its forecasted
dividend payout ratio?
Capital budget
$12,500
% Debt
40%
Net income (NI)
$11,500
a. 25.36%
b. 28.17%
c. 31.30%
d. 34.78%
e. 38.26%
52.
Becker Financial recently declared a 2-for-1 stock split. Prior to the split, the stock sold for $80 per share. If
the firm’s total market value is unchanged by the split, what will the stock price be following the split?
a. $36.10
b. $38.00
c. $40.00
d. $42.00
e. $44.10
53.
Toombs Media Corp. recently completed a 3-for-1 stock split. Prior to the split, its stock sold for $90 per share.
The firm’s total market value was unchanged by the split. Other things held constant, what is the best estimate of
the stock’s post-split price?
a. $30.00
b. $31.50
c. $33.08
d. $34.73
e. $36.47
54.
Mid-State BankCorp recently declared a 7-for-2 stock split. Prior to the split, the stock sold for $80 per share. If
the firm’s total market value is unchanged by the split, what will the stock price be following the split?
a. $20.63
b. $21.71
c. $22.86
d. $24.00
e. $25.20
55.
Fauver Industries plans to have a capital budget of $650,000. It wants to maintain a target capital structure of 40%
debt and 60% equity, and it also wants to pay a dividend of $225,000. If the company follows the residual
dividend model, how much net income must it earn to meet its investment requirements, pay the dividend, and
keep the capital structure in balance?
a. $584,250
b. $615,000
c. $645,750
d. $678,038
e. $711,939
56.
Ring Technology has a capital budget of $850,000, it wants to maintain a target capital structure of 35% debt and
65% equity, and it also wants to pay a dividend of $400,000. If the company follows the residual dividend model,
how
much net income must it earn to meet its capital budgeting requirements and pay the dividend, all while
keeping its
capital structure in balance?
a. $ 904,875
b. $ 952,500
c. $1,000,125
d. $1,050,131
e. $1,102,638
57.
D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45%
debt and 55% equity, and she also wants to pay a dividend of $500,000. If the company follows the residual
dividend
model, how much income must it earn, and what will its dividend payout ratio be?
a. $ 898,750; 55.63%
b. $ 943,688; 58.41%
c. $ 990,872; 61.34%
d. $1,040,415; 64.40%
e. $1,092,436; 67.62%