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Chapter 14: Distribution 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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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 a company declares a dividend of $1.50 per share, payable on January 31 then the price of the stock
should drop by approximately $1.50 on January 31.
a.
True
b.
False
22. If on January 3 a company declares a dividend of $1.50 per share, payable on January 31 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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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: Distribution to Shareholders: Dividends and Share Repurchases
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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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?
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
a.
Under the tax laws as they existed in 2015, 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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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.
Chapter 14: Distribution to Shareholders: Dividends and Share Repurchases
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
