Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 13 Dividend Policy and Internal Financing
13.1 Learning Objective 1
1) Dividends per share divided by earnings per share equal the dividend payout ratio.
2) A firm’s dividend policy includes two basic components: the dividend payout ratio and
dividend stability.
3) Corporations distribute cash back to their owners (stockholders) either as cash dividends or by
repurchasing shares of stock in the open market.
4) Expected dividends and share repurchases are the cash flow that underlies stock valuation.
5) Share repurchases are not part of the stock valuation process because by definition the cash
flow from a share repurchase ends the investment as the stock is no longer owned by the
shareholder.
6) A firm’s dividend policy includes two basic components: the dividend payout ratio and the
profit retention ratio.
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7) Memory, Inc. expects earnings per share this year to be $8. If earnings per share grow at an
average annual rate of 6 percent and if Baker pays 60 percent of its earnings as dividends, what
will the expected dividend per share be in 7 years?
13.2 Learning Objective 2
1) An investor who pays no tax would be more likely to accept the view that high dividends
increase stock values rather than the view that low dividends increase stock values.
2) According to the clientele effect, dividend policy matters even if capital markets are perfect
because investors self-select into dividend preference groups.
3) The information effect suggests dividend policy matters because dividends act as a persuasive
communications tool, signaling investors about the financial condition of the firm.
4) A closely-held company whose owners are trying to maintain control would be less likely to
pay dividends so that all earnings may be retained to finance future growth.
5) One potential rationale for paying dividends is that the payment of dividends indirectly results
in a closer monitoring of management’s investment activities, hence lowering agency costs.
6) According to the expectations theory, the actual dividend must equal the expected dividend, or
lese the stock price will decrease after the dividend amount is announced.
7) In order to maximize shareholder value, a corporation must earn a higher rate of return on a
dollar that is retained in the corporation than the shareholders can earn by investing the dollar
elsewhere.
8) A fast-growing company with many high net present value projects may maximize
shareholder wealth by NOT paying a dividend.
9) Because of the overriding importance of cash flows to valuation, one basic tenet of finance is
that dividends increase the value of a company’s common stock.
10) According to the “bird-in-the-hand” dividend theory, the required return for a stock that pays
its entire return from dividends is higher than the required return for a high-growth stock that
pays no dividend.
11) Low dividends may increase stock value due to the advantage of tax deferral that comes with
capital gains.
12) The residual dividend theory is based on the observation that flotation costs make the cost of
new common stock significantly higher than the cost of retained earnings.
13) As a corporation’s investment opportunities increase, the dividend payout ratio should
decrease so that the corporation can avoid flotation costs.
14) Since stock dividends do not require payment in cash, their impact on a corporation’s share
price can be only positive (if there is an information effect) or neutral, but not negative.
15) The residual theory of dividends connects a firm’s dividend policy and its level of capital
investments.
16) We typically expect to find rapidly growing firms to have high payout ratios.
17) Under the ideal conditions of perfect capital markets, dividend policy has no effect upon
share price.
18) If a firm were to unexpectedly omit payment of its quarterly dividend, that firm’s stock price
would probably drop.
19) If a company in a perfect capital market decreased its dividend per share, an investor would
be forced to sell his common stock at a depressed price.
20) A firm’s dividend policy provides information pertaining to the firm’s payout ratio and its
stability.
21) Security markets are considered to be perfect when firms can issue securities at no cost and
the investor incurs no brokerage commissions.
22) The existence of taxes can directly affect a common shareholder’s preference for capital
gains or dividend income.
23) When an unexpected change in dividend policy develops, investors may attach informational
content to the events.
24) When Firm X makes the decision to pay dividends, they also make the decision not to
reinvest the cash in the firm.
25) The residual dividend theory suggests that dividends should be paid to stockholders first and
then what is left can be reinvested by the firm.
26) In a perfect market, investors are only concerned with total returns and are not concerned
whether it is in capital gains or dividend income.
27) When considering taxes, most investors prefer capital gains over dividend income.
28) According to the bird-in-the-hand dividend theory, investors value a dollar of expected
capital gain more highly than a dollar of expected dividends because capital gains are more
unpredictable than dividends.
29) An investor who requires an 18% percent return for a stock that pays no dividends and
requires a 12% return for a stock that pays its entire return from dividends may be following the
bird-in-the-hand dividend theory.
30) Federal tax law is irrelevant to corporate dividend policy because dividends are not tax
deductible.
31) The residual dividend theory implies that internally generated funds (i.e., retained earnings)
should be used to fund all new investment projects before the company uses any additional debt.
32) If the tax rate on dividends and the tax rate on capital gains are the same, then investors are
indifferent to dividend policy.
33) The clientele effect does not imply that either high or low dividends are optimal, rather that
firm’s should not make significant and arbitrary changes in their existing dividend policy.
34) In order to reduce agency costs, managers may decrease dividends, thus shifting the focus of
investors to future capital gains than can only be attained by a well-run corporation.
35) The information effect hypothesis implies that increasing dividends provides a more credible
signal of higher future earnings than does management’s assertion that future earnings will be
higher.
36) Corporation A announces is quarterly dividend will increase from $3.80 to $4.00. After the
announcement, the price of Corporation A’s stock drops. The most likely explanation is that
A) the stock market is a perfect market.
B) investors are irrational.
C) investors were expecting a larger increase.
D) Corporation A’s debt ratio decreased.
37) A corporation announces a large increase in its annual dividend, but its stock price declines.
This could result from
A) residual dividend theory.
B) Bird-in-the-Hand Theory.
C) perfect capital markets.
D) MM’s indifference theorem.
38) A corporation announces a significant increase in its annual dividend and its stock price
increases on the news. This could be explained most directly by
A) residual dividend theory.
B) bird-in-the-hand theory.
C) perfect capital markets.
D) MM”s indifference theorem.
39) An investor who requires a 17% percent return for a stock that pays no dividends and
requires a 13% return for a stock that pays its entire return from dividends is most likely a
proponent of
A) the bird-in-the-hand dividend theory.
B) the residual dividend theory.
C) the clientele effect.
D) the information effect.
40) The dividend irrelevance hypothesis is based on all of the following assumptions except:
A) investment decisions will not be altered by the amount of dividend payments.
B) investors do not need cash dividends to supplement their current income.
C) perfect capital markets.
D) borrowing decisions will not be altered by the amount of dividend payments.
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41) JB Corporation has a retained earnings balance of $2,000,000. The company reported net
income of $600,000, sales of $4,000,000, and has 200,000 shares of common stock outstanding.
The company announced a dividend of $2.00 per share. Therefore, the company’s dividend
payout ratio is
A) 66.7%.
B) 50%.
C) 20%.
D) 10%.
42) Willows Corporation is experiencing high demand for its products and high growth rates.
The company just reported earnings per share of $5 for the most recent year and has many
positive NPV projects to fund. One vice president wants to pay a dividend of $5 per share,
arguing that this will maximize shareholder value. You argue that a much smaller dividend will
maximize value. Your argument may be based on
A) the bird-in-the-hand theory.
B) the residual dividend theory.
C) the information effect.
D) the very high agency costs of the corporation.
43) A corporation with very high growth prospects and many positive NPV projects to fund may
want to increase its dividend based on
A) the tax bias against capital gains.
B) the residual dividend theory.
C) the information effect.
D) the very low agency costs of the corporation.
44) CDE Corporation declared a $2 per share dividend on October 1. The date of record is
October 20th, the ex-dividend date is October 18th, and the payment date is October 31st. Joe
owns a share of stock on October 1. Joe sells his share to Mary on October 18th, Mary sells the
share to Tom on October 20th, and Tom sells the share to William on October 30th. Who will
receive the dividend?
A) Joe
B) Mary
C) Tom
D) William
45) Low dividends may increase stock value according to the
A) bird-in-the-hand theory.
B) information effect.
C) impact of agency costs.
D) tax bias in favor of capital gains.
46) The “bird-in-the-hand” dividend theory suggests that
A) high dividends increase stock value because shareholders believe they can earn a higher
return than the company.
B) high dividends increase stock value because shareholders are more certain of the dividend
yield than of potential future capital gains.
C) high dividends increase stock value because capital markets are inefficient and dividends are
the only sure way to get money from an equity investment.
D) high dividends decrease stock value because dividend payments take money out of the
corporate “nest” and reduce the ability of the corporation to function effectively.
47) Which of the following supports the “bird-in-the-hand dividend theory?
A) investors prefer dividends to capital gains because of the time value of money
B) increasing a firm’s dividends transfers risk and ownership from the current shareholders to
new owners
C) investment decisions are not influenced by dividend policy
D) capital mix decisions are not influenced by dividend policy
48) The residual dividend theory suggests that dividends will only be paid
A) if the tax rate on capital gains is higher than the tax rate on dividends.
B) if the corporation has more positive NPV projects than it can fund.
C) if interest rates available to shareholders are higher than the required return on the company’s
stock.
D) if current retained earnings exceed the equity portion of the firm’s capital budget.
49) Dividend changes may be used by management as a credible communication tool to signal
investors about future earnings under which of the following dividend policy theories?
A) the clientele effect
B) the residual dividend theory
C) the information effect
D) the expectations theory
50) The payment of dividends may indirectly result in closer monitoring of management’s
investment activities, thus increasing shareholder value by
A) reducing agency costs.
B) increasing information asymmetry.
C) increasing a company’s amount of free cash flow.
D) reducing auditing fees.
51) JBC Corp. declared a dividend of $2 per share, which was an increase of 25% from the prior
year, yet JBC Corp. stock declined by 3% the day of the announcement. RBG Corp. declared a
dividend of $2 per share, which was the same as the prior year, and its stock increased in value
by 2% on the day of the announcement. These events could be most readily explained by the
A) information effect.
B) clientele effect.
C) expectations theory.
D) residual dividend theory.
52) All of the following factors support the proposition that dividend policy matters except:
A) investors desire to minimize and defer taxes, and capital gains get preferential tax treatment
over dividend income.
B) perfect capital markets.
C) information asymmetry exists between shareholders and managers.
D) flotation costs significantly increase the cost of new common stock compared to retained
earnings.
53) An increase in flotation costs will most likely result in which of the following?
A) smaller dividend payments so that less external equity financing is needed
B) larger dividend payments so shareholders are able to earn their required returns
C) larger dividend payments to offset higher taxes paid by investors
D) no change in dividend policies because flotation costs are paid by purchasers of common
stock
54) High dividends may increase stock values due to all of the following reasons except:
A) dividends are more certain than capital gains.
B) higher dividends are used to signal higher expected future earnings.
C) dividends are used as a tool to minimize agency costs.
D) higher dividends allow companies to increase their proportion of external equity financing.
55) According to the clientele effect,
A) companies should have dividend payout ratios of either 100% or 0%.
B) companies should avoid making capricious changes in their dividend policies.
C) companies should change their dividend policies to please their target group of investors.
D) even if capital markets are perfect, dividend policy still matters.
56) According to the perfect markets approach to dividend policy
A) other things equal, the greater the payout ratio, the greater the share price of the firm.
B) the price of a share of stock is unrelated to dividend policy.
C) the firm should retain earnings so stockholders will receive a capital gain.
D) the firm should pay a dividend only after current equity financing needs have been met.
57) According to the residual theory of dividends
A) dividends are a residual after investment financing needs have been met.
B) earnings remaining after payment of preferred stock dividends should be paid to common
stockholders.
C) dividend payments are a constant percentage of earnings per share.
D) a dividend is the residual above the payout ratio.
58) Dividends generally
A) are paid as a fixed percentage of earnings.
B) fluctuate more than earnings.
C) are guaranteed by the SEC.
D) are more stable than earnings.
59) All of the following may influence a firm’s dividend payment except:
A) investment opportunities.
B) investor transaction costs.
C) common stock par value.
D) flotation costs.
60) In perfect capital markets there
A) is no informational content assigned to a particular dividend policy.
B) are no income taxes.
C) are no flotation costs.
D) all of the above.
61) A justification for no dividend payments that would be pleasing to shareholders could be
A) insufficient cash available for dividend payments.
B) positive NPV investment projects that require the firm to retain cash for investment purposes.
C) an investor clientele that prefers current liquidity.
D) cash will be used for a stock dividend.
62) A firm’s dividend payout ratio is
A) the ratio of dividends to sales.
B) the ratio of dividends to market equity.
C) the ratio of dividends to earnings.
D) the ratio of dividends to book equity.
63) Which of the following statements would be consistent with the Dividend Irrelevance
Theory?
A) There is no relationship between a firm’s dividend policy and the value of its common stock.
B) Perfect capital markets are assumed to exist which allow investors to buy and sell stock
without incurring any transaction costs.
C) Investors are indifferent whether stock returns come from dividend income or capital gains
income.
D) All of the above.
64) Which of the following statements would be consistent with the bird-in-the-hand dividend
theory?
A) Investors are indifferent whether stock returns come from dividend income or capital gains
income.
B) Dividends are more certain than capital gains income.
C) Wealthy investors prefer corporations to defer dividend payments because capital gains
produce greater after-tax income.
D) Dividends are less certain than capital gains.
65) Which of the following statements would be consistent with the residual dividend theory?
A) Wealthy investors prefer corporations to defer dividend payments because capital gains
produce greater after-tax income.
B) Dividends are more certain than capital gains.
C) Dividends should only be paid if a firm has profits in excess of the amount needed to finance
the current year’s capital investments.
D) Investors are indifferent whether stock returns come from dividend income or capital gains
income.
66) Assume that a firm has a steady record of paying high dividends for years. A new
management team decided to cut the current year’s dividend in half without disclosing why. The
market value of the stock fell 35% on the day the dividend cut was announced. Which of the
following would best explain the stock market’s reaction to the announcement?
A) Empirical theory
B) Dividend Irrelevance theory
C) Residual Dividend theory
D) Information effect
67) Assume that a firm has a steady record of paying stable dividends for years. Market analysts
had expected management to increase the dividend by 7.5% in the latest quarter. However,
management announced a 15% increase in the current year’s dividend. The market value of the
stock rose 20% on the day of the announcement. Which of the following would best explain the
stock market’s reaction to the announcement?
A) Expectations theory
B) Dividend Irrelevance theory
C) Residual Dividend theory
D) Agency theory
68) Assume that the tax on dividends and the tax on capital gains is the same. All else equal,
what would a prudent investor prefer?
A) The prudent investor would be indifferent between receiving dividends or capital gains.
B) The prudent investor would prefer dividends a dollar today is always worth more than a
dollar to be received in the future.
C) The prudent investor would prefer capital gains the capital gain tax liability can be deferred
until gains are realized.
D) More information is needed.
69) Which of the following is (are) true?
A) In general, the higher the number of positive NPV investment opportunities for a firm, the
lower the dividend payout ratio.
B) If the clientele effect is correct, firms should follow a constant dividend payout ratio policy.
C) According to the informational content of dividends, an increase in dividends is always a
positive signal.
D) In industries with volatile earnings, the residual dividend policy results in the most consistent
dividend stream.
70) Which of the following is true if dividend policy is irrelevant?
A) Perfect capital markets exist.
B) The clientele effect exists.
C) The information effect exists.
D) Tax deferral on capital gains exists.
71) The “bird-in-the-hand dividend theory” supports which view of the effect of dividend policy
on company value?
A) A firm’s dividend policy is irrelevant.
B) High dividends increase stock values.
C) Low dividends increase stock values.
D) Constant dividends increase stock values.
72) The viewpoint that low dividends increase stock value is based on which of the following
principles?
A) Time Value of Money
B) Risk-Return Trade-off
C) Taxes Bias Business Decisions
D) The Agency Problem
73) The viewpoint that high dividends increase stock values is based on which of the following
principles?
A) Time Value of Money
B) Risk-Return Trade-Off
C) Taxes Bias Business Decisions
D) The Agency Problem
74) Company A and Company B both paid a $2 per share dividend last year. This year,
Company A announces an increase to $3 per share while Company B announces an increase to
$2.50 per share. After the announcement, the price of Company B stock increases and the price
of Company A’s stock decreases. Which of the following best explains this situation?
A) The stock market is irrational.
B) Company A had higher agency costs than Company B prior to the announcement.
C) Both companies need to raise capital for positive NPV projects and flotation costs are high.
D) Capital markets are perfect.
75) The Clydesdale Corporation has an optimal capital structure consisting of 70 percent debt
and 30 percent equity. The marginal cost of capital is calculated to be 14.75 percent. Total
earnings available to common stockholders for the coming year total $1,200,000. Investment
opportunities are:
Project
Investment
IRR (%)
A
$1,000,000
22
B
$750,000
18
C
$1,250,000
15
D
$500,000
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a. According to the residual dividend theory, what should the firm’s total dividend payment be?
b. If the firm paid a total dividend of $675,000, and restricted equity financing to internally
generated funds, which projects should be selected? Assume the marginal cost of capital is
constant.
76) Coppell Timber Company had total earnings last year of $5,000,000, but expects total
earnings to drop to $4,750,000 this year because of a slump in the housing industry. There are
currently 1,000,000 shares of common stock outstanding. The company has $4,000,000 worth of
investments to undertake this year. The company finances 40 percent of its investments with debt
and 60 percent with equity capital. The company paid $3.00 per share in dividends last year.
a. If the company follows a pure residual dividend policy, how large a dividend will each
shareholder receive this year?
b. If the company maintains a constant dividend payout ratio each year, how large a dividend
will each shareholder receive this year?
c. If the company follows a constant dollar dividend policy, how large a dividend will each
shareholder receive this year?
77) Bass Frozen Foods, Inc. has found three acceptable investment opportunities. The three
projects require a total of $5 million in financing. It is the company’s policy to finance its
investments by using 40% debt and 60% common equity. The firm has generated $3.8 million
dollars from its operations that could be used to finance the common equity portion of its
investments.
a. What portion of the new investments will be financed by common equity and what portion
by debt?
b. According to the residual dividend theory, how much would be paid out in dividends?
78) What is the information effect associated with dividends? Why does it occur?
79) A corporation decides to cut its dividend from $2 per share to $1.50 per share. Give two
rationales/theories to explain why this action may cause the stock price to decrease and two
rationales/theories to explain why this action may cause the stock price to increase.
80) Describe the three divergent views of dividend policy’s effect on share price.
13.3 Learning Objective 3
1) The higher the dividend payout ratio, the more a company must rely on external financing.
2) A corporation with $1 million in retained earnings at the end of the year could easily pay a
dividend of $500,000.
3) As long as a firm has a positive level of retained earnings, it can pay a dividend.
4) Analysis of dividend policy begins with the basic assumption that shareholder wealth
maximization is the primary goal, and therefore dividends should be of primary concern even if
their payment results in capital rationing.
5) Statutory restrictions may prevent a company from paying dividends if the firm’s assets are
less than the firm’s liabilities.
6) Radon Corp.’s balance sheet is as follows:
Cash $1,000,000 Current Liabilities $1,300,000
Other Current Assets $2,000,000 Long-term Debt $4,100,000
Long-term Assets $8,000,000 Common Stock $5,000,000
Retained Earnings $ 600,000
Total Assets $11,000,000 Total Liab. And Equity $11,000,000
Radon decides to pay a dividend. Which of the following statements is most correct?
A) The dividend cannot exceed $1,000,000, the amount of cash available
B) The dividend cannot exceed $1,700,000, the amount of net working capital
C) The dividend cannot exceed $600,000, the amount of retained earnings
D) The dividend cannot exceed $11,000,000, the amount of total assets
7) Statutory restrictions on dividend payments include all of the following except:
A) if liabilities exceed assets.
B) if the amount of the dividend exceeds the firm’s retained earnings.
C) if the dividend is being paid from capital invested in the firm.
D) if, because of the dividend payment, the firm intends to sell new common stock to fund its
capital budget.
8) All of the following are likely to result in a lower dividend, other things the same, except:
A) statutory restrictions.
B) debt covenants.
C) liquidity constraints.
D) highly diverse ownership.
9) Each of the following factors may cause a corporation to lower its dividend payout ratio
except:
A) the corporation’s earnings predictability is high.
B) the corporation’s current and quick ratios are higher than industry average.
C) the corporation’s retained earnings balance is high.
D) current common shareholders are unable to participate in new equity offerings.
10) Which of the following factors would most likely be present if a company increases its
dividend payout ratio significantly?
A) a high debt/equity ratio (i.e., use of a large amount of financial leverage)
B) a quick ratio that is significantly below the industry average
C) current shareholders cannot participate in a new offering and desire to maintain ownership
control
D) the variability of expected future earnings decreases