Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Chapter 22: Dividend Policy
Multiple Choice Questions
1. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Basic
2. Section: 22.1 Forms of Dividend Payments
Learning objective: 22.1
Level of difficulty: Intermediate
3. Section: 22.1 Forms of Dividend Payments
Learning objective: 22.1
Level of difficulty: Intermediate
4. Section: 22.1 Forms of Dividend Payments
Learning objective: 22.1
Level of difficulty: Intermediate
5. Section: 22.2 Historical Dividend Data
Learning objective: 22.2
Level of difficulty: Intermediate
6. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Intermediate
7. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Intermediate
8. Section: 22.5 Dividend Policy in Practice
Learning objective: 22.5
Level of difficulty: Intermediate
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
9. Section: 22.5 Dividend Policy in Practice
Learning objective: 22.5
Level of difficulty: Intermediate
returns of the two stocks are the same).
10. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Intermediate
11. Section: 22.7 Share Repurchases
Learning objective: 22.7
Level of difficulty: Intermediate
12. Section: 22.7 Share Repurchases
Learning objective: 22.7
Level of difficulty: Intermediate
Practice Problems
Basic
13. Section: 22.1 Forms of Dividend Payments
Learning objective: 22.1
Level of difficulty: Basic
Solution: A cash dividend plus a DRIP gives the investor a choice to decide whether to buy more
14. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Basic
Solution:
Given the M&M assumptions (no taxes, perfect market, all firms maximize value, and no debt),
15. Section: 22.4 The “Bird in the Hand” Argument
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Learning objective: 22.4
Level of difficulty: Basic
16. Section: 22.5 Dividend Policy in Practice
Learning objective: 22.5
Level of difficulty: Basic
Solution:
According to Lintner, the adjustment factor β measures how quickly a firm’s actual dividend
17. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Basic
Solution:
18. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Basic
Solution:
With transaction costs, the firm may have no cash or decreased cash available for dividend
Intermediate
19. Section: 22.2 Historical Dividend Data
Learning objective: 22.2
Level of difficulty: Intermediate
Solution:
We use the dividend yield formula at this point to find the price per share:
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
20. Section 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Intermediate
Solution:
21. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Intermediate
Solution:
e
22. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Intermediate
Solution:
b. Current equity market value = $64 × 5m = $320 million
c. This implies the firm will need to issue the following number (n) of new shares:
23 Section: 22.5 Dividend Policy in Practice
Learning objective: 22.5
Level of difficulty: Intermediate
Solution:
Number of shares outstanding = 5,600,000/32 = 175,000
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
24. Section: 22.5 Dividend Policy in Practice
Learning objective: 22.5
Level of difficulty: Intermediate
Solution:
Setting dividend payout as a portion of profits increases the volatility of the dividend payments,
25. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Intermediate
Solution:
We can calculate the after-tax dividend amount by multiplying the dividend by (1-T) where T is
26. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Intermediate
Solution:
Dividend initiation is usually a positive signal to the market, and pushes the equity price up. A
27. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Intermediate
Solution:
The amount of the per share dividend increase is:
28. Section: 22.7 Share Repurchases
Learning objective: 22.7
Level of difficulty: Intermediate
Solution: Firms repurchase shares to:
• Offset the exercise of executive stock options (ESOs).
• Take the firm private.
Challenging
29. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Challenging
Solution:
a. Currently the firm has free cash flows of $2 million a year which could be paid in dividends
and has a value of $50*2 million shares = $100 million. This valuation implies a discount rate of
b. From the Modigliani-Miller dividend irrelevance theorem, we know that the value of the firm
will not be changed. For George to receive a dividend of $20 million, the firm will need to pay a
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
30. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Challenging
Solution:
b. If the firm undertakes the project, there will be no dividend in the current year. Starting next
Therefore:
c. If investments for the kind of business the firm is in typically provide a rate of return of 15%
31. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Challenging
Solution:
a. If the firm pays out all earnings in dividends,
b. If the firm retains the current dividend for reinvesting at 15%, then the dividends from next
32. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
b. Share buyback:
33. Section: 22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Learning objective: 22.3
Level of difficulty: Challenging
Solution:
Each share pays a dividend of $2,000 a year. The value of a share is $2,000/.05 = $40,000. Note
Marie: wants $400,000 at the end of year 1.
• At the end of year one, she will receive 100*2,000 = $200,000 of dividends.
Value at time 2 = $3.99 million. PV at 5% = $3.62 million. Note: this is less than the value of the
shares at time zero because her consumption of the dividends at time 1 was a negative NPV
project. The value of the stock was based on the assumption that the dividends would be
reinvested at 5%.
Charlie:
• Receives $200,000 dividend and sells 5 shares
Radha:
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
• Receives $200,000 dividend and buys 5 more shares
34. Section: 22.4 The “Bird in the Hand” Argument
Learning objective: 22.4
Level of difficulty: Challenging
Solution:
a. The “bird in the hand” argument is consistent with Client A. She prefers to have the “sure
35. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Learning objective: 22.6
Level of difficulty: Challenging
Solution:
a. If the change in dividends was unexpected, then I would expect the price of Abacus to increase
b. If the shareholders do not pay taxes, I would expect the stock price to decline by the amount of
c. The stock price reaction will be less than the value of the dividend. Investors buying the stock
36. Section: 22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Learning objective: 22.6
Level of difficulty: Challenging
Solution:
Kumar has not considered the impact of the information asymmetry between investors (the
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Answers to Concept Review Questions
22.1 Forms of Dividend Payments
Concept review questions
1. Define four important dates that arise with respect to dividend payments.
2. Explain the similarities and differences of DRIPs, stock dividends, and stock splits.
A cash dividend along with a DRIP is similar to a stock dividend because investors receive
shares rather than cash payments. However, there is one very significant difference between
them. With the cash dividend plus DRIP, the cash is distributed first and it is up to the investor to
22.2 Historical Dividend Data
Concept review questions
1. What obvious question arises when we examine historical patterns in aggregate dividend
payouts?
This naturally raises an important question (1): Why are dividends smoothed and not matched to
profits? Or another way of saying this is: why don’t firms just pay a constant proportion of
22.3 Modigliani and Miller’s Dividend Irrelevance Theorem
Concept review questions
1. Explain how and under what assumptions M&M show that dividends are irrelevant.
The assumptions are as follows: (1) There are no taxes; (2) Markets are perfect; (3) All firms
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
2. Explain the relationship between M&M’s argument and the use of a residual dividend policy.
According to M&M’s argument, stock value equals the present value of future (X–I). According
3. Briefly describe the notion of homemade dividends as it relates to M&M’s irrelevancy
argument.
The example above illustrates that investors can buy or sell shares in an underlying company to
22.4 The “Bird in the Hand” Argument
Concept review questions
1. Explain the “bird in the hand” argument about dividends.
“Bird in the hand” argument is a notion that a cash dividend is worth more than an equivalent
capital gain. The intuition is that firms that pay cash dividends are less risky than ones where the
2. Reconcile the predictions of M&M with Gordon’s arguments about dividend policy.
Gordon is right in arguing that the dividend yield does indicate the risk of the firm and firms that
22.5 Dividend Policy in Practice
Concept review question
1. What does real-world evidence imply about how firms manage their dividend payments?
M&M suggests that a firm can cut the dividend if it is short of cash and increase it when it has
22.6 Relaxing the M&M Assumptions: Welcome to the Real World!
Concept review questions
1. Explain why dividend policy will be relevant in the presence of transactions costs,
informational asymmetry and agency problems, and taxes.
(1) Transactions costs are important because in the M&M model, it is assumed that the firm can
(2) Information asymmetry. M&M assumes perfect markets where all market participants have
access to the same information. In practice, management usually knows more than external
investors. Investors tend to view firms’ information releases with a great deal of skepticism. One
(3) Agency costs. Investors are worried that senior management may waste corporate resources
in over-investing in poor (negative NPV) projects, since it is not “their” money but the
(4) Tax. Investors with low tax rate on dividends buy high dividend stocks, but investors with
2. Describe split shares, and explain what their popularity implies about investor preferences for
dividends in the real world.
The popularity of split shares has two major implications. First, there are investor dividend
22.7 Share Repurchases
Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
Concept review questions
1. Why can share repurchases be viewed as an alternative to paying a cash dividend?
Share repurchase is simply another form of payout policy. It is an alternative to a cash dividend
2. What factors may influence a firm’s decision to enter into share repurchases?
Several other reasons may motivate share repurchases, including: offsetting the exercise of